H.B. Fuller Company (FUL) 2005 Q2 法說會逐字稿

Good afternoon and welcome to the second quarter year 2005 earnings release. At the request of the Company, this conference is being recorded for instant replay purposes. This conference has been scheduled for one hour. Following today's presentation, there will be a formal question-and-answer session. Instructions will be given at that time should you wish to ask a question.

Management in attendance on today's call include Mr. Al Stroucken, Chairman of the Board, President and CEO; Mr. John Feenan, CFO; and Mr. Steven Brazones, Director of Investor Relations. At this time, I would now like to turn the meeting over to Mr. Steven Brazones. Sir, you may begin.

Thank you, Sarah, and welcome, everyone. Today's conference call will be available for replay approximately one hour after we are finished with the question-and-answer portion of our call.

Before beginning, I would like to inform everyone that certain matters discussed during this call will include forward-looking statements as that term is defined under the Private Securities Litigation Reform Act of 1995. Since such statements reflect our current expectations, actual results may differ.

In addition, during today's conference call we will be discussing certain non-GAAP financial measures, specifically free cash flow. Management believes that the discussion of these measures is useful to investors because it provides insight into the ability of the Company to fund such things as debt reduction and acquisitions. For more information, please refer to our recent press release, quarterly report on Form 10-Q and annual report on Form 10-K filed with the Securities & Exchange Commission. All of which are available on our website at www.hbfuller.com under the Investor Relations section.

Now, John Feenan.

Thank you, Steven. Good morning to everyone. Before I begin, I want to remind everyone that per share amounts discussed are on a diluted basis. Net revenue for the quarter was $387.9 million, 6.8% higher than the $363.1 million of net revenue in the second quarter of 2004. This quarter represents the first year-over-year comparison in which the results of the Company's Probos acquisition are included in both quarters.

In addition, as we previously announced, during the quarter we entered into a joint venture with Sekisui Chemical Company in Japan, in which we contributed our Japanese operations to the joint venture. Consequently, this year's second quarter only includes the results of one month's performance of our Japanese operations. Our Japanese operations were deconsolidated effective April 1st, 2005.

The components of the 6.8% net revenue increase were as follows -- Pricing increased 6.6%; volume increased 0.1%; currency effects accounted for a 2% increase; and the deconsolidation of the Company's Japanese operations accounted for a 1.9% decrease. Gross margin for the second quarter was 25.7% compared to last year's second quarter gross margin of 27.6%. The 190 basis point decline in gross margin was the result of higher raw material and delivery costs, each of which were up over 10% compared to the second quarter of 2004. Despite the progress made at the increased price level, we were unable to fully offset the impact of these higher costs during the quarter.

Selling, general, and administrative expenses were $78.5 million or 20.2% of net revenue. This represents a decline of 120 basis points versus last year's second quarter of 21.4%. Included in this year's second quarter SG&A is approximately $2.6 million of severance and other related expenses associated with the outsourcing of a portion of our IT organization, as well as certain other business reorganizations. An additional $300,000 of expense related to the aforementioned was recorded in cost of sales during the second quarter.

Also included in SG&A are higher accruals for incentive compensation due to our stronger performance, which were partially offset by a reversal of an accrual related to the 2004 long-term incentive plan. In aggregate, the decline in SG&A was the result of thorough cost controls across the entire organization, coupled with process improvements brought about through the implementation of Lean Six Sigma.

Operating income for the second quarter was $21 million, down slightly from last year's second quarter operating income of $22.4 million. On a segment basis, operating income in Global Adhesives in the second quarter was $15 million compared with $13.2 million in the second quarter of 2004. Full-Valu/Specialty's operating income was $6.1 million versus $9.2 million in the previous year. Of the total $2.9 million in severance and other related expenses discussed earlier, $1.4 million related to Global Adhesives, and $1.5 million to the Full-Valu/Specialty segment.

Interest expense of $2.9 million was 20.4% lower than the $3.6 million for the second quarter of 2004. This decrease was due to the repayment of private placement debt earlier this year, and a lower utilization of our revolving credit facilities. Net gains on sales of assets were $5 million in the second quarter of 2005, as compared to 0 net gains in last year's second quarter. This year's second quarter includes a 4.8 million gain related to the sale of a 20% equity interest in our China operations to the Sekisui Chemical Company.

Other expense net in the second quarter was $462,000 compared to $2.3 million for the second quarter of 2004. The decline was primarily driven by lower currency exchange losses and higher interest income. Pre-tax earnings of $22.7 million for the second quarter of 2005 reflect a 38% increase from last year's second quarter Pre-tax earnings of $16.4 million.

