Timken Co (TKR) 2005 Q2 法說會逐字稿

Good morning. My name is Nikki and I will be your conference facilitator. At this time, I would like to welcome everyone to the Timken second quarter 2005 earnings release conference call.

(OPERATOR INSTRUCTIONS)

I would now like to turn the conference over to Mr. Steve Tschiegg, manager of investor relations. Please go ahead, sir.

Thank you and welcome to our second quarter conference call. I'm Steve Tschiegg, Manager, Investor Relations. With me today are Jim Griffith, President and CEO, Glenn Eisenberg, Executive Vice President of Finance, Administration and CFO, Jackie Dedo, President of our Automotive Group, Mike Arnold, President of our Industrial Group, and Tim Timken, President of our Steel Group.

We have remarks this morning from Tim and Glenn and then we'll all be available for Q&A. At/ that time, I would ask that you please limit your questions to one question and one follow-up at a time to allow an opportunity for everyone to participate.

Before we begin, I'd like to remind you that during our conversation today you may hear forward-looking statements related to future financial results, plans and business operations. Actual results may differ materially from those projected or implied due to a variety of factors. These factors are described in greater detail on today's press release and in our reports filed with the SEC, which are available on our website, www.timken.com.

Reconciliation between GAAP and non-GAAP financial information are included as part of the release, as well as on the investor's overview portion of our website. This call is copywrited by The Timken Company. Any use, recording or transmission of any portion without the express written consent of the company is prohibited.

With that, I'll turn the call over to Jim.

Thanks, Steve.

Our overall results for the second quarter were strong, as we recorded record sales of $1.3 billion, an increase of 17% over last year, and record second quarter earnings per share, excluding special items, of $0.77, more than double last year's earnings and above our prior estimates. Actions taken to differentiate ourselves in the market, as well as our ability to leverage strong industrial markets, contributed to solid performance in the quarter.

Let's talk about the industrial and auto markets for a minute. We see continued strength in the global industrial markets, especially rail, mining, aerospace and energy. This is evidenced by the U.S. Federal Reserve's Industrial Production Index for June, which rose by 0.9%, the largest increase in nearly 18 months, and the production of industrial equipment in the United States up 20% since 2003. The rate of growth through 2006 looks remarkably like the growth rates achieved in the mid '90s.

Some of the markets that were significantly depressed now show sustained strength. Rail is a great example. Freight car deliveries have returned to the strong levels seen five to 10 years ago, as there is pressure to replace an aging fleet. The rail car backlog of 12 months implies good demand through 2006. Other examples are construction, mining, oil, aerospace and industrial machinery production where economists are anticipating continued growth beyond this year.

Economists are also projecting substantial growth in U.S. machinery exports, up 22% from 2003 to 2004, with an increase of 16% expected in 2005. And this is just the United States. In Asia and emerging Europe, the growth rates are much greater.

Unfortunately, the automotive market has not performed as well. In fact, the challenges are intensifying as the combination of the overall slowdown of light vehicle production in North America, along with high raw material costs, continue to adversely impact the auto industry.

Overall, we view our performance in the second quarter as a clear signal that The Timken Company is positioned to achieve higher levels of profitability than during the last business cycle of the 1990s. We continue to focus on improving performance over the cycle, with a special focus on minimizing the impact of business troughs.

We have made significant progress in restructuring our industrial business to reduce fixed costs and streamline our ability to service our customers. Detailed restructuring plans will be announced for our automotive business later this quarter in order to again reduce fixed costs and improve both our business focus and our ability to serve our customers. These moves, coupled with efforts to diversify both our products and our markets, point to continued improvement in company performance.

Now I'd like to review the performance of our individual segments. In the second quarter our Industrial Group continued to perform well. Sales for the quarter were $498 million, up 14% from last year. Continued strong demand increased sales in all end markets, with the strongest growth in industrial distribution, rail, mining and agriculture.

Industrial EBIT was $64 million, or 13% of sales, an increase of 150 basis points from last year. Performance continues to be favorably impacted by volume and pricing actions, as well as our ability to recover material cost increases through surcharges.

