CIRCOR International, Inc.
Q4 2013 Earnings Call Transcript

Published: 27 Feb 2014

[Operator:]

Good day, ladies and gentlemen. Welcome to CIRCOR International Fourth Quarter and Year-End 2013 Financial Results Conference Call. Today's call will be recorded. [Operator Instructions] I'll now turn the call over to Mr. Dennis Walsh from Sharon Merrill for opening remarks and introductions. Please go ahead, sir.

[Dennis J. Walsh:]

Thank you, and good morning, everyone. On the call today is Scott Buckhout, CIRCOR's President and CEO; and Rajeev Bhalla, the company's Chief Financial Officer. The slides we'll be referring to today are available on CIRCOR's website at www.circor.com on the Webcasts & Presentation section of the Investors link. Please turn to Slide 2. Today's discussion contains forward-looking statements that identify future expectations. These expectations are subject to known and unknown risks, uncertainties and other factors. For a full discussion of these factors, the company advises you to review CIRCOR's Form 10-K for 2013 and other SEC filings. The company's filings are available on its website at circor.com. Actual results could differ materially from those anticipated or implied by today's remarks. Any forward-looking statements only represent the company's views as of today, February 27, 2014. While CIRCOR may choose to update these forward-looking statements at a later date, the company specifically disclaims any duty to do so. On today's call, management will often refer to adjusted operating income, adjusted operating margins, adjusted net income, adjusted EPS and free cash flow. These metrics exclude any pretax special charges, restructuring inventory reserves and intangible impairments. The reconciliation of CIRCOR's non-GAAP adjusted operating income, adjusted operating margins, adjusted net income, adjusted EPS and free cash flow to the comparable GAAP measures are available in the financial tables of the earning's press release on CIRCOR's website. I will now turn the call over to Mr. Buckhout.

[Scott A. Buckhout:]

Thank you, Dennis, and good morning, everyone. We closed 2013 with solid order intake and strong bottom line performance. Orders for CIRCOR overall were up 14%. The backlog ended the year at $463 million, up 3% from a year ago. We reported a 6% increase in revenue compared with Q4 2012. While revenue at $214 million came in below our expectations, margins were strong, helping us deliver adjusted EPS of $0.95. We posted adjusted operating income at 11.6%, an increase of 380 basis points over last year. Our focus on growth, coupled with strong margin expansion, resulted in free cash flow of nearly $15 million in the quarter. For the year, our free cash flow to net income ratio was 116%. During the fourth quarter, we announced our plan to change CIRCOR's organizational structure to simplify the way we manage the company and better align our businesses with end markets. As part of the organizational change, we consolidated our group structure from 3 groups to 2. Operating as 2 segments should enable us to accelerate organic growth, further expand margins and more effectively deploy capital. We completed this realignment in Q4, and we now operate as CIRCOR Energy and CIRCOR Aerospace & Defense. This reorganization has reduced our annual expenses by approximately $5 million. The other 3 restructuring actions announced in the first half of 2013 are either complete or on schedule for completion in early 2014. As we've discussed in the past, a key driver of our margin expansion efforts is our ongoing simplification process. We continue to see cost reduction opportunities from simplifying the organization. We operate with significant complexity at CIRCOR. We will continue to reduce rooftops, P&Ls, IT systems, back-office organizations and suppliers. In addition to simplification, we're focused on driving operational excellence at CIRCOR. Part of that effort is to create a global sourcing and a global operations organization. I'm pleased to report that we have had a global sourcing leader in place at CIRCOR for several months now, and we're in the process of realigning the organization. We source a significant amount of our material from high-cost parts of the world, including locally, near our 20 manufacturing locations. Much of the spend will be consolidated into fewer suppliers in lower-cost parts of the world. We're currently recruiting for Head of Operations at CIRCOR. This leader will accelerate improvements in delivery, quality, cost, safety and inventory performance across all of our businesses. We're expanding the CIRCOR business system to drive sustainable results in all these areas. We're focused on building a more robust system that reaches well beyond the 4 walls of our existing manufacturing facilities. This program will include strong leadership at the top of CIRCOR, more effective training and standardization across the organization, robust processes and metrics and clear lines of accountability. Achieving operational excellence will be one of the main driving forces behind our future growth, margin expansion and improved working capital. With that, I'll turn the call over to Rajeev. I'll come back later to give you more detail on our recent order trends and our guidance for the first quarter.

