Neptune Insurance Holdings Inc (NP) 2017 Q1 法說會逐字稿

Good morning, and welcome to the Neenah Paper First Quarter 2017 Earnings Conference Call. (Operator Instructions) Please note, this event is being recorded.

I would now like to turn the conference over to Bill McCarthy, Vice President, Financial Analysis and Investor Relations. Please go ahead.

Okay. Thank you, and good morning, everyone. With me today are John O'Donnell, our Chief Executive Officer; and Bonnie Lind, our Chief Financial Officer. As usual, I'll start off with a few brief comments, and then John and Bonnie will discuss progress on key initiatives, financial results in detail. Following these prepared remarks, we'll open up the call for questions.

We released earnings and filed our 10-Q yesterday afternoon. Revenues of $242 million were equal to prior year as modest growth in Technical Products and Fine Paper & Packaging was offset by negative currency impacts and lower sales in our other segment. On a constant currency basis, consolidated sales increased 1%.

Operating income of $27 million declined from $31 million last year but included approximately $5 million of costs in Technical Products related to the start-up of our new North American filtration capacity and downtime at our German filtration plant. There were no non-GAAP adjustments to income this year, while in 2016, operating income was adjusted to exclude $1.1 million or $0.04 a share for nonrecurring integration and restructuring costs.

Earnings per share of $1.03 compared to $1.11 a year ago. The decline in earnings per share reflected a lower operating income that was partly offset by a reduced tax rate for the quarter.

Lastly, I'll remind everyone that our comments today may include forward-looking statements and that actual results could differ from these statements due to uncertainties and risks noted in our SEC filings and on our website.

With that, I'll turn things over to Neenah's Chief Executive Officer, John O'Donnell.

Good morning. It's been a busy year so far at Neenah. Certainly, a major activity has been the start-up of our North American transportation filtration asset. With a newly repurposed paper machine and adjacent solvent-saturating facility, this is a complex manufacturing process with a typical start-up learning curve. We believe these are the best and lowest cost assets capable of making advanced transportation filtration media in the world and are confident in the success of this investment.

On the customer front, enthusiasm for the project remains high. And with tight capacity in Germany, customers are anxious to receive samples so they could complete their product testing and approval process. We've begun to provide these samples, and our revenue forecast for the year are on track. As we've indicated, qualification periods can be lengthy, depending on the customer and the grade, and we're prioritizing qualifications that maximize our global capacity and the needs of our strategic customers. I'll talk more about our filtration outlook later in the call.

In other technical products categories, R&D efforts have allowed us to begin commercializing new products, such as filtration media for industrial gas turbines and in performance materials. Our teams delivered growth, driven by backings, which was up 4%; and labels, which grew by double digits.

Backings continues to expand globally and was helped by strong abrasives growth in Asia during the quarter, while labels reflected sales of newer products that began to gain traction in the marketplace.

In Fine Paper & Packaging, there are a number of activities underway. In March, we refreshed our CLASSIC brand portfolio, the first major update in a number of years. Classics are the clear premium brand leader. And after changes made based on market feedback, customers will now be able to choose from broader, more current selection of colors, textures and digital papers. In addition to marketing efforts supporting our core brands, our team has relentlessly pursued new market opportunities. Recent successes include working with retail customers to transition from plastic gift cards to environmentally friendly paper-based solutions; building our premium packaging pipeline in target of verticals of beauty, alcohol, and retail; and gaining new business with direct sales and through key retailers.

Returning briefly to financial results. As you know, we expected the first half of the year to be challenging due to the filtration start-up and the typical lag time between input cost increases and selling price realization. First quarter results were also impacted by onetime costs for downtime in Germany, which further constrained filtration production.

Even with these headwinds, I was very encouraged by the progress made during the quarter in a number of areas. Both segments delivered solid volume growth, and our market positions remained strong. We delivered record profits in Fine Paper & Packaging. And cash from operations of $22 million was well ahead of last year. We continue to increase our return to shareholders through a growing dividend and opportunistic share buybacks.

At this point, I'll turn things over to Bonnie to cover our first quarter financial results in a little more detail.

