Materion Corp (MTRN) 2007 Q3 法說會逐字稿

Greetings, ladies and gentlemen, and welcome to the Brush Engineered Materials' third quarter 2007 earnings conference call.

At this time all participants are in a listen-only mode. A brief question and answer session will follow the formal presentation. (OPERATOR INSTRUCTIONS) As a reminder this conference is being recorded.

It is now my pleasure to introduce your host, Mr. Mike Hasychak, VP, Treasurer and Secretary for Brush Engineered Materials. Thank you, Mr. Hasychak, you may begin.

Good afternoon.

With me today is Dick Hipple, President, Chairman and CEO, John Grampa, Senior Vice President, Finance and Chief Financial Officer, and Jim Marrotte, Vice President and Corporate Controller. Our format for today's conference call is as follows. John Grampa will comment on the third quarter 2007 results and the outlook, and Dick Hipple will give a market update. Thereafter we will open up the teleconference call for questions.

A recorded replay of this call will be available until November 9, 2007, by dialing (877)660-6853, account number 286, and conference I.D. 257973. The call will also be archived on the company's website BEMINC.com. To access the replay click on "quarterly earnings conference call" under the investors page. The broadcast requires Real Player software which is available as a free download from the icon as indicated.

Any forward-looking statements made in this announcement including those in the outlook section and during in the question and answer portion are based on current expectations. The Company's actual future performance may materially differ from that contemplated by the forward-looking statements as a result of a variety of factors. Those factor are listed in the earnings press release issued this morning.

Now I will turn it over to John Grampa for comments.

Thank you, Mike. Good afternoon, everyone, and thank you for joining us today.

As in the past I will review the quarter and then comment on the outlook, and then following my prepared comments Dick Hipple will provide you with a market update, then we'll open the call for questions. I'll attempt to adequately reinforce and expand on the key points made in the press release about the quarter. I'll comment on seven specific points.

First, the continued strong organic growth and what drives it, including what we currently expect will drive it looking forward. Second, the specifics of the growth in media. In sales dollars terms as well as in volume terms. Significant swings in ruthenium material prices can and have dramatically affected the reported sales dollar growth here, and it's important to talk through volume which is a better indicator of what is happen with the perpendicular media recording launch.

Third, I will talk about the margin benefit related to the sale of product containing the low cost ruthenium inventory that was in the production system at the beginning of the year. In this and in the coming quarter the impact is far less significant than it has been to date as this material has almost entirely cycled through the system. Fourth, I'll talk about the one time factors related to the ramp up of the new ruthenium based materials and the impact that that has had on our results to date.

Fifth, we'll discuss the volatile cell phone handset market and the lower than expected third quarter demand for our engineered alloy segment products in certain portions of this market. Sixth, I'll review our operating margin levels as well as our expectations for operating margin looking ahead. And finally I'll review the effect of the tax rate changes in our year-over-year operating result comparisons.

Following my comments on those seven points, I'll review the outlook whereas identified in the press release we are currently seeing good improvements in that two areas that were weaker than we had expected coming into the third quarter. Both our reversals of the trends were demand for our new materials from the perpendicular media market as well as demand for engineered alloys for the cell phone handset applications were weaker earlier in the third quarter.

Let's begin, first, reviewing growth. As you know this morning we reported sales that were up 15%, or about $31 million, to the $231 million level. This was the 19th consecutive quarter where sales were higher than the comparable quarter of the prior year and the eighth consecutive quarter where our sales growth was greater than 15% above the comparable quarter of the prior year.

Metal price inflation, or said differently, that portion of both precious and non-precious metal price increases that we were able to pass on to customers in the quarter had far less of an effect on the reported sales increase than in prior periods. Approximately two percentage points of the reported 15% growth is metal price pass through, thus real growth or, if you will, organic growth, was approximately 13% in the quarter.

Year-to-date, sales are up 29%, or about $160 million. Metal price represents about 4% of the year-to-date growth, thus organic growth was approximately 25% in the first nine months of the year. We continued to see solid growth in many of our key markets in the quarter. Growth of our new products remained very strong. I'm going to address the media market here and Dick Hipple will follow later with additional comments on the media market as well as comments on our other markets and our other new products.