The effective tax rate for the quarter was 32.7%, on par with last year's second quarter tax rate of 32.8%. The effective tax rate for the second quarter was higher by 70 basis points over the first quarter due to a slightly higher tax rate associated with the gain on the sale in China. Accordingly, for the second quarter of 2005, net income increased from $11.2 million in the prior year to $16.2 million. Earnings per share were $0.56 compared to $0.39 for last year's second quarter.

As we turn to the balance sheet, I would like to remind everyone the following figures are subject to minor changes prior to filing our 10-Q. Cash at the end of the quarter totaled $82 million. Networking capital, which is defined as net trade accounts receivable plus inventory, minus trade accounts payable, amounted to $259 million. As a percentage of annualized net revenue, networking capital was 16.7% for the second quarter. This represents a decline of 200 basis points from the previous year's second quarter.

Improvements were made in all working capital components, with the largest improvement being generated through the reductions in accounts receivable. We are encouraged by the progress we have made, and we remain committed to achieving our goal of reducing networking capital to between 14 and 15%.

Capital spending for the quarter was $5.3 million, compared to last year's second quarter spend of $7.6 million. Depreciation and amortization expense were $13.9 million for the quarter. Total debt at the end of the second quarter was $150.7 million, compared to $179.3 million at the end of the second quarter of 2004. This represents a decrease of $28.6 million year-over-year. The Company's capitalization ratio was 21.1% at the end of the quarter, compared to 25.6% at the end of the second quarter of last year, and 24% at fiscal year end.

Free cash flow for the quarter, defined as cash flow provided by operations less dividends paid and purchase property, plant, and equipment, was a positive $26 million, compared to a positive $37 million in the second quarter of 2004. The components for the second quarter of 2005 were as follows -- Cash flow provided by operating activities was a positive $35 million; dividend paid were $4 million; and purchased property, plant, and equipment was $5 million.

In summary, our second quarter performance was respectable, although gross margin declined year-over-year as we continued to play catch up on pricing, incremental progress was made. We moved closer to our goal of reducing networking capital to 14 to 15%. We reduced operating expenses through both global cost containment initiatives, and benefits garnered from Lean Six Sigma, and we began closing the gap between the growth in our raw material costs and our implemented price increases. Consequently, we are raising our 2005 earnings expectations. We now expect full-year earnings per share on a fully-diluted basis to be in the range of $1.75 to $1.85 per share.

With that, I would now like to turn it over to Al.

Thank you, John. And good morning to all of you on the conference call. Second quarter developed pretty much along the expectations that we had for the market at the time of our last conference call. Raw materials continued their strong upward movement and our pricing actions gained additional momentum, but we're not yet able to make up entirely for the rapid rise in many of our costs related to transportation, packaging, and various chemistries that we purchased.

In general, we can observe that price increases are finding greater acceptance, and we also see that pricing actions are now taking place on a broad base. The latter is, however, a more recent development because during the last quarter several large competitors gained some market share because they were willing to continue to supply products at prices that did not take into account the escalation in raw materials.

We believe that our decision to put our emphasis on passing through the increased costs was the right decision and that we will be able to regain some of the accounts that may have switched suppliers at conditions that are more in line with our cost structures in the quarters ahead. Even in Europe, where we have seen the greatest reluctance to get to higher pricing levels, we are now finding a somewhat more receptive environment.

We expect that cost pressures will continue in the third quarter and carry through the remainder of the year. Several industry observers believe that the recent drop in benzene, propylene, and styrene are temporary adjustments and do not signal a trend change. Certainly, in the derivative products that are supplied to the adhesives industry, we have not seen a drop in prices as you can see from our gross profit margins. Current with our efforts to pass through increases, we're making good progress on cost containment and in generating benefits from our Lean Six Sigma roll out.

Our operating expenses as a percent of sales declined 1.2 percentage points from the level we had in the second quarter of last year. As John indicated in his comments, this quarter includes $2.6 million of operating expense related to our IT outsourcing and certain other business reorganizations.

By the end of this year, we will have trained more than 1,000 employees in the Lean Six Sigma methodology. It is obvious when I go around the Company and discuss with people how they are going to achieve their objectives and implement their strategies, that Lean Six Sigma has become an integrated part of how they run their businesses. I am convinced that our Company has come a long way in its transition to become a leaner and more effective organization. One that is attuned to the needs of its customers, and that can build value for both its customers and itself by having a disciplined and fact-based decision-making process.

