Schnitzer Steel Industries, Inc.
Q2 2013 Earnings Call Transcript

Published: 3 Apr 2013

[Operator:]

Good day, ladies and gentlemen, and welcome to the Schnitzer Steel's Second Quarter 2013 Earnings Release Conference Call. [Operator Instructions] As a reminder, today's conference call is being recorded. I would now like to turn the call over to your host, Alexandra Deignan, Vice President, Investor Relations. Please begin.

[Alexandra Deignan:]

Thank you, Sean. Good morning, everyone. Welcome to Schnitzer's Second Quarter Fiscal 2013 Earnings Presentation. We're glad you are able to join us today. In addition to today's audio comments, we have a prepared set of slides that you can access on our website at www.schnitzersteel.com or www.schn.com. Before we get started, let me call your attention to the detailed Safe Harbor statements on Slide 2, which are also included in our press release of today and in the company's most recent Form 10-K and in the Form 10-Q, which will be filed later today. These statements, in summary, state that in spite of management's good faith, current opinions on various forward-looking matters, circumstances can change and not everything we think will happen always happen. Please note that we will be discussing some non-GAAP measures during our presentation today. We've included a reconciliation of those metrics to GAAP in the appendix to our slide presentation. Now let me turn the call over to Tamara Lundgren, our Chief Executive Officer. She will host the call today with Richard Peach, our Chief Financial Officer.

[Tamara Adler L. Lundgren:]

Thanks, Ally. Good morning, everyone, and welcome to our call. This morning, we'll review our second quarter results. I'll summarize our consolidated performance, and I'll provide some commentary on the activities and market trends that drove our improved results this quarter. Richard will provide the segment financials and review our capital structure, and then we'll open up the call for Q&A. This morning, we reported second quarter adjusted earnings per share of $0.36, reflecting higher volumes, higher prices, improved margins and lower cost. Our results exceeded the market outlook that we issued in February. And this was a result of 3 primary factors. The first factor was better-than-anticipated operational performance in both our Metals Recycling and Auto Parts divisions, including lower costs. The second factor was lower corporate expenses as a result of our restructuring initiatives. And the third factor was the positive impact from additional tax benefits. From a market perspective, as we highlighted in our outlook, we experienced stronger demand for our products, which led to higher sales volumes and higher prices. In our Metals Recycling Business, we more than doubled our operating income per ton to $13 from the prior quarter. In our Auto Parts Business, we delivered higher operating margins sequentially, excluding the impact from the startup of our 10 new locations. And in our Steel Manufacturing Business, we stayed profitable, notwithstanding lower utilization due to seasonality and planned maintenance downtime. From a cost perspective, through the first half of our fiscal 2013, the restructuring initiatives that we announced at the start of our fiscal year have so far delivered an 11% reduction in SG&A year-over-year. Our cash flow enables us to continue to pursue growth and the return of capital to our shareholders through our attractive dividend while maintaining a healthy balance sheet and low leverage. During the quarter, we invested in 10 new sites in our Auto Parts Business in order to strengthen our supply chain of raw materials to our Metals Recycling Business and to enhance our APB franchise. We also began initial operation of our shredder in Western Canada to enable us to export directly from British Columbia. As 2013 progresses, we'll continue to focus on the areas that we can control, and that will position us to deliver improved performance when the macroeconomic environment improves. Those areas are the same areas that underpin this quarter's results

[Richard D. Peach:]

