Universal Stainless & Alloy Products Inc (USAP) 2020 Q3 法說會逐字稿

Ladies and gentlemen, thank you for standing by, and welcome to the Universal Stainless Third Quarter 2020 Conference Call. (Operator Instructions)

Now it's my pleasure to turn the call -- the conference over to your speaker, June Filingeri. Please go ahead.

Thank you, Carmen. 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 2020 results reported this morning.

With us from management are Denny Oates, Chairman, President and Chief Executive Officer; John Arminas, Vice President, General Counsel and Secretary; and Chris Scanlon, 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. Carmen 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 complete, I would now like to turn the call over to Denny Oates. Denny, we are ready to begin.

Okay, June, thank you. Good morning, everyone. Thanks for calling in today.

As we described during our last conference call in July, we expected a very challenging third quarter. Second quarter order entry and backlog trends pointed towards a steep sequential step down in sales and operating activity, reflecting lower supply chain demand, customer destocking and shorter industry lead times. In fact, third quarter sales of $37.4 million were down 29% sequentially, while ship pounds declined 32%. Currently, we are seeing sales levels stabilizing and modest month-to-month improvements in order entry.

We reacted quickly to the COVID-induced market disruptions in the second and third quarters, executing on plans designed to rapidly reduce costs, conserve cash and pay down debt without jeopardizing our long-term strategic plans. Despite these actions, the decrease in sales and operating activity took a heavy toll on our bottom line, and we reported a net loss of $7 million or $0.79 per diluted share on a generally accepted accounting principle basis. Excluding the pretax fixed cost absorption charge of $4.3 million due to abnormally low activity levels and $300,000 pretax gain on insurance proceeds, the third quarter net loss was $3.9 million or $0.44 per diluted share.

Let's look more closely at third quarter results, starting with the top line. Consistent with last quarter, aerospace and oil and gas sales were hard hit, declining 32% and 24%, respectively, on a quarter-to-quarter basis. Other end market sales were sequentially lower as well, with power generation down 25%, heavy equipment down 16% and general industrial down 7%. However, I should point out that general industrial sales increased a noteworthy 43% from the third quarter of 2019 due mostly to semiconductor business.

Premium alloy products, which reached nearly 25% of our total third quarter sales, are holding up better than air-melted products, reflecting ongoing demand coming from defense and specialty applications. It is worth underscoring that premium alloys are our highest priority for targeted growth and remain a focus of our very active product development and customer approval efforts.

Order backlog before surcharges fell to $54.8 million at September 30 compared to $71.7 million at June 30 and $119.1 million at year-end 2019. Gross order entry stabilized at $21 million before surcharges compared to $45 million in the first quarter. Interestingly, July was the low month for gross order entry this year with steady increases in August and September. September order entry was the highest monthly total since the COVID pandemic hit, and October is tracking about 10% ahead of September.

Also on a positive note, cancellations have slowed significantly, falling to $2.3 million in the third quarter versus $10.5 million in the second quarter. We continue to expect more modest improvements in order entry during the fourth quarter and sequential improvement as we move through the first half of 2021.

From a profitability standpoint, the reduced sales and operating activity in the third quarter resulted in our reporting a negative gross margin of $4.4 million, which included the $4.3 million write-off of fixed cost due to the abnormally low production levels as required under GAAP. Additionally, $2.1 million in negative efficiency variances associated with sharply lower activity levels were expensed during the quarter.

We've been working our operating plan designed to reduce costs and conserve cash. Our plan includes periodic shutdowns of entire facilities, coupled with rolling shutdowns of major work centers, stringent capital and operating spending controls, workforce reductions and reduced work schedules. Here are the results in terms of plant activity levels and our cost structure. Plant activity levels were driven down 45% sequentially and 60% compared to the first quarter, as measured by pounds processed through our facilities. Air melt operations were reduced 50% sequentially and 67% compared to the first quarter. Vacuum melting operations were static sequentially due to somewhat healthier backlogs, but declined 35% compared to Q1. Variable nonmaterial spending has been cut in half since COVID hit.

