Universal Stainless & Alloy Products Inc (USAP) 2015 Q3 法說會逐字稿

Good day, ladies and gentlemen, and welcome to the Universal Stainless third-quarter 2015 conference call and webcast. (Operator Instructions). As a reminder, this call may be recorded.

I would now like to introduce your host for today's conference, Ms. June Filingeri. Please go ahead, ma'am.

Thank you. Good morning. This is June Filingeri of Comm-Partners. And I also would like to welcome you to the Universal Stainless conference call and webcast. We are here to discuss the Company's third-quarter 2015 results reported this morning.

With us from management are Denny Oates, Chairman, President, and Chief Executive Officer; Larry Pollock, Executive Vice President and Chief Manufacturing Officer; Chris Zimmer, Executive Vice President and Chief Commercial Officer; Paul McGrath, Vice President of Administration and General Counsel; and Ross Wilkin, Vice President Finance, Chief Financial Officer, and Treasurer.

Before I turn the call over to management, let me quickly review procedures. After management has made formal remarks, we will take your questions. The conference operator will instruct you on procedures at that time.

Also, please note that in this morning's call management will make forward-looking statements under the Private Securities Litigation Reform Act of 1995. I would like to remind you of the risks related to these statements, which are more fully described in today's press release and in the Company's filings with the Securities and Exchange Commission.

With these formalities out of the way, I would like to turn the call over to Denny Oates. Denny, we are ready to begin.

Okay. Thanks, June. Good morning, everyone. Thanks for joining us today.

We expected the third quarter to be a challenging quarter based on business industry conditions, commodity prices, and normal seasonality. Unfortunately, the quarter lived up to that expectation and more. Our third-quarter sales of $43.4 million were down 13% sequentially and 19% from the third quarter of 2014.

Falling commodity prices and customer destocking picked up momentum in the quarter, with bookings, excluding surcharges, falling to $31.8 million, a 14.5% sequential decline. After reaching a low point in August, bookings rebounded nicely in September, yielding a September 30 backlog of $39 million, down from the $48.9 million in June.

A bright spot in the third quarter was the growth of our sales of premium alloys, which totaled $4.4 million, an increase of 4% sequentially and 34% compared to the third quarter of 2014. Our team has worked long and hard towards our goal to increase premium alloy sales and there was no let up in the third quarter, despite the difficult industry conditions.

Gross margins continue to be pressured by reduced sales, lower plant activity levels, and the continued misalignment of melt cost and sales surcharges caused by falling commodity prices. Nickel was down an additional 23% in the quarter, bringing the cumulative decline to 45% over the past 12 months. Similarly, moly fell 19% during the third quarter, or 53% over the prior 12 months. Iron scrap slipped 25% in the third quarter or a 50% decline over the past four quarters.

Excluding iron scrap, the key commodities appear to have reached the bottom over the past eight weeks. We'll need a few more months of data to truly validate an inflection point.

We took strong actions in the third quarter to navigate through this unusually harsh down cycle, which has been negatively impacting the entire specialty metals industry. Specifically, we temporarily idled plant capacity, reduced our hourly and salary workforce, initiated mandatory unpaid leave for all salaried employees, partnered with vendors and service providers to reduce costs, and cut our inventory levels by $10.7 million. Our focus has been reducing cost and conserving cash to better position Universal for what we expect to be a stronger 2016.

These proactive initiatives reduced our gross margin in the third quarter. In addition, we experienced unusual scrap rates and traced the root cause to the unauthorized substitution of a critical melting supply part by a vendor. The total financial impact on the quarter's gross margin was approximately $1 million pretax.

Before including the charges related to all these items, our gross margin for the third quarter of 2015 was $3.1 million or 7.1% of sales.

As we also noted in today's release, as well as in our preannouncement on October 16, our third-quarter results included non-cash charges of $1.87 per share after taxes for the write-off of intangible assets. The decline in our stock price since June caused our market capitalization to fall to a level requiring an interim goodwill impairment review under generally accepted accounting principles. The charge fully eliminates goodwill from our balance sheet.

As a result, we reported a net loss of $2.41 per diluted share for the third quarter of 2015. Before all charges, our loss was $0.22 per diluted share. Our Chief Financial Officer, Ross Wilkin, will further delineate the third-quarter charges in his report.

