Timken Co (TKR) 2006 Q3 法說會逐字稿

Please stand by for real-time transcript.

Good morning. My name is Carrie and I will be your conference operator today.

At this time, I would like to welcome everyone to the Timken Company third quarter earnings conference call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question and answer session.

[Operator Instructions]

I would now like to turn the conference over to Mr. Steve Tschiegg, Manager of Investor Relations. Thank you, Mr. . Tschiegg, you may begin your conference.

Thank you and welcome to the third quarter conference call. Thank you for joining us today and if after our call you should have further questions; please feel free to contact me at 330-471-7446.

With me today are Jim Griffith, President and CEO; Glenn Eisenberg, Executive Vice President of Finance and Administration and CFO; Mike Arnold, President of our Industrial Group; Jacque Dedo, President of our Automotive Group and Sal Miraglia, President of our Steel Group.

We have remarks from Jim and Glenn and then all will 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 would like to remind you during our conversations today you may hear forward-looking statements related to future results, plans and business operations. Actual results may differ materially from those projected or implied due a variety of factors.

These factors are described in greater detail today's press release and in our report filed with the SEC which are available on our website www.timken.com. This call is copyrighted by Timken Company. Any use, recording or transmission of any portion without written consent of the company is prohibited. With that I will turn the call over to Jim.

Thanks Steve and good morning. About four weeks ago we reviewed a change in our outlook for the third quarter and at a high level of our performance. As you have seen from today's announcement, our results were consistent with that, with what we expected at the last teleconference.

Despite the drop in our performance in comparison with our original expectations this was a strong quarter for the Timken Company. Sales and earnings continued near record levels. Moreover, it was a quarter in which we made good progress on our strategic initiatives. Our strategy is to grow our business disproportionately in industrial markets. In the third quarter we made progress to enable growth in these markets through capacity expansion and new product launches.

We expanded our aerospace after market business in Mesa, Arizona more than doubling our current capacity and strengthening our ability to develop solutions for the aerospace after mark. Supporting that move, we have investments under way that will increase our aerospace bearing manufacturing capacity by almost 50%, strengthening our world leading position in this key market.

We made great progress in increasing our capacity at plants in Romania, China, and in the United States, producing large core bearings to serve heavy industrial markets. And we expanded our line of industrial seals to include large bore seals to provide a more complete line of friction management products to our distribution channels.

Our strategy in steel is to focus on business where we can achieve real differentiation. We had a record third quarter for both sales and earnings in our steel business. At the same time, we continue to shift the business toward our core of higher value products. Earlier this month, we announced the intention to exit our tubing business in the United Kingdom. This builds on previous actions including the sale of our precision steel components business in Europe and the closure of our [Worcester], Ohio, small tubing mill.

We also announced an investment in a new heat treat capacity to provide differentiated products, especially those used in energy applications. All of these reflect our strategy to focus on the alloy steel, bar and tubing business in the United States. Our strategy in automotive markets is to right size our business to a core that can earn above cost capital. We have already begun initiatives to move us down this path. The restructuring plan that we announced in July of last year is on target to reduce our costs by $40 million by the end of 2007. Some elements of that plan were completed in the third quarter.

We closed our automotive engineering center in Torrington, Connecticut and we closed our manufacturing engineering center in Norcross, Georgia. We consolidated both of these functions at a lower cost site in Greenville, South Carolina, that's focused on serving automotive transplant manufacturers. Additionally, we made solid progress in the downsizing of our plants in Vierzon, France and Clinton, South Carolina. However, the unexpectedly large downturn in demand from North American auto makers makes it clear that stronger and more immediate actions are necessary.

Last month we announced the reduction of an additional 700 positions across the business to counter the immediate impact of the reductions in demand. This will result in savings of about $35 million. When completed, these two programs will combine to -- excuse me. Will combine to deliver total annual savings of approximately $75 million and will result in a workforce reduction of approximately 1,200 positions.