[Rajeev Bhalla:]

Thank you, Scott, and good morning, everyone. We reviewed the overall results, so let's move right into the segments, starting with Energy on Slide 5. Energy revenues of $163 million for the fourth quarter increased 4% year-over-year. This was driven by our international projects business, especially in the upstream oil and gas market, with particular strength in support of off-shore production. In addition, we saw moderate growth in our global downstream markets. On the other hand, we did experience lower sales from our distributed valves business and from our Brazil operation. Energy's adjusted operating margin was a very strong 17.1%, up from 11.9% in the fourth quarter last year, driven in large part by pricing and our large international projects business, as well as restructuring and productivity benefits. As a reminder, the orders we booked during 2012 had favorable pricing and product mix. We saw that favorable impact coming through the fourth quarter results. However, due to the competitive pricing environment in 2013, coupled with lower order volume, we do not expect a repeat of these favorable Q4 margins in the first half of this year. But based on our current backlog, we do expect higher volume and improved margins in the second half of this year. For the Aerospace & Defense segment, please turn to Slide 6. Aerospace & Defense revenues of $51 million were up 13% from the prior year, largely driven by strength in our defense OEM programs. Aerospace & Defense adjusted operating margin in Q4 was 8.4% compared to 5.1% in the fourth quarter last year. As we take a look at this fourth quarter performance, we did see a deterioration in margin sequentially. Some of you may recall that we have been working through startup issues after the factory consolidations and in launching our new landing gear program. A number of these issues continued to impact our operations in Q4. This was exacerbated by a fire at a critical sole-source supplier that burned their factory to the ground. As we worked through the recovery plan and qualified a new supplier, we did see incremental cost. While we anticipate some ongoing headwind in the near term, we expect margins to improve as we look ahead. Turning to Slide 7 for selective P&L items. Our all-in tax rate for Q4 was 20.7%. Excluding the impact of restructuring and impairment charges, the comparable tax rate was 29.5%, in line with our expectations. We anticipate our first quarter tax rate to be approximately 29%. Q4 2013 adjusted earnings per diluted share was $0.95, excluding the impact of restructuring, impairment and special charges. This is a 38% increase compared with the $0.69 in the prior year. Slide 8 shows the adjustments we recorded during the fourth quarter for a noncash intangible impairment for $6.9 million and a $5.8 million charge related to our restructuring actions. For Q1, we anticipate charges relating to restructuring to be in the amount -- in the range of $1.5 million to $1.7 million. The anticipated annualized savings of these actions announced in 2013 will be approximately $9 million, with the full run rate beginning in the second half of this year. Turning to our cash flow and debt position on Slide 9. During the fourth quarter, we generated a positive $14.7 million in free cash flow, which brings us to $54.9 million for 2013 or 116% of net income. For the full year 2013, revenues were up 1%, adjusted operating margin increased 210 basis points to 9.9%, and adjusted EPS grew 25% to $3.21. With that, I'll turn it back over to Scott to provide an update on our orders and guidance for the first quarter of 2014.

[Scott A. Buckhout:]