Turning to media. As you know the most significant factor driving our growth in 2007 is the growth of our new ruthenium based magnetic media materials for the perpendicular media recording segment of the data storage market. The growth here is driven by the rate at which the market and our customers in that market transition to the new perpendicular media recording technology and our ability to capture a significant share of that business.

These materials accounted for approximately $28 million of our growth in the third quarter, reaching a sales level of approximately $35 million in the quarter. This brings the year-to-date sales to about $130 million. That represents approximately $115 million, or over 70% of the Company's $160 million of sales growth to date.

You'll recall that following a strong product launch in the first quarter, second quarter demand levels were driven down by a combination of factors including some softer hard disk drive demand levels, slower than expected perpendicular media recording transition rates, inventory corrections due to supply chain filling during the initial ramp up in the first quarter, and some temporary loss share due to the internal issues we had in the second quarter. Many of the factors that drove the second quarter demand to below the first quarter levels began to reverse themselves coming into the third quarter.

While we didn't enjoy the third quarter demand level we thought we'd see coming into the quarter it was clear by the end of the quarter that demand levels had increased significantly. Average ruthenium prices which are a pass through were significantly lower in the third quarter on average compared to the first and second quarter. Thus, while sales dollars were up about 15% compared to the second quarter, actual volume shipped, which is a better measure of our growth in this market, was up 65% in the third quarter compared to the previous quarter, being the second quarter.

We currently expect similar volume growth in the fourth quarter compared to the third quarter which will result in the fourth quarter being the strongest quarter of the year in this market. For the full year, then, given what we currently expect for the fourth quarter, total sales into this market should reach the $180 million to $190 million level depending on metal prices.

Moving on to the one time inventory margin benefit. As for the margin benefit related to the sale of the product containing the low cost ruthenium inventory that was in the production system at the beginning of the year, you'll recall this was a cash benefit of $0.52 a share in the first quarter and $0.14 a share in the second quarter. By the ends of the second quarter we had sold nearly all of this material. The third quarter benefit was approximately $0.04 a share, bringing the year-to-date to $0.70 a share cash benefit. There was no additional lower of cost or market charge in the third quarter.

Turning to the non-recurring ramp up factors in the media market. The total of the non-recurring factors related to the ramp up of the new ruthenium based media materials is approximately $0.42 year-to-date. This includes the $0.70 benefit from the inventory that was in the production system netted by the $0.28 cents in charges taken in the second quarter for the reduction in market price of ruthenium and the ramp up quality issues we encountered then. In addition, there was a $0.02 a share charge taken in the first quarter related--in the first quarter related to the sale of a small non-performing subsidiary. The total net non-recurring P&L benefit through the third quarter is thus approximately $0.40 a share and at this time is forecast to be approximately $045 a share for the year in total.

Moving to the alloy cell phone handset volume. As you know the cell phone handset market has historically been one of our most volatile and unpredictable markets. We serve this market with products for specific customers and specific applications from both our Williams Advanced Materials unit and our specialty engineered alloys business.

Williams Advanced Materials continue to see strong growth in this market in the third quarter. But while the overall handset market was strong in the quarter, the products and applications we supply from the specialty engineered alloy segment of our business did not live up to our expectations in the quarter due to inventory corrections, some design out to lower cost materials and lower demand for our customers handsets. As with the magnetic media market there was noticeable improvement in orders here as the quarter came to a close.

Before moving on to the outlook I want to comment briefly on the remaining two items, our operating margins and our tax rates. The third quarter gross margin was 20% compared to just under 20% in the prior year, and the year-to-date gross margin was 22% compared to about 20% in the prior year. The year-to-date gross margin percent is favorably affected by about two points due to the non-recurring factors that I reviewed a few minutes ago.