In entering the third quarter, a major priority was to generate positive cash flow by tight management of working capital. In fact, cash from operating activities increased significantly to $12.7 million and debt was reduced by $10.1 million. As we noted in today's release, the debt reduction and our recently amended debt agreement give us the liquidity and flexibility to build back working capital as business rebounds in 2016. Ross will also give more detail on our debt position in his remarks.

We reached an agreement on a new five-year collective bargaining agreement with our hourly employees at our Titusville facility. The new agreement maintains the flexible work rule terms and profit-sharing incentives contained in our prior agreement.

Turning now to our end markets, let's take a minute and talk about aerospace. Our sales for the aerospace market reached 65% of sales in the third quarter of 2015. Aerospace sales totaled $28 million in the third quarter, which is 12% lower than the third quarter of 2014 on 15% lower volume and 8% lower than the second quarter of 2015 on 6% lower shipments sequentially. For the first nine months of 2015, our sales to aerospace increased 4% on 1% higher volume.

All of our end markets, including aerospace, are being affected by customer uncertainty, their drive to reduce inventories before year end, falling commodity prices, and very short mill lead times industrywide.

That said, we remain bullish on the long-term growth in aerospace, as underscored by increasing commercial build rates and a fairly active aftermarket. Boeing recently pointed specifically to airline profitability, solid passenger traffic, and meaningful replacement demand as having created a healthy environment for their commercial airplane business. Boeing also reiterated plans to increase production on several platforms, continuing to introduce new technology, and debunked recent allegations about a bubble in the wide-body market.

General Electric continued to have strong orders for aviation aftermarket, with spare-parts orders growing 28% in the third quarter. GE further noted that orders for Gen X engines tripled in the 2015 third quarter and they added $300 million of orders for the LEAP engine, bringing their backlog of LEAP engines to 10,000. GE's total commercial engine backlog is up 22% from last year.

United Technologies reported their third-quarter commercial aerospace aftermarket sales were up 8% at Pratt & Whitney.

All told, the underlying demand in the aerospace market remains strong and it has been the driver behind our increased sales of premium alloys. We feel the most probable outlook for the next two quarters is that customer inventories come into balance, commodity prices stabilize, and activity levels at the mill level will improve.

Our power generation market sales represented 9% of net sales in the third quarter of 2015, compared with 11% of sales in the third quarter of 2014 and 10% of net sales in the second quarter of 2015. Sales were down 33% from the third quarter last year on a 39% decrease in volume. Sales were down 25% sequentially on 32% fewer pounds shipped. Year to date, sales were down 8% and 16 -- on 16% lower volume.

Our power generation sales are a prime example of the destocking momentum we saw in the third quarter amid the continued spillover from the slump in oil and gas demand. Additionally, aside for the positive news that GE's acquisition of Alstom will proceed, their report on orders for new turbines was muted. GE booked a total of 22 orders for gas turbines in the third quarter versus 23 last year. That included four orders for their advanced H turbine, bringing the backlog to 21 units. GE also saw 10% growth in power generation services in the third quarter.

We continue to expect that quick-turn maintenance, rather than new turbines, will be our main market in power generation for the next several quarters. We continue to hear anecdotal comments from customers that the capacity installed in the 2000 to 2008 period is reaching a critical capacity utilization threshold which will spur new unit builds, but no evidence has surfaced in terms of hard orders in our business.

Our sales [view] on gas market represented 6% of third-quarter 2015 net sales versus 10% in the third quarter of 2014 and 8% of second-quarter 2015 net sales. Sales were down 46% from the third quarter of 2014 on 34% lower volume and down 32% from the second quarter of 2015 on 28% lower volume. Year to date, our oil and gas sales are down 12% on 3% lower volume.

The news from the oil and gas market remains fairly dismal. Metal inventories are heavy, E&P budgets have been cut dramatically, and major oil producers and oil service companies are not expecting recovery anytime soon.

Our customers are mixed in their outlook. Some feel things will be balanced out by the second half of 2016 and others feel it's looking more like 2017. In any event, we have confidence oil and gas markets will be a meaningful consumer of our products in the future and we are continuing to work diligently on customer and product development.

