NN Inc (NNBR) 2004 Q1 法說會逐字稿

Good morning, ladies and gentlemen, and welcome to the NN Inc. first quarter conference call. (Operator instructions) This conference contains time-sensitive information and is intended for replay through May 6th, 2004. I would now like to turn the conference over to Ms. Susan Garland of the Financial Relations Board. Please go ahead, Ma’am.

Thank you and good morning. Welcome to NN Inc.’s first quarter 2004 conference call. If anyone needs a copy of this morning’s press release, please call my office at 212-445-8474 and we will send you a copy. Before we begin, we ask that you take note of the cautionary language regarding forward-looking statements contained in the press release. That same language applies to comments made on today’s conference call and live webcast available on www.fulldisclosure.com.

With us this morning is Rock Baty, Chairman and CEO and members of NN’s management team. First management will give an update and overview of the quarter, and afterwards we will open the call for questions. Rock, are you ready to begin?

Yes, thank you, Susan. Good morning, everyone, and thank you for joining today’s call. I have with me this morning Dave Dyckman, our CFO; Steve [Soy] our corporate controller; and Will Kelly, our CAO.

Today, Dave Dyckman will cover the first quarter results and I will conclude the call by commenting specifically on our progress associated with 2004 business objectives. I would now like to turn the call over to Dave for his analysis and comments regarding first quarter results.

Thanks, Rock. Revenues in the first quarter of this year were up 35 percent, or $20m, versus 2003’s first quarter. $15m of this increase was due to the contribution of [Andal] and the remaining $5m increase particularly reflects favorable currency translation. Excluding the impact of these two items, revenues were essentially flat versus the same period in 2003, reflecting gradually improving industrial related demand, however automotive related demand continuing at essentially flat, albeit good levels.

With regard to profitability, in summary it was a good quarter that was matched by the income statement effect of healthy inventory reductions. Gross profit, excluding the impact of depreciation, which I am required to remind you is a non-GAAP measure, was 22.2 percent for the first quarter of 2004, versus 25.8 for the first quarter of 2003. As mentioned, the inclusion of [Andal] and the impact of the inventory reductions more than account for the difference.

Additional dynamics affecting the 2004 first quarter gross profit margins include the negative impact of material inflation, and certain start-up expenses in [Slovakia] which were more than offset by cost improvements within each division.

Also mentioned in the press release, SG&A expense for the quarter was $2.5m higher than for the same period in 2003 and was related to [Andal], currency, start-up expenses and section 404 compliance work. All but $200,000 of this increase was expected and included in our prior guidance. The primary unplanned hiring expense relating to the company’s Sorbian Oxley 404 compliance work, which in conjunction with recently issued stricter requirements we now estimate will cost $1.2m for the year.

While roughly two-thirds of this $1.2m is a one-time expense, roughly one-third will be an ongoing, annual fixed expense for the business, which is a significant incremental cost to the company.

Diluted EPS of 19 cents in the first quarter of 2004 compared to the prior year’s first quarter EPS of 23 cents. Reaching this change, and starting with 2003’s first quarter’s EPS of 23 cents, we had the income statement effect of the inventory changes, were minus 6 cents. Start-up expenses for China, Slovakia and to a lesser extent [level 3] minus 2 cents. Material inflation, minus 1 cent and Sorbian Oxley section 404 related expenses, minus a penny.

These, partially offset by the benefits of accretion from the purchase of [Andal] and [inaudible], a positive 3 cents. Cost improvements, positive 2 cents, and all other items netting favorably to a penny, which builds to 2004 first quarter EPS of 19 cents.

Changing focus to capital structure, we are pleased to announce today that we’ve restructured our existing debt through the completion of a $40m private placement. The notes from this placement mature over 10 years, with principal reductions beginning in 2008, which quotes to a seven-year average life.

As mentioned in the release, the notes are at 4.89 percent. [Inaudible] from the placement are being used to pay down existing bank debt. Specifically, the placement enabled the company to lock in historical low, fixed interest rates for 10 years; immediately created $12m of availability under the company’s existing revolver, and reduced required annual principle payments 50 percent in each of the next four years, from $12m to $6m annually. With that, I would like to turn it back over to Rock.