Other factors including the Company's business mix which today includes significantly more higher priced material and lower production levels affects gross margins negatively compared to the prior year. Lower production levels in specialty engineered alloys driven by softness in the wireless handset application also negatively affects gross margins as well. In spite of these negative affects, gross margins still improved in the quarter compared to the prior year.

A 20% gross margin level is a more normalized measure of the gross margin to expect in the near term given the new business mix which includes a higher and growing proportion of the high priced ruthenium metal and other precious metals in it. I also want to reinforce today that in our company, operating profit is a better measure of profitability than gross margins due to the precious metal and other expensive metal content that is now in the top line.

Operating profit percent without the impact of the sale of the ruthenium inventory, the lower of (inaudible) market charge or the charge for the production issues noted in the second quarter is approximately 7%. This is a more normalized run rate of the operating profit percent to expect in the near term and is up 150 basis points compared to the prior year. While the improvement is in a large way due to the top line growth we are seeing, it is important to point out that it's also in part due to the ongoing efforts to control the growth of overheads and SG&A required to support the organic growth.

Finally, the reported income tax rate increased significantly in the quarter. The increase in the reported rate affects the year-over-year comparisons significantly. The rate change compared to the prior year is principally due to the significantly higher level of income as well as a reduction in foreign source income benefits. The reduction in foreign source income benefits is tied to statutory changes.

The additional tax affects the third quarter earnings comparison by approximately $0.08 per share and the full year comparisons by approximately $0.19 a share. Note, though, that while our current tax rate is approximately 36%, our cash taxes are in the 15% to 16% range for the current year and are expected to be in the 20% to 25% range for 2008.

Now I'd like to turn to the outlook. As I noted earlier, coming into the third quarter, the Company expected stronger sales of both magnetic media materials and specialty engineered alloys for the cell phone handset markets. Conditions in both of these areas disappointed us early in the third quarter, but both improved nicely late in the third quarter. August was stronger than July and September was stronger than August.

Assuming that these conditions hold, the Company at this time expects sales and earnings levels for the fourth quarter of the year to be stronger than the third quarter. The current expectation is for the fourth quarter sales to be in the $245 million to $255 million range, up 18% to 23% compared to the same quarter of the prior year. Earnings are expected to be in the range of $0.50 to $0.60 per share.

It's important to continue to reiterate, though, that these sales and earnings estimates are subject to significant variability such as that demonstrated in the most recent quarters. Metal prices, metal supply conditions as well as fluctuations in demand levels driven by inventory swings in the market and new product ramp up rates in critical markets such as the media market can have a significant effect on actual results. The outlook for the quarter is based on our best estimates at this time and are subject to significant fluctuations due to those factors.

Now I'll turn the call over to Dick Hipple who will review the state of our key markets and their outlook.

Thank you, John.

First I'd like to say that I'm pleased with our ongoing progress with our organic growth and profitability with 19 consecutive quarters with sales higher than the comparative quarter of the year earlier and our 40% increase in net income. In spite of this progress our third quarter was challenging from several perspectives.

First, as we had a difficult time in predicting the speed at which sales would rebound for us in the magnetic media market resulting from the market inventory adjustment and our brief ramp up production issue in the second quarter. And second we experienced softer sales than normal summer seasonal declines in our alloy strip sales going into the consumer electronics market. Inventory adjustments and impacts at a major customer were key issues. Also we are seeing increased application penetration by less expensive alloy systems as cell phone producers cost down their designs.

In our Advanced Materials segment in the third quarter we saw solid strength in the wireless, semi-conductor and photonics markets. So overall in our consumer electronics markets we began to see across the board improvements in September and expect a solid fourth quarter.

Although our magnetic media sales for hard disk drive generally fall into the consumer electronics market they are not following normal macro industry patterns due to the industry conversion to PMR technology. We expect to see stronger sales in the fourth quarter as we continue to ramp with PMR conversion in the hard disk drive market.

As you may be aware, magnetic media has three primary types of layered materials, the ruthenium layers, the SUL, or soft underlayer, and the oxide recording layer. We are well-established in the ruthenium layer and are shipping materials to several customers in the SUL layers. Our next qualification initiative is the oxide layer which we are making good progress on and I hope to bring you good news on this front during our next conference call.