Thank you, Tamara, and good morning. I'll begin on Slide 8 with Metals Recycling. Operating income for Metals Recycling was $14 million, which was more than double the first quarter. Operating income per ferrous ton was $13, representing a sequential increase of 117%. The key drivers of the improved second quarter performance were significantly improved sales volumes, higher ferrous selling prices and benefits from the timing of sales. These results were also better than our MRB market outlook because both cost of goods sold and SG&A in the month of February were lower than our expectations. Compared to the first quarter, ferrous sales volumes of 1.1 million tons increased sequentially by 16%, primarily reflecting higher export demand on the West Coast and timing of shipments. Export shipments off the East Coast were also up sequentially but more moderately. Due to higher levels of production, nonferrous sales volumes were also up sequentially by 6% and amounted to 126 million pounds. Compared to the previous quarter, average ferrous selling prices were up by 4%, and nonferrous selling prices were up by 2%. Although the second quarter represented a significant performance improvement, our reported margins are still compressed compared to historical levels as a consequence of supply constraints over raw materials and the impact of macro uncertainties on the strength of demand. Now moving to our Auto Parts Business. Please turn to Slide 9. On a sequential basis, second quarter car purchase volumes increased significantly by 11%. Just more than half of the entries came from existing stores, with the remainder coming from immediate contributions by our new locations that we acquired in the second quarter. The increased car volumes, higher commodity prices and lower SG&A all drove a sequential increase in APB's operating margins to 11%, excluding the impact of new stores. APB's performance also exceeded our market outlook due to lower SG&A and benefits to gross margins from higher commodity prices in the month of February. During the second quarter, we acquired an additional 8 stores and began development on 2 greenfield locations. Including transaction, integration and start-up costs, APB incurred $2 million of operating losses on these new sites, which lowered APB's reported operating margin to 9%. In the third quarter, we expect to incur a similar level of start-up costs on these new locations as we convert some acquired stores to self-service facilities and develop our greenfield locations. In total, APB now has 59 stores which are operational, and 2 more are planned to be opened by our fiscal year end. This represents a 20% increase in stores from the beginning of the fiscal year, and we expect an increase in annualized car purchase volumes of 15% after integration is completed. Now turn to Slide 10 for a review of our Steel Manufacturing Business. In the second quarter, Steel Manufacturing generated $1 million of operating income on rolling mill utilization of 63%. Compared to the first quarter, sales volumes declined 26% to 96,000 tons, mainly as a result of seasonally low demand and scheduled plant downtime. However, year-to-date, we've had a 20% pickup in rebar sales on strengthening market demand in advance of the construction season. Average net sales prices of $690 per ton approximated the first quarter but were lower than the second quarter of last year due to the impact on selling prices of decreases in the cost of raw materials. Now moving to Slide 11, I'll review some of the key corporate items during the second quarter. In August 2012, we announced an aggressive cost reduction program and a major corporate restructuring initiative. As a consequence, SG&A in the first half of our fiscal 2013 is 11% lower than the same period of the prior fiscal year. Our focus on cost efficiency is ongoing, and we remain on track to achieve our annualized target of $25 million of pretax savings through a combination of production and administrative cost reductions. Second quarter tax expense included the release of a $2 million valuation allowance on the deferred tax assets of a Canadian subsidiary. This reversed the valuation allowance recorded in the first quarter and was driven by steps we're taking to create more operating synergies between MRB and APB in Canada, and plans to implement a new Canadian tax structure, which will be more tax efficient. In addition, the second quarter also includes $1 million in other discrete tax benefits, including qualifying manufacturing deductions and credits for research and development activities. In the second quarter, we also performed an annual goodwill test and determined that the fair value of both our MRB and APB operating segments exceeded their carrying value. As part of our normal process, we will continue to closely monitor our goodwill in light of macroeconomic uncertainties, financial performance, our market capitalization and market conditions in the recycling industry. Now let's turn to a review of our capital structure on Slide 12. During the second quarter, net debt increased by $36 million, which equates to leverage of 25%. We generated positive cash from operations of $16 million, which in part funded our investment in new auto parts locations for $23 million and capital expenditures of $21 million, including the Canadian shredder project. For 2013 as a whole, we anticipate total capital spend of up to $100 million, including capital expenditures related to the new APB acquisitions and development of greenfield sites. In the second quarter, we continued to make significant progress on our strategic growth plan in Western Canada. The combination of APB's 4 new sites acquired in Vancouver, BC, and the successful completion of testing of the new MRB shredder in the same region will allow for additional synergies between these 2 businesses. We took further strategic actions subsequent to the second quarter, as we acquired all of the noncontrolling interest in one of MRB's Canadian subsidiaries for a total consideration of $25 million. In summary, we believe Western Canada offers a good opportunity for Schnitzer to continue its growth strategy and for synergistic benefits between our MRB and APB divisions. Now I'll turn the call back over to Tamara to conclude our formal remarks.

