NN Inc (NNBR) 2006 Q2 法說會逐字稿

Good morning, ladies and gentlemen, and welcome to the NN, Inc. Second Quarter Results Conference Call. [OPERATOR INSTRUCTIONS.]

As a reminder, this conference is being recorded today, Thursday, August 3, 2006.

I would now like to turn the conference over to Susan Garland of the Financial Relations Board. Please go ahead.

Thank you. Good morning. Welcome to NN's 2006 Second Quarter Conference Call. If any needs a copy of this morning's press release, please call my office at 212-827-3746, 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. The same language applies to comments made on today's conference call and live webcast, available on www.earnings.com.

With us this morning is Rock Baty, Chairman and Chief Executive Officer and members of NN's management team. First, management will give an update and an overview of the quarter and, afterwards, we'll open up the line for questions.

Now, I'd like to turn the call over to Rock. Rock, please begin.

Susan, thank you. Good morning, everybody, and thanks for joining the call this morning. With me this morning I have Jim Dorton, our CFO and VP of Business Development, Will Kelly, our Chief Administrative Officer, and Tom Burwell, our Corporate Controller. Today, Jim is going to offer an analysis and commentary on our second quarter results and year-to-date results through June 30, 2006. I will conclude the call with general comments regarding overall business conditions, including an outlook for the remainder of 2006 and comments regarding the progress we are making with respect to the execution of the objectives outlined in our five-year growth strategy.

I'll turn the call over to Jim now.

Thanks, Rock.

Revenue in the second quarter of $83.6 million was flat with last year and right on our business plan. The average euro exchange rate was about the same as last year during the second quarter, so currency was not a factor in this quarter comparison. Revenue in Europe was off slightly due to the reduction of INA volume, but this was offset by a planned increase in U.S. business with Delphi.

Year-to-date, revenue was also flat with the first six months in dollar terms, but revenue would have been up 2.6% if not for the devaluation of the euro against the dollar in the first quarter. Gross margins in the second quarter improved compared with last year by 1.1% due to cost savings from our Level 3 program and raw material price pass-throughs from the prior year. Our Level 3 program reduced costs by about $2 million year-to-date, which is right in line with our targets.

SG&A expense totaled $7.1 million during the quarter compared with $7.3 million last year. This represents 8.5% of sales, down from 8.7% last year. SG&A spending remains slightly below budget so far this year.

Interest expense was almost exactly flat with last year during the second quarter and year-to-date even though debt was $13 million lower than the same period last year. There are two reasons for this. The first is that interest rates are up about 200 basis points since last year, and about one-third of our debt is floating rate. The second reason in this quarter was that we repaid the remaining balance of our euro term loan early, earlier than scheduled, which required us to write off $133,000 in unamortized arrangement fees in Q2.

Other expense was another big item. Other expense was $479,000 during the second quarter versus income of $168,000 last year, which is a swing of $617,000, or nearly $0.03 a share. The primary driver in this is a foreign exchange loss resulting from the devaluation of the Slovak kroner against the euro, and this exposure arises strictly from inter-company loans between European entities, and so it's not really a cash flow item, although GAAP requires us to run the gains and losses through the income statement. Now, this exposure is difficult to forecast, and so it could go either way in Q3.

The tax rate was 39.3% during the second quarter, down from 39.7% last year. The rate is lower because of a 2% reduction in the corporate tax rate in the Netherlands that began this year, and an increase in income in Ireland, where our tax rate is only 10%. And we think the tax rate should be roughly the same level in Q3.

In terms of net income, we made $3.5 million, which is up 6% from 2005. Earnings per share were $0.20 in the quarter versus $0.19 last year, a 5% increase. Year-to-date, we made $0.50 per share versus $0.43 per share last year, which is an increase of 16% and pretty much right on our business plan.

Taking a look at the balance sheet, the first thing to point out is that we reclassified all of our revolving credit bank debt from long-term to current because the credit facility expires in June of next year, which puts it within one year. As I mentioned in the press release, we have already syndicated a new $90 million 5-year credit facility, which we hope to finalize during the third quarter. We would expect for the majority of the new facility to be used for acquisitions.