Controllable fixed spending has been reduced 30% since March. SG&A expenses totaled $4.2 million in the third quarter, down $1.8 million or 30%. Managed working capital has reduced $16.8 million during the third quarter, reflecting a reduction of $14 million in inventory and $6.7 million in receivables. These reductions were partially offset by lower payables of $4.1 million. We are tracking to the $30 million second half reduction in managed working capital we committed to on our last call.

Similarly, capital spending was $1.2 million in Q3 and is tracking to the $9 million to $10 million annual estimate cited on our last call. Taken together, these actions generated $11.9 million in cash, which we used to pay down total debt to $60.6 million at September 30. The $20 million second half debt reduction called out on our last call remains our goal.

I would be remiss if I did not also highlight that our safety performance, as measured by an OSHA recordable rate of 1.3 marking new universal record low during the third quarter despite the many disruptions on the shop floor. My compliments to all, great job, guys.

With regard to COVID, we have been very fortunate to only have 2 positive cases, given that we have worked throughout the pandemic as an essential business. Cost for COVID-related mitigation have run $150,000 to $200,000 per quarter for PPE and enhanced sanitizing activities.

Our priorities for the balance of the year are to continue executing our operating plan to reduce cost and generate cash. We are expecting fourth quarter activity levels and sales to closely parallel third quarter performance.

For the longer term, we are moving forward with our strategic initiative to add a vacuum arc remelt furnace, which will be installed in the second quarter of 2021 and an 18-ton crucible for our vacuum arc melting operations, which is scheduled to be installed and commissioned by 2021's third quarter. These investments are critical to support our growth in premium melted products and to reduce operating costs significantly.

Turning to commodity prices. Nickel strengthened each month in the third quarter, reaching $6.74 per pound in September, a 17% increase from the end of the second quarter and the highest level since November of last year. This morning, nickel was at $7.23 a pound. Moly and vanadium exhibited small sequential increases and scrap started to show an upward trend in September. As a result, our surcharges on shipments have been moving up in a positive direction, maintaining metal spreads. We expect these trends to continue this quarter.

Let me turn to our end markets, beginning with aerospace. Aerospace sales were $25.1 million or 67% of sales in the third quarter of 2020, compared with $37.2 million or 71% of sales in the second quarter of 2020. In the third quarter of 2019, aerospace sales were $40.9 million or 72% of sales. The challenges facing the aerospace industry are many. 737 MAX return to service, reduced air travel, weak financial health of airlines, growing order cancellations, uncertain build rates and unstable supply chains, just to name a few.

Let's start with the 737 MAX. It appears that the 737 MAX will be returned to service by year-end based on recent developments. Europe's top regulators said the 737 MAX is safe enough to return to flight in Europe by the end of the year. Europe is one of the largest markets for the MAX. American Airlines also announced plans to reintroduce the 737 MAX on domestic flights, beginning with New York to Miami runs, pending a late November FAA approval. While this news is a welcome boost for the industry and the supply channel, we do not see an immediate effect on airplane build rates, given Boeing has an estimated 450 MAX airplanes on the ground ready for delivery.

Another issue weighing heavily in the commercial aerospace market has been the coronavirus pandemic and its impact on air travel. IATA now expects full year 2020 traffic to be down 66% from 2019 versus their previous estimate of 63% decline. Travel for August 2020 was down 75% from August of 2019, including an 88% drop in international passenger demand and a 69% drop in U.S. domestic travel. While these numbers do reflect improvement compared to the April and May time frame when domestic travel was down over 90%, the pace of improvement has slowed due to secondary COVID outbreaks.