Thank you, Rajeev. Before I get into our guidance, let me start by providing you with an overview of our fourth quarter order intake, as well as our current market trends. Let's start with Energy. As a reminder, we compete in the upstream, midstream and downstream oil and gas markets, as well as power generation. Most of our revenue is in the upstream market today. Incoming orders were $187 million in the quarter, up 20% year-over-year. In our large project business, we received a record number of orders for off-shore production facilities in the North Sea. We expect these orders to begin to ship in the back half of 2014 and early 2015. We anticipate ongoing order strength in this part of our business. On the other hand, market demand remains rather soft in our North American distributed valves business due to rig count levels and destocking at distributors, in some cases, resulting from consolidation of our distribution channel. We're optimistic that orders will pick up in the second half of this year due to strength in unconventional drilling and moderation of destocking activities in our customer base. Our instrumentation business continued to experience strong orders from international upstream projects in Australia and the North Sea. In our downstream markets, while we're experiencing some softness in Europe, we're seeing moderate growth globally. We also have experienced recent success in further penetrating the downstream markets in China. Finally, regarding power generation, we're experiencing a significant increase in quote activity globally. In Aerospace & Defense, orders were down 4% year-over-year to $44 million as we booked relatively high U.K. defense orders in Q4 2012. Going forward, we expect to see low to moderate growth in our defense programs overall, with particular strength in missile-related platforms. On the commercial side, we expect to see moderate growth in fluid control with softness in our landing gear business. That brings us to our guidance. We expect the first quarter revenue will be in the range of $200 million to $210 million. We expect to report adjusted EPS in the range of $0.68 to $0.73, which brings us to year-over-year growth of EPS of 31% to 40%. Our focus in 2014 will continue to be on growth, margin expansion and strong free cash flow. But before we go to Q&A, let me remind you of our upcoming Investor Day on May 15 in New York City. Invitations will go out shortly for this event, where we will discuss our longer-term targets for CIRCOR. With that, Rajeev and I are available to take your questions.

[Operator:]

[Operator Instructions] Our first question comes from the line of Kevin Maczka with BB&T Capital Markets.

[Kevin R. Maczka:]

Can we go back to the comment on Energy margins and some of the -- I think it was price and mix you called out that was very favorable in the second half that doesn't repeat in the first half, but then it does again in the second half of '14. So we were, I guess, 16% on average in the second half. Can you quantify anything there beyond what you did in terms of what you mean first half versus second half?

[Scott A. Buckhout:]

Yes. So the volume that we saw -- the revenue that we saw in Q4, Kevin, was orders that we booked in 2012, when the market was a little bit different from -- well, I guess, say, significantly different from what we saw in early 2013, say, the first 3 quarters of 2013. So we had better pricing, frankly, in 2012 than we did in early 2013. So the revenue that you're going to see us deliver here in the first half of 2014 is revenue that we booked early last year in '13, which was at a relatively lower margin. We had very good order intake as we closed the year. And we had, I'd say, improved margins versus the first half when we closed out all these orders that we got in Q4, so we had better margins than we had earlier in the year. We're not back to 2012 levels, but it's better than the margins we booked earlier in the year. So that's why you see the dip in revenue because orders were down in the first half in large projects, but you also see a slight dip in the margin as well because the margins were down the first half as well. So we made some improvement in pricing in Q4 that you'll see in the back half of this year.

[Kevin R. Maczka:]

Things like restructuring and productivity, of course, don't go away, but they -- so maybe the first half, it sounds like -- should be more in line with the first half of '13 than the second.

[Rajeev Bhalla:]

Yes, Kevin, this is Rajeev. The restructuring, for us, full run rate starts to kick in in the middle of this year, so you'll start to see the full run rate benefit of that in the back half of this year. And going to your earlier point, as Scott mentioned, we will see better volumes in the back half, which will help drive the margin performance in the back half of this year as well.

[Scott A. Buckhout:]

It's improved pricing, not back to 2012 levels. But certainly, improved margins as well, of course, gives us better leverage and better margins in the second half, when we start to ship all that revenue.

[Kevin R. Maczka:]

Okay. In the release, you mentioned some big Energy shipments that are pushing out. Are they pushing out beyond Q1? Is that why we see a Q1 revenue guidance that looks a little lighter than was expected?

[Scott A. Buckhout:]

Well, it's 2 things. I think the Q1 -- some of the orders that were pushed out of Q4 have already shipped in Q1, so we did get some of that. And some of it got rescheduled into Q2 and even later in the year. So we haven't lost orders that we expected to have in Q4, but some of them moved pretty significantly out. The other impact that -- if you look at our revenue trends over the last few years, you'll see there's a decent seasonal effect in our business. And so revenues tend to come down in Q1 and pull back up through the rest of the year. So Q1 is -- always tends to be our lowest quarter in terms of revenue, so that's why you see some of that as well.

[Kevin R. Maczka:]

On that point, Scott, in Energy, Q2 looks like it's been a seasonally strong quarter the last 2 years. Should we expect normal seasonality if we -- if there is such a thing?