During the quarter we announced the sale of our Linear Motion Systems division located in Western Europe that had been acquired as a part of the Torrington transaction in 2003. Linear Motion had annual sales of approximately $40 million. This divestiture was part of our ongoing process to review all of our businesses for strategic fit and the ability to differentiate ourselves in the marketplace.

The Industrial Group continues to focus on improving capacity utilization, product availability and customer service in response to strong industrial demand. We are aggressively pursuing growth opportunities in industrial markets and in bringing new products and services to the market. For example, during the quarter, sales in China increased nearly 50% over the second quarter of 2004. We also introduced a new line of industrial oil seals and expanded our maintenance tool line in North America.

Automotive Group sales for the quarter were $426 million, up 5% from last year despite continued declines in North American light vehicle production. Increased sales were primarily driven by favorable pricing actions and demand in heavy-duty trucks, which were up roughly 15% from the same period a year ago.

The automotive market has been especially challenged in North America. While we've continued to make progress in the recovery of higher raw material costs, these costs adversely impacted the second quarter results. In addition, we are in the position of being challenged by lower volume in facilities producing applications for North American passenger cars, while at the same time experiencing heavy costs due to the need to run other facilities, those that serve the heavy truck and industrial markets, beyond their economic capacity.

Consequently, the Automotive Group reported a loss before interest and taxes of $1 million for the quarter compared with EBITDA $7 million last year. While the performance has improved from the prior quarter, it fell far short of our expectations. We have made progress in diversifying our automotive customer base and reducing our costs. However, with several major customers continuing to lose market share, we have determined that it is necessary to take more decisive actions to improve performance.

Over the third quarter we will announce plans to restructure our automotive manufacturing and engineering channels to reduce fixed costs and to improve effectiveness. These actions are targeted to achieve annual savings of approximately $40 million. We believe that these actions will reduce employment in our Automotive Group by approximately 400 to 500 positions and will result in a one-time charge of earnings -- or to earnings of approximately 80 to $90 million. The auto restructuring will be completed over the next two years.

Timken Steel Group continues to benefit from strong market demand, reporting sales of $445 million, an increase of $115 million or nearly 35% from 2004. The increase was driven by stronger demand, price increases and surcharges to recover high raw material and energy costs. Sales into the aerospace, energy and general industrial markets continued to be much stronger than last year.

Steel Group EBIT for the quarter was $57 million compared to 3 million last year as the Group leveraged strong volume with productivity improvements, price increases and surcharges. Our investment in a new continuous rolling mill at Timken's specialty steel operation in Latrobe, Pennsylvania also contributed to the improved results.

While scrap costs in the quarter were about the same as a year earlier, alloy costs using the production of steel have increased significantly. Surcharges to help recover these increased alloy costs were collected on nearly all shipments during the quarter. This was not the case last year. The Steel Group also benefited from a positive difference between the scrap surcharges versus the costs in an extension of our experience in the first quarter. As anticipated, this difference diminished in the second quarter and is not expected to continue.

On June 21st, members of the United Steel Workers Union failed to ratify a new labor agreement agreed to by the company and the Union. The current agreement covers approximately 2,700 associates at Bearing and Steel Operations in Canton, Ohio. Obviously, we are disappointed with this outcome. The company and Union are continuing to discuss the next course of action. We expect to achieve a favorable resolution prior to the expiration of the current labor agreement on September 25th, 2005.

Overall, the performance in the second quarter reflects The Timken Company's ability to deliver strong results for 2005. We continue to see strong demand for our products and are committed to achieving increased levels of profitability.

Thank you. Now I'll turn it over to Glenn.

Thanks, Jim.

For the second quarter we reported fully diluted earnings per share of $0.73. The quarter included $3.7 million of pretax expense, primarily related to manufacturing rationalization and reorganization expenses, which were partially offset by a $2.6 million gain on the sale of the Linear Motion Systems business. In the same period last year, earnings included $7.6 million of pretax expense, which primarily related to Torrington integration. The rest of my comments, consistent with those by Jim, will exclude the impact of these special items.