[Tamara Adler L. Lundgren:]

Thanks, Richard. Our second quarter performance is indicative of the operational leverage we're harnessing with our restructuring initiatives and our strong focus on cost, business processes and continuous improvement, as well as the strategic growth initiatives we're actively pursuing. We achieved significant margin expansion on higher commodity prices and improvements in volumes in both our Metals Recycling and Auto Parts businesses during the second quarter. In addition, our Steel Manufacturing Business maintained profitability despite a material reduction in volumes due to seasonality and planned downtime. We continue to make targeted investments in our core businesses to drive profitability and growth. In MRB, we're driving operational efficiencies while developing a new franchise. In APB, we're expanding our stores through acquisitions and greenfield developments. Both of these initiatives enable us to further penetrate core markets, leverage existing operational resources and increase our supply chain. And in our Steel Manufacturing Business, we continue to optimize performance and to position our mill to benefit from improving trends for long products on the West Coast. We're on track with our restructuring initiatives, and we will continue to assess adjustments to our cost base to reflect the current market environment. The global economic outlook remains challenging in the near term, but we believe the long-term fundamentals of our market remain intact. Broad-based demand for recycled metals continues to be driven by increasing production levels for finished steel and underpinned by long-term trends in urbanization, infrastructure developments, energy efficiency and reductions in greenhouse gas emissions. While we see some early indications of economic recovery and stability in the U.S., and in the markets where we export our products, near-term headwinds are affecting the availability of scrap supplies and the global demand for steel. Our strategy is focused on the areas we can control

[Operator:]

[Operator Instructions] Our first question comes from Brent Thielman with D.A. Davidson.

[Brent Thielman:]

Yes, just on the Auto Parts Business, it looks like, with a little over a 200 basis point drag on margins related to the new sites, I'm sorry if I missed this, but should this drag narrow in the coming quarters? Or is this about what you'd expect over the near term?

[Richard D. Peach:]

Brent, it's Richard. It will narrow, but we will see in the third quarter something similar in terms of start-up costs in Auto Parts because we're converting some of the acquired stores to self-service facilities and we're also developing our new greenfield locations. So we do have some costs associated with labor, supplies, building of inventory and the customer base in those locations. But that will quickly place, we hope, a system. And as we said, we do expect, after the integration is completed, that we'll see an increase in auto parts car purchase volumes by around 15% on an annualized basis.

[Brent Thielman:]

Okay, and sorry, Richard, the greenfield sites will be up and going by Q4, did I hear that right?

[Richard D. Peach:]

Correct.

[Brent Thielman:]

Okay. And then just on the steel business, can you just give us an update on the environment and opportunities you're seeing there right now?

[Tamara Adler L. Lundgren:]

Well, we are seeing strengthening of construction demand on the West Coast. And so, it's interesting, this second quarter was the first second quarter that the Steel Manufacturing Business was profitable since the onset of the global financial crisis. So we're seeing the green shoots of construction demand strengthen on the West Coast. And we think the mill is well positioned to benefit from that as that takes hold.

[Brent Thielman:]

And then just last one, the remaining $5 million in restructuring costs, is that going to be fairly spread out during the second half or weighted toward Q3, any sense there?

[Richard D. Peach:]

Well, we spread over both Q3 and Q4, Brent. I don't have the exact split to hand to you, but it should all be gone through by the end of the fiscal year.

[Operator:]

Our next question comes from Luke Folta of Jefferies.