Thanks, Dave. I’d like to conclude today’s call if I could by just commenting briefly on several updates with respect to our 2004 business objectives. Raw material fuel price update, second an economic demand outlook, third an operation update; and finally a structural cost and quality initiatives associated with Slovakia, China and [Level 3].

Beginning with the raw materials fuel price update. Although recent news associated with steel appears to be more stable and higher prices are actually coming down some, we’d like to make the point that the stability is still at much higher prices than we experienced less than a year ago. Our second quarter surcharges that we are currently experiencing in Europe for our steel consumption in Europe are in line with the original forecast we provided to you in February.

Again, based upon our best available information, we still believe that for a $2.1m after-tax impact, or 12 cents a share, will occur for 2004. We are successfully passing through those increases to our existing customers effective May 1st of this year, where contractually entitled to do so. As we also mentioned previously, however, the vast majority of the pass-through will occur beginning January 1st of 2005.

On the economic front, the demand as we mentioned in the release continues to be very good. We expect more of the same on into the second quarter. Economic improvements have occurred in the industrial segments of our served markets, particularly as we look into the second quarter, but those improvements are principally in Asia and North America, and to a much lesser degree in Europe.

As Dave mentioned, automotive remains relatively flat but still at very healthy levels, and we anticipate good capacity utilization moving forward into the second quarter of the year, as well as for the balance of the year.

With respect to integration of our newest acquisition, [Andal], we’ve made good progress with both cost reduction efforts and the overall integration of the business. The business is meeting our accretiveness to earnings objectives that we established and forecasted when we made the acquisition. Sales and marketing efforts are currently underway to expand the business to additional customers.

I would like to conclude my comments today by discussing Slovakia, China and [Level 3] together. Each of these three issues represents NN’s proactive long term, structural and cultural response to the realities of today’s competitive market. First Slovakia. We continue to be incredibly pleased with our decision to locate in Slovakia. It’s a great location, generally located in central Europe around most of our existing customers. We have an excellent management team and skilled employees in place. There is a good overall long-term cost structure in place with respect to doing business in Slovakia. We’ve established best practices not only in process but facility lay out, and it is true that we have a world-class facility in every way. The facility did begin production this month and is expected to ramp up production through the balance of the year.

With respect to China, again excellent progress is being made and we are on schedule. We have completed a site selection in [Punching] and [Majingsu] Province, some 50 miles northwest of Shanghai. Our location, of you were to draw 100 mile radius around our site covers the vast majority of our existing global customers.

We anticipate constructing 100,000 square foot plant to begin sometime within the next 30 to 45 days, and again we anticipate completion and production start up in the first quarter of 2005.

I would like to conclude, like Slovakia and China, commenting on Level 3. Level 3 is a direct response to meeting the needs of our customers ongoing requirements for cost, quality and service improvement.

Within the current environment, it is important to note that marginal year-over-year improvements are not sufficient to meet our customers and ultimately their customers and the ultimate consumer’s demand for value in today’s global business environment. We really expect nothing short of a cultural transformation in that end as a result of the Level 3 implementation. Combining the elements of [Lean Enterprise], [Sig Sigma] and Total Productive Maintenance we expect our employees through the development of new skills in all three areas to really deliver twice the rate of improvement in cost, quality and service from that of our global competitors.

This rate of improvement, as I mentioned, is an absolute requirement to meet not only our customers needs but concurrently deliver healthy rates of return and levels of profitability for our shareholders as we look forward three to five years.

It is important to note that our employees remain very enthusiastic throughout our global organization with respect to embracing the new skills and the new level of involvement that they are seeing as a process of Level 3 as it evolves. With that I would like to turn the call over to questions you may have.

Thank you. (Operator instructions) Our first question comes from Mr. Mark Par of McDonald Investments. Please go ahead with your question, sir.

Thanks. Good morning, guys.

Good morning, Mark.

First of all, just for a point of reference, it took me about 12 minutes to get onto the call this morning, so I don’t know what this company is you are using, but I offer that feedback.

Thank you.

Secondly, Dave, could you just review – I apologize, I missed some of this. Could you review the pluses and minuses that you were giving? I caught the 3 cent from [Adal], 2 cents from cost reduction and one cent positive from all other, but I didn’t get the other stuff.