Aftermarket aerospace demand will be stressed until travel demonstrates more meaningful improvement, probably not until vaccines are readily available next year. The latest reports from U.S. carriers further attest to depressed industry conditions with difficult liquidity issues at the forefront. Not surprisingly, this has resulted in order cancellations and postponements of new aircraft. Although a possible upside in this situation is that airlines are also retiring older aircraft, which may eventually bolster new plan sales. We look for government assistance to support the industry's financial health and employment levels over the near term.

Our aerospace customers and the entire supply chain, for that matter, are destocking at an unprecedented pace. We expect this process to continue through the end of the year and perhaps into Q1 of 2021. With destocking easing by then, orders for the mill sector will increase. We expect this increase to be supported as we move through 2021 by further travel growth, especially upon the introduction of vaccines.

Against this challenging backdrop, there are some positives. The defense market has been a strong and a positive countervailing force in the aerospace market for Universal and our expanding premium alloy offerings. Although small, it is also worth noting that the business ship market is active as well.

In summary, our aerospace customers continue to expect solid demand from the defense and general aviation sectors over the next few quarters. Slow improvement in melt bookings as destocking eases and travel picks up are also in the books. Significant improvement in the commercial aerospace build rates are not expected until beyond 2021.

The heavy equipment market remained our second largest market in the third quarter of 2020 with sales of $4.7 million or 12% of sales compared with $5.6 million or 11% of sales in the second quarter and $4.4 million or 7% of sales in the third quarter of 2019. After 2 quarters of recovery in plate sales, the market paused somewhat for normal seasonal reasons. Our plate sales are driven by a variety of metal fabrication markets, particularly automotive and new model introductions. News from the automakers has been mainly favorable lately, aided, in part, by low interest rates but also by what General Motors described as pandemic-induced auto demand as consumers opt for more private vehicle transportation over public transportation, families take more vacations by car, and city residents move in the suburbs. New model launches are projected to recover to the 2019 level in 2021 and accelerate in 2023 and 2024. This is all good news for plate demand. We expect our fourth quarter plate sales to be up 10% based on existing backlogs and recent bookings trends.

The general industrial market became our third largest market in the third quarter with sales of $2.9 million or 8% of sales. While 7% lower than the second quarter of 2020 sales of $3.1 million or 6% of sales, they increased 43% from $2 million or 4% of sales in the third quarter of 2019. As a reminder, our general industrial category includes such markets as semiconductor, medical and general manufacturing.

The Semiconductor Industry Association reported a 4.9% increase in worldwide sales of semiconductors in August 2020 versus August 2019, using a 3-month moving average and a 3.6% increase from the July 2020 total of $35 billion. Growth was especially strong in the Americas, where sales increased nearly 24% year-over-year. We're continuing to focus on the semiconductor market as well as pursuing opportunities in the additional markets within the general industrial segment to broaden our future sales potential. We already have the grades of steel and the service center relationships, so there is no need to invest capital or develop new products to support this effort.

The oil and gas end market became our fourth largest end market in the third quarter with sales of $2.8 million or 7% of sales. This compares with sales of $3.6 million or 7% of sales in the second quarter of 2020 and $5.7 million or 10% of sales in the third quarter of 2019. That represents declines of 24% and 51% from respect to prior periods. The severe challenges in oil and gas demand are reflected in the latest rig count data from Baker Hughes. The average U.S. rig count for August 2020 was 250, down 5 from July and down 679 from August 2019. While the rig count seems to be stabilizing, we are a long way from what many analysts would consider a normalized U.S. rig count of 400 to 600 rigs. Likewise, worldwide rig count for August 2020 stood at 1,050, up 20 from July but down 1,156 or 52% from August of 2019.

E&P companies are continuing to restrict spending to protect cash flows. On Friday, Schlumberger reported a 2% sequential decline in third quarter North America revenues with improved land well completions, offset by reduced land drilling and lower offshore activity, impacted by lower rig counts and hurricane disruptions. On the other hand, Halliburton called out, and I'll quote second half 2020 as the bottom with a better 2021, reflecting progressive improvement in activity throughout the year