In our heavier industrial markets such as oil and gas and aerospace, we have continued to experience solid conditions. We have seen a leveling off, although--although at a strong level in the oil and gas market. Drilling activities have reached a peak as there was a need for additional rigs. So in the meantime we expect to continue to grow through new applications in this market.

Our BE & BE composite segment is having a very strong year. We saw a few defense order cancellations in the second quarter which raised some concerns, but these turned out to be isolated events and we continue to experience strong order rates. I'm very pleased with the progress in this division with respect to their success in gaining new specialty applications in both the defense and commercial markets building an even stronger base for the future.

Our engineered materials systems segment, or TMI, relies on two major markets, the automotive and telecommunications market. We have been surprised by the strength of the automotive market in the third quarter and this strength appears to be following through to the fourth quarter. Some of this strength is derived from some new applications that drive our sales to higher levels. Also the new clad hard disk drive arm application continues to be designed into additional platforms resulting in higher sales.

Our new high technology processing center at TMI is now being completed which will provide for additional growth from new--for new market opportunities. And finally we continue to move the ball forward in increasing our international growth, our international sales are now 40% of sales year-to-date as compared to about 34% last year, and as I've stated earlier I'd like to see this exceed 50% within the next several years.

And, moderator, we will now take questions.

Thank you. (OPERATOR INSTRUCTIONS)

Our first question comes from the line of Avinash Kant with Broad Point Capital. Please proceed with your question.

Good afternoon, Dick and John.

A few questions, maybe I didn't catch the number right, the ruthenium numbers for the current quarter were how much, 35 or $45 million.

$35 million, approximately $35 million.

And you said so far for the first nine months they were $130 million?

In the first nine months?

Yes.

That's correct.

So could you give me the quarterly break down in Q1, Q2 and Q3?

I don't have that with me here, Avinash. I think it was about $85 million for the first two quarters and $35 million or so in the third quarter.

So 85 and 35 will get to 120, not 130.

Talking about the growth or the gross number?

The absolute number.

The absolute number is $130 million.

That's what I'm thinking. If it was 85 in the first two quarters and 35 in the third one, it should be 120, not 130.

No, the total for the three months is $130 million. The growth is $115 million. So you must have a difference between growth and the raw numbers. The first two quarters growth was $85 million.

So growth was 85?

Growth was 85.

I see.

It was 95 in the first two quarters, growth of 85 and an additional $35 million in the third quarter which is growth of about 28 to 30.

I see. It was like 65 and 30 in the first two quarters.

Something like that, yes.

And now it's getting back to 35?

Yes, but what's important here is not the raw sales dollar value, what's important is the ounces because of the significant differences in average metal prices in the three quarters that we have in the year, metal prices have moved around significantly. What's important is the comment that I made about the unit volume growth and I won't give the specifics on the actual unit volume but as I indicated third quarter unit volume was 65% ahead of second quarter and we expect that the fourth quarter unit volume will be another 65% ahead of the third quarter, that's what's really relevant in this market. Ruthenium material prices have moved around. It affects the top line but that does not affect the value-add or the profit.

I see. I see. And the weakness that you're talking about, the handset market, that seems to be specific to your customers. Could you highlight how much of the weakness is because of other materials are coming in or because your customers are not doing well, could you kind of that parse that out?

Well, again, I think, Avinash, and that's not a total company question, that's only isolated into the specialty alloys business because, again, we participate in the handset market both at Williams and the alloy business. So we haven't seen any negatives there in the Williams business, and the alloy business certainly one of our major customers is Motorola and certainly we all know what's gone on with Motorola and their press releases and their volumes and their market shares and so that's had a significant impact on us, and they were, they were a significant factor in our supply chain.

So that's a key issue and then the other one is--and I think you can see this on all the handset producers whether it's the recent reports from Motorola or even from Sony Ericsson, volume is up, profit is down. So there's a hell of a lot of pressure out on the supply chain right now on reducing cost of phones. So we are losing some applications there because of that but at the same time things are getting smaller and tougher so there's a balance between all that but I'd say we've seen some stunted growth right now in the alloy business because of that.