[Luke Folta:]

I guess quickly, first, on the restructuring efforts. Can you talk about how much of that, on a run-rate basis, kind of excluding the upfront costs, you think you've achieved in the second quarter? And then how that -- some sense of how that breaks out on the segment reporting side.

[Richard D. Peach:]

Yes, Luke, it's Richard. There's $25 million of pretax savings that we're going for on an annualized basis. And of that amount, half of it is in the Metals Recycling Business, and the other half is split roughly equally between Auto Parts and Corporate. And we did see, when we announced this back in August, that as the initiatives were taking place throughout fiscal 2013, that we would see a part-year benefit in this current fiscal year. We also said, in terms of the split of the $25 million, that $18 million was in SG&A on an annualized basis, and about $7 million was in production costs, which are in cost of goods sold. So if you stand back and you look at our SG&A for this first half of this fiscal year, we spent $97 million, which is actually $11 million less than we had spent at the same time in fiscal '12. So we are on a good run rate to obtain a substantial portion of these part years -- of these full year savings in this current year. We won't get all the $25 million this year, but we'll get a significant portion of it. Now one other thing to say here, in terms of looking at Metals Recycling, that $12 million that we're going for. And then, if you look at that on a per ton basis, on an annualized basis, when we're -- we've achieved the full run rate, that's about $3 a ton, they are so, as I said, it's making a significant difference to our current earnings and future earnings. And in the Auto Parts Business, if they are half of the remaining part of the $25 million, then the $6 million or $7 million we're aiming for in there is up to a couple of hundred basis points on to their operating margins. So they're material to the performance of the businesses, especially in this current market environment.

[Luke Folta:]

And so it sounds like you're actually tracking ahead of where you thought you'd be when you announced the restructuring. I guess where I'm, trying to get...

[Richard D. Peach:]

We're very much on track with it. We're very much track -- on track with it, but we're aggressively pursuing our cost reduction program.

[Luke Folta:]

Okay. So when we look at this, the second quarter results, if we wanted to use that kind of as a base, has the things that you've done, is that now fully reflected in that second quarter number, kind of on a run rate basis?

[Richard D. Peach:]

Well, all of that more -- there's a little bit more still to do. We've outlined a substantial portion of it. And you can see, if you took the $97 million of SG&A for the first half of the fiscal year and you doubled it, and then took a little bit off that, and that would give you a decent estimate, I think, of where our SG&A could end up for the year as a whole.

[Luke Folta:]

Okay, all right. And then, you said a number of things regarding Canada. And Tamara, she said something about 17 facilities being kind of newer or something involving your strategy there, and then there's a new shredder coming online, and there are some new auto parts facilities there. Can you maybe just step back and give us kind of an overview of what's going on in Canada these days and kind of what it's going to look like when all that stuff is kind of ramped up? What do you expect the benefit to be from that shredder in terms of tonnage? Or I guess anything that you can say to help put that into perspective, that whole strategy up there.

[Tamara Adler L. Lundgren:]

Well, what we're trying to do there is to create a differentiated buying and operating strategy, where we take a base of business that we've had in the Auto Parts Business. The Auto Parts Business has been in Western Canada for quite a number of years, and we grow that business as a supply chain into the Metals Recycling Business, where we're putting up a shredder. And actually, just this last quarter, the first export of shredded material from British Columbia in British Columbia's history took place. So what we're trying to do is to create an integrated structure up there. Canada's got a good GDP outlook. It's a growing economy, and it is a place where the products and services that we have -- that we undertake and do in the U.S. doesn't take place there. So the 17 facilities are a combination of auto parts facilities, feeder yards and our shredder. We haven't broken out, and you know that we don't break out tons per shredder, so we can't disclose that. But from a strategic perspective, we're looking to create a true integrated franchise, not dissimilar to the integrated franchise that we have, for example, on the West Coast, between APB and MRB.

[Luke Folta:]

Okay. Can you give us some sense at the end of, say, fiscal '13, how many facilities you will have or how much -- well then some sense of volume and how much volume you'll be processing, whatever, in Canada as a whole or in that region as a whole, relative to the end of fiscal '12?

