Helios Technologies, Inc.
Q3 2010 Earnings Call Transcript

Published: 9 Nov 2010

[Operator:]

Good day, everyone, and welcome to the Sun Hydraulics Corporation's third quarter earnings release conference call. Today's conference is being recorded. After today's prepared remarks, there will be a question-and-answer session. (Operator instructions) At this time, I would like to turn the conference over to Richard Arter. Please go ahead, sir.

[Richard Arter:]

Thank you, Corinne. Good morning. Thank you for joining us today. Allen Carlson, Sun's CEO and President; and Tricia Fulton, Sun's Chief Financial Officer, are participating in the call. Please be aware that any statements made in today's presentation that are not historical facts are considered forward-looking statements. For more information on forward-looking statements, please see yesterday's press release. We will take questions once we have completed our prepared remarks. I would now like to introduce Allen Carlson.

[Allen Carlson:]

Thanks, Rich. Good morning, everyone. We finished the third quarter with about $1 million more in sales than we had forecast in August and business conditions remained robust in all areas. New customers continue to account for a significant portion of our sales gains. And as we pointed out on our press release yesterday, some of the traditional markets that have been slow to recover are showing signs of life. Third quarter results reflected normal seasonality and subsequent orders rates remained strong. The PMI that came out last week showed a small upward movement, which bodes well for the future. To reiterate what I've said in the past, our ability to respond to the upturn is due to the actions taken in the downturn. Our workforce was ready, new products continued to be released, and we improved our manufacturing processes. We came out of the recession with more capability to respond to the market. 2010 is actually looking a lot like 2006. Sales are expected to be $147 million, very similar to 2006. However, I think Sun is in better shape operationally. Our operating leverage came back very quickly this year and Tricia will comment on that further. To continue the comparisons to past periods, right now we are expecting 2011 to look like 2007, but with some upside on operational results. When we were at the depth of the downturn in the spring of 2009, it was hard to imagine we could regain lost ground as quickly as we have. That is why it's so important to be prepared and continue to invest in the enterprise, even in difficult times. I'll turn it over to Tricia now for details, and then we'll take questions. Tricia?

[Tricia Fulton:]

Thanks, Al. Operating performance has improved dramatically in 2010 with the increased sales. Everyone at Sun worked hard during 2009 to improve processes, prospect for new customers, and implement productivity improvement throughout the organization. We knew business would rebound. History has shown us that our demand increases very quickly in recoveries, indeed, often more quickly than the overall economy demonstrates. That is why we work so diligently at the bottom of the cycle. It is this work that allows Sun to respond immediately to increases in demand, which ultimately results in market share. Order rates in 2010 increased from the beginning of the year through June. Then, there were some seasonal slowing in July and August. In September, orders increased, contributing to the better-than-expected sales in the third quarter. As evidenced by our outlook, orders are expected to remain strong throughout the year. Recent PMI levels lead us to believe we will see continued growth into 2011. PMI has demonstrated an expansion phase in the economy over the last 15 months and has historically been a very accurate leading indicator for Sun's future growth pattern. Now, I'll move on to some details. Compared to last year, third quarter sales were up 76% to $38 million. Revenue was affected by two items. Foreign currency reduced third quarter sales by about $0.5 million. This was offset by a price increase implemented July 1st, which added approximately $1 million to third quarter sales. The net of these two items is an increase of about $0.5 million. Third quarter earnings increased to $0.34 per share from $0.03 last year. The current quarter's earnings were affected by year-to-date pension adjustment that was not included in our original Q3 estimates. Without this pension expense, earnings would have been $0.38 per share. Gross profit, as a percentage of sales, increased 13 points to 36% compared to 23% in the third quarter of last year. Throughout 2010, we have continued to leverage our fixed costs and pick up substantial gross profit on the incremental sales increase. Our workforce has been agile and quick to respond to constant changes in demand for our product. And productivity improvements derived from new equipment and processes implemented throughout the downturn have driven profitability as demand has rebounded. SEA expenses were up $400,000 to $5.4 million compared to third quarter last year. The change is related to additional retirement benefits, primarily in the U.S., and marketing efforts in Asia. The provision for income taxes for the third quarter was 32.1% compared to 2.8% for the third quarter last year. The prior-year provision included a tax benefit recognized in the U.S. We expect the Q4 effective rate to be approximately 34%. Net cash from operations for the quarter was $7.7 million. Inventory turns were 10, up more than 1 turn over Q3 last year. Day sales outstanding were down three days to 39 compared to Q3 '09. A normal quarterly dividend of $0.09 was paid on October 15th to shareholders of record as of September 30th. A special dividend of $0.50 per share was declared on October 26th. The special dividend will be paid on November 30th to shareholders of record on November 15th. NASDAQ has set an ex-dividend date of November 10th. The special dividend totals approximately $8.5 million. Sun's strong financial position and ability to generate cash allows us to reward our shareholders with this one-time special dividend. In our consideration of the timing of this declaration, the Board took into account potential upcoming changes in dividend tax rate. We have improved our operational performance and enjoyed the impact of productivity enhancements as demand has ramped up throughout 2010. We expect that demand will remain strong throughout Q4, with sales expected to be $38 million and earnings, $0.34 to $0.36. This represents a 39% increase in revenue over Q4 last year, with earnings up four-fold. Q4 earnings estimates include an additional pension accrual and a year-end compensation adjustment that total approximately $0.03 per share. These Q4 estimates will bring the year to $147 million in revenue, with earnings of $1.23 to $1.25. As Al discussed previously, this puts our top line for 2010 very much in line with 2006, but creates substantially more earnings at that revenue level. We know we have capacity to grow in 2011 and beyond, and at this juncture, expect the economy to continue to improve. This bodes well for Sun's future. We will now open the call for questions. Rich?