And, of course, the move towards the lower end cell phones especially in India and China, is that a contributor to what is happening in terms of lower cost materials getting in?

Oh, absolutely. Because we are going to play in the more sophisticated handset, so as the volumes go up and they are selling more phones into areas where they are less concerned about the longevity or reliability, certainly they are not going to use the upper end materials for those phones.

And just to clarify, you said in the current quarter had you a $0.04 contribution from the sale of ruthenium, would that be a one time or--?

The inventory--that's correct, the ruthenium inventory that was in inventory at the end of 2006.

So ex that, if I had to look at the operating for a fair comparison it should be like 42--?

Well, no, I think you could do that if you want. There were other factors probably that occurred in the quarter. If you're after a run rate I would think that the reported number is a good number for a run rate.

Okay, so I will just keep that. Perfect, thanks so much. I will ask more questions once people have asked them. Thanks.

Thank you.

Our next question comes from the line of Bob Schenosky with Jeffries, please proceed with your question.

Good afternoon.

Hi Bob.

First question for Dick, on top of the last question there, what types of metal products are you seeing losing share at the sake of other types of products coming in?

Well, the normal products that are out there would be high phos bronze, there is copper nickel silicons, there is copper titaniums, there is a lot of products out there, and again they don't have the equivalent property set as the copper beryllium side but if an engineer works real hard in some instances he can get a design change and use a lesser quality material.

And how much do you think that that's impacted you here?

I would say that--I like to put it in these kind of terms, Bob. The connector market itself is growing at around, probably this year we will see about an overall 8%, 10% growth in the connector market, and the strip business, this year is down a little bit. So that although we are still gaining new applications we are not growing with the marketplace. So that reflects some of that substitution going on.

Okay, and then secondly you talked about your cash tax rate and given your cash relative to your debt position, what can we expect if anything this year in terms of commentary on what you are going to use cash for or more likely '08 since we really haven't heard--really heard anything to date in terms of acquisitions or the shareholders?

I guess our first priority, Bob, as we've stated is the organic growth side and we do have some exciting thing that will be unfolding organic growth which would being capital investment internally but nothing what I would call huge at this point in time but still we have some great opportunities for organic growth. We have been working very hard and still are on the acquisition front.

As you know we have not made an acquisition since early 2006, but also we are being very careful that when we do make that it's going to be--we hope to be accretive very quickly and it's also going to fit very strategically within our business portfolio. So we've had a couple of opportunities and we passed on them quite frankly because we didn't think they were the right fit. So it's an area that has a lot of energy with the Company right now and I do expect and I hope that in the next--near future we are going to see something unfold here.

Okay, and then finally and I don't want to misquote John, but if I'm correct after the last call the commentary was made that you could see similar type top line growth in '08 over '07 that you could in '07 over '06. Is that still consistent?

That's correct.

Okay. Thanks, guys.

Thank you. Our next question comes from the line Chuck Murphy with Sidoti. Please proceed with your question.

Good afternoon, guys. As far as the $0.04 benefit that you got and kind of going back to John's commentary about looking at 7% as a normalized operating margin for the near term, I mean, how do those two jive? Are you still, even though you won't have that $0.04 benefit going forward you still feel comfortable with 7% and what should we look at as we go into '08 on the kind of operating margin we can expect?

I think two things. Let me reinforce our stated goals which are that we believe we can improve our operating profit percent in this company by about 100%--100 basis points or one full percent a year. The 7% number, a current run rate number is already adjusted for those one time items.

Okay.

Okay? So I think the normal run rate right now is about 7%. I think if you look at the consolidated data you see a different number because of the one time items, I net those one time items out of that.

Okay.

7% is a run rate.

Okay, and then as far as the other layers of the hard drive, the soft underlayer, the oxide layer, how should we think about that as--in terms of how large of an opportunity that could be for you?