[Richard D. Peach:]

Yes, I think we said somewhere in our release that we've got around 17 facilities in Canada, split between the Metals Recycling Business and the Auto Parts Business. So as -- we are creating a substantial operation up there. In terms of volumes, I think in the current fiscal year, we'll be between 5% to 7% of the Metals Recycling volumes for the year. So it's not a very significantly material business as yet. But we think it's a very good growth opportunity for us in the future given the network we've establishing out there and the new shredder and export capability.

[Luke Folta:]

Okay, and if I could sneak one more into just the -- on the steel side, you talked about some improvement in the West Coast. Commercial Metals, the other day, kind of was saying the same thing, that they're starting to see some improvement in California as well. Are you seeing that in your backlogs? So when -- should we see kind of a marked improvement, when we look at the steel shipments in the spring construction period, over the next couple of quarters relative to last year?

[Tamara Adler L. Lundgren:]

Well, the spring activity hasn't really taken place yet. But construction activity in the spring is -- the season that we're going into right now tends to be the strongest. And we are seeing order books strengthen from our customers. But we don't operate on a backlog basis. So this is really a function of 7 months of strong ABI performance input from our customers that indicate high bidding activity and pickup that we've seen in rebar sales.

[Operator:]

Our next question comes from Timna Tanners of Bank of America Merrill Lynch.

[Timna Tanners:]

I just had a couple of questions. One is, really in the past, what we've seen is that from quarter-to-quarter, there'd be sharp variations in EBIT per ton in the Metals Recycling Business. Sometimes, you'd underearn, sometimes, you'd overearn, sometimes there'd more of a normal environment. So taking aside what you're expecting to do in terms of the -- what you can control on the cost cutting, how would you characterize the second quarter's earnings per ton on Metals Recycling?

[Tamara Adler L. Lundgren:]

Well, I think if you look at the market demand, if you look at the price and volume, you saw a modestly improving tone, which is what we suggested in our January call. And that was fundamentally a combination of steadier market sentiment and more opportunities internally to generate synergies and savings. So we still have a situation where customers worldwide are keeping low inventories and that's -- that can cause the market to spike. We're seeing prompt delivery requests and that continued low inventory that still reflects probably relatively weak long-term confidence.

[Timna Tanners:]

Okay. But for the recent environment, this is about a good run rate for earnings, you think, for the Recycling business, absent a better GDP environment, et cetera?

[Tamara Adler L. Lundgren:]

Well, we don't project margins going forward or volumes or prices, obviously. But clearly, what you can see here is that in a rising -- higher volumes, rising prices, we accelerate very quickly. And that was a very different tone and level of activity than what you saw in the first quarter.

[Timna Tanners:]

Okay. When I look at your balance sheet, as far as leverage goes and ratios, this is about the higher end of your usual comfort zone, as far as I've seen historically. So I just wondered if you could characterize kind of your appetite for uses of cash or kind of your priorities for cash use going forward, please.

[Tamara Adler L. Lundgren:]

Sure. Well, it's actually been higher, I mean, towards the end of -- I think, last year, we were at 30% or even a little bit higher than 30%. So we're down significantly from that after making a lot of investments and acquisitions and in CapEx. But our uses of capital are split over growth opportunities between acquisitions and CapEx, and our dividend and return of capital through opportunistic share repurchases.

[Timna Tanners:]

So this is a comfort level -- can you just remind us what comfortable level you might be at net debt to equity, or another metric that you might use?

[Tamara Adler L. Lundgren:]

Well, we don't set targets. But we've ranged, I think, within the last 1.5 years -- and Richard, you can correct me, but I think we've ranged within the last, let's say, 18 months to 2 years between 18% and 30%.

[Richard D. Peach:]

That's correct.

[Timna Tanners:]

For a net debt to equity, yes?

[Tamara Adler L. Lundgren:]

Yes, for net debt. Yes, net debt, so.