This is also evident in our creation and introduction of new products for existing and new applications. I may have mentioned before that this is not an industry that is likely to develop blockbuster new products, but it certainly is a business where we can continue to develop and introduce products that provide unique properties and allow our customers to improve their processes as well. In the aggregate, these new products now constitute more than 17% of our total sales and are helping us in achieving healthier margins.

Turning to our two business segments, we experienced good growth in Full-Valu/Specialty as well as in Adhesives. In the second quarter, we increased our sales in our Full-Valu/Specialty business by 7.2%. In construction-related brands like our tech, ceramic tile installation products, and insulated glass products had particularly strong growth. Price increases in most businesses and regions represented 4.6 percentage points of this growth.

Our paints business in Central America found itself battling a surge of off-spec or H material coming from liquidators that buy out-of-date stock from the U.S. often with U.S. brands still on the label, and dump it at severely distressed prices into these markets. We are working with the local government authorities and hope to be able to resolve this issue soon.

Demand in powder coatings was weak, but we saw a broad-based effort at raising prices, which may have had an impact on the demand. Many of the applications that we serve have also seen some migration to lower cost manufacturing countries. After more than 20 years of uninterrupted growth the last couple of years in powder coatings, have been flat to slightly down. Within adhesives, we achieved 6.7% growth including the deconsolidated results of our Japanese operations, the comparable growth would have been 9.3%.

With the emphasis on pricing, a significant portion or 7.5% came through higher selling prices. All regions showed solid price movement. The various regions differ of course somewhat because the raw material cost development had a distinct regional profile as well. Latin America and North America had the highest increases in both raws and selling prices, and Europe and Asia are now seeing a similar pattern, but running several months behind.

Demand for product in North America and Latin America stayed at a pretty good level and is reflective of the overall economy in those regions. As I said earlier, in our efforts to increase our selling prices, some of that strong demand went to companies who elected to take advantage of the situation, even though I fail to see how that might be economically attractive. The business that we lost was mainly in the lowest margin categories where there was a lot of upward raw material cost pressure. Continuing at the old prices would not only have been uneconomical, but also would not have been in line with our successful pricing actions in general.

Europe is having a real difficult economic environment, and some of the promising signs of increasing demand and output we saw earlier in the year are disappearing quickly. However, our business is progressing well despite these challenging conditions. Company-wide actions with regard to cost control and benefits from Lean Six Sigma are giving us a helping hand in achieving our financial goals despite some strong local competition. In particular, the mainland-based [ph] competitors have been very slow in reacting to the run-up of raw materials.

In Asia-Pacific, the joint venture with Sekisui in Japan is now established and the integration is going well. We are convinced that this step is going to reinforce our position in the region and our customers will benefit from Sekisui's strong position and reputation in Japan, combined with H.B. Fuller's global scope and technology portfolio. Later in the quarter we also completed the sale of an interest in our operations in China to Sekisui. Here too, we have started to work with our partner to benefit from our respective strengths.

Within Asia, the Japanese market is relatively stable, whereas we have seen some softening in demand from China. Based on what I heard at a recent conference in Beijing, this is likely to be a temporary phenomenon because the longer term growth outlook for China remains strong, and this market appears to maintain its role as a driver for economic growth well into the future.

Given our strong balance sheet, we are pursuing several opportunities in the M&A area. We believe that the temptation of doing a deal has to be balanced by the economic feasibility and the interest of our shareholders. The operational capabilities that we have developed over the last couple of years give us a great deal of confidence that any acquisition can be absorbed and integrated quickly and efficiently. It also has given us the ability to have a more fine-tuned segmentation capability that allows us to make more intelligent choices. All M&A activities and opportunities are notoriously unpredictable, but we expect that some of our efforts will come to fruition.

As you heard earlier in John's comments, we think that the progress that we have made so far, together with the solid economic outlook for most of the regions, will allow us to improve the results for this year beyond the previously expected level. The combination of all the efforts to contain or reduce costs, the introduction and growth of new products, the culture change that Lean Six Sigma has brought together with a more conducive environment to recover higher raw material costs, are finally coming together to show the benefit of our efforts over the last couple of years to create leverage in our Company.

I believe that I have covered the main points and would now like to open it up for your questions.

[OPERATOR INSTRUCTIONS] Your first question comes from Jeff Zekauskas from J.P. Morgan. Your line is open.

Hi. Good morning.