As significant as these moves are, they alone will not bring our automotive business to its cost of capital. We are continuing to examine and implement additional actions and will continue to do so until we're firmly on that path.

And finally, we have made significant progress in our project one initiative. We successfully completed the pilot installation in Canada in July and are now preparation installation for the first major portion of the new systems and business process improvements in the United States early next year.

In closing, this is an exciting time for Timken Company. Our core industrial markets are strong and we expect that to continue. We are on the verge of achieving record results. At the same time, we are shifting the portfolio in terms of customers, markets and geographies as evidenced by record capital spending and broad restructuring initiatives. All aimed at improving profitable growth. Now, I will turn it over to Glenn for a more detailed review of Timken's third quarter performance.

Thanks, Jim. For the third quarter Timken generated sales of $1.3 billion and fully diluted earnings per share of $0.49. Excluded special items earnings per share came in at $0.57. The quarter included $7 million of pre-tax expenses primarily relating the restructuring and manufacturing rationalization, compared to $28 million in the third quarter of 2005. The rest of my comments will exclude the impact of these special items.

Sales for the third quarter were $1.3 billion, 1.2% above 2005, driven primarily by strong demand across broad industrial markets; which was largely offset by a significant decline in automotive demand. Key growth markets continue to be in the aerospace, energy, distribution, mining and heavy industry sectors.

Gross profit margin for the quarter was 19.8%, 50 basis points lower than last year. Reflecting the impact of lower volumes in the automotive group, which I will speak to in a moment when I cover our segment performance.

SG&A was 12.8% of sales; ten basis points favorable compared to last year and continued to include the increase investments in our Asia growth and project one initiatives. As a result, EBIT for the quarter came in at $87 million or 6.8% of sales, 30 basis points lower than 2005.

Net income for the quarter was $54 million or $0.57 per diluted share, compared to $0.58 last year, and in line with our revised estimate for the quarter of $0.50 to $0.55. The tax rate for the quarter was 29%, getting us to an estimated effective tax rate for 2006 of 32%. The lowered tax rate resulted primarily from having a higher percentage of the company's earnings in lower tax rate foreign jurisdictions.

Now I'll review the results for each of our businesses. The industrial group continued to perform well, driven by strong end markets where the group is investing for further growth. Industrial sales for the quarter were $502 million, up 7% from a year ago, benefited from strong demand across its broad industrial markets with the highest growth coming from the industrial distribution, aerospace and heavy industry sectors.

Industrial EBIT was $48 million or 9.6% of sales, 50 basis points lower than last year. The impact of favorable pricing and volumes was offset by a higher manufacturing cost including those related to capacity additions, as well as investments in our project one and Asia growth initiatives. Looking forward, we continue to expect strong industrial markets with improving margins.

Automotive group sales for the quarter were $364 million, down 11% from a year ago. Significant reductions in demand by North American OEM manufacturers, more than offset improved pricing. For the quarter, the group reported a loss before interest and taxes of $26 million, compared to a loss of $6 million last year. Lower automotive volume resulted in higher unabsorbed manufacturing costs, which more than offset the positive impact of pricing and mix.

As Jim mentioned, we're taking immediate actions in response to volume declines in the automotive markets and we will be taking additional structural actions to improve the performance of this business.

Steel group sales for the quarter were a record $443 million, up 3% from a year ago. The group benefited from increased pricing, surcharges and continued high demand, especially in the service center, aerospace, energy and general industrial markets but was negatively impacted by a decline in automotive sales. Steel group EBIT in the quarter was $63 million, up 27% from $50 million last year. The increased results were due to pricing, surcharges, mix and productivity. We continue to expect strong results from our steel group.

Looking at our balance sheet, we ended the quarter with net debt of $699 million, $43 million higher than the end of last year; with strong earnings offset by capital expenditures in support of our growth initiatives, pension contributions and seasonal working capital requirements. The company's leverage of net debt to capital decreased to 29.2%, compared to 30.5% at the end of the last year.