Heavy equipment sales were 9% of total sales in the 2015 third quarter, in line with comparable quarters. Heavy equipment market sales were down 13% compared with third quarter of 2014, although volume increased 4%. Sequentially, sales were down 18% on 14% lower volume. Year to date, our heavy equipment market sales are up 6% on an 18% increase in volume.

The tool steel plate market, which constitutes the majority of our heavy equipment sales, reflected seasonally lower sales in the third quarter. The growth in our year-to-date sales more clearly reflects both the strength of the automotive market, as well as our efforts to better serve the tool steel plate market. While automotive production expectations for 2016 are reasonably healthy, recent reductions in estimates suggest we could see a modestly slower Q4 as customers address year-end inventories.

Let me now turn the call over to Ross Wilkin, who joined us as Chief Financial Officer in August. Ross is getting a real baptism of fire, given industry conditions, but he has hit the ground running. He is doing a great job for us and is another important example of the quality of the leadership team we've assembled here at Universal Stainless. Ross?

Thank you, Denny. Good morning, everyone.

As Denny noted, we continued to see an increased demand for our premium alloy products, both the third quarter and year to date showing a 34% increase versus 2014. At the same time, our overall third-quarter net sales of $43.4 million were down 13% sequentially and down 19% for the third quarter of -- from the third quarter of 2014. The decline in net sales reflects continued inventory destocking by our customers, combined with lower commodity-driven surcharges.

Our year-to-date net sales of $149 million were down a more modest 2.4% versus 2014, despite the more significant decline in the third quarter, reflecting the relative topline strength in the first half of 2015.

Looking at gross margin, on a reported basis our gross margin for the third quarter was a negative $0.4 million or a negative 0.9% of net sales. The reported gross margin was impacted by a number of pretax charges, including $1.9 million for charges associated with reduced mill output in the third quarter, $950,000 charge for costs associated with an unauthorized vendor substitution of a critical supply part, $400,000 expense associated with non-cash inventory charges, and $300,000 associated with employee exit and related healthcare costs. Excluding the charges just noted, the underlying gross margin for the third quarter was $3.1 million or 7.1% of net sales.

That said, our underlying gross margin of 7.1% of net sales continues to be weighed down by the ongoing misalignment of surcharges and melt costs. As a result, gross margin was less than the second quarter, which totaled 10.5% of net sales, and the third quarter of 2014, which totaled 16.1% of net sales.

Driving the continued misalignment is the further decline in commodities, which have been in decline for most of the past year. Material costs are calculated at the time of melting, while surcharges are calculated with a two-month lag. Only 5% of our third-quarter shipments were actually melted in the third quarter. 48% were melted in the second quarter, 31% in the first quarter, and 8% in the fourth quarter of 2014. We expect our material costs and surcharges to become better aligned by the first quarter of 2016, assuming commodity prices continue to stabilize.

In addition, the underlying gross margin has been negatively impacted by lower activity levels, causing the further decline since the second quarter.

To help offset the surcharge misalignment and the impact of lower volumes, we are aggressively looking at all ways to reduce production costs, with an emphasis on optimizing our shutdown windows, improving synergies across our four production sites, and securing better commercial arrangements with suppliers. These actions are important catalysts to improve our gross margin and return us to profitability.

Looking at selling, general, and administrative costs, for the third quarter SG&A was $5.2 million, which includes a $250,000 intangible write-off charge associated with an exit of a noncompete arrangement. Excluding this intangible write-off, underlying SG&A was $5 million, compared with $5.5 million in the third quarter of 2014. Reducing SG&A is a key area of focus for us for us during this challenging period.

As previously disclosed, goodwill of $20.3 million was written off in its entirety in the third quarter. The stock-price decline since June 2015 caused our market capitalization to fall sufficiently below book value, thus requiring us to perform an interim goodwill impairment assessment in line with GAAP.

Based on the assessment performed, goodwill has been fully written off. Note the impairment was limited to goodwill only with no impact to net tangible assets and, as noted in our press release, net tangible assets are $188.2 million or $26.62 per diluted share.

The operating loss for the third quarter was $25.9 million, but excluding goodwill, intangible, and other charges noted separately earlier, our operating loss was $1.9 million, reflecting primarily the impact of the surcharge misalignment and the reduced shipment volumes.

