Cooper Tire & Rubber Company
Q3 2017 Earnings Call Transcript

Published: 30 Oct 2017

[Operator:]

Good morning, and welcome to Cooper Tire & Rubber Company's Third Quarter 2017 Earnings Call and Webcast. At this time, all participants on the call are in listen-only mode. Later, we will conduct a question-and-answer session, and instructions will follow at that time. As a reminder, this conference call is being recorded. I would now like to turn the conference over to Jerry Bialek. Please go ahead.

[Jerry Bialek:]

Good morning, everyone, and thank you for joining the call today. This is Jerry Bialek, Cooper's Director of Investor Relations and Strategic Planning, and I am here with our Chief Executive Officer, Brad Hughes; and Ginger Jones, our Chief Financial Officer. During our conversation today, you may hear forward-looking statements related to future financial results and business operations of Cooper Tire & Rubber Company. Actual results may differ materially from current management forecasts and projections. Such differences may be a result of factors over which the company has limited or no control. Information on these risk factors and additional information on forward-looking statements are included in the earnings release we issued earlier this morning and in the company's reports on file with the SEC. During this call, we will provide an overview of the company's third quarter 2017 financial and operating results, as well as our business outlook. Our earnings release includes a link to a set of slides that summarizes information included in the news release and in the 10-Q that will be filed with the SEC later today. Please note, we will reference certain non-GAAP financial measures on this call. The linked slides include information about these measures and a reconciliation to the most directly comparable GAAP financial measures. Following our prepared remarks, we will open the call to participants for a question-and-answer session. Now, I'll turn the call over to Brad.

[Bradley E. Hughes:]

Thanks, Jerry, and good morning, everyone. As noted in our earnings release earlier this morning, Cooper's performance in the third quarter reflects challenges we have felt throughout the tire industry so far in 2017. Total company unit volume was down 2% for the quarter. Unit volume in the Americas segment was down 7.5% compared to the prior year with decreases in both North America and Latin America. International segment unit volume was up 31.3% driven by a significant increase in Asia. The volume decline in North America reflects raw material cost variability, weak trends in retail sell-out of tires to consumers, elevated inventory in the channels and a fluid promotional landscape. These conditions which affected the U.S. industry in particular were exacerbated by the hurricanes in Texas and Florida. We are obviously not satisfied with our unit volume performance and continue to engage in initiatives to improve our results. These actions include ongoing cost reduction initiatives, optimization of the company's manufacturing footprint and disciplined management of selling, general, and administrative spending. Additionally, we are responding to market conditions in North America by remaining competitively priced and are addressing the unit volume decline which was personally driven by reductions in our private brand business by expanding into additional channels. This work has resulted in new positions in the car dealer and e-commerce channels, including the recent addition of Cooper products to both our large consumer direct e-commerce site and a leading car retailer. We also have new OE fitments in the U.S. and Europe including the Cooper Zeon CS8 passenger car tire that was selected as original equipment for the new Volkswagen T-Roc compact SUV sold throughout Europe. Initiatives like this further expand our reach into new channels. We also have an aggressive schedule of new product introductions that will continue throughout 2018 and 2019. For example, tomorrow with the SEMA show, we are unveiling the new Evolution product family, which is priced attractively and is positioned to complement our popular premium Discoverer line, giving consumers more choice and products from Cooper. While having an impact currently, we do not expect the current industry conditions represent a new norm for the tire industry. Macro factors such as gas prices, miles driven, low unemployment, growing wages and others are positive. Historically, when these trends are favorable, they generally drive positive trends in the tire industry and we believe they will ultimately drive opportunities for Cooper. The programs that we have already started, combined with our strong business model and global footprint, position us well to benefit over the longer term. With that, I'll cover our third quarter results in more detail before turning the call over to Ginger. Net sales for the third quarter were $734 million, down about 2.3% compared with the same period last year. Operating profit for the third quarter was $101 million or 13.8% of net sales, which is an increase of $23 million from the prior year and included a $39 million benefit from lower product liability costs. Ginger will cover this is more detail in a few minutes. Operating profit margin for the first three quarters of this year was 10.7% of net sales. Our raw material index was sequentially down during the third quarter from 163.5 million in the second quarter to 150.2 in the third quarter as shown on page 6 of the supplemental slide deck. While down sequentially, this was a 6.4% higher index than our third quarter of a year ago at 141.2 in 2016. Raw material cost increased by $19 million in the quarter from the prior year. Light vehicle volume in the U.S. was down 10.4%, which reduced profits and had a related effect on manufacturing costs, which were up primarily due to the unabsorbed costs from managing our inventory levels by reducing production output. The U.S. light vehicle volume decline I just mentioned, compared with the U.S. Tire Manufacturing Association's (sic) [U.S. Tire Manufacturers Association's] reported decrease of 1.7% and the total industry decrease of 1.4%. While it's difficult to quantify precisely, our third quarter sales in the U.S. were impacted by the hurricanes in Texas and Florida, both from reduced consumer demand in the impacted areas and disruption to warehouse facilities of some of our large customers. Although we did not see an ongoing impact from raw materials sourced from the affected areas, we did proactively pull ahead some production down days into September out of concern for a potential disruption in raw material supply. U.S. TBR tire unit volume was down about 3% in comparison to a very strong Q3 2016 performance. Year-to-date, U.S. TBR tire unit volume for Cooper is up 49% (7