Thanks, John. Good morning. Let me begin with Technical Products. Sales of $122 million were slightly ahead of last year in U.S. dollars and up over 2% on a constant currency basis. Higher volumes accounted for around 1% of the increase, led by strong growth in labels, continued good performance in backings and modestly higher transportation filtration, where we had to draw from inventory to meet demand due to the tight capacity. In addition to increased volumes, our higher-value mix also contributed to sales growth.

Operating income of $12.5 million declined from $19.2 million last year, largely due to $3 million of filtration start-up costs and $2 million of higher costs in Germany, mostly for production downtime taken to improve the safety and reliability of our saturation process.

In addition, profit was negatively impacted by almost $2 million due to a combination of higher input prices, currency and other cost increases. Input costs reflected a double-digit rise in the price of latex, one of our most significant raw materials used in technical products. As noted in the past, a portion of our customer contracts have raw material price adjusters that typically lag by a quarter or 2, so there was limited price realization in the first quarter. Finally, there were no integration or restructuring costs in 2017. These costs totaled $300,000 last year, and were reported that in adjusting item.

Turning next to Fine Paper & Packaging. We began the year with a very strong start as we refreshed our CLASSIC brand, raised selling prices and continued to expand our retail presence. Net sales topped $114 million, and we're slightly ahead of last year. Volumes increased 5%, mostly due to increased sales of nonbranded grades sold directly to certain leading costumers and strong growth in the retail channel. These nonbranded direct grades carry a lower selling price, which contributed to a lower price mix, but they helped to optimize our assets and generate cost efficiencies that add to the bottom line.

Price increase on selected brands was implemented early in the year and should have a full year benefit of $2 million to $3 million.

Operating income for Fine Paper & Packaging was a record $20.3 million, up from $17.5 million in 2016.

In addition to the top line drivers, the bottom line benefited from reduced SG&A, improved manufacturing performance and lower input costs. SG&A spending was almost $2 million below prior year, with the large part of this due to timing of advertising and other expenses. In 2016, these costs occurred more in the first half, whereas in 2017, they're expected to be more evenly weighted throughout the year.

Unlike Technical Products, Fine Paper & Packaging input costs for the quarter were moderately lower than last year. Hardwood and other fibers are the largest raw material consumed in fine paper. And while prices have continually risen this year, they haven't topped year-ago levels. 2016 results also included integration and restructuring costs of $300,000, which did not repeat in 2017.

Consolidated SG&A expense was $24.9 million. This is down from $26.4 million last year, spending was lower in large part due to timing of the advertising and other fine paper packaging costs that I mentioned before. Both periods included approximately $1 million of higher costs due to timing of recognition of stock compensation. For the full year, we expect SG&A to average around the $24 million per quarter we previously communicated.

Unallocated corporate costs were $5.5 million compared to $5.3 million last year and include a portion of the higher stock compensation expense. Unallocated costs are expected to average $4.5 million to $5 million per quarter, again, consistent with our past guidance.

First quarter net interest expense was $3.2 million. This is up from $2.9 million in the first quarter of 2016. The increase was primarily due to interest expense related to the filtration project that was capitalized last year.

Quarter-end debt was $226 million, up $5 million from year-end. Of the total, $175 million is at a fixed rate of 5.25%, and the remainder is at variable rates that have recently been between 2.5% and 3%.

Our balance sheet remains very strong, with debt-to-EBITDA of around 1.5x and over $100 million of borrowing capacity that's available on our existing credit facility.

Turning next to tax. The book rate in the first quarter was 26% compared to 33% in the first quarter of last year. With the required change in the accounting standard for taxes on stock-based compensation, tax expenses now impacted each quarter positively or negatively by vesting of performance stocks units and exercises of stock options. The amount of the impact is influenced by both stock price and the number of shares vested or exercised, and as you would imagine, is impossible to forecast.

Assuming minimal benefits for the remainder of the year, we would expect our 2017 tax rate to average around 32% and the rate for the remaining 3 quarters to be closer to 35%. This 2017 full year rate is higher than last year's 29%, largely due to changes in income mix between our tax jurisdictions.