Year-to-date, we have reduced debt by $3.7 million, with about $500,000 coming in the second quarter. Working capital is currently at a high level, up about $6 million from year-end, and this is usual at this point in the year for NN. We still plan to repay approximately $10 million of debt by year-end.

Capital spending year-to-date totaled $6.4 million versus a plan for the full year of approximately $16 million, excluding the SNR investment. We are spending roughly equal to our depreciation level this year as we continue building up production capability in our low-cost facilities in China and Slovakia.

Finally, we repurchased approximately 36,000 shares of NN stock during the second quarter for roughly $430,000 and this brings our year-to-date total of shares repurchased to approximately 57,000 shares for just under $700,000. All this repurchase activity is occurring under the $10 million share repurchase program that we announced in February of this year.

So, those are the financial highlights, and now Rock will talk more about the business.

Jim, thank you.

I'd like to close today's call, if I could, with comments regarding our overall business outlook, including a forecast for the remainder of 2006 and execution progress we're making with respect to our strategic growth plan. Let me begin commenting specifically on overall business conditions and our outlook for the balance of the year.

As Jim mentioned, our revenues for both the quarter and year-to-date comparisons from a year ago were essentially flat in pure dollar-to-dollar terms. Revenues for the first six months were negatively impacted, as Jim mentioned, by the dollar-euro exchange rate differences in 2006 versus '05, and market share loss at INA and volume in certain automotive sectors. These negative factors were essentially offset by higher selling prices associated with material pass-through and market share and volume improvements in several of our global business units. The $83.5 million and $169.5 million in revenue for the quarter and year-to-date met pretty much exactly our original revenue forecast in our 2006 plan.

From an overall economic and business level perspective, we anticipate more of the same for the last six months of the year, meaning essentially flat automotive demand in North American and Europe, and continuing robust demand in industrial segment.

In looking at our customers from their perspective, they continue to confirm in their forecast that they do expect relatively flat automotive levels to continue for the last six months of the year versus the first six months, and with industrial demand again continuing at robust levels. As was the case in the first half of 2006, at NN our overall--the net result of these economic factors, we continue to expect good capacity utilization rates in both North American and Europe for the balance of the year. Given the overall economic outlook that I just mentioned and the factors that we mentioned, we are reaffirming our revenue guidance for the full year at approximately $325 million.

With respect to the earnings outlook for the remainder of 2006, we are confirming our beginning of the year guidance for full year earnings in the range of $0.86 to $0.92 a share. As Jim mentioned in his comments, our year-to-date net earnings of $8.7 million and $0.50 a share are exactly on our original plan for 2006 for the first six months of the year.

Based upon the seasonality of the third quarter in Europe and the fourth quarter in general, we believe our original guidance in the $0.86 to $0.92 a share range is sound. Our operating results for the quarter and year-to-date continue to reflect good margin improvements associated with momentum in our Level 3 initiative. 2006 earnings continue to be negatively impacted by the startup costs in our Slovakia and China facilities. We anticipate those startup costs continuing through the end of the year, with both operations running at volumes beginning in 2007 that will sustain long-term profitability.

We do face some downward risk associated with rising scrap surcharge costs in Europe during the last half of this year, and that's approximately around $0.03 a share. But, this issue remains a timing problem only until January 2007 when pending new contract language will provide for more timely quarterly pass-through of changes in raw material economics moving forward.

With respect to the Euroball contract extensions negotiations, we have made progress with both customers, INA and FKF but, given current holiday schedules in Europe, we will not resume our discussions until later in the month of August. While we are also making good progress on managing our core business from a cost and profitability perspective, the results for the quarter and year-to-date in comparison to '05 make it imperative that we achieve profitable revenue growth in our business at NN beginning in 2007 and beyond.

That will lead to my final comments this morning regarding progress on the execution of our long-term strategy. As I mentioned in the first quarter call and we also mentioned in this press release today, our Board and management team concluded in the fourth quarter of '05 the development of a long-term strategic growth plan for NN. Since the Board approved the plan in November of 2005, our global management team has been focused on the successful execution of that plan--of the objectives outlined in the plan.