Sure, let me start at the top, Mark. 2003, EPS is 23 cents. You’ve got the impact on the income statement or the inventory changes of minus 6 cents. Start-up expenses, minus 2. Material, inflation, minus 1. [Inaudible] minus 1. Accretion from [Adal] and cost improvements to all of our net lines.

So that would be the first then, minus 23. Just as a follow-up to that, can you talk about the inventory situation in terms of what makes that swing so much? I just don’t – I just need some explanation and some help here, some color around that.

Sure. In the first quarter of last year we actually brought inventories, not to the extent that we reduced them in the first quarter of this year, we had a 2 cent favorable untax, I think we talked about that in the release a year ago. You had a total of [inaudible], two of it was servable in the first quarter of last year. We are going the other way this quarter. Basically in Europe and as you know, there have been some dynamics and production ships between [Adal] and [Konkani] and it has given us some opportunity to reduce inventory levels. We also had healthy demand, so it was a good time to do it, and it is completely consistent and a little bit in advance, quite honestly, of the Level 3 and Lean Initiatives that are really beginning just to hit the plants.

So this 6 cents shift is just a reduction in absorption issues or fixed charge –

Exactly.

Okay.

Labor and burden issues. Favorable on Q103, negative in Q104.

Okay. What’s your sense of the impact of this in the second quarter?

I think it will be not nearly the delay as it was in the first quarter, but I would guess we’ll see – and this is purely an estimate – I would guess we might see 50 percent of that.

Okay. All right, terrific. Thank you very much and congratulations.

Thanks, Mark.

Thank you. Our next question comes from Mr. Larry Baker of Legg Mason.

Thank you. Good morning.

Good morning, Larry.

One housekeeping question. Tax rate, 39 plus in this quarter? Is that going to be the rate for the year?

No it won’t. We had some principally Italian driven mix impacts in the first quarter which we did forecast, Larry, but the rate more of a historic 37ish rate is the appropriate one to use for the year.

Okay. And then second, can you talk about the two start-up programs, what the expected volume would be as those approach full capacity, and how much of that do you think would be incremental as opposed to cannibalizing other facilities?

The initial volume in Slovakia, Larry, for this year was 100 percent and we anticipate revenue around €4m out of Slovakia this year, it is all incremental new business beginning in the second quarter. And long term, we anticipate more than 50 percent of the volume in Slovakia to be incremental business, and 50 percent coming from existing operations, principally in Western Europe.

In China, it is a very similar situation, about 50 percent of the volume coming – we don’t begin production until 2005, but our first year revenue forecast for 2005, while it is certainly not finalized is in the range of $5m to $6m. Our intentions there are to build a facility where 50 percent of the volume will be in new, incremental business in Asia as a result of locating there, and approximately 50 percent serving existing customers with existing business that we are serving out of our European or North American facilities.

What was the long-term –

You know, we really, Larry, have the ability to expand it very dramatically based on the needs of the marketplace and what happens in the marketplace over the next three to five years. We are building 100,000 square feet. We have the ability to add to that in China to the tune of almost doubling the size, around 70,000 additional square feet. In Slovakia, we currently have 140,000 square feet with the ability to expand it up to and including almost 200,000 square feet.

That kind of square footage allows us to produce revenues up into the $30m to $40m range in precision balls, so we’ve got lots of flexibility based on how it kind of flows out into the marketplace in terms of capacity.

Can you talk about what sort of part of the industrial market is providing strength currently?

It is real hard for us to get a fix on that since we tend to be second and third tier, Larry. We read our customers releases and kind of what they are saying, but they tend to segment their business in a couple of different areas in terms of machine tool and general industrial applications, and almost a customer – our customers are saying that Asia and North America on the broad categories of industrial are up pretty dramatically, 6 to 10 percent improvement that they are seeing year-over-year. In Europe it tends to be maybe 1 or 2 percent. Yet we don’t have visibility on price, to be totally honest, relative to the end markets that are better than others in the broad category of general industrial.

Great, thank you.

You bet.

Thank you. Our next question comes from Mr. Michael Correlli; Barry Vogel and Associates.

Good morning.

Good morning, Michael.