Our cash tax rate in 2017 will be significantly lower than prior years and less than 15%. In addition to consuming remaining prior-period R&D credits, we'll benefit from the start of accelerated tax depreciation on the U.S. filtration investment. For the following few years, we expect the rate to be around the 20% that I previously communicated. Our low cash tax rate represents a cash benefit of over $15 million this year versus the book rate.

Cash flow generation remains strong. And in the first quarter, cash from ops was $22 million, up from $16 million last year. Lower net income in the quarter was more than offset by an $8 million improvement in working capital as we were able to negotiate extended payment terms with certain vendors, and we turned down inventories and filtration due to the production outage in Germany that we've mentioned.

Full year cash contributions and payments for postemployment plans are expected to be $16 million, down from $23 million last year. Like last year, the majority of these payments are expected to be in the back half of the year, and total cash payments are likely to be around $7 million more than expense.

Finally, capital spending in the first quarter of 2017 was $11 million, in line with the prior year. Full year spending is projected between $35 million and $40 million, within our target range of 3% to 5% of sales and down from $68 million expense in 2016, which we used for the filtration project.

As part of our balanced capital deployment, we continue to return an increasing amount of our cash flow to shareholders through a growing dividend, supplemented by opportunistic share buybacks. In the first quarter, these totaled $13 million, split fairly evenly between dividends and buybacks, and up from a combined $11 million in the first quarter of last year.

The annual dividend payments are now $25 million, providing a yield of just over 2% and a payout ratio in the mid-30s. We continue to target an attractive dividend yield while managing our payout ratio to no more than 50%.

So to wrap up, we had a good start to the year with volume-driven top line growth, record Fine Paper & Packaging profits and improved cash flow. We're managing spending and assets carefully to maintain our attractive double-digit return on invested capital, and our strong financial position provides us the flexibility to act on future opportunities.

Now I'll turn things back over to you, John, to comment on our outlook for the rest of the year and wrap things up.

Thank you, Bonnie. The (inaudible) for our 2 largest geographies, the U.S. and Europe, they appear to remain on solid footing. And this should hold true for our end markets as well. The U.S. dollar, as expected, is stronger versus the euro and the pound this year, although the euro has recently regained some ground. As noted in February, input prices are rising in 2017, while the first quarter impact differed by segment and was modest overall. Year-on-year comparisons in both segments are expected to be more challenging towards the middle of the year as these costs continue to rise.

As a reminder, our businesses have demonstrated the ability to overcome changes in input costs over time through pricing changes and other improvement activities. In fine paper, we increased prices on key brands earlier in the year and are realizing improvements as a result.

In Technical Products, we've been working with customers to implement increases consistent with our commitments, annual contracts or agreed-to adjusters. We expect to recover a majority of the input cost increases in the year, but improvements will likely lag cost increases for the next couple of quarters.

Looking further at our businesses and Technical Products, we expect second quarter start-up costs for filtration to be in line with the first quarter, in advance of commercial sales ramping up in the second half of the year. Consequently, start-up losses this year are likely to be closer to $7 million or $8 million versus the $4 million originally communicated. The higher costs reflect increased trials, which should enable faster future customer qualification. Accelerated labor didn't ensure our readiness for increases in demand and the typical earnings in other areas as we progress through the normal asset start-up.

Given the complexity and the numerous variables associated with any major start-up, in hindsight, I probably could have been more conservative in our initial communication of estimates; though our excitement about the market opportunity and return this investment provides hasn't changed. Demand remains very strong for transportation filtration, though our growth will remain constrained until global capacity can be balanced with customer qualifications in Appleton. Our revenue projections are unchanged for this project, with sales of $10 million to $15 million this year and $80 million and $90 million in the curve, and we still expect the business to turn a profit in the second quarter of 2018.

In other Technical Products categories, we're seeing growth in backings and labels, and we're excited by new product opportunities being developed in both performance materials and filtration. In Fine Paper & Packaging, team is doing a great job finding ways to help offset market pressures with gains in nonbranded, greeting card business, incremental distribution at key retailers and implementation of plans to meet our double-digit growth targets in premium package.

As I mentioned in the past, and to save you a question later, while organic initiatives remain our highest capital deployment priority, M&A is expected to continue to play an important role as we increase our presence in growing categories, and our pipeline has been very active. Unfortunately, timing is always unpredictable, and even though our organization remains very busy, there's nothing I can say to add any more specificity for you on today's call.