Briefly, we have developed strategic specific growth objectives that call for top and bottom line growth that we estimate will double the size of the company by the end of 2010. Roughly 50% of our five-year growth goals will come from our core bearings components business via further geographic expansion and acquisitions of independent and captive producers of bearing components. The remaining 50% will result from acquisitions that leverage our manufacturing competencies and related high precision steel component manufacturing. In addition, the plan calls for an increasing emphasis on applications marketing, research and development and acceleration of the improvement objectives outlined in our Level 3 program.

As Jim mentioned, we are positioning our capital structure to enable us to fully execute the strategy over the next five years. We remain committed at NN to profitably growing the company via both organic and acquisitive growth as outlined in this new plan while, at the same time, remaining focused on our core manufacturing competencies in our precision metal components business.

With that, we would like to open up the call for any questions that you may have.

[OPERATOR INSTRUCTIONS.]

Holden Lewis with BB&T.

About the guidance, if memory serves, I believe that your original guidance was given with currency levels being well below where they are currently, I think 120 or 121. The revenues have been largely I guess as expected. You're maintaining the guidance there. I would have thought that the currencies doing what they're doing would have lent an upward bias to guidance, given inline revenues, and yet you're keeping them kind of the same, which suggests that maybe something has not lived up to expectations on the profit side. Can you just comment to that, please?

Sure, Holden. I did just touch on it discussing kind of where we see down side. I don't know if you follow this, but global scrap prices are up the last six months of the year versus the first six months, and a portion of our material costs in Europe are associated with scrap surcharges that are variable and change quarterly. That is an element that's kind of offsetting the currency, and I mentioned kind of the impact associated with that. Other than that, there really aren't any. We've seen margin improvement. We did have a pretty substantial hit associated with the exchange rate issue out of Slovakia that Jim mentioned. But, beyond those two issues versus the currency, really no big differences in the earnings expectations versus the first part of the year.

Now on that, I thought when we had those issues in 2004 that you had sort of re-negotiated in the ability to reset price sooner than just every January. Is that not the case in Europe? Is that still just an annual reset, or what's up with that?

The current contracts with both FKF and INA. As I think you know, expired mid-year, expired essentially in the June-July time frame. And with FKF, we've extended the contract through the end of the year, and both languages of the contracts for both the original Euroball deal, there was a delay in terms of pass-through, and so we accumulate the changes and then settle up the following January 1. And so, we're currently negotiating extensions, as you know, that will insist upon quarterly reviews of pass-through, but these extensions that we're talking about with INA and FKF aren't finalized but, when they are finalized beginning January 1 of '07, we will begin quarterly adjustments. But, today, with the current contract language that we have with both FKF and INA, there's this delay, and that delay will continue through the last six months of '06.

I was just under the impression that, in some way, you had amended the contract.

No. We attempted to, Holden, but we did not have the ability to do it.

Okay. And then also on data, I think you made mention that the Level 3 had yielded a $2 million year-to-date cost reduction. Wasn't that number supposed to be significantly higher than that for the full year?

I think we said that we were targeting around a 2% total cost of goods sold, which yields about a 1 to 1.2 basis point improvement on margin, which we're--through the first six months we're at 1.1 margin improvement.

Shouldn't there be a benefit from Level 3 initiatives as well as the SG&A cost line?

Our focus for the first 18 months of the process has been on the manufacturing floor and, while there are certainly initiatives that we could focus on in terms of SG&A, we hawk and monitor our SG&A costs pretty religiously as a company, and I don't see the level of magnitude improvement on the SG&A line that we're certainly seeing on the manufacturing cost line.

Mark Parr with Keybanc Capital Markets.

One thing I was curious about is, if you could give us any color on the near-term or intermediate-term revenue growth opportunities, new contracts, new programs, potential additional outsourcing. Could you help give us some color on that and quantify the magnitude of the potential over the next 12 months?