You might have to break out your crystal ball for this, but I just have some questions, kind of looking ahead to 2005. First of all, I just wanted to ask you about some of the cost issues this year and how some of these things might change as we look ahead. If you do end up having the negative 12 cents a share impact from steel costs as you are projecting at this point, you would have the ability to get all of that back next year?

We found it is 85 to 90 percent of it, yes, Michael.

Okay, and as far as the Sorbian Oxley costs are concerned, it sounds like at 4 cents a share, maybe you’d be able to get 2 to 3 cents of that back next year, because two-thirds of that is one-time costs.

We have an ongoing testing in maintenance process, but the majority of it ought to be one time.

All right, then I think you said Slovakia, China start-up expenses this year would be around 4 cents a share. Would that disappear next year?

The Slovakia piece would disappear. The China piece should –

Okay, then would you have incremental profits from those facilities that you wouldn’t have this year?

Yes, although the reason I said Slovakia first, Slovakia will be in the second year of production and we certainly expect accretive earnings contribution from that facility in ’05. China, on the other hand, is just beginning production in ’05 and would likely be break even for the first two to three quarters of ’05.

Okay, and then on the Level 3 program, would you anticipate incremental cost savings next year above what you have this year?

Substantially more cost savings in ’05 versus ’04, but we’ve really established pretty dramatic goals for the program over a 36 to 42 month period and as we’ve mentioned, we are getting the program up and going, we are starting to see some momentum. Most of the improvements that we will achieve this year will occur in the last half of the year, but in ’05 much more improvement than we experienced in ’04.

All right, so if all things stayed equal, and again, nobody knows exactly what will happen next year, and you were projecting earnings of 76 to 78 cents this year, and you got approximately 10 cents back from these fuel costs, a couple of cents on Sorbian Oxley, a couple of cents on the start-up expenses, Level 3 savings, maybe some more profitability out of the Slovakia or China operations, you could be looking at a pretty substantial increase in earnings next year.

Michael, obviously we are going to tell you that we are not going to talk about next year. There are always dynamics that you’ve got to be careful of when you look forward like that, including as Rock mentioned, the pricing dynamic and volume dynamic. You know, those are pieces that favorably we know we should be able to look for. Other than that, I think that we are going to just back away from providing you with any guidance.

Okay, but with all of that said, my thought process is relatively on target, is it not, with some of the things we’ve talked about?

The outlook that we’ve mentioned are one-time expenses overall, yes, and we will try to get some improvement from the businesses ramping up.

Okay. Thank you.

Thank you. Our next question comes from Mr. Brian Raphine of Morgan Dempsey Capital Management. Please go ahead with your question, sir.

Good morning, guys.

Good morning, Brian.

Can you guys kind of break out capacity utilization? You can do it by continental Europe versus U.S., plant by plant, kind of give us a range of where you are right now. Obviously I know this dynamic, as you’ve talked about Slovakia being able to expand, but give us a sense right now of where you are at with capacity utilization.

Really, the capacity utilization in our U.S. operations and – let’s exclude Slovakia and the capacity, the incremental capacity we are installing. You have to exclude it to compare apples to apples, but we are in the 85 percent range in terms of capacity utilization, 85 to 90 in both the U.S. and Europe, and there is not much difference.

Well how many shifts are you guys running?

Around three shifts, 24 hours a day, usually five days a week.

Can you put a financial metric or a measurement? You talk about Level 3, Lean Enterprise, Power Productive Maintenance. Can you give us some type of measurement with reductions in cycle time or scrap rates or something we can kind of use as a governor for this process, or is it just strictly labor savings?

Well we’ve established three-year goals for the program in floor space, in inventory reduction, provides cash flow for improvement; [inaudible] improvements, throughput improvements and we’ve communicated very substantial improvement goals for the program to all of our employees globally. I would prefer not to get into percentages with you, just because setting internal goals and objectives for our employees versus what we might communicate to our investors and shareholders –

Perhaps could you give us kind of a historical dynamic to that, could you go –

I mean, I think it is fair to say that I said in my comments, Brian, that margin improvement, and by marginal improvement I am talking 2 to 3 percent a year. That’s just not good enough any more.

Okay.