As referenced on our last call, 2017 will reflect short-term impacts from investments that will prove to be catalysts for growth and make us a stronger company.

My thanks to our employees for the continued efforts to build on their impressive track record of profitable growth and to those on the call for your interest in Neenah.

I'd now like to open up the call for questions.

(Operator Instructions) Our first question comes from Dan Jacome of Sidoti & Company.

So just a couple of questions here. First, on Appleton, good to hear that you're still targeting this $90 million. Once you climb up your kind of capacity cost curve, what sort of utilization rate on that capacity does that assume? Is that like 80%? Or is that closer to 100%? I was just curious.

Yes. I mean, we tend to view these assets, if you're in the 80s, you're in full capacity from that standpoint. So given the number of grades and the products associated with it, that's what we believe is a full outlook.

Okay. And then if I heard you correctly, I think you said, profitable by the second quarter of '18. Was that correct?

No. It wasn't. You're very attentive, and my whole group probably gasped. I meant to say second half of the year. But I did say that, Dan. Thanks for hanging on my every word.

No, I have -- I do have my days today. In the rare days, I -- today was one of, okay, because I was looking at the last transcript, and it said second half '18, so I got very excited. I'm still excited, don't get me wrong. I just wanted to see if there was a difference. Okay. No, that's fine. Let's touch on labels here. Obviously, double-digit growth, very encouraging. I think in the last call, you gave us an idea that you're going to be introducing new product in '17. So just wondering for the double-digit growth, how much of it was maybe a core run rate growth versus the new product? What drove this outsized performance?

Yes. I did give honorable mention last time to label's new products, but this was predominantly products that were commercialized earlier. One of them being like our harsh environment product, which is a lot of the growth has been driven by regulation, changes which introduced new colors. Once it did that, it introduced digital print, and that brought it to our products as a solid solution. So we're still enjoying growth from that. The pipeline is still good on the labels. And I hope to talk on the future earnings calls about some of the successes.

Okay. Great. And then on the production outage in Germany, can you just give us a little flavor of like what exactly you are doing? I think the press release cited you're boosting the saturation capabilities, which I understand. Just kind of give us a better understanding of what the long-term goal there is. Is it like to improve the quality, better cost curve or both?

Now we're very happy with the quality from our facility in Bavaria. It really was the safety and reliability of the process. So this is going to be at a very high level, but we saturate with methanol, which is a liquid, but our resins can come either in a liquid or in a dry form. So when you combine the 2 together, you've got fumes from one and potentially, a combustion material on another. So when we built our Appleton facility, everything is state-of-the-art and the latest. And we had a solution built in, in Appleton that, from a safety standpoint, realize, we need to make sure that we implement that in our legacy business in Bavaria. So as much as I didn't want to take a week of downtime out, I never want to look back and say I wish I did, if that makes any sense. So it's really safety and reliability. The team was awesome in the fact that they were able to reduce inventories, but it's going to be a while before we can replenish our inventories, getting Appleton qualified.

Okay. And then last couple here on the Fine Paper. Still seeing great numbers just on the retail side. Just -- given -- I know it's a public call here, but what's your secret sauce, you think, on the retail channel? Why are you guys continue to be seen as a supplier of choice, if I could call you that?

Yes. No, I would tell you, I'm very, very pleased that -- you're exactly right. First of all, first quarter disproportionally has retail sets. So if there's going to be change, it's going to happen typically in the first quarter. The team was able to grow their business by 9% in the first quarter. It's going to be -- that's not a run rate you should expect all year, but they did have a lot of success. And a lot of it is because it's consolidating category that has significant brand recognition. I mean, we really are the brand leaders. Nothing more important at retail than your brand presence. So team's done a great job at that, grown well in the first quarter. And retailers can be relentless. If your products don't perform, you're not going to sit on that shelf, so...

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Okay. And then the last one is on the M&A pipeline. Looks still healthy, but any color there in terms of what's coming to your table? Is it more on premium packaging or maybe Technical Products? Or you just rather not get on, talk about that on a public call?