Sales for the quarter were $1.3 billion, a record quarter for the company and 17% over 2004, driven by strong industrial markets. Strong performance by our Steel and Industrial Groups generated EBIT for the quarter of $118 million, nearly double last year. This resulted in an EBIT margin of 8.9%, 360 basis points better than 2004, driven by strong gross profit.

Net income for the quarter was $71 million, or $0.77 per diluted share. Earnings per share were more than double last year's results of $0.33 and compared favorably to our estimate for the quarter of $0.55 to $0.60.

The tax rate for the quarter was 32%, getting us to a year to date rate of 34%. The lower tax rate resulted primarily from higher earnings generated in lower tax rate jurisdictions. The lower tax rate for the quarter benefited earnings per share by $0.04 compared to the 36% rate provided in our prior estimate. We expect to maintain our year to date tax rate of 34% going forward.

We ended the quarter with net debt of $775 million, 47 million higher than the end of last year, principally due to higher working capital requirements to support the company's sales growth and seasonality. The company's leverage of net debt to capital of 36.6% was comparable to the end of last year. By the end of 2005, we expect our net debt and leverage to be below year-end 2004 levels.

Operating working capital increased $166 million during the first 6 months of 2005 to support the company's sales growth. We expect working capital to be a source of cash in the second half of this year.

Capital expenditures were $83 million, or 3.2% of sales, during the first six months compared to depreciation and amortization of 108 million. This spending level will increase over the course of the year as we continue to make investments in support of our growth objectives and process improvements.

We contributed $73 million to our domestic pension plans during the first half. Our full year 2005 contributions are expected to be approximately $125 million compared to 185 million last year.

At the end of the quarter, we took advantage of the favorable bank market and amended our $500 million senior credit facility and extended it for another five years.

We are increasing our earnings per share estimates for the year, excluding special items, to be $2.40 to $2.55 and for the third quarter $0.50 to $0.55. This increase results from our expectation of continuing to leverage well the strong industrial markets that are affecting our industrial and steel businesses. However, as we've discussed in the past, steel results are expected to be lower in the second half of the year due to seasonality and lower raw material surcharges.

While we expect our automotive business to improve in the second half, it is unlikely that we will achieve last year's automotive results. However, our restructuring actions will better position this business for improved profitability in 2006.

This concludes our formal remarks and now we'll be happy to answer any questions. Operator?

(OPERATOR INSTRUCTIONS)

Your first question comes from Andrew Obin of Merrill Lynch.

Yes, I guess it's still Good morning. I have a question about automotive growth. Growth this quarter was around 5% and it's the highest it's been in a couple of quarters and I'm just wondering are you guys considering trying to ramp this growth down? You're not making a lot of money in this business and my understanding is that some of the capacity that is used to support this growth could have been used for higher margin industrial business or is it just the fact that the contract, your contractual obligations, are just sticky and it's just going to be hard to do it in the short term?

Andrew, yes. This is Jackie Dedo. Thank you for the question. We are, as we've mentioned over the last several quarters, focusing on contract renewal. For unprofitable contracts, we are exiting them as they come up. For our contracts that we have, we are fulfilling them. I can tell you that a large part of the growth that you saw quarter over quarter was not due to growing volume in the industry, but rather success in our contract renewal and raw material negotiations. So we are taking all of the volume that we don't need to fulfill contracts in automotive, pushing it onto industrial markets. We are also running -- ran in the second half our plants further past peak to continue to try to serve the industrial markets wherever we can.

And just a follow-up question that may be sort of non-related. You sort of talked about net debt reduction through the end of the year. What would be sort of -- can you quantify what we're expecting in terms of net debt reduction from year-end of '04 to year-end '05, excluding any divestitures you might be planning.