The company expects to generate strong free cash flow for the remainder of the year due to strong earnings and lower working capital requirements. Capital expenditures for the quarter were $74 million or 5.9% of sales, above depreciation and amortization of $50 million. This higher level of spending reflects our investment and growth initiatives including capacity to meet strong industrial demand. We expect this level of investment to continue.

We contributed $33 million to our domestic pension plans during the third quarter, bringing our year to date contributions to our targeted level of $150 million. As with last year, we will consider making additional contributions in the fourth quarter based on our pension-funding status and financial leverage.

In summary, we continue to experience strong industrial market demand that will be partially offset by lower automotive sales. The company has revised its earnings per share estimate, excluding special items, to $2.65 to $2.75 for the year, effectively raising the low end of our range by $0.05 per share.

From a cash flow standpoint we expect to see higher free cash flow in 2006, benefiting from earnings growth, better working capital management and lower pension contributions which will be partially offset by higher cash taxes and capital expenditures to support our growth initiatives. Despite the challenges we're experiencing within our automotive markets, the company is benefiting from its diverse end markets with the potential to deliver record results in 2006. This ends our formal remarks and now we will be happy to answer any questions.

[Operator Instructions]

And your first question comes from Mark Parr with KeyBanc Capital Markets.

Good morning.

Good morning.

Morning.

I had a question about SG&A. Glenn, I was wondering, sequentially the number looked like it came down quite a bit. Was there any adjustment to SG&A, accruals as a result of the reduction in your out look and what other color could you give us on the sequential reduction on SG&A?

Well, I'd say when you look at it, Mark, from an absolute level, SG&A has increased a little bit but obviously volume is going up as well. But as a percentage of sales, it's coming down. Obviously we're continuing to focus on our model of S&A spending to try to leverage the volume that we're getting.

Given the impact that is going on within the automotive group in particular, there's a heightened focus on S&A, as well to mitigate the negative impacts in the marketplace. So, no special changes, if you will, other than just the way we're managing the businesses and focusing on all of our cost structure.

Okay, terrific. And if I could ask a follow-up question on the steel business. I was wondering if we could get your best guess as to the trend of scrap pricing for the fourth quarter. And also what you are seeing as far as contract price realizations heading into next year in terms of, you know, plus or minus ore magnitude, et cetera.

Yes, good morning, Mark this is Sal Miraglia.

Hey, Sal.

I'm sure you're looking at the same publications as I'm looking at. We have seen a real softening in the scrap pricing for the fourth quarter. We expected to see that. It has come down quite a bit. Such that the amplification of it, because the auto schedule reductions, is more intense than we would have otherwise seen. Everything that we see says that the markets, including the automotive markets, are remaining pretty firm. That they will return pretty readily as we move from the fourth quarter into the first quarter.

So we actually expect, while not quite as extreme, we actually expect to see the Paris unit prices to firm back up again a bit, not going extremely wildly high, but getting larger. Again, that very same condition of market is still strong. The ones we participate in are dealing well with us, relative to our ability to continue our contract negotiations in line with the way we have been up to this point in time. So we're still looking at a pretty solid business environment.

Are you seeing the need to pull back production schedules as a result of weaker automotive schedules for the fourth quarter.

We're going to be slightly weaker in the fourth quarter on shipments. We won't necessarily be weaker on sales. Because, what we're not shipping there, we are shipping with much higher valued products in the industrial, energy and aerospace markets. We're not nearly as highly impacted as some of the big steel companies, the flat producers, as I'm sure you have seen who are taking a very big hit because of the reduced schedules. So we're much, much more mildly affected than that.

Okay. Thanks very much and congratulations.

Sure, Mark. Thank you.

[Operator's Instructions] Your next question comes from Eli Lustgarten with Longbow.

Good afternoon -- or good morning, it feels like afternoon today.

Good morning, Eli.

Good morning.

A couple of questions. There's a 7.3 million charge, showing up in the segment date for automotive, is that where it is being reported? It should be in the segment data also, isn't it?