And on productivity and cost, we certainly expect to more than double that as a result of this program.

Okay. Could you go back in the last five years, say, perhaps? Give me just the manufacturing side like cycle time, rates, that type of thing, say from the end of the late 90’s to where you are at today, what have you accomplished so far?

It depends on whether you are talking about productivity or quality and service and throughput related issues, but on the cost side the number of 2 to 3 percent productivity cost improvements has been kind of what we’ve achieved historically over the last three to five years.

Okay.

On the quality front, we’ve seen pretty – we measure, there’s a wide variety of quality measures, Brian, but the measure that we tend to look at the most is internal parts per million defective.

Okay.

And again, we’ve seen good improvement in that area, but with respect to Level 3, we’ve established a three-year goal of a 90 percent improvement on internal parts per million.

Okay. Just internal parts per million, the last five years. What has been the change numerically?

Again, the numerical, it varies a great deal by client and business, but we’ve seen 5 to 10 percent improvement over the last five years.

Okay. Can you give us a sense of the adoption cycle of Level 3, is Mountain City or Johnson City different than [Andal] versus your FAG, SKS operations?

That’s a good question, and we really have six-month cycles of training throughout the company and our North American operations are going through the six-month cycle all together, and our European operations are going all together. Our European operations are approximately six weeks behind our U.S. operations, but the first wave of six-month blocks of training is scheduled to be all completed by the end of the third quarter, but we are getting benefit as modules, as the managers going through the process get trained in the various elements of Lean, [Sig Sigma] and Total Productive Maintenance.

Do the cultural impediments of a socialist Europe – and I’ve asked this question before – Do your U.S. manufacturing laborers, is their adoption rate or their tolerance to this change better or worse, or is it about the same with Europe?

That’s a good question and it tends to be much more of a cultural challenge in Europe than it is in the U.S., but having said that, I would tell you that the leadership, our management team from a leadership perspective and therefore the employees in each of the facilities have embraced it to a degree that’s equivalent to the U.S. But you do have the cultural issues, not necessarily a socialist type attitude as much as the cultural differences of Irish, German, Italian and Dutch that just merging those cultures together in a common kind of program tends to be challenging, but we are really excited and enthusiastic about thus far overcoming those challenges.

Do you see a difference in the degree of that with say of Slovakia, Central Europe versus the older Europe? France, Germany, Holland, that type of thing? Is there more of an energy or a pulse to become part of the global industrial world? Again, having not traveled to Slovakia, I think some of us may kind of see a post-WWII, all the ruined buildings and stuff like that.

That’s really not an adequate description –

That’s right, that’s right.

Slovakia is getting an incredible amount of outside investment and yet really from a perspective of skilled employment and moderate cost structure, for those reasons is getting a lot of investment, and it is centrally located with respect to Europe. But I do think that generally speaking I can make the statement to you that the total employees, the 1,700 employees globally that we have, Level 3 engages them in a manner that they’ve never been engaged before, and the enthusiasm for the fact that we are engaging them in an improvement process to a degree and level that we never have creates some enthusiasm regardless of what country they are in.

Okay. Can you, are you doing any specializations relative to ball and roller sizes or applications as you break out your production from here in the U.S. versus [Konkani] versus [inaudible] or are the plants pretty much providing and manufacturing uniform sizes and tolerances, metallurgical tolerances, that it is just a geographic location?

It is a combination of both, honestly. I mean there is always size rationalization of what makes sense to produce what sizes, and what served end markets in what location. In Slovakia, for example, we are focusing heavily on automotive applications coming out and I think that will be true in China as well.

Okay, can you kind of give a flavor for Konkani, [Pinarola] and [Adal]? Are they just basic industrial, does one have more machine tools or is it pretty much across the board?

It’s across the board, but there is always this rationalization on size and mix that based upon the geographies of where we are serving the customers makes sense, and that ultimately tends to be driven by what geographic proximity are customers are producing in, not necessarily what makes sense from our perspective.

Okay, and then one final one. Most of the anecdotal information coming back from the agricultural sector has been that the agriculture and construction has pretty much been on fire. Have you seen any more demand for your rollers, a little heavier load bearing with some of this equipment, heavy construction, heavy agriculture? Are there any signs that you’ve seen that you are getting some flow through, as you said, to a second and third tier supplier?