Andrew, this is Glenn. We obviously don't talk about the magnitude, but at least I'll tell you the direction. Obviously we continue, based upon the new estimates, look to provide improved performance and cash from earnings and obviously we're increasing our estimates from that respect. We did have a buildup in working capital, probably higher than what we would have expected in the first half of the year, in part against seasonality and supporting our growth initiatives. But we do expect to see good contributions of cash coming from our working capital. We're maintaining our CapEx. As you know, we target roughly around 4% of sales, or a little bit below depreciation. So all the factors in the second half then again follows our normal seasonal patterns such that we'll push off very good cash flows.

In addition, we always true up our pensions in the first, call it nine months of the year. We'll put around 125 million, so in the second half we would be contributing less than the first half. So all the dynamics tell us, excluding acquisitions and divestitures, that we'll push off very good free cash flow that would be used to pay down debt, barring other type of opportunities.

And automotive restructuring, what are the cash outlays you're going to have? This is an event that's beyond 2005, is that correct?

That's correct. Obviously what we've done is set the broad parameters of the program, as we go ahead and announce the specific plans, if you will. As we go forward, we'll give you the more specifics as far as costs versus cash costs versus P&L costs and so forth.

Your next question comes from Mark Parr of KeyBanc Capital Markets.

Had two questions. First, related to the automotive bearings business, the -- I understand and actually want to congratulate you on getting some positive pricing momentum in that area. And I guess I'd like more color on how far along in the process are we? Are we just seeing the beginning of this process or could there be an acceleration over the next several quarters?

Mark, Jackie. Yes, as we've told you before, as I've told you before, in 2004 we had about 25% of our total contracts opened and renegotiated. This year our total renegotiation will culminate somewhere between 65 to 70% of our sales, depending on final sales. We are on track through the year with closing them or renegotiating them as they come up.

I can tell you, to give you some color, that the second half will have a larger impact than the first half because those that we negotiated in the last part of the second half, namely the second quarter, start to have an impact in the third quarter and we will continue to negotiate through the third quarter and the fourth quarter as the contracts come up.

Okay, thanks very much. Had another question, if I could. This is more on capital allocation and looking at your goals on capital spending. Could you talk a little bit about where you anticipate allocating those funds, particularly geographically, such as the U.S. versus Europe versus Asia versus India, et cetera? Could you talk -- give us some color on that, please?

Mark, this is Jim. I think we've been very clear that our aspiration is to grow disproportionately in Europe -- or excuse me, in Asia. And that is the focus of our new manufacturing capacity. If you step back and look at our capital overall, about a third of it is maintenance capital and that will be spent on the geographic base of where our assets are. About a third is spent driving performance improvement and again, that's going to be where our assets are. So when we talk about disproportionately -- we're putting new capital into Asia, it is disproportionately in that final third that is the growth capital.

Okay thank you very much and Congratulations, keep up the great work.

Your next question comes from Wendy Caplan with Wachovia Securities.

Good morning. In the Industrial Group, could you please give us an update on field inventories and, in addition, pricing in that sector? And can you give us some idea of the mix shift from auto production being replaced with industrial production?

Sure, Wendy. This is Mike Arnold. From the inventory position in the field, I think as you referred to it, it's consistent with what we've really said for the last four quarters. The inventory balloon of products, specifically on the fastener line, has come down, as planned. That continues to happen, which has brought us back to more normal buying patterns now into the second quarter, which is a little bit of what you'll see some of the hump-up of volumes. That has returned to more normal buying in those lines of products because the inventory is back to reasonable levels.

On the pricing, pricing remains strong, Wendy, across the globe in most of the industrial markets and I'm sure that you're seeing that throughout most of the people who participate in power transmission side of the industries. But pricing does remain strong and the recovery of obvious material issues over the last year or so has continued strong.

And then the last question around mix, Jackie alluded to that a little bit earlier, is that when we find the opportunity that we have capacity that is in excess of demand in any given month, but then we move very aggressively to satisfy customers who have orders with us. And you've seen a little bit of that also in the second quarter, some of the slowdown in the automotive industry, the opportunity to take some of that capacity and dedicate it to our industrial customers across the world. And so you're seeing some of that benefit.

And we would expect to see that benefit going into the second half of the year?