[Ginger M. Jones:]

Thank you, Brad. I'll start with our third quarter financial review. Net sales were $734 million, compared with $751 million in the third quarter of 2016, a decrease of 2.3%. Overall, unit volume decreased 2%, primarily driven by decreased unit volume in the Americas segment, which partially offset the strong unit volume growth in the International segment. This resulted in a net decrease to sales of $19 million. Price and mix was $1 million unfavorable, while we experienced $3 million of positive foreign currency impact. Operating profit was $101 million or 13.8% of sales compared with $78 million or 10.4% of sales in 2016. Third quarter operating profit as compared with the same period in 2016 was impacted by the following factors which are summarized on page 7 of the supplemental slide deck

[Bradley E. Hughes:]

Thanks, Ginger. Looking ahead, industry conditions may continue to be challenging. In North America, weak sell-out demand and corresponding promotional activity are likely to persist into the fourth quarter. As a result, we expected operating margin in the fourth quarter will be below our previously stated expectations. Cooper will continue to price our products appropriately given market conditions, and will benefit from newly developed pricing and promotion tools. We will also remain focused on executing the programs we have in place to expand into additional channels. For the full year, consolidated operating margin is expected to be near the high-end of the company's previously-announced mid-term target of 8% to 10%. In addition, we will continue to manage our production levels and inventories during the fourth quarter. This will have an impact on our profitability during the fourth quarter, which is included in our guidance, but will help position Cooper for a strong start to 2018. In 2018, we will also expect to see more impact from the new business we have won in e-commerce and automotive dealer channels. And we look forward to announcing more on the OE fitments we have been awarded. That's all for our formal remarks. Let's move on to your questions. Operator, will you take the first question, please?

[Operator:]

Sure. We will now begin the question-and-answer session. First question comes from Rod Lache with Deutsche Bank. Please go ahead.

[Rod Lache:]

Good morning, everybody.

[Bradley E. Hughes:]

Hey, Rod.

[Rod Lache:]

Two things I wanted to talk about. One was maybe a little bit more color on how the margins come in a little bit below the 8% in the fourth quarter and specifically what you're thinking about vis-à-vis pricing, or it sounds like raw materials will be up slightly, are you thinking that pricing is down a couple percent sequentially or am I missing something?