[Scott A. Buckhout:]

Yes. Will the degree change a little bit? Probably. But yes, you should expect similar trends to what you've seen in the past with our revenues increasing through the year. The back half tends to be better for us. And you're right, Q2 tends to be decently strong as well.

[Kevin R. Maczka:]

Okay. And just finally for me, you made the point about the unusual event that happened to your supplier in the Aerospace. Is that your recovery plans there and the elevated costs that pressured the margin in Q4? Are we beyond that now? Does that margin snap back to a double-digit rate like we saw in the prior 2 quarters?

[Rajeev Bhalla:]

Kevin, this is Rajeev. The supplier issue, we are largely -- it is largely behind us now. We have qualified a new supplier. We're not completely out of the woods, but a lot of it is. So we will start to see some bounce-back, but it's going to take a little longer than we had originally anticipated.

[Operator:]

Our next question comes from the line of Charley Brady with BMO Capital Markets.

[Charles D. Brady:]

Just on the Defense business, can you give us a sense of just -- I mean, how -- quantify -- I mean, how much is that U.K. business up? And maybe the rest of the business, put some numbers around -- and then the landing gear business being down.

[Rajeev Bhalla:]

Charley, are you asking for the fourth quarter, or are you asking as we look ahead?

[Charles D. Brady:]

I'm asking for what we saw in Q1. And I guess the next part of that question will be as we look to the orders, the orders are down because your comp on the U.K. Defense business was a tough comp. But outside of that, I guess I'm just trying to square up with what your expectation is on the order trends going forward in the Defense business.

[Rajeev Bhalla:]

Yes, so from the order side, we will see probably lower orders in the Defense, in particular, in the early part of this year. We do expect it to pick up in the back half in large part due to some of our U.K. business. But in the earlier part of this year, from an order standpoint, we do see it a little lower in the first half.

[Scott A. Buckhout:]

So as he says, low to moderate order strength in the first half, so low single digits but better than flat. On the commercial side of our business, in Aerospace & Defense, we'll be more or less flat, with some growth in fluid control and slightly down on landing gear.

[Charles D. Brady:]

Okay. And on the Energy segment, can you -- I mean, how much was the impact on margin in Q4 from pricing and mix? And then as we look out into '14, given that some of the pricing you're booking, stuff you're going to ship in the first half is at lower price levels, what is the margin headwind directly attributable to pricing?

[Rajeev Bhalla:]

As you look at the margin headwind from pricing, it's probably about 150 basis points from the Energy piece of the revenues, Charley. So you're seeing about -- at least about 150 basis points delta from Q4 to Q1 just on the pricing side.

[Operator:]

Our next question comes from the line of John Franzreb with Sidoti & Company.

[John Franzreb:]

Just to stick to the pricing issue a bit. Can you talk a little bit about why we've had a less favorable pricing environment? Is there an irrational competitor out there? Can you just talk -- maybe the demand isn't as we expected. Just a little bit why we're having that difficulty now.

[Scott A. Buckhout:]

Yes, sure. So the pricing challenge that we've had has really been going on for -- it went on for about a year, maybe a little less, say, 3 quarters. So if you look at Q1, Q2 and Q3 in our large project business 2013, our order intake was quite low. But order was -- the quoting activity was quite high. And so what happened was -- and if you listen to Cameron or Flowserve and a lot of the guys we complete with in this business, there was a similar dynamic happening in the first 3 quarters of last year, where we're all getting a lot of quotes and then we're being asked to requote, and then we're being asked to requote again. And these quotes are not turning to orders. So what's happening is that they're just taking more time, holding back on issuing orders and, I guess, preserving capital, I'm not sure, but holding back on issuing the orders and allowing us to continue to rebid and requote. And this, over time, starts to push down prices. So that's what was happening. So we saw that start to moderate in Q4. Our order intake in this business was much, much better than it was in the first 3 quarters of 2013, and our pricing improved as well. So just in terms of magnitude, we didn't get back the pricing we had back in 2012, but we're -- we have better pricing than we had in the first 3 quarters of 2013, if that makes sense.

[John Franzreb:]

Okay, it's helpful. Now going back to another question. You talked about the second half of the year's revenue as being -- I think you said much better than the first half. But then you also alluded to the fact that it will be gradually increasing through the balance of the year. Can you give me a sense of what the magnitude is of the revenue recognition in the second half versus the first half? How big of a difference are we looking at here?