The charge that we had for the quarter includes both the restructuring within our automotive and industrial and it's probably under the 7 call it around 5 million associated with auto and around 2 million with our industrial program. When you look at the segmented results we exclude the unusual items that are reported there. But if you wanted to add it back, those would be the numbers to add back.

In other words you reported a loss of 26 million in automotive. Is it 21 or 31?

It would be -- you would add back the $5 million restructuring charge to get to 31.

So we're looking at 31 million in that.

That's correct. And again, just consistent, Eli with all the restructuring or the unusual charges, whether positive or negative, that we have incurred, we treat that as a one-time charge

Yes, I'm trying to figure out how to reconcile the segment data into an income statement is what I'm trying to do here.

Yes, that's what you would do.

Is the fourth quarter auto loss going to be similar to the third quarter auto loss? Is that the kind of magnitude that we're looking at?

Well, Eli, let me start off obviously, we're not in a position to speak about forecasting the earnings going forward, as you know. Clearly, the expectations that we had in automotive, in this quarter, as well as going into the fourth quarter was that we would be back to a break even type of level. And obviously that was before the recent announcements of the big three cutting back their production levels.

As Jim mentioned in his opening comments, a lot of the changes that we have made right now, the headcount reductions, the work force reductions, are to help mitigate that. But additional structural changes will be need to be done to get back to profitability and obviously we wouldn't expect that to occur right away. So you can read into it that we will still be challenged to get our profitability level, but obviously we're working in that direction.

Well, I'm just trying to figure out you lost 26 million before any of those charges, the fourth quarter big three auto production is down 13%, the same as the third quarter. So it makes it's a little different but it went down. Will the loss mitigate it a little bit? I'm not looking for precision, but are we looking at the same kind of magnitude losses in the automotive in the fourth versus the third? Is that what is built into your forecast of $0.50 to $0.58 or something like that for the fourth quarter?

Yes, I guess the implied guidance by looking at our 260 numbers, or 265 to 270 numbers for the year would imply, call it a $0.47 to $0.57 range in the fourth quarter. I think it's fair to say on the margin we're looking at a comparable type of performance. We expect it to be better, but obviously we're working through all of the issues that are going on. Obviously to hit the upper end of the range that we have we would like to see and expect that auto could improve its results

Now, let's turn to industrial, which originally, the forecast was the margin for the year would be letter than last year. And you know, no matter what you do, you have to almost look at the fourth quarter, the third quarter operating margin and industrial being disappointing being so far above last year. Are we still holding to that forecast at the operating profitability of industrial will exceed last year or has that gone by the boards, too?

Well, again I will respond first. From a standpoint of the margins within industrial, we are clearly are being constrained by the investments that we're making and adding the new capacity given the growth opportunities that we see. We do believe that we will see margin improvement within the industrial group. As we go into the fourth quarter, relative to the third quarter, so we will start to see the positive trend. As a result, that will be a nice improvement over the margins that we have experienced in the fourth quarter of last year

Yes, you had 8.5% margin which was very depressed.

That's right, but that's why we say we expect that the margins should be even higher than we achieved in the third quarter. So it will be well above what we did in the fourth quarter of last year. Having said that, how will we come out the year plus or minus, it's going to be close. But whether we're up a little bit or down a little bit, we do expect to see the trend in margins to be improving

I mean to get close you have to show not only double digit margins but because probably of the 11% and 10%; is that still possible in the kind of environment we're talking about?

Well again, it's not something that the group has not done before, so again.

Just, 12 in the second, I understand that.

That's right. The way we would like to leave it is that, again, we are growing the volume. We're not leveraging it to the extent that we would expect or like because of the commitments of the investments that we were making and that is what is con training it more than anything else. We do expect that as we have said that we'll improved results and improved margins as we go forward. But they will still be constrained relative to the performance that the business could be doing were it not for the investments

And that will continue and get heavier in the first quarter with SAP going in won't it. The first half of next year?