Mark, it's interesting but, if you look at the revenue as we mentioned in terms of flat year-over-year comparison, that's quite different for us as a company versus kind of what we've achieved over the last four or five years. And in my comments, I was relative to the strategy execution, wanted to comment specifically on that. We aren't used to, as a company over the last five to six years, of not seeing good top line revenue growth. And there's a lot of noise, or a lot of factors, behind the revenue numbers in the year-over-year comparison. Even though they're flat, you look at it and you say, “Well, geez, you've got currency going on,” and we have gained share. And both volume and new share business in several of our business units globally, that's offset by the INA. INA is now starting in the second quarter to take the business that we've talked about publicly last quarter in terms of the overall $12 million reduction in business.

So, we do have ongoing discussions with customers associated with additional outsourcing transactions. Those tend to be acquisitive in nature, and we mentioned them in the strategy piece relative to our focus there. And we've gained some share in automotive-related business in the U.S. as an example. But, in the short-term, the loss at INA versus some of the good stories we can tell are tending to offset each other.

Moving forward long-term, the growth in both Europe and North American is essentially at GDP plus or minus what happens with share and some of these potential captive acquisitions of internal capacity. And so, I really, in the very shortest of short-terms, meaning this next quarter and for the next six months kind of as the balance of 2006, pending any conclusion of acquisition in our base business, I don't see it changing much in terms of kind of flat, and that's why I've mentioned that we were reconfirming our $325 million guidance.

On into 2007 and '08, as we begin executing on the strategy, both acquisitive and kind of the organic growth strategy, I see it changing.

But, can you give us an updated outlook for Sarbanes-Oxley expenses for the full year?

Yes, Mark, this is Will. We're probably coming in around the 500,000 to about $550,000, of which we've already spent probably 350 of that.

On the 404 compliance.

On the 404 compliance.

That's down from last year, isn't it?

It's down, and we're just talking about the 404 compliance, the internal part of that right there. but, yes, it's down probably 50, 60, $75,000.

And what about total Sarbanes-Oxley?

Total? That's probably running--it's $2 million. That includes all of our external audit, too. It's hard to pull out the external audit in the Sarbanes-Oxley piece of it. It's 1.8 million I think total.

The internal control 404 piece, Mark, is around 500,000, and our audit expenses, which have a portion of 404 audit in them plus traditional audit, is a total of about 1.3 million. So, 1.8 million of combined traditional audit plus 404 internal audit, it's about 1.8 million. I don't know if you were asking for that or total kind of public company costs. I'm not sure.

I'm not sure of your question, I guess.

Okay, that works, too, but no, that's okay. You're helping me out.

They haven't changed much, frankly, since last year. A lot of companies are saying they see reduction after the first full year, and we, frankly, haven't experienced that. A little bit on the 404 as Will mentioned but, on the total audit bill, it is either flat or going up every year.

The external audit, which combines the external 404 piece, is fairly flat with last year. The internal audit piece of that and the compliance piece of it, we do see some reduction of that, probably $75,000 to $100,000 over last year.

How significant is natural gas costs for you guys?

It's not a big--we use it in some of our heat-treating operations around the world. It's not a significant piece, frankly.

Electricity is more significant than gas?

Yes, electricity, because most of our furnaces either tend to be driven by electrical in all of our equipment, so electricity is more significant, for sure.

Carlo Cannell with Cannell Capital.

Can you tell me, first of all, what the cash flow from operations was in the quarter?

Yes, Carlo. We don't give that out until we publish the Q, which will come out shortly. And so, all I can advise you to do now is take the balance sheet and work back into it. But, it's fairly simple.

I gave you the capital spending number of 6.4 million, and I think you got most of the other pieces. Sorry, but we don't give that out yet.

Can you give me some broad-brush information on who your customer base is, and specifically in two areas? One, if you're designed into any aerospace-related stuff, or hope to be that is significant? And then secondly, what portion of your business is to automotive, and can you split that out between transplants, foreign companies, Honda, whatever, doing business or assembling automobiles in the U.S. versus domestic companies, Chrysler and so forth?

I can give you some very macro numbers in terms of some of the specifics on platforms and whatever. Obviously, that's a little bit more detailed than we can probably go into on the call. But, generally speaking, when we look at our global macro 325 million in revenue, we believe that about 60 to 65 percent of that ends up--and we're a second and third-tier supplier, not direct to the OEM automotive manufacturers. And light vehicle and truck application, 60 to 65. The 35% is in broad categories of general industrial markets, things like machine tool and industrial and Ag and so forth, material handling.