[Richard Arter:]

Corinne, I think we are ready to take questions from the dial-in audience.

[Operator:]

Thank you. (Operator instructions) We'll pause for a moment to assemble the queue. And first, we will go to Kristine Kubacki with Avondale Partners.

[Kristine Kubacki:]

Good morning.

[Tricia Fulton:]

Hi, Kristine.

[Allen Carlson:]

Good morning, Kristine.

[Kristine Kubacki:]

I was just curious a little bit on the outlook for 2011 versus the kind of a broader group of industrials as to kind of what gives you the confidence to go ahead right now and give an initial look at 2011? And do you think at this juncture it's a pretty conservative base forecast for 2011?

[Allen Carlson:]

I'll start with that and Tricia can add to it. We've watched the PMI as a leading indicator and we've plotted the PMI index relative to Sun's order rates over the last 25, 30 years and it's pretty clear that PMI is about a six to eight-month leading indicator. So with the PMI floating around 56 where it's at and probably going to even get stronger going forward, that's where I get my best input as to what the next six to nine months are going to look like. And that is kind of where I get my 2011 projections from.

[Tricia Fulton:]

I think also, if you looked at order patterns that we had in demand throughout 2010, Q1 was a pretty low number relative to the other three quarters that we are looking at. So if we can take our current orders and sort of put those into at least what we might expect for the first quarter this year in '11, I think it bodes for a higher number than what we are seeing in 2010.

[Kristine Kubacki:]

That's good. Appreciate the color. In terms of commodities, we've seen a lot of commentary on the metals side. And what are you seeing in terms of it and what are you expecting, I guess, in terms of impact on commodities and how are you managing any expected increases in costs into 2011?

[Allen Carlson:]

We saw some increases in commodities in late '08, significant increases. We didn't recover all of those '08 increases obviously in '09. We put a price increase in mid-2010 to help recover some of that – what we weren’t able to get in 2008, 2009 to make us back even. Right now, things are kind of moving sideways relative to commodity, at least the commodities that we use. And you can't really just look at the commodity index for steel, for example, because we don't use rebar in our – or bridge material. We use refined cold-rolled alloy steel and that's always been quite expensive. It hasn't adjusted upward significantly compared to steel in general. The same would be true with aluminum. Going forward, we keep a very close watch on our material input and we try to offset that with productivity gains throughout the company. If we feel that we can't get the productivity gains to make us whole in terms of input pricing, then we are forced to raise pricing and we will keep a very short watch on that.

[Kristine Kubacki:]

Okay. And then my last question is, you've made some comments in previous quarters about expedited orders and that you are still seeing kind of a lack of willingness to take on inventory in the channel. What have you seen there in terms of your customers, and still seeing an increase in expedited orders at this point of the cycle?

[Allen Carlson:]

Yes, we have. In fact, last week was a very strong week in total orders and a very strong week in terms of expedited orders, which is unusual. I think last week, 20% of our income in orders were expedited orders.

[Kristine Kubacki:]

Okay. Very good. Thank you very much. I appreciate it.

[Operator:]

(Operator instructions) And next, we will go to Jon Braatz with Kansas City Capital.

[Jon Braatz:]

Good morning, Allen and Tricia.

[Allen Carlson:]

Good morning.