[Bradley E. Hughes:]

Okay. So to start with that one, Rod, as we look at the guidance for the full year in the fourth quarter, you're right on raw materials being up slightly. Pricing, as we've described, we think that we're going to be looking at market conditions that are similar to what we've been experiencing through the first three quarters and into the third where the sell-out is going to be relatively weak on – and that there are higher inventories in the channel than required at this point given that sell-out. So we think there will be a continuation of the promotional activity. But again, I would suggest that that's a continuation of what we saw in the third quarter as opposed to anything significantly different. From our perspective, one of the other factors is we will manage our inventory levels to make sure that we've got the right level going into 2018, and that will affect our manufacturing costs.

[Rod Lache:]

Okay. So I presume the pricing will be slightly negative on a year-over-year basis. It's been up until now. Is that a reasonable assumption?

[Bradley E. Hughes:]

I don't know that I'm prepared to say that yet.

[Rod Lache:]

Okay.

[Bradley E. Hughes:]

As we look at – I mean, when you look at year-over-year or sequential on, we're going to have to monitor where raw materials move and...

[Rod Lache:]

Okay.

[Bradley E. Hughes:]

...how their promotional landscape plays out.

[Rod Lache:]

How big is that impact from the production cuts? It sounds like that's – something that's significant since you called that out.

[Bradley E. Hughes:]

Well, we haven't quantified that yet, and I'm not prepared to do that in this call. But it's important enough that it's a factor in the guidance that we provided on the operating margin.

[Rod Lache:]

Okay. And then on your volume, you mentioned in your release the U.S. volumes were down 10%. Is that a function of segment exposure or relative pricing strategy? And maybe you could just give us a little bit of color on what Q4 looks like and maybe some of these wins that you're talking about, are they significant enough that they could actually move the needle vis-à-vis relative performance?

[Bradley E. Hughes:]

Yeah. I think that the – there are some important factors here. One is, it is – part of this is related to the first half of the year on the market and the volatility we saw on the market, specifically related to pricing in response to raw materials where we, among others, tried to get out ahead of that a little bit and that affected our start to the year and actually carried into the second quarter. Again, the overall market conditions have been, on the sell-out side, challenging and inventories were built up. There are many programs that are on an annual basis, and if you get off to a slow start in the first half of the year, it's difficult to recover momentum inside of that calendar year. And I would acknowledge that that's something that's affected us going into the third quarter and may continue into the fourth quarter. What is good about that is we're about to turn the corner on those annual programs as we get into next year, and we're going to make sure that we're in a position to get off to a good start next year including seeing more impact from some of the new business that we've won in channels that have been – we haven't been as penetrated in as we will be going forward.

[Rod Lache:]

Have you been able to size or give us any kind of brackets around some of the new business that you've won?

[Bradley E. Hughes:]

We have not yet, and we will watch as that begins to contribute as we get into next year. And we're also excited because we will be in a position to announce some additional OE fitments that we've been awarded a little bit closer to the start date on top of the one that I mentioned this morning with Volkswagen on the T-Roc in Europe.

[Rod Lache:]

Okay. All right. Thank you.

[Bradley E. Hughes:]

Thanks, Rod.

[Operator:]

Our next question is from Christopher Van Horn with FBR Capital Markets. Please go ahead.

[Christopher Van Horn:]

Good morning. Thanks for taking my questions. I wanted to get into the product liability just a little bit more, just the timing of it, and was it around the move to HVA and maybe less private label? Are you just seeing more reliability in the tires that you're selling that gets you comfortable to do this now?

[Ginger M. Jones:]

Chris, this is Ginger. I'll start that one and then Brad may jump in. So as you know, we do, as we talked about, we regularly look at these reserves and reserves build over many years, and we can only adjust them once we see a fact (25

[Bradley E. Hughes:]

Hey. I wouldn't add much that – I mean there's other factors, but you hit the high ones and you get to a point where, by accounting rule, you need to make an adjustment and that's where we found ourselves in the third quarter.

[Christopher Van Horn:]

Okay. Great. And then on the – you mentioned some new channels, car dealerships, some online channels. I mean, I think car dealers have been talking about doing this for a while. Where do you – do you think they're getting more aggressive here just given the opportunity, and maybe what stage do you feel like we're in on that channel? Do you think it's still early innings, or do you think there's just select opportunities out there for you?