Good morning, Jeff.

A few things. Just on the housekeeping side, where does the 2.9 million charge fit into the income statement?

Jeff, this is John. 2.6 of it is in SG&A and 300,000 is in cost of goods.

In general, when I look at the operating performance of the Company, the gross margins are still under pressure, yet what you've done is you've increased your earnings expectations for the year. Does that primarily reflect your view about continued pricing improvement or is there something else behind it?

I think, Jeff, I've mentioned before, that what our results reflect in general, of course, is a combination of what's happening in raw materials and what's happening on the pricing end.

Yes.

And there is a time lag sometimes in getting our prices up at the same level as raw materials have coming up -- have been going up, and what we've seen in the last quarter is that we are gaining on the pace that we have seen over the last couple of quarters, and that gives us the confidence, especially when we look at what's happening in the last part of the quarter, that we are able to make up some of the lost ground.

Okay. And then sort of a last question is, your margins in Full-Valu/Specialty were down this quarter year-over-year, what's the reason for that and do you expect there to be improvements in that area?

Full-Valu/Specialty did get a 1.5 million of the total 2.9 million charges. So that certainly had an impact on it. And I also mentioned and commented briefly that we saw some volume issues in the paint business in Central America because of the dump product from North America, but we believe that we will be able to correct that situation fairly quickly.

Thank you very much.

Your next question comes from Ray Kramer from First Analysis. Your line is open.

Good morning, guys.

Good morning.

A couple questions. I guess, first, a little bit on the competitive front. You mentioned, at least during the quarter, you were seeing, especially from the big players, a willingness to trade price for volume. Are you seeing any change of that as you get into the August quarter here or any signs that that may be improving?

I would say that in the first part of June we certainly saw a much more -- a much more intense effort on the part of some of those competitors that were still trying to gain volume in the second quarter to become a bit more price conscious.

Okay. And then secondly, looking at this second quarter, it looks like a lot of your strength and the driver from the strong results came from trimming down SG&A expense. Is that -- it sounds like from what I hear that's a lot of the Lean Six Sigma and cost-cutting stuff. So should 19 and change be sort of a typical range we should look for for SG&A expense going forward or there were some sort of more one-timish things in there?

I believe, Ray, if you look at the results for this last quarter, and you take out the additional charges that we had of 2.0 million, you already come at a rate of about --

19.6.

-- 19.7 or 19.6%.

So you're saying that's easily sustainable.

Well, "easily" is a moniker that I would not put to it. But I think that certainly shows that we can do it.

Okay. And then just finally, in terms of your M&A activity, can you share with us any specific areas that you're focusing on there or certain types of acquisitions you would like to make at this point?

Well, I believe I have commented in the past about the directions that we are pursuing, and the Adhesives side it clearly would be consolidation play, and the Full-Valu/Specialty area, it's market extension, either geographically as well as product lines. And that's really all I can say at this point. I mean, you know very well that most of these discussions take place under secrecy agreements, and therefore, are not really to be discussed in a public forum.

All right. I understand. Thanks a lot.

All right.

[OPERATOR INSTRUCTIONS] Your next question comes from Robert Kirkpatrick from Cardinal Capital. Your line is open.

What is the capacity of Fuller to digest a large acquisition? Is there a calculation that perhaps John could provide us that would let us know what the maximum size is of an acquisition that you could digest at this point?

Robert, how are you?

Fine thanks, John. Yourself?

Good. We've done those calculations and I think as you heard from the call, we have a lot of flexibility where we are right now with the deleveraging of our balance sheet and the availability to borrow funds, obviously, a very conducive environment as everybody knows with the current interest rate scenarios. But I think we could confidently and comfortably, as Al alluded to, with the skill sets that we put in the organization in the last two or three years, digest an acquisition somewhere well north of 500 million. I would say somewhere in the $500 to $800 million range.

Great. That's what I'm looking for. Thank you so much.

You're welcome.

Your next question comes from Richard O'Reilly from Standard & Poor's. Your line is open.

Good morning, gentlemen. I'm sorry, just going to ask you to repeat the operating profits by the two segments.

Just one second, please. I am just trying to get the data. John, would you --?

15 million.

15.

15 million for the Global Adhesives, okay? Which was versus 13.2 for the second quarter of '04. And then for Full-Valu/Specialty, 6.1 million versus 9.2.

Okay, fine.

Q2 of 2004.

Okay, good. And the Specialty included 1.9 of the severance charges?