[Tricia Fulton:]

Hi, Jon.

[Jon Braatz:]

Couple of questions. Allen, you mentioned that new customers have been important. Then you mentioned also the traditional markets that have been slow to recover are now recovering and showing some good gains. What might those traditional markets be?

[Allen Carlson:]

Aerial lift devices, man lifts; those kinds of things have been very traditional for Sun.

[Jon Braatz:]

Okay.

[Allen Carlson:]

Maybe some of the mining and drilling equipment, excavators, those kinds of markets is what I was referring to.

[Jon Braatz:]

Okay. Would they be in a broader term more construction-oriented, oil and gas, sort of the end markets?

[Allen Carlson:]

I can't draw that conclusion.

[Jon Braatz:]

Okay.

[Allen Carlson:]

I know where you would like to go.

[Jon Braatz:]

Yes.

[Allen Carlson:]

And I wish I could paint that picture. I can't.

[Jon Braatz:]

Okay, okay. Very good. Also when we broke – when you break down revenue by geography, I saw that the Korean revenue was $3.3 million and it was down sequentially. Has that market slowed or was that sort of timing – a timing issue regarding some revenues from that area?

[Tricia Fulton:]

It's really more of a timing issue. Our Korean entity tends to see more orders happen in the March-April-May time frame and that's their peak in their seasonality within the year. So we typically do see some Q3 drop there, but the Korean business is going very well and we don't have any reason to believe that there is a decline in demand going on there.

[Jon Braatz:]

Okay, okay. And Tricia, where are the retirement benefit charges or whatever you want to call them? Are they in cost of goods sold or SG&A?

[Tricia Fulton:]

Primarily cost of goods sold; probably 85% of them are in cost of goods sold.

[Jon Braatz:]

Okay. And I guess I was sort of asleep at the switch, but you said there was another $0.03 charge in the fourth quarter?

[Tricia Fulton:]

Yes. And that's related to the Q4 pension adjustment, which is the same type of charge that we took in Q3 on a year-to-date basis, as well as just some year-end compensation adjustment –

[Jon Braatz:]

Okay.

[Tricia Fulton:]

(Multiple Speakers) – happened in the fourth quarter as well.

[Jon Braatz:]

Okay. One last question. Allen, you talked a little bit about the dividend policy, you paid the one-time dividend and you reflected upon the change in maybe dividend tax rates next year. Would that suggest that there might be a dividend policy change regarding the quarterly dividend of $0.09 as we move into 2011?

[Allen Carlson:]

No, there will be no change to that. This was clearly a special dividend.

[Jon Braatz:]

Okay. Okay. Thank you very much.

[Tricia Fulton:]

Thanks.

[Operator:]

(Operator instructions) Next, we will go to BB&T with Holden Lewis.

[Holden Lewis:]

Thank you. Good morning.

[Tricia Fulton:]

Good morning, Holden.

[Allen Carlson:]

Good morning, Holden.

[Holden Lewis:]

Sort of, I guess, going back to your 2006 and 2010 relationship, if you will, with revenues being kind of the same, the big difference – the profitability difference is pretty remarkable. And I guess it really rests at the gross margin. I think in '06, you had a 30.9% gross margin. This year you are looking at probably in the neighborhood of 34.8% gross margin, something like that. So a big change would suggest that, on the same level of revenues, you probably got $5 million or $6 million of COGS savings. And I mean, I hear you in terms of productivity, but typically productivity is a benefit when you have more volumes. And here, we are comparing really comparable revenue periods. And so I'm kind of wondering what that $5 million or $6 million in sort of vacated costs, if you will, what that constitutes over that period of time?

[Allen Carlson:]

I think it falls in the category of just doing more with less throughout the organization, and our supply base as well. It's not just the internal adjustments. During the downturn, we kept our workforce completely through a furlough program. And on top of that, we invested in that workforce with training programs, we did a lot of lean manufacturing initiatives, we made some investments – I'll just give you one example. We implemented a new heat treat facility, closed one down. The new heat treat facility can produce maybe twice as much as what we were able to produce before, with half the number of people. We've got new machining centers in place at – some of these productivity gains actually began – had their beginnings in 2008, 2009, where we put in some new machining centers that can produce maybe 50% more with less floor space, those kinds of things. And it's not just one, they are kind of all over the company, and they are in our supplier base as well. So, I'm not surprised.