It remains the primary focus of the management team to return the business to profitability through the cost-reduction initiatives highlighted earlier, as well as topline sales improvements and the expectation of improved go-forward surcharge alignment.

Our effective tax rate was 35.9% for the third quarter, reflecting the full booked tax benefit of the charges recorded in the third quarter. Note, however, for federal income tax purposes, there is no write-off of goodwill, given that there was never any goodwill recorded for tax purposes at the time of the 2011 acquisition of our North Jackson operation. For federal tax purposes, this portion of the purchase price had been allocated to fixed assets and has already been fully depreciated.

Turning our attention next to the balance sheet, during the third quarter our managed working capital, defined as accounts receivable plus inventory, minus accounts payable, was reduced by $12.1 million to $97.9 million. The key driver for the improvement in working capital was the reduction to inventory. Inventory was reduced by $10.7 million in the third quarter, reflecting the conscious effort to generate cash through lower mill output relative to shipment levels.

Capital expenditures for the third quarter were $2.6 million, compared to $2.8 million in the second quarter, and we will continue to contain capital spending going forward until there is more sustained improvement in business conditions.

During the third quarter, we generated $12.7 million of cash flow from operating activities, primarily through the reduction of working capital, and this has been used to reduce debt and fund capital expenditures. As Denny already mentioned, debt was reduced by $10.1 million to $82.6 million during the third quarter.

As has been reported in our 8-K filing earlier today, we have finalized an amendment to our existing bank facility which incorporates certain changes, including an addback to EBITDA for some of the charges incurred in the third quarter of 2015, given their one-time nature. In addition, the go-forward covenants have been changed to provide improved liquidity and flexibility to support the need to increase working capital as the business trends improve.

That said, given that our existing bank facility expires in March 2017, we are in advance discussion with the banks about putting in place a new facility prior to the existing facility becoming current in the first quarter.

That concludes my financial report. Denny, I turn it back to you.

Thanks, Ross.

In summary, the third quarter of 2015 was even more challenging than expected as destocking picked up momentum, commodity prices continued their steep decline, and customers moved farther to the sidelines due to heightened market uncertainty. Even so, sales of our premium alloys continued to grow, increasing 34% on a year-to-date basis.

We had planned to further reduce costs in the third quarter, but substantially intensified that effort, given the deteriorating market conditions. Our major focus during Q3 was to generate positive cash flow in the quarter, reduce debt, and position ourselves for an improved 2016. We beat our internal targets by cutting inventories by $10.7 million and reducing debt by $10.1 million. These actions have strengthened our position as we have entered the fourth quarter.

While uncertainty continues in our marketplace, we have seen some improvement in our order book, even if it has been uneven. We have no uncertainty, however, about our plan for transformation and growth. We will continue to execute that plan with drive and energy and I think we have the team here to do it. I want to thank everybody for their attention and, Operator, we are ready to take questions.

(Operator Instructions). Phil Gibbs, KeyBanc Capital Markets.

Hi, thank you. Welcome to the organization, Ross.

Thank you.

Anything that you could provide us in terms of a little bit more color on the covenants or the bank relief that you've received there?

You will see a fair amount of detail in the filing, which is summarized what you will see there. The -- as I said in my script that there were questions. Some specific addbacks related to -- addbacks to EBITDA for the one-time items. There is an elimination of the maximum leverage ratio covenant starting in 12/31/15 and a delay of testing the minimum fixed charge ratio until 9/30/16. And then, lastly, there are some minimum LTM EBITDA covenants that are also -- have been implemented.

Okay.

The specifics of that you will see, but that's the highlight.

Terrific. And did you also mention that the SG&A had a little bit of headwind in it relative to the number that you reported as well and didn't adjust out?

That's about -- yes, about $250,000 wrote off associated with an intangible that had been set up some years ago for a noncompete that we've exited (multiple speakers)

That was not in your adjusted loss, though, Denny, right?

Right.

Okay. So that's additional to that.

And then, in terms of when -- in terms of what your customers are telling you right now in the various channels, where do you feel like the inventory is most heavy at this point in time? And if you could also comment on the fact that you said your heavy industrial business is up quite a bit. That's, I guess, in the face of a lot of the heavier equipment and construction guys being down, but maybe that also includes some automotive system help there would be useful.