[Bradley E. Hughes:]

Well, I think that the importance of the auto dealerships in terms of selling tires in the replacement market has grown fairly significantly over the last decade or so. It's more than doubled in terms of their penetration of the overall market. And we believe that that's going to continue to change and grow. Overall, consumers are going to end up telling us where they want to buy tires. And right now, many of them are telling us that they would prefer to go to their auto dealership relative to some of the more traditional channels that we've all sold into overtime. And so, I don't know if I would be able to declare, its early middle or late innings but we see more runway in terms of growth in that particular channel being the auto dealerships.

[Christopher Van Horn:]

Okay. Got it. And then just one last one for me. Could you give any detail on how the Roadmaster brand or heavy-duty truck or classes 4 through 8 did during the quarter?

[Bradley E. Hughes:]

Maybe you mean Roadmaster, instead of Mastercraft?

[Christopher Van Horn:]

Oh, yes. Sorry. I thought I said Roadmaster.

[Bradley E. Hughes:]

Or maybe you said Roadmaster and I'm – I'm sorry. Yeah, Roadmaster was down on – in the quarter. However, it was against a very strong quarter in 2016. Year-to-date, we're up almost 15% with Roadmaster and TBR in the U.S. which is well ahead of both the USTMA and the industry, and we feel really positive about what's going on in that business and in the future of that business for the balance of this year and as we get into next year.

[Christopher Van Horn:]

Okay. Got it. Just one quick follow-up. Are there any OE fitment opportunities on the heavy truck side for you?

[Bradley E. Hughes:]

Well, right now, we do have a couple of OE trailer fitments that have been very positive for us and we are looking for additional opportunities as we move forward, yes.

[Christopher Van Horn:]

Okay. Great. Thanks for the time, guys.

[Bradley E. Hughes:]

Thank you.

[Operator:]

Our next question is from Ryan Brinkman with JPMorgan. Please go ahead.

[Ryan Brinkman:]

Great. Thanks for taking my question. I was just curious if you could comment on what you think are the reasons for the heightened competitive activity in the U.S. with regards to promotions and pricing. Is there a particular tire maker or group of tire makers making life difficult for the others? And then there seems to be some anecdotal evidence at least that some of the earlier price increases announced by competitors are actually starting to take effect. Are you starting to see any firming of the price environment so far in 4Q, and when would you expect such firming to take place?

[Bradley E. Hughes:]

Hi, Ryan. That was a long one. So I'll try and hit the points, and if I miss something, please...

[Ryan Brinkman:]

Sure.

[Bradley E. Hughes:]

...please, let me know. So with regard to the overall pricing environment, I – a couple of things. One is, I think, again, that what we've seen this year is a relatively weaker sell-out volume that's been combined with a volatile raw material environment which has had pricing going up and down across quarters through the first nine months of the year. Channel inventory levels have built as a result of the sell-in being stronger than the sell-out, and so there is some competition to try and find your way and maintain your position in the channels given that overall environment. I think that when we see – and we continue to expect this, I'll circle back in a moment, but when we see the sell-out environment improve, that's when you're going to see a stabilization in the pricing. Overall, we do not believe that the current market conditions represent what we're going to see going forward and that it's any kind of change overall. The discipline in the market, while there have been some sporadic deviations, overall, we think the industry has continued to demonstrate the kind of discipline around pricing that we would expect. It's just been a pretty up-and-down year with regard to raw material prices against that backdrop of weaker sell-out volume. So we think that when we start to see that pickup – and, again, all the indicators that we've historically looked at are trending in a way that would suggest that we should see some firming of that as we move forward. So we're positioning ourselves. We're making sure that we're being very prudent about our cost position while we're in this environment, but we're also making sure that we're ready to take full advantage of the market when it begins to pick up, and that we're looking forward to that happening. I don't know if it's going to be the fourth quarter. Right now, based on what we see, we think it's probably more likely to be early next year than the fourth quarter.