I think that the level of spending that we're doing on the project one initiative is fairly steady, so I don't think that from a change standpoint. And in fact as we go into 2007, the comparison relative to any of our businesses will be that we will have had the cost the prior year. Some of the issues that we're dealing with in 2006 is that we didn't have the costs in 2005. That is negatively impacting the margin. Going forward you shouldn't expect to see that be an increase year over year.

The 32% tax rate this year, does that continue into next year or does it go back up, 33, or what happens?

For modeling purposes, I think it's fair to say it will be in the 33 to 34% range. In part, because we're going to be moving out of the export tax incentives that the company has enjoyed and it's moving toward this manufacturing deduction. So net-net that's 33 to 34 is probably a normalized range going forward. But for the fourth quarter, obviously our expectation is the 32%

One final question. When you're talking about steel and the changes in scrap prices should we expect that we will see a moderate decline in the steel profitability in the fourth quarter versus the third because of the changing surcharges and stuff like that?

I would at least couch it this way, Eli. We expect to see improved performance over what steel had done the same period last year and there are always seasonal factors and so forth. The profitability that steel is going at is a run rate that has been a record level. There are certain things like material prices, scratch prices that will have an impact on the result, either positively or negatively. So it's -- you know, we're not in a position to forecast that other than to say the relative level of performance that steel is enjoying, we would expect that to continue

Thank you very much.

Thanks, Eli.

Your next question comes from George [Shalukos] with Baldwin Brothers.

Thank you; if I could I get back to the industrial group and the EBIT margins, capacity additions and growth initiatives, could you quantify the amounts? And could these be capitalized as opposed to expenses?

Well, again, we look to the proper accounting treatment to determine whether or not we will capitalize or expense any items. What we have consistently said is that we are burdening the results with the expense relating to it. We are adding capacity. We probably put on, -- well, I will have Mike address the growth.

Sure, George, this is Mike Arnold, just a couple of comments. Yes, we can quantify it to the fact that as Glenn talked about, our continued investment in project one the two single biggest investments from an industrial perspective is in Asia. And that continues to grow quarter-on-quarter, year-on-year, which is one of the issues that puts the pressure on the eventual margins. If you looked year-on-year; third quarter-on-third quarter, you could put Asian in terms of 60 basis points just to give you a feel for what that looks like.

From a pure capacity standpoint and this is the ramp-up of facilities that are focused on our growth markets. As Glenn and Jim pointed out earlier, our growth markets are clearly the aerospace industry, any of our distribution markets, the heavy industries, mining and then of course establishing ourselves with a broad-based manufacturing capability in Asia. And again in that area, we put it in that same sort of level of investment from a capacity standpoint.

So as you can see, if you just take those issues and put them together and compare those on a year-on-year margin, quarter-on-quarter margin that we continue to leverage the positive growth in sales. While we're investing in the future and the investments that we are making are directly tied to those industries that they are providing the strong sales growth and our forecasts remain strong for some time in the future.

Thanks, guys.

Thank you.

our next question comes from Mark Parr with KeyBanc Capital Markets.

Thanks very much. I was wondering if you could give us an update on your growth in China. I have seen some trade press recently indicating some concern that growth in China might be slowing. I was just wondering if you're seeing anything along those lines or if you could give the Timken perspective on what is happening over there right now. Thanks.

Yes, Mark, this is Mike Arnold. Let me give you a little insight. We obviously not only read the press but we are part of China. We now have over almost 15% of all of our associates actually operate in China. We're in the midst of our fifth manufacturing facility being built. We will probably announce in the next few months, two more facilities in the Asian region to serve the Asian market.

So it's all still very exciting from a growth perspective. There is some slowing of growth but you have to put it in the context of it's still is the fastest growing area of the world even after the slower growth. Plus, what we watch very closely Mark, is the mix of what that growth is. So that as they have installed an enormous amount of energy creating power plants that are based upon coal, they then begin to move on to other places of infrastructure, wind energy and these kinds of markets.