It’s an excellent question, and in the U.S. in particular the answer is yes, our roller business in the U.S. extends into the first quarter and we are continuing to see it in the second, but it tends to be in North America only.

Thanks guys, appreciate it.

Thank you.

Gentlemen, at this time there are no further questions. Please continue with your presentation.

Again I would like to thank you for joining this morning’s call.

I do apologize, gentlemen, there is one follow-up question from Mr. Mark Par from McDonald Investments. Please go ahead with your question, sir.

One thing, I was wondering, Dave, again getting back to this inventory situation, was the inventory reduction that you experienced, was that a deliberate strategy on your part or was that just something that happened given surge of demand at the end of the quarter? Can you talk a little bit about why that happened?

Well as you look at the numbers, the revenue is fairly close to the initial guidance, so I don’t think we were surprised by the revenue in a large way. It was very much an active, managed effort to wring capital out of the business, and one of the questions we got earlier which was a good question is, culturally are we having difficulty across all the groups we have participating in this Level 3. And if you look at where that inventory reduction really happened, the majority of it happened in Europe. Those guys really came to the pump on delivering and –

Mark, I think one thing that’s important here is that as we ratchet inventories down associated with Level 3 and implementing Lean and putting systems in as opposed to batch and cue type systems, as we do that inventories over the next three to four years in our business, the amount of inventory required to run our business is going to substantially be reduced. In the absence of any other improvement activities relative to productivity or quality or cost, that would be significant yet to our earnings over the next three years. We anticipate offsetting that with improvements as we’ve mentioned before, on the cost side.

But having said that, it is the right thing to do. It improves long term our returns, our asset base, reduces our asset base on our improved cash flow, it pays off debt. So we intend to continue to aggressively pursue the cash flow improvements associated with inventory reduction.

And just to square it off, Mark, I think if you look back over the last two years, traditionally in the first quarter we are either a flat or a consumer of cash, and this is the first quarter that we have actually gone out of that debt level. And on a net debt level we’ve gone almost double what the absolute debt retirement was, net of cash against your debt. So it was a good development in the quarter.

Okay, as far as the magnitude of inventory reduction, maybe the best way to talk about that is in terms of turns. What do you see the potential for this program to create as far as improvement in inventory turns? How much can you get?

We set a three-year objective of a 50 percent reduction in our total inventory.

Wow.

That’s over three years.

Still, that’s a big number. That’s a lot of cash.

$13m to $16m. It’s a target but other people who have implemented the Level 3 concepts have achieved the same kind of results.

Okay. One last question, just looking on the growth side for a minute, you obviously have got good growth opportunities on your plate here with the internal infrastructure. I just wonder if you are seeing any new signs of opportunities to grow the business via acquisition, and what would your appetite be over a magnitude perhaps over the next 12 to 18 months should appropriate opportunities arise.

We do, I would say we continually have in our pipeline acquisitions that are consistent with our stated strategy, Mark, and before we first started executing our strategy some five or six years ago I couldn’t honestly tell you that we had that pipeline, but it exists today, and our appetite in terms of size is certainly governed by what is out there, but it is also governed by our debt and capital structure, and what we realistically think we can absorb.

We have said in virtually every acquisition we’ve made that we would never, from a size perspective, bet the farm on any one transaction in terms of size, and that to us means generally speaking no acquisition greater than 15 to 20 percent of our total overall business in terms of revenue for acquisition price.

So yes, we have an appetite to continue our acquisition strategy consistent with the strategy, but it is governed by getting our debt in line with kind of our self-induced, 2X debt to EBITDA level and we obviously factor in pro forma EBITDA in any acquisition we would make as well.

Okay, terrific. Thank you very much.

Thanks, Mark.

Thank you. At this time, gentlemen, we have no further questions. Please continue with your presentation.

Again, thank you for joining this morning’s call.

Ladies and gentlemen, this does conclude the NN Inc first quarter results conference call. If you wish to listen to a replay of today’s call please dial 800-405-2236. Once again that number is 1-800-405-2236 and enter pass code 577527. Today’s replay will be available until May 6th, 2004. Once again, thank you for your participation, you may now disconnect.