No. The Specialty -- the break out of the 2.9, 1.4 was related to Global Adhesives and 1.5 was related to Full-Valu/Specialty.

Okay, fine. Thank you then.

You're welcome.

Your next question comes from Jeff Zekauskas. Your line is open.

Again, just a couple of housekeeping issues. So are the net nonrecurring gains $0.05? So that if the operating results were really $0.51 in the quarter; is that correct?

Jeff, let me give you the bridge, just so we're clear. If you take our reported EPS the 56, you obviously strip out the gain on the sale of China, which was 11 and then you would add back the 2.9, which is basically the restructuring in the IT costs that we mentioned, and that would get you to $0.51.

$0.51. Can you give me the volume growth by geography?

No, we don't provide that information.

Or just some sort of rough sense of where your volumes are growing and where they're not?

Well, volumes are basically growing overall for the Company, but very slightly. But we are seeing in particular, in North America we saw a weakening of the volume in Adhesives and that was mainly related to the pricing actions that I described.

Yes. I guess another question for John, the -- in the income statement I think the asset gain is listed at 5.005 million, if I remember that correctly, but in the commentary in the press release, you talk about a $4.8 million gain.

Correct.

Can you reconcile that for me?

We had another small $200,000 real estate transaction down in Australia.

Okay. All right. In general, what you've said is that you haven't really seen any raw material price decreases. Is that true all the way across the board or are there smaller items where you have begun to see things come down?

As you know we buy thousands of items, so I am sure there was one or another that had a slight decrease, but if I look at the basic raws that are driving our costs, and like for instance benzene, you saw some weakness earlier in the quarter, but they began to rebound lately. Propylene in Asia just went up $100. Increased purchases in China, along the styrene and polyester chains are going to put some pressures on those lines.

We also believe that the methyl methacrylate balance is expected to tighten in the third quarter. And if I go one step further and look at the raw materials for the Adhesives side, we see particular continuing upward pressure on MDI, on acetone, butadiene, isoprene, titanium, resins, [inaudible], so it is fairly broad still at this point in time. And I believe that certainly from as far as we can see it at this point in time, there is no indication that this is really going to slack it off pretty soon.

So when you increased your guidance, you didn't put in a raw material decrease component, it really had to do with your pricing actions.

That's correct.

And your cost cutting efforts.

That's correct.

Though I must tell you we're much less sparish on your raw material costs than you are.

If you are correct, then we're going to get some benefit from it.

Okay. Thank you very much.

Your next question comes from Robert Kosowsky from Sidoti. Your line is open.

Good morning. I was wondering if you could comment on the gross margin trends of the particular regions -- the specific regions.

Well, again, we generally do not report on the regional gross margin trends. Typically, the gross margins in Europe tend to be a bit higher than in North America, but also then operating expenses, because of the multinational infrastructure in Europe, tend to be a bit higher. So in the end, it is not really that significant and I believe that certainly a bit of the impact on what a particular region is having, as far as gross margin, is also dependent on the product mix. So it really varies all over the place, but I would say, generally, the pricing for Adhesives tends to be fairly global in scope and fairly global in nature.

Okay. So we can kind of extrapolate the trends on the Company as a whole for the different regions kind of uniformly.

Yes.

And we'll be looking for kind of a flat volume estimate for the year? Do you think it might be down a little bit?

That's really, of course, at this point in time, still one of the uncertainties that we're looking at and we are projecting at this point in time that some of the losses that we've seen in the second quarter are, of course, not going to recur, and remainder of the year and we will have a fairly stable environment.

Okay. Thank you.

[OPERATOR INSTRUCTIONS] Your next question comes from Robert Kirkpatrick from Cardinal Capital. Your line is open.

A follow-up question about the joint venture that you formed. Could someone review the cash impact of the formation of the joint venture? I realize that you booked a $4.8 million gain, but I'm just not sure what the cash impact of all of this is.

Let us get the information.

Robert, this is John. The proceeds of that was $8 million. And then the gain ended up being what I reported at 4.8, which incorporates, obviously, our book basis, and then the correct accounting reflecting the option two years in the future. And then, obviously, that's subject to effective tax rate over there which is slightly higher than our U.S. rate, which is what drove my rate slightly higher for the quarter.

Super. Thank you so much.

You're welcome.

I am showing no further questions at this time.

We would like to thank all of those who took the time to listen and participate in today's conference call. Since there are no more questions, we will conclude this call. Thank you very much.

Thank you.

This does conclude today's conference. You can disconnect at this time.