So we have a very strong infrastructure in China, we have a growing manufacturing base and capability. We, therefore, are part of the -- not only China, but the Asian market and we sense, just like we would any place else in the world as to which ones are strong and which aren't, where we should forecast our capacities, our technologies, et cetera. So, it's still a very, very exciting market

Okay. Terrific. Thanks Mike.

Your next question is from Andrew Obin with Merrill Lynch.

Good morning, guys. Just a question, after the preannouncement, I guess my sense was that there would be a big restructuring announcement eventually. And I'm not getting the sense that we're getting to announce some sort of plan of action for auto. Am I wrong here or there going to be a big restructuring announcement for auto or are we going to take it a little by little over time?

Andrew, this is Jim, let me see if I can put this in some perspective. The assets that we are talking about being idled in the auto business are assets that serve both the automotive and industrial markets. I think we talked about that as we talked about the impending heavy truck shut down.

It's the same stuff that deals with Detroit. And these are the same assets that 12 months ago we were sitting in this room talking about how full they were and they were constraining sales into industrial markets. And given that perspective, it causes us to move cautiously. We have made the changes to neutralize the variable costs and we're now looking at what changes we need to make to impact the structural costs in the assets. And we're going through that in a very straightforward process.

We are looking to where we can accelerate sales to transplant customers or to more profitable industrial markets. We are considering facility rationalization. We're considering asset rationalization to more competitive markets and we're also continuing to look at our portfolio, looking at their places in the automotive markets that we should no longer continue to participate. Just like we did with the European tubing business in the last month. So it is that process and that process will continue.

I appreciate this, but I guess what it means is that eventually there will be a comprehensive restructuring announcement, is that right?

I didn't say that.

Okay, but I guess I'm just a little bit confused. So are we going to take it sort of -- but that probably means that there will be more charges in the next couple of quarters? I mean, the way I thought about it, that we're going to take a big restructuring announcement, clean it -- you know, clean up the earnings and then just sort of start off with a clean slate. But based on what you're telling me, we're going to see if something gets worse and if there are more disappointments, we're back to being reactive instead of proactive on the restructuring here.

Let me come back and tell you what I said before, just so we're all on the same wavelength. We're continuing to examine and will implement actions as appropriate to adjust the structural costs. We're not prepared to talk about the timing, the size, the form of what those actions are going to be at this point.

Now that's a fair answer. In terms of recent announcements by Caterpillar; which is a big customer of yours about under production in 2007. I'm just wondering, when was that communicated to you guys? Did that come as a surprise to you or were they communicating this to you all throughout the quarter?

Yes, this is Mike Arnold, Andrew. We are in daily communication with Caterpillar with regards to not only current schedules, but future forecasting, for where we do our capacity planning and our operations planning and et cetera. So the announcement you have to look very closely as to what they were talking about as Caterpillar, I think they phrased it as it was a pause from a corporate perspective.

As you know, that they're on highway truck engine was a piece of that and the slow down on that in '07 and the pickup in '08. But in the markets that we are very participative with Caterpillar on, it is still very strong. And I think they talked about that as they announced earnings with regard to particularly the mining industries and this is an area where we participate very heavily across the industry. Caterpillar is a key customer of ours and so we are fully engaged with regards to their schedules their requirements

So, effectively the announcement from Cat in terms of production shutdowns maybe was a surprise to us, but it was not as much of a surprise as the order shutdowns, right?

That's correct. There was nothing in their announcement that would have been a surprise to us with regards to what we planning to do to supply them.

Thank you very much I do appreciate, Jim, your answers on the restructuring. Thanks a lot.

Okay, thanks, Andrew.

[Operator Instructions] Sir, at this time there are no further questions.

All right, thank you very much. We appreciate your interest in the second teleconference this quarter. I appreciate the guess and I appreciate the insightfulness of the questions and I appreciate the fact that they reflect what we feel, that this is an exciting time for Timken Company.

This concludes today's Timken Company third quarter earnings conference call. You may now disconnect.