We have three very large customers led by FKF, and they represent about 46% of our business, INA at about 14% and Timken at 8 to 9. And those three customers are global in nature in every way, and have varying degrees of market share with either the transplants or the European auto manufacturers and the North American manufacturers and the Asian producers. And so, our share tends to follow exactly where their shares lie.

Is FKF an integrator or is their functionality simply a distributor and holding the inventory?

Oh, no, they are integrated manufacturer of finished bearings, finished precision bearings globally, and they market those bearings on an OEM basis to first-tier automotive companies.

So, does FKF have to approve NN, Inc. for delivery of systems into Toyota projects and so forth?

Absolutely. There's a whole homologation approval process in the supply chain that exists for all of our global customers, and so we are approved not necessarily program-specific but generally with each individual customer for each individual application.

To answer the final part of your question associated with aerospace, we have approximately $1 million--it's very small--out of our $325 million in revenue that's specifically end-market aerospace related.

And what is your forecast regarding growth in aerospace?

Well, it's going to continue to grow, of course but, generally speaking, what happens with aerospace is it involved specialty materials, and our customer base, kind of on a global basis, has tended to captively produce those specialty materials within their bearing facilities to control the entire supply chain on the finished product side of things from a risk perspective as well as kind of a strategic perspective. That's the reason for the difference in terms of our relatively small share there.

And regarding the fall pow-wow with your directors regarding doubling the size of the company in five years, what implications does that hold for gross profit? Will there be a significant mix in the profitability of the products, higher or lower?

It's too soon to predict on that, of course but, as a general rule, we like to acquire businesses and at multiples that ensure accretiveness coming right out of the chute relative to post-acquisition. And in fact, we haven't done a single acquisition in the history of the company that that has not been the case. We have acquired businesses that, coming right out the chute, have lower margin and associated growth profits than our consolidated company margins.

But, if we cannot foresee a way to improve those margins at least to our overall corporate average, it tends to be a filter and that, with respect to not wanting to move forward with a transaction. And we've got several examples of that in the history of the company associated with some of our larger transactions of improving the margins, both the deal to kind of a corporate average of around 20 to 23%.

Is your industry one where your customers, FKF and others, scrutinize your financials and basically dictate what your gross profit margin will be akin to doing business with a municipality?

Certainly because we're a public company, our customers have access to our financials. But frankly, just kind of speaking on a global basis right now, our customers expect us to achieve certain levels of return and remain healthy relative to the supply chain. I mean, it's in their best interest, obviously long-term, to have healthy integrated suppliers in their supply chain, and they don't dictate to us returns.

Having said that, that does not mean that they don't put intense pressure on because they're faced in their end markets with intense pressure on the cost and price side relative to demanding improvements in our cost structure year-over-year and passing some of those savings along to them on a regular basis. But no, we've never had a customer say, “Look, here's what we expect you to make, and no more.” In fact, to the contrary. Most of our customers, as our earnings profile has improved over the last 18 months or so, are glad to see it.

Is there any product lines that the plan might call for pruning? And in connection with that, that possibility, what needs to happen to get up to the 25, 26, 27% gross profit margin? Is that indeed possible in your industry?

I think that we tend to look at the gross profit margins in the 22 to 24% range and operating margins in the 10 to 12% range as realistic goal, and kind of where we've been historically the last 12 to 14 months. I don't think that moving our corporate average from 22 or 23 to 25 to 27 or 28 is realistic in our business, but I do think that after-tax returns in the 5 to 8% range and the resulting operating earnings and gross profit margin improvement, given our Level 3 initiative plus whatever happens with our growth strategy are.

So, that implies that there will be very little margin leverage if you double your revenues. There will be some, but not significant.

There will be some, and we'll get some on the SG&A line, too.

Regarding the receivables, is there a great range in the days that it takes your customers to pay you? Do some customers pay in 15 days and other ones are, like, 120 days? Or is it generally around the 60-day range?