[Ryan Brinkman:]

Okay. I guess what I'm hearing is that you don't think anything has really structurally changed. As you know, one of the concerns that the investors have had for a while, questioning the sustainability of tire company margins in recent years, yourselves included – it's been very strong – has been this increase in capacity, including in HVA tires in North America. I mean, is there anything that changed this year, or is that more of an evolution and that couldn't really be responsible for this?

[Bradley E. Hughes:]

Again, we think the factors are around the market conditions in that – in the sell-out demand is a big driver there against a backdrop of a volatile raw material market, which has caused us all to be looking at our pricing and be implementing price actions over the course of the year. The capacity side of this, again, a lot of the capacity that people are focused on is its new capacity coming into North America, a lot of which is replacing import volume right now, and particularly out of Asia. So people are looking to onshore capacity, but it isn't all incremental capacity. Now, there will be an absorption period of time. But when we look at the overall global rising demand for replacement tires, we still think that the capacity is going to be well balanced against that demand, and it's just a repositioning of where that capacity is. Now, that's all happening at a time where we've got these other factors that are making the market quite challenging over the first nine months of this year. So it might be easy to want to connect those two dots. But at this point, we don't think that that's appropriate.

[Ryan Brinkman:]

Okay. That's extremely helpful. Just lastly for me, if you had to take a stab at the hurricane impact, I think Goodyear said it might have been 1% to volume. Is that sort of the neighborhood we're talking about? And was there anything else unusual like, I don't know, maybe the earthquake in Mexico or something that could also help to explain some of the softness?

[Bradley E. Hughes:]

Yeah. Ryan, it's hard in a market like this to try and precisely call out what was specifically related to the hurricane. So we do definitely believe there was an impact, but we're not going to try and quantify that. For sure, the two events – tragic events in Mexico, the earthquake and the hurricane that hit Mexico, had an impact on that market. Again, that's against a backdrop of a fairly volatile economic and political environment anyway. So splitting it up as to what falls into what category of explanation is difficult. But the Mexico market was down about 15% in the quarter. We were down less than double digits. And so, we made some progress on market share, but it was in a pretty weak market down there that which – again, that's a big change for that market. It's been growing quite well recently.

[Ryan Brinkman:]

Great. Thanks for all this color.

[Operator:]

The next question is from Brett Hoselton with KeyBanc. Please go ahead.

[Brett D. Hoselton:]

Good morning.

[Bradley E. Hughes:]

Hi, Brett.

[Brett D. Hoselton:]

I wanted to ask you about pricing, pricing on a go-forward basis. So let's assume that sell-out improves and – for whatever reason. So let's assume sell-out improves as we move through the first half of 2018. Inventory levels, let's say, are healthy and maybe start to get draw – or drawdown. And then sell-in starts to improve. So all of that bodes well for pricing based on what you're suggesting. Can you talk about kind of the mechanics of how that rolls through your pricing dynamics? In other words, how much of your pricing is – what portion of your tire sales are indexed and therefore, maybe take six months to see a pricing adjustment. How much of your sales are under these one-year contracts and how many can be adjusted within three months versus how many can you adjust within one month? I mean, you understand what I'm asking, Brad?

[Bradley E. Hughes:]

Yeah. I do. I think so. If I don't answer what you were looking for, let me know. But the – when you – again, under the environment that you painted there with the improved sell-out, we have very little on – of our business, and I'm going to focus on the U.S. and North America. It's a little bit different than in China where we have a heavier OE presence. But very little of our business is indexed. And so it is – we are in a position where under those circumstances, if the market will absorb it, and again, we will remain competitive for our customers to be successful. But in a healthier environment, we're in a position where we can respond to positive changes in the pricing environment from a Cooper perspective.

[Brett D. Hoselton:]

Okay. Well, let's see. So you talked about annual contracts being a inhibitor in terms of being more price competitive in the marketplace in 2017. So it sounds like a material number of your contracts are annually priced. Is that the case and is that...