[Operator:]

Our next question comes from Chris Haberlin of Davenport & Company.

[J. Christopher Haberlin:]

I wanted to see if you could maybe comment on what you're seeing in terms of export demand, just given the stronger dollar here recently. I know you that you mentioned that you're seeing some moderating demand in April for export shipments, just given expectations on pricing. Can you kind of throw out a little bit more color there?

[Tamara Adler L. Lundgren:]

Sure. March -- you look at the East Coast and West Coast, the East Coast focuses -- East Coast export market focuses very heavily on what goes on in the domestic market, and the West Coast looks at it as well. And in March, what you saw was a significant uptick in domestic prices. And then, during the month of March, you saw capacity utilization decline in the U.S. And that typically -- and this month was -- this past month was no different, starts a certain amount of chatter about lower prices the next month. And when you start to see those, that chatter in trade journals and the like, that usually puts a damper on export activities until those prices settle out. And the opposite behavior happens when the reverse is true. So the lull we're seeing right now is a reflection of watching April prices settle. Having said that, capacity utilization and general demand has softened year-over-year in terms of both the Asian markets and the Turkish markets. But we're seeing both of that -- or both coasts, we've seen them in the market over the last couple of quarters and couple of months. China was back in the market in the second quarter after being away from the market in Q1 and Q4. And Turkey is regularly in and out of the market, so this behavior is not as unusual.

[J. Christopher Haberlin:]

You mentioned China. With iron ore prices rolling over here and forecasted to go lower with new supply coming on later this year and into next year, are you seeing them starting to kind of arb the iron ore and scrap pricing there, where they're starting to use maybe more iron ore?

[Tamara Adler L. Lundgren:]

Well, when -- what we see with China in iron ore is what -- when there are significant moves, we see China arbitrage iron ore and scrap. But they don't move dollar per dollar as scrap isn't, as you know, fully substitutable for iron ore and integrated. And scrap is necessary for EAF. So it's really the significant moves in iron ore when we see China arbitraging that.

[J. Christopher Haberlin:]

And then, just one last one for me. What are you seeing in terms of scrap flows into your yard? I guess, with the winter weather kind of lasting through the end of March, are you seeing a normal seasonal uptick? Or is that maybe muted compared to what you've seen in prior years?

[Tamara Adler L. Lundgren:]

Well, we haven't seen spring yet because, as you point out, there was snow in the Northeast last week and elsewhere [ph] in the country. Normally, with spring, scrap supply flows improve. But scrap flows, both on the ferrous and nonferrous sides, are very, very low and quite constrained.

[Operator:]

Our next question comes from Phil Gibbs of KeyBanc Capital.

[Philip Gibbs:]

Just had a question on March export volumes, and if you could give us any color just regarding that month versus maybe average February quarter levels.

[Tamara Adler L. Lundgren:]

I'm sorry, I missed the first part of your comment on my mic. What was your question?

[Philip Gibbs:]

How did March export shipments compare to average February levels, February quarter levels?

[Tamara Adler L. Lundgren:]

Yes, as I mentioned in my remarks, March price -- export shipments, price levels held steady from February.

[Philip Gibbs:]

Not pricing but the volume side?

[Tamara Adler L. Lundgren:]

[indiscernible] volumes. Volumes were in line with what we saw last year this time.

[Philip Gibbs:]

So relative to the last -- the quarter you just announced, the second quarter?

[Tamara Adler L. Lundgren:]

Well, we've only -- we're only 1 month into the quarter. So you -- we really can't benchmark it against the last quarter. We benchmark it against the a year ago flows.

[Operator:]

I am not showing any other questions in the queue at this time.

[Tamara Adler L. Lundgren:]

All right. Well, thank you, everyone, for joining us today, and we look forward to speaking with you again when we report our third quarter results in June.

[Operator:]

Thank you. Ladies and gentlemen, thank you for your participation in today's conference. This does conclude the conference. You may now disconnect. Good day.