No. I'll tell you, I will talk about that piece of it. I believe that our packaging team has a lot of the capabilities required to activate their strategy. Some other minor things, but really, we are focused on the Technical Products side, either in additions to our filtration business, which would be ideally, or into our performance materials. So we'll likely be focusing on the technical side of the business in the near term.

The next question comes from Jon Tanwanteng with CJS Securities.

Really nice performance in the Fine Paper segment with 18% operating margins. I think you mentioned that advertising was light in the quarter. It's going to normalize for the rest of the year. Can you just give us a magnitude of what the swing is going to look like in sequential quarters? And was that $2 million in difference that you noted from year-over-year?

I think -- well, we meant to characterize if we said that. But we meant to characterize that you're going to see a much more quarter-to-quarter spending level this year. Last year, if you go back to the first quarter, we had some pretty high costs early in the year. And it's going to be really -- going to be flat quarter-to-quarter. So I look at our spending in Q1 as being more representative of how we anticipate our quarter-to-quarter expense to be.

Got it. And the follow-on question would obviously be, do you think those 18% opportunity margins are sustainable there?

I would be disappointed if you didn't ask me that. I think what I publicly said is mid-teen margins, 14% to 16%, is a good expectation for the business. What those 18% really highlight is the fact that even though this business was not impacted by the fiber increases that are coming over the next 2 quarters yet, they've already acted in the marketplace and been able to move their pricing already. So I think what we're seeing is price increases being able to be pulled through yet the early parts of fiber impact. But I expect it will back down a bit.

That's helpful. Okay. And then just a little bit more color on the downtime in Germany. It's nice to see that you're putting in a process improvement. Was that actually planned beforehand? Or something that you just realized, as you implemented Appleton, you realized you had something better?

I think when we -- I think we've known that the current process, we have the same process in Germany for quite some time. So we've known that process. I think it really became, I think, more of a sense of urgency when we realized the differences between the 2 processes and felt we needed to implement this in the first quarter. There was consideration. At the end of last year, we were talking about it, but understanding just how different the 2 processes and the handling was. Clearly, the safety component of this made it a very easy driver that rather than wait and put it in our forecast, we really want to get that in and implement it. So that was the choice.

Got it. That's helpful. And then just finally, Bonnie, on the interest expense, is that the run rate we should be using going forward, given the way you're changing out how it happened last year?

Yes. I think that's a reasonable assumption.

The next question comes from Kurt Yinger with D. A. Davidson.

So first off, speaking of fine papers, given some of the maybe incremental input costs and then the lag of the price increases, is there any way to sort of talk to how maybe the CLASSIC branding relaunch would maybe help offset those things as the year went on?

Sure. Those are separate things. So let me back up just a little bit. The fine paper business was able to early activate their overall pricing. So they've been able to move. I was talking more in general and probably leaning more towards a customer-by-customer view on the Technical Products. So she's enjoyed -- I'd say she, Julie Schertell, runs our business there. They've implemented pricing. That's really what's given that 18% margin in the overall quarter. The CLASSIC relaunch does create some strong market interest and excitement. But just as a reminder, even as good as our marketing is, this is still a business in secular decline, so it'll help offset some of the pressures that they feel as customers bring new solutions to the marketplace. So both of those are value adding, but I would fully expect second quarter, third quarter really feel a lot more and put pressure up from her fiber.

Okay. So it's fair to say that the record earnings in the first quarter are obviously good run rate and probably are the best of the year?

Yes. So sometimes when -- yes, don't multiply that times 4, I think is what you -- they would really watch it, not to do. And by definition, from a record standpoint, the moons have to come in alignment. I don't want to take anything away from them. What we saw was real successful progress in the retail business, capturing new shelf sets, the courage to announce pricing early on, the market awareness to relaunch the CLASSIC businesses overall and then the consistent commitment to packaging and packaging growth as they reinvent their overall business. So yes, there's lots of great things going on and there are all those things come together to deliver a record quarter, but there's a lot of excitement in that business.

Okay. That's very helpful. And then just one more higher level. Looking at the secular decline that you mentioned, the struggles in the commodity market, can you talk about any sort of increased competition you've seen from people trying to move up the value chain? Or sort of what gives you comfort with your competitive positioning?