[Rajeev Bhalla:]

It'll be -- there'll be parts of our business that'll be significantly higher, but then there'll be parts that are probably a little more moderate. As you know, we don't really get into full year guidance at this point, John, so -- but we will see parts of our business that will be substantially higher.

[Scott A. Buckhout:]

And John, just to -- there is seasonality in Q1. I think hopefully, everybody recognizes that it's always our lowest quarter. But the optimism in the back half is also based on the backlog that we're looking at right now. So all these orders that we got in Q4, you're obviously not seeing that in Q1, but we know when you will see it. So there is support, if you will, in the backlog that would tell you that we're going to have a stronger back half. But getting into the magnitudes would be hard for us to do right now. But certainly, back half will be, I'd say, significantly better than the first half.

[Rajeev Bhalla:]

Yes. The one wildcard, just to add to what Scott said, John, is our short-cycle business. Scott talked a little bit about what we're seeing on the distributed valves side, and obviously, we do think it's going to improve market-wise in the back half. But that is the short-cycle, take the orders and deliver them.

[Scott A. Buckhout:]

Yes. Well, I'd say there's a lot of certainty on our longer-cycle business on what the back half will look like for us. There's less certainty. So we feel better about short-cycle simply because of what's happening in the market with unconventional drilling and the destocking that we absorbed in our distribution base in Q4 and probably some more in Q1. So there's reasons for us to be a little more optimistic, but I think Rajeev is right. There's more uncertainty in short-cycle than there is in the long-cycle.

[John Franzreb:]

On the short-cycle, do you get a sense that maybe inventory levels are too low with the distributors?

[Scott A. Buckhout:]

Not necessarily. I think it's just -- they're bringing it down to reflect the new reality in North America and the rig counts, et cetera et cetera. So they do tend to swing. And it's a good question. They do tend to swing, and we get a little bit of that bullwhip effect. So when the end users are up 5%, the distribution -- distributors are buying a lot more than 5%. So we tend to see bigger swings. So it's possible, but I wouldn't count on it. We're more or less thinking it's going to get down to more of a moderate level and we'll see some lift based on activity in the unconventional drilling.

[John Franzreb:]

Okay. One last question, and I'll get back in the queue. Some of the consolidation issues that you had in Aerospace, are we beyond that point, I mean, right now?

[Rajeev Bhalla:]

The consolidation, specifically on the factory, John, is in good shape. We've gone through a lot of the kind of startup issues and incremental costs associated with that. So the shop is in much better shape now from the factory side.

[Scott A. Buckhout:]

It's really -- the ongoing costs that we are likely to still be absorbing are more related to the launch of the A350 and Sikorsky. So we're still absorbing some startup costs with those 2 programs. But the factory consolidation, we're pretty confident we're done with those costs.

[John Franzreb:]

Okay. So factory consolidation costs are done. Launch issues will still be continuing. And when should we be beyond that point?

[Rajeev Bhalla:]

I would look to -- probably in the second quarter. Probably, mid to late part of second quarter, we should be through that.

[Operator:]

[Operator Instructions] Our next question comes from the line of Matt Summerville with KeyBanc Capital Markets.

[Matt J. Summerville:]

It sounded like, in your comments regarding power, that there's sort of been a bit of a step function change in the activity level you're seeing there. I was just wondering if you can provide a bit more granularity around that.

[Scott A. Buckhout:]

Yes. That's a good question. We are quite bullish on power. It's not a big piece of our business, as you know, today, but it's a higher-growth part of our business. We've seen a significant increase in quoting activity globally in this business, in particular. And it's where you would expect. It's where all the power investments are going. In India, China and Brazil, those are both -- we're seeing 2x to 3x the quoting activity that we've seen historically, we're seeing in these 3 markets right now. So we're quite excited about what's happening in power.

[Matt J. Summerville:]

And then with respect to the fourth quarter and kind of how you're thinking about the full year, can you give a little more detail on how the large project business performed and then how the short-cycle business performed? Your total Energy revenue organically was up kind of mid-single digits. Can you just give a little bit more color how to frame that up better?