Certainly the first two benefits. The one with regards to the mix, we would expect that to happen, that's correct. But that is an ongoing industry-by-industry issue as to softness, weaknesses, strengths, et cetera. But we would expect to continue to see some mix change in that direction.

Your next question comes from Stephen Volkmann with Morgan Stanley.

Jackie, can I just follow up with you for a second? I think you mentioned at one point that you were -- as you put through these price increases to your customers that there were certain business that you were willing to walk away from. I was just curious if that's happened or if they've sort of come back and been fairly responsive on the price increase.

Steve, thanks for the question. This is Jackie. It's a mixture, quite honestly. As we've talked about over the last 18 months, going through both a contract renewal program, as well as a portfolio management, we are finding out where we differentiate in our customers' eyes and where we don't. We're -- the majority of our portfolio, we're finding they create -- they see value in and we are renegotiating prices and long term contracts with them. The minority of the portfolio, but certainly a reasonable portion, we're finding that we have to restructure. And we have sufficient now data and analysis to take the first step of that and hence our restructuring announcement this morning.

Okay, great. And then just maybe more broadly, what are we expecting for raw material cost trends through the second half? I'll just leave it at that.

Hey, Steve, Tim Timken. Right now we're seeing -- I think we've seen scrap bottom out. In fact, I think if anything, through the rest of the year I think we'll see it tick back up. Alloys, we didn't see the magnitude of the falloff in alloys that we did in scrap and again, I believe those have stabilized to a certain extent. So I'm not sure the picture changes too much for the second half from where we are today other than a modest move upwards.

Okay, Tim. And maybe just a follow-up real quick. What do you think the breakdown is in terms of you've gotten a lot of pricing; some of it's been surcharges, some of it's been sort of pure pricing. How do you think we could break that down just roughly?

Let me make sure I understand your question, Steve. From a financial performance in the second quarter, how do you break it down or looking forward?

I guess I was thinking more broadly. What you're saying, I think, is that as you give back some of these raw material price surcharges in the second half, your margins are likely to come down a little bit. I'm just trying to get a sense of how much of your pricing in the past six months has been surcharge versus sort of pure price increase that we might not have to give back.

Earlier in the year obviously we had -- there was a larger impact from surcharge. As we've gone through the last four or five months, that's skinned down, so the performance that you've seen in the second quarter, while inflated to a certain extent, is getting closer to our kind of core profitability.

Okay. Would you be willing to say what the core profitability would be?

I would say, Steve, when you look at the -- just from a margin perspective, steel had obviously very strong performance in the first half. Even in the second quarter it was still at 12.7 and they did still benefit from some of that mechanism in place. As we look to the second half, assuming peak performance within the business, excluding that kind of opportunity or benefit, historically we've run the steel business at around 10% margin. So it gives you a little bit of perspective.

And obviously you have to temper it a little bit that in the first half as well we enjoyed good volumes within the auto business that's now starting to slow down a bit. So overall, we expect them to do well, but have a lower second half than first, in part for the material issue as well as just the overall market.

Your next question comes from Chris Olin with Longbow Research.

Just two quick questions. First is, can you talk a little bit about the industrial services business, how is that growing and what your outlook is for that?

Yes, this is Mike Arnold. It represents -- depending upon how you define the services side, but if you just talk about non-bearing product or sales not manufactured by us, it represents about 10% of our revenue, which continues to grow year on year. And it grows not only in our traditional markets, but even as we grow in Asia, service is a significant component of what we (technical - audio gap). Does that answer your question?

Yes, yes. Second question is just on the steel business. Can you talk a little bit about the aerospace business, what percentage is that making of the volumes right now and where you see that going?

The aerospace part of our steel business is located in Latrobe, Pennsylvania. Latrobe is a relatively small part of our total business and within Latrobe's business, it's about half their business. So we're -- total, you're in the, I'm going to say $70 million to $80 million range sales. Obviously they're enjoying some pretty strong performance this year and we expect that to continue as long as the aerospace and defense markets stay hot.

Your next question comes from Holden Lewis of BB&T.