Sure. On the -- and predominantly, we're talking about fine paper here because on the technical side, we really do create and do solutions that pricing isn't. Usually, the only way to get knocked out on that, there are inherent product solutions. So on the fine paper side of it, I talked about the brand equity. So that -- those brands have been built already from the standpoint. Second, there's a significant technological barrier, whether it's in the amount of grade changes that our assets can do, the post paper machine processes converting and the ability to do small runs. Those are going to be all real clear barriers for anyone stepping in. It doesn't mean that the highest end of somebody's white papers couldn't be -- challenge some of the lowest end of ours, but what we're finding is also that when people are looking for direct mail solutions or greeting cards, they're looking for a little higher tactical quality level. I mentioned in the call, we had a significant increase in what we would consider being nonbranded greeting card, which we would say from a product portfolio, it's at the bottom of the list. Good news is that when people are deciding to print, they're going to print with the best, so...

All right. And then moving to Technical Products. Could you provide a bit more color on some of the support from your customers as far as the ramp from Appleton? Is there any way to sort of quantify, spoken for volumes? Or should we just sort of take away that 30% breakeven capacity for your use and then say, well, if in the second half of '18, you're going to be profitable, maybe you're at like a $30 million revenue run rate. Is that sort of a good way to look at it?

Yes, I think that's appropriate. As you can imagine with customers, our products are a very small cost component in the overall engine. So making sure that what they -- when they transition or move to a different asset that they are very, very comfortable with that. The efficacy of the product replicates what we do in Germany. So we knew going in this process that it's going to be a longer approval time. The customers will decide how quickly they get to their comfort level. We've already qualified a number of grades into commercial, and we'll start to see some of that revenue into the second quarter. And we've made the majority of the samples that we need to on our paper machines and continue to move that through our saturating processes. So the customers will decide the speed in which we go. I want to make sure that you have an awareness of our expectation. And I think it's -- consider my expectation that by the back half of next year, we should have about 30% of that asset utilized, which is where we grow that breakeven line. I hope it is faster.

Okay. And then so the incremental $7 million to $8 million versus the $4 million you'd talked about before, that was at speed, that was you deciding to ramp up quicker? Or maybe just...

Yes, it's a variety of things. And I would say, the first is we did a lot more trials than we had anticipated or planned. So that's a very positive thing, if you assume more trials means potentially more qualification. So -- but unfortunately, if you're running trials, you've got a very, very low yield. And that was one of the poor assumptions, I think, that -- from the beginning. Second piece is the labor. With more trials, I better be able to go not just to 1 shift to 2 shifts, and I better have prepared and trained the labor. So we pulled labor costs up from that standpoint, and that's impacting us early. But I would hate to get a qualified product and then not be able to optimize the speed on this asset. So those are a couple. We probably were more conservative than we should have been. What we are ensuring is that our customers know that we've got incremental capacity to support their growth, and we need to make sure that we're prepared to do it at the speed that they're willing to do it. So it's adding a little more costs up front for us. I'm not concerned on the project, though.

Okay. And then finally, forgive me if I missed this, but can you -- could you tell us where you'd sort of be comfortable taking the debt on your balance sheet? I think it's maybe 1.5x EBITDA now. Or where would you be comfortable as far as like a sizable acquisition or taking it up to or where you would like to just sort of run consistently?

Yes. What we communicated as ideal leverage target would be 2 to 3x. You're right, we are below that 2x period. And even we've been below that 2x for the last 4 years, 5 years, even though we've made 4 acquisitions. Our expectation would be that if we find the right opportunity for Neenah, we would be willing to lever up to 4x. But then our priorities for debt reduction, it would be in prepayable debt, and our priorities would change and we bring ourselves back down to that comfort level. We threw off a lot of cash, but getting the right acquisition is by far the most important thing. The leverage metrics are more of a byproduct of the decision than the driver of the decision.

This concludes our question-and-answer session. I would like to turn the conference back over to Bill McCarthy for any closing remarks.

Okay. Just very briefly, thanks, everyone, for your time today. Please feel free to contact me if you have any follow-up questions, and we look forward to updating you on our progress later this year.

The conference has now concluded. Thank you for attending today's presentation. You may now disconnect.