[Bradley E. Hughes:]

Okay, Brett. I think I know how I may have confused it a little bit here. So what I was referring to earlier as to what was going on in the first half of the year is related to promotional activity. So there will be incentive programs that many manufacturers offer to customers that are based on meeting annual unit volume sales objectives or dollar sales objectives. And if halfway through the year it doesn't appear that they're going to be able to achieve those for a specific manufacturer, they will direct more of their activity to the others where they do think that they can meet that. And as we went through the first half of the year, you may recall that we tried to be on the front end of some the pricing activity in terms of increases in response to raw materials and it affected us to a degree. So I was referring to those annual incentive programs. I apologize if I didn't make that clear.

[Brett D. Hoselton:]

No, no. That's exactly what I understood it to be. My question is that's prohibited you or limited you from becoming more competitive in the marketplace. And so if pricing firms up in the industry in the first half of 2018, how long does that take for it to roll through Cooper Tire's pricing? Whether they are annual contracts that are going to prohibit that? Are you potentially going to set-up a price structure January 1, that even if pricing improves in the first quarter or second quarter, it prohibits you from adjusting your pricing?

[Bradley E. Hughes:]

So our invoice pricing will be market-based and then the promotional and incentive programs that we put into the market will also be market-based. But we'll essentially be starting from zero at the beginning of 2018. So you're – we'll be in a position where we're resetting and can ensure that we are appropriately positioned to win.

[Brett D. Hoselton:]

Okay. Thank you very much. Oh, wait. One more quick question. The $39 million benefit, was there – what is the tax amount associated with that? Maybe you could provide that or the after-tax amount of that.

[Ginger M. Jones:]

That was based – that's the North American business, Brett. So that would be at a higher rate. So we don't disclose our rate per jurisdiction. But you could think about that as at a North American tax rate.

[Brett D. Hoselton:]

Okay. Thank you very much, Ginger.

[Operator:]

Our next question is from Bret Jordan with Jefferies. Please go ahead.

[Bret Jordan:]

Hey. Good morning, guys.

[Ginger M. Jones:]

Good morning.

[Bradley E. Hughes:]

Hi, Bret.

[Bret Jordan:]

On the dealer channel and the e-commerce channel, is there any margin difference? And, I guess, strategically, is there any reason you weren't doing e-commerce before? I mean, you haven't been on Tire Rack or TireBuyer.com for a while.

[Bradley E. Hughes:]

And we are now. So, the way I would think about the pricing there is as we look at some of our private brand business going away, that this is – to the extent that this is backfilling some of that, that's a net positive for margins. And the – from a timing perspective, we've wanted to make sure we are in the appropriate position to support this type of business and to manage it within our overall portfolio of customers. Other than that, we've just been looking for the right opportunity. And so we're very pleased to be in these new relationships right now, and we're looking forward to their contribution going forward.

[Bret Jordan:]

Okay. And a similar question, I guess, on the OE side. Is there much of a margin delta between your average margin and what you're seeing out of these new contracts?

[Bradley E. Hughes:]

Again, as – on balance, relative to some of the business that's going away right now, it would be an improvement.

[Bret Jordan:]

Okay. Great. Thank you.

[Bradley E. Hughes:]

Thank you.

[Operator:]

This concludes our question-and-answer session. I would like to turn the conference back over to Brad Hughes for any closing remarks.

[Bradley E. Hughes:]

Okay. Thank you, and thank you for being on the call with us today. As I said earlier in the call, we do not expect that the current industry challenges represent a new norm for the tire industry. Macro trends remain positive and should ultimately drive improvement. The programs that we have already started, combined with our strong business model and global footprint, position us to benefit well over the longer term. And as always, please reach out to Jerry with any further questions or comments you have. Thank you very much.

[Operator:]

The conference has now concluded. Thank you for attending today's presentation. You may now disconnect.