So the first part of your question, Phil, was where are the inventories heavy? So they are basically heavy in each of the markets, I would say.

Just to recap what's been going on this year, we had the big drop-off in oil and gas prices, as you know, which led to basically a standstill in that market itself. And the reaction on the part of the specialty metals group of our customers to reduce inventory, they were unable to reduce their inventory by the magnitude they wanted to using just oil and gas type products, so that spilled over into the other markets. We've seen basically all the markets in the destocking mode here over the last two quarters.

As I sit here now looking at aerospace, aerospace continues to be fairly active from a demand standpoint. Most of our customers indicate their inventories will be in balance as we exit this year. Oil and gas has continued basically [dead]. A lot of inventory in the supply chain there. When that will be worked off, as I said in my prepared comments, the second half of next year, maybe 2017. I think there's still big question marks out there about how long it will take to work off that inventory. So that is probably the most overinventory of the markets that we serve.

Power generation is a victim of some of that spillover from oil and gas, but I would characterize that as getting back into line by the end of this year. In the industrial -- or the heavy equipment, you've got two issues there. Automotive is one piece of it. The other piece is the Caterpillars of the world and the John Deeres of the world and the mining companies, which are off.

Automotive is still reasonably healthy, but the estimates have come down from where they were three or four months ago, so I would say that our customers would say that their inventories are a bit high right now and they would intend to work them off as we exit this year, which means we would probably look at the fourth quarter with some lower sales -- low order entry in that market from a Universal standpoint.

Why would there be -- if this is just more of an oil and gas issue, at least on the demand side to be the most glaring issue, why do you feel like there's heavy inventories, to your point, in most of the markets at this point in time (multiple speakers)

Let's use aerospace as an example. Many of the customers -- in fact, most of the customers who are aerospace customers of ours also service the oil and gas business. Their reaction to the dramatic changes in oil and gas has been to reduce inventory. They've been unable to hit their targets in oil and gas products alone, and that's spilled over into aerospace, and there's a general theme of we need to reduce our inventories across the board and that's what we're seeing from distributors and forgers alike.

It's further compounded and really driven home by what's happened to commodity prices over the last four quarters. That step-down in a product like nickel, which is the poster child, was steepest in the third quarter of 2015. It fell over 20% just in one quarter.

So they are sitting there looking at their inventory. They generally want to get it down. They know if they can hold off and postpone, they are going to buy at lower prices. So that's what's driving this whole kind of standstill from the buying standpoint.

The reason why I look towards 2016 as improved is underlying demand in aerospace and in power gen, unlike oil and gas, is still pretty active. So those inventories are going down and will come into balance, and customers will have to buy or else they are going to find holes in their inventory and be unable to service their customers.

So that's what we're seeing as we sit here today as we look into 2016. That's why we feel -- have felt the third quarter would be weak. The fourth quarter is going to be nothing to write home about either. But as we get into 2016, our anticipation is what we saw in 2015 will be partially unraveled. We'll start to see some stabilization in commodities. Arguably, we're already seeing that because if you look at nickel for the last eight weeks, it's been bouncing around between $4.40 a pound and $4.75 a pound, which to me is stability. You need a couple of more months of that before you can say there is truly an inflection point.

The same thing would apply to moly. The only real commodity we use that you see continued very obvious high probability of reductions over the next couple months is in iron scrap.

Right.

(Multiple speakers) to put off buying and to buy in smaller lots, to delay blankets, to be reluctant to commit to annual type business will begin to diminish and you will start to see the inverse of what we saw in 2015.

I was trying to characterize the difference between you saying there's heavy inventories across the supply chain, even in aerospace. But is there a difference between saying that they have too much inventory versus the customers wanting to bring inventory down because of commodity prices? So, any level is too high when commodity prices are falling, but are they indeed overinventoried relative to their demand levels or are they just trying to get cute on the buy? That's sort of what I was getting at and that may be a little bit tougher to know.

I think the initial thing that started was the whole oil and gas thing, and then as it became obvious as we got out of the first quarter of 2015 into the second quarter that commodity prices were going to continue to diminish, it kind of reinforced that whole behavior, that whole thought process.