There is a range, but it tends to be more regional. In the U.S. it tends to be a little slower and, in Europe, it tends to be on a payment schedule, and it's kind of a regional plant-by-plant basis. But, in general, I think the answer to your question is there is not a great differential between our customer base as to how they pay.

Michael Corelli with Barry Vogel & Associates.

The earnings guidance, I was trying to remember back. I know in the first quarter you had some unusual items, which came out to a $0.04 gain combined. Is that included in the earnings guidance or excluded from the earnings guidance?

It's included. And Michael, I'd just add that we had some extraordinary items in the second quarter, including the currency movement in Slovakia that Jim mentioned, that we really didn't highlight in the second quarter press release. But, had we done that, and then the interest cost write-off of the unamortized loan, when you look at it, as we look at it kind of through the first six months, some of those “extraordinary items” are a push. They're kind of a wash through six months. And so, yes, the guidance includes that first quarter benefit, but it also includes the second quarter items I just mentioned.

And then just a question about capital spending. Jim had said $16 million excluding the SNR investment. What does that mean exactly?

Well, last year when we did the SNR acquisition, the payment for that was phased over a period of time, and we spent about $2 million in '05, and we have about $4 million more to go in '06. And that's on top of the capital spending, although we haven't spent a lot of that so far this year but, as we make that, we'll show that, or at least we'll account for it internally, as an investment in an acquisition as opposed to capital spending.

Okay, so CapEx will be $16 million, and then on top of that you'll have a $4 million payment?

Right, and that's been built into our plan from the beginning.

[OPERATOR INSTRUCTIONS.]

Holden Lewis with BB&T.

Just trying to get a few numbers to plug in here. Can you talk about how much in incremental SNR revenues there were for the business? And then, can you also speak to how much pricing impact in dollar terms existed in the quarter?

Hold on, Holden, we're trying to get--are you talking about the impact of incremental SNR for the first six months of the year?

Well, for the quarter, but yes.

I think we'll have to get back to you on the SNR revenue. We just don't have that level of detail in here with us.

And what about the pricing?

Would you repeat the question? We were buffaloed by the SNR question.

The pricing for the quarter was $2.2 million.

$2.2 million?

And for the six months, 4.9.

And then, the currency, if I'm doing my math right, was only about a 300,000 drag?

For the quarter?

Yes.

It was even less than that.

Yes, it was flat, 150 or something like that, right?

It was about 200,000 in sales revenue.

And then, can you talk a little bit about this--you made mention of the Slovakian currency issue and how that's difficult to project. I mean, is that truly kind of a one-time circumstance, or every quarter we might be talking about something regarding the Slovakian currency being an up or down? What exactly is behind that?

Well, it relates to the fact that we have financed our buildup of the Slovakian plant basically with inter-company funding, and that's subject to the difference each quarter in the Slovak currency and the euro. So, until we change that funding, and we're in the process of doing that now, but until we change that, yes, it will be an ongoing item. The amount of that inter-company debt times the change in the relative exchange rates between the Slovak and the euro.

But, I mean, a $0.03 swing, as you said, that's a big number. Are we looking at something of that order of magnitude of uncertainty every quarter, or is there something unusual about what took place this quarter in particular?

The swing between the two currencies was unusually large, because we've been living at this level for at least a year, and maybe at a lower level before that. But, there was an unusual amount of volatility between those two currencies.

Yes, but there was no one-time devaluation that was conducted by the governments or anything like that? It just was a particularly dramatic swing in what is a quarterly swing factor?

Yes. And long-term, we're going to eliminate that exposure, but it is somewhat complicated.

Holden, we'll get back to you on the SNR.

At this time there are no further questions. I'd like to turn the conference back over to management for any closing comments.

Thank you again for listening in on today's call.

Ladies and gentlemen, this concludes the NN, Inc. Second Quarter Results Conference Call. If you'd like to listen to a replay of today's conference, you can do so by dialing either 303-590-3000 or 800-405-2236 with the access code 11066445. Again, for a replay, you could dial either 303-590-3000 or 800-405-2236 with the access code 11066445#.

Once again, we thank you for your participation. You may now disconnect.