[Rajeev Bhalla:]

Sure, yes. If you look at it and you're looking at it the right way, Matt -- by the way, before I answer your question, on the power side, we're very bullish. Recognizing that I'm just speaking on India for a second, there are elections coming up, and that obviously puts a little bit of a speed bump in our ability to nail some of those orders here. But going to your question specifically, a majority of the increase was being driven by the large cycle business in the fourth quarter. And on the short-cycle, it is actually flat to slightly down.

[Matt J. Summerville:]

Okay. So the magnitude of year-over-year decline in the short-cycle has abated over the last couple of quarters. And so, I guess, what is your thought in terms of when that inflects positively?

[Rajeev Bhalla:]

Yes, you're right. It has kind of abated. We are optimistic about the back half of this year, as Scott mentioned, so we think the inflection point will start to turn probably midyear.

[Scott A. Buckhout:]

Yes, I would not -- we're kind of -- we're bouncing around right now where we have been recently, and I really don't expect that to change in a really meaningful way until, probably, late in the second quarter, to be honest.

[Matt J. Summerville:]

So if we look at the profitability, the last couple of quarters averaging about 16%, is there much variance between the large project business and, say, the short-cycle North American in terms of operating margins?

[Scott A. Buckhout:]

They're actually similar in terms of operating margin. The North American distribution business and the long-cycle international project business have similar operating margins. What will happen is that -- the longer-cycle business, as you know, is lumpy, and the volume moves around a lot more than our short-cycle business has been recently. And that volume will affect our margins. So depending what kind of revenue they're shipping in a quarter, our large-cycle business can go significantly higher than our distribution business.

[Matt J. Summerville:]

And then I just want to make sure with respect to the restructuring and cost saves, there were some actions taken in late '12, certainly a busy year in '13, and you're still working things here in '14. How much in terms of dollars did you realize in cost saves in '13? And then in absolute dollars, how much will you realize incrementally in '14?

[Scott A. Buckhout:]

So let me take '14, and I'll let Rajeev talk to '13. So in '14, we expect to save around $9 million as an ongoing run rate. The majority of that -- the majority of the $9 million starts now, but there's some of that $9 million that doesn't kick in until the end of the second quarter. So starting in, let's say, day 1 of the second quarter, our run rate is $9 million. Starting on day 1 of 2014, it will be somewhere around $7 million.

[Matt J. Summerville:]

And that $9 million relates to the $5 million from the consolidation of business segments and then some of what was, if you will, has yet to anniversary from actions taken in '13?

[Scott A. Buckhout:]

Correct.

[Rajeev Bhalla:]

Exactly, yes. That's exactly right.

[Operator:]

Our next question comes from the line of Charley Brady with BMO Capital Markets.

[Charles D. Brady:]

So I don't want to beat this up too much, but I'm going to anyway. I just want to be clear on the Energy business going into Q1. Given the pushout, some stuff shipped in Q1, the rest is going the rest of the year. The distributor side of the business being a little bit soft from destocking. Are you expecting Energy business in Q1 to be up year-over-year?

[Scott A. Buckhout:]

Yes, we are. I want just to give you a little more color, Charley, on some of these orders that shipped out. What ends up happening in these large projects at times is that the customer or their representative will require inspections to our production in the middle of the process. And depending where, whether it's Italy or whether it's Brazil, sometimes, it can be quite burdensome. It can be up to between 5 and 10 inspections before we actually ship the product. And so it makes it difficult for us at times to actually forecast the revenue because we're somewhat dependent on when the inspectors show up. That's what happened to us in Brazil in Q4. We ended up really struggling at the end of the year getting inspectors in the door. So we're sitting there with product ready to be inspected, and nobody's there to inspect it. So that was one of the bigger challenges we had there in Q4.

[Operator:]

We've come to the end of our allocated time for questions. Mr. Buckhout, I'd like to turn the floor back to you for any closing comments.

[Scott A. Buckhout:]

Okay. Thanks, everyone, for joining this morning. We look forward to speaking again at the end of Q1. Thank you.

[Operator:]

Thank you. This concludes today's teleconference. Thank you for your participation. You may disconnect your lines, and have a wonderful day.