On the automotive side, in terms of the profit margin, I think you talked about this passenger car sort of larger car mix in the last quarter and thought that you'd have some success or be able to sort of right-size both of those businesses and get them blended more successfully. I guess we did not have any success there. Are we seeing that there is a more structural issue in terms of how you have passenger versus SUVs or is that something that we might be able to get fixed just based on what we're doing now? Where are we on that issue and what are the prospects for getting it solved in the near term?

Holden, Jackie. Let me take a shot at that and then if I don't answer it, you can re-ask the question. We are -- we have seen a larger degradation in some of our core customers, namely the Big Three domestics, in the last quarter than anticipated. We have been taking out, to the extent possible, headcount in order to deal with that. We have that combined with our work with our customers through contract renewal to understand which products will be long term viable.

You take the combination of the increase, the larger decrease of volume with the Big Three this year, combined with the understanding of which products we clearly want to move forward with versus which products we don't, and we put that together and announced the restructuring that addresses this issue. We'll be giving you the details of the restructuring over the next 60 days, as mentioned, in some staggered announcements, which then we will implement over the next two years. Does that answer your question, Holden?

Yes, that's fine. Gives me a sense of how you got to a to b. And then the 80 million or 90 million in charges, I know you're not going to give a lot of detail, but do you plan on taking that in sort of Q3 or is it going to drag out over an extended period of time in pieces?

Holden, until we're in a position to announce each of the plans, it'll be a function of that. But, as you know, most charges these days relates to almost a little bit of charge-as-you-go along the process. As Jackie commented, the whole program is envisioned to be within the two years, so the charges would occur there. But as we announce the different programs, we'll let you know the impact on timing, as well as just cash versus P&L expense.

Your next question comes from Andrew Obin of Merrill Lynch.

Just a follow-up question. Based on what I see in my model, the growth margin this quarter was the best since the second quarter of 1998 and that was pretty much the time your business was peaking. Given that the margins in the steel business are probably going to get a little bit softer going forward, what do you think -- and I'm not talking about next quarter, but sort of thinking about over the next two years -- what do you think is the opportunity to drive the gross margin forward given that we'll probably have another couple of years left in this recovery?

Andrew, this is Jim Griffith. I think you have assessed The Timken Company very well. I believe we are below peak earnings as a company. A different way to say it is we delivered a record second quarter with two of our businesses delivering good profitability and one of them not delivering good profitability. As this management team has done when we see that situation, we identified a solution, we will implement that and that by itself will propel earnings to a higher level. Plus I believe this industrial market has got at least another years of good wind in it that I believe can take us to higher levels of profitability.

So I should be thinking even with what we're seeing in steel, auto should catch up enough to allow for further expansion in gross margin?

That would be our expectation.

At this time there are no further questions. Are there any closing remarks?

Would you go ahead and just poll again one more time, please, to see if everyone had an opportunity to ask a question?

(OPERATOR INSTRUCTIONS)

Your next question comes from Mark Bishop (ph) of The Boston Company.

I was just wondering on your savings in the auto area from the restructuring how much of that -- like what the timing is, like what percentage of it might be done on a run rate by, say the end of this year and what next year?

Mark, again relative to the program, we just wanted to give you the broad analysis of it and as we roll out each of the individual programs, we'll be able to speak specifically to the timing in those issues. But not until we're announcing those programs.

At this time there are no further questions.

Okay. Well, thank you very much. My question from Andrew, the last one, perhaps got my closing comments out. It is clear to us that our performance in the second quarter provides evidence that the initiatives we began five years ago to differentiate ourselves in the marketplace and to improve our operational effectiveness have shifted us to a new level of profitability. As evidenced by our auto announcement today, we continue to aggressively redefine ourselves to respond to dynamic market changes and to customer needs. We believe that this will lead to even higher levels of performance throughout the business cycle.

Thank you for your interest and your investment in The Timken Company.

Thank you again for joining us today. If you have any further questions, please feel free to give me a call. This is Steve Tschiegg. Telephone number is 330-471-7446. Thank you.

This concludes today's Timken second quarter 2005 earnings release conference call. You may now disconnect.