And the other issue to keep in mind is all the mills are running at very low activity levels. Lead times are very, very short, so there's even less of an impetus to place orders because if you get into trouble with a hole in your aerospace inventory, for example, you know you've got pretty well -- damn near record low lead times so you can place an order pretty quick and get fast turnaround.

We will see what happens when they need to buy again how quickly they can get it. Thanks.

Okay.

(Operator Instructions). Ralph Marash, First Manhattan Company.

Good morning. With GE's potential or threatened moving some manufacturing offshore as a result of the Ex-Im Bank impasse, do you see that affecting you at all?

I haven't seen anything in the marketplace that would indicate that would have a direct bearing on us.

Many of our customers who we deal with are international players, so a fair amount of what we would characterize as power generation type sales may be sold directly to a domestic location, but end up in a foreign product being exported overseas. Much of the product is transported in raw form overseas for further assembly and construction.

Okay. Thank you.

Some of our power gen business, for example, goes to India, China, Germany.

To local manufacturers over there?

To forgers, yes.

Okay. And on the supplier issue of the substitution, can you just explain that a little bit more?

Yes. We have some parts that come into contact with liquid metal and it's critically important that that be very good high-quality product that doesn't change, and we found some unusual micro-cleanliness problems in our product, which resulted in scrapping of material. And in doing the study as to what was going on, we traced it back to some changes in that product which were not authorized. We're still in the process of doing our investigation and we're still in discussions with the vendor on that subject.

So, potentially there's some recourse.

We're looking at all of our options, yes.

And do you continue to use that supplier?

No.

Okay.

Not for those products.

Okay. Thanks.

Gregory Macosko, Montrose Advisors.

Yes. Thank you. That was my question, regarding the parts problem and the scrap problem. Just to say, really impressive quick reduction in expenses and costs and you remain flexible. Thank you.

Thanks, Greg.

(Operator Instructions). Phil Gibbs, KeyBanc Capital Markets.

I'm back, thanks. A question just on your inventory study. I don't know if you said it in your script. I apologize if you did, but what as of right now are your plans for your own inventory levels in Q4? I know Ross talked about having the flexibility within your covenants, potentially, to support a working capital build when that time comes, but what are we looking at for the next couple of quarters, based on the visibility that you have right now?

Our most probable internal number there would be relatively flat inventories in the fourth quarter -- at the end of the fourth quarter relative to the end of the third. That's our most probable, but we're saying this is a day-to-day, week-to-week thing.

As we see things build, bookings should improve as we get into the lead time window for first-quarter deliveries, we would have the opportunity to ramp up. And if things do not do that, we could have the opportunity to reduce somewhat. But generally speaking, if I was looking at us I would say count on something relatively flat in the fourth quarter.

And then in terms of how you expect sales to move along in Q4, are you anticipating your sales are going to be improved versus 3Q?

No. Given where bookings are -- with short lead times, there's a couple of wild cards here. I would expect sales to be in the 30s, not in the 40s, based upon the bookings we've seen and the backlog we ended the quarter.

The wild cards are going to be what happens at the end of the quarter with regard to customers taking orders and cutting off receipts and so forth. We've already got notified by some customers about cutoffs -- 14 December, that kind of thing, where they won't take receipts after that date. So that is going to have a negative effect, obviously.

The other thing that's a little bit of a wild card this year, I mentioned short lead times, so our quick turnaround business is a wild card, tough to forecast. That will be a function of what's going on out in the marketplace. But with the short lead times, you can expect to see some strange numbers there.

So there are the two wild cards. Putting those aside, though, looking at our bookings in the third quarter, our backlog coming into the quarter, we will be back down in the 30s.

Okay. Thanks so much.

(Operator Instructions). And I'm showing no further questions. I would now like to turn the call back to Mr. Dennis Oates for any further remarks.

Okay. Thanks again for joining us today and for your interest in Universal Stainless. While challenging industry conditions intensified in the third quarter, we move forward in our strategy to transform Universal with continued growth in our premium alloy sales.

While the fourth quarter presents its own challenges each year, we will continue to pursue all market opportunities as we focus on making further progress on our longer-term strategy, and we'll look forward to updating you all on our next call. Have a good day and thanks again.

Ladies and gentlemen, thank you for participating in today's conference. This does conclude today's program. You may all disconnect. Everyone, have a great day.