Well, the oxide layer is about a one to one ratio to the ruthenium layer in opportunity, and the SUL layer is actually greater than that but there's differences in property sets and difficulties in margins between those layers. I would say we are most excited about the oxide layer and what that may bring to the Company.

And is the competitive environment the same as it would be for ruthenium, will it be more difficult for you to take share or no?

Well, there's not a lot of players in the marketplace so I would say it's very similar.

Okay.

And it's important to reinforce that these are 2008 opportunities, not 2007.

Sure, sure. Okay. All right, that's all I had. Thanks.

Thank you. (OPERATOR INSTRUCTIONS) Our next question comes from the line of Mark Parr with KeyBanc. Please proceed with your question.

Hi, this is Philip Gibbs calling in for Mark, how is everyone?

If I remember correctly you had stated last call that your normalized, or your run rate for your gross margin you'd like it in the 22% range, and this quarter had you mentioned 20, I just want to know incrementally, I know you had cited some mix in there but incrementally what has changed in those assumptions? And I'll get off and listen. Thank you.

I think what's different, we are talking about the 20% is the near term run rate is reflective of the higher proportion of the precious metal and ruthenium based materials in the top line vis-a-vis the other copper based kinds of materials. So that by definition when you drive that into the top line our gross margin gets put under stress, and when you consider the implication of the reduced third quarter copper based alloy business and the higher third quarter relative ruthenium level business, for example, along with the precious metals that's where we ends up with around 20. 22% going beyond the current couple of quarters is certainly within our target, it depends again on mix.

Thank you very much.

Thank you. Our next question comes from the Avinash Kant. Please proceed with your question.

Yes, some follow-up questions for John and Dick.

Typically on the consumers and the semi-conductor driven businesses, the third quarter and fourth quarter tend to be pretty strong and there's usually an inventory situation in the first quarter. Should we expect something like that for your side of the business?

Well, I think that's a tricky one because that all depends, and it all depends on how have the Christmas sales gone and have the producers over built or under built as a function of the ultimate Christmas buy. So I can say that can go either way. We've seen some very strong first and second quarters and we've seen some adjustments, and so it all depends on what that hit rate is around Christmas.

What I'm trying to understand is that, could your oxide business that you are talking about, could that start to come in early during the year just in case there was some unit shipment demand slow down to offset that slow down in Q1?

Well, I look at that as a totally different situation. Again, when I take a look at the media market, at this point in time it is kind of separated from what I call macroeconomic conditions because of the ramp that's going on which is the technology change issue. It's kind of got nothing to do with it. So if we are successful in the qualification for the oxide layer, no matter what's going on in the market we should see growth in that, or hopefully early next year.

That's what I'm trying to see. Could the timing of that be early next year you would start to generate meaningful revenue from that?

That's what we are trying to achieve. It all depends on how we do with the qualifications here in the fourth quarter.

And I know that at Motorola you've been in Razor phone, are you in Razor two?

Are we in Razor two?

We are a strong supplier into the Motorola cell phone market, yes. That's -- that's, that razor is cut both ways.

Okay, perfect. Thank you so much.

Thank you. Our next question comes from the line of Phil [Tillau] with Kingdom Capital. Please proceed with the question.

Hi, guys, are you designed into the Apple iPhone and if so what's the dollar content per phone?

We are in the Apple iPhone and I--the dollar per phone, I don't have that. We are on a couple of connectors in that phone.

And what's the outlook for revenue from your work in thin film solar?

Well, that's too, too early. That's a major area that we've targeted for future growth. We do sell into that market today. It's not huge in revenue but we hope on a longer term basis that that will be a major platform of growth for us.

Thank you. There are no further questions at this time. I would like to turn the floor back over to management for closing comments.

Hi, this is Mike Hasychak.

We would like to thank all of you for participating on the call this afternoon. I will be around for the remainder of the afternoon answering any further questions. My direct dial number is (216)383-6823. Thank you very much.

Thank you. Ladies and gentlemen, this does conclude today's teleconference. You may disconnect your lines at this time. Thank you for your participation.