[Holden Lewis:]

Right, but I mean all of those things mean that for any – as revenues increase, you need to invest less. And '07 and '10, we are really talking about a sense of the same revenue base. And so, I guess I'm kind of curious, I mean, have you been able to reduce head count at all? Because again you kind of kept head count, you kept your facilities. Productivity is great as revenues climb, but we are talking about the same revenue year-over-year, the $5 million or $6 million in costs that aren't there on the same revenue level. And I am trying to just figure out what those costs are.

[Tricia Fulton:]

We do have some decreases in headcount over that time period of end of 2006 to where we are right now. It's probably an 8% decrease and that's probably all in the direct labor piece and a lot of that lends itself back to the productivity that we are actually able to do more with less people even. So yes, there are some head count reductions there, which happen naturally.

[Allen Carlson:]

Attrition.

[Tricia Fulton:]

Yes, natural attrition.

[Holden Lewis:]

And then does that – that 8% on direct labor, does that add up to sort of that $5 million or $6 million? Is that the primary explanation?

[Tricia Fulton:]

Well, that's part of it. The other piece of it is we are working a lot less overtime right now than we were in 2006, even with more people. So again, that leads back to the productivity and I think a lot of that goes back to process improvements, so people can do their jobs a lot easier. We've improved the efficiency of our operations over those four years.

[Allen Carlson:]

Holden, if you are looking for one magic silver bullet that answers the question, there isn't one. There is probably 10.

[Holden Lewis:]

Yes. No, no, I just – I guess I just – I've been very surprised at how strong the gross margin has been at the same revenue levels. I'm just trying to get some of the moving pieces. Because like you said, I mean you didn't really let many people go. You didn't – obviously didn't change your facilities. So, I was just trying to get a little bit of color as to exactly where that $5 million to $6 million comes from. That helps.

[Allen Carlson:]

Well, we worked very hard in the downturn to position ourselves to do what you are seeing today.

[Holden Lewis:]

Yes. Okay. And then on sort of the investment side, obviously, capital expenditures have remained very light. Your incremental margin has been fantastic. You are approaching record margins and record revenues again. I mean, are we getting to the point where we are going to have to begin adding some SG&A or – where do we think that we need to start investing in the business again or can we just keep these tight levels indefinitely at this point?

[Tricia Fulton:]

I don't think we are going to have to add a lot of SG&A cost to that. Historically, we have not had to add those types of positions as revenues increase. And part of that is because we don't have a sales force.

[Allen Carlson:]

Yes.

[Tricia Fulton:]

Our distributors work as our sales force. So as sales increase, we don't have to add heads in those areas where a lot of other companies do.

[Holden Lewis:]

Okay, and then on the cost of good side? And I guess one of the ways I'm coming at this is, I mean, normally you guys put up a pretty good incremental margin of 35% on a given revenue increase. This year, obviously, it's been substantially above that. I guess what I'm trying to get a sense for is when and how do we expect current incremental margins to sort of back off to the normal?

[Tricia Fulton:]

I think that the margins that we are experiencing right now are sustainable for going into 2011. I don't know how much incremental gross margin more we can get at this point, because we are near those highs and you do start to see additional costs come in there. But I don't think we are going to see a large increase or decrease in 2011 in the margins. I think that we are at a point where we can sustain those.

[Holden Lewis:]

Well – and what's going to limit you from leveraging the additional revenue specifically to get better margins? Or are you just referencing gross margin, not total margin?

[Tricia Fulton:]

I'm just referencing gross margin.

[Holden Lewis:]

Okay. So, gross margins kind of stay flat?

[Tricia Fulton:]

Yes, and I – yes, at that point, we are able to leverage further to the operating margin level, because we don't expect to add a lot of cost into the FD&A [ph] line.

[Holden Lewis:]

Okay. And what is it about – what's going into the mix that's going to cause the gross margin to sort of stay flat on higher revenues? That's usually pretty leverageable in manufacturing models, certainly in yours.

[Allen Carlson:]

I think we are just – we are operating – right now, we are operating in our sweet spot and I don't expect to see the gross margin as a percent to increase where – from where we are currently at. Maybe there are some slight upside potential.

[Tricia Fulton:]

Yes.

[Allen Carlson:]

But it's not significant.

[Holden Lewis:]

Okay. All right. Great, thanks, guys.

[Tricia Fulton:]

Thank you.

[Allen Carlson:]

Thank you.

[Operator:]

We have no further questions at this time. I'd like to turn the call back over to our speakers for any additional or closing remarks.

[Richard Arter:]

Well, thank you all for joining us today and we will look forward to better times ahead and we'll talk to you next quarter.

[Operator:]

Once again, this does conclude today's conference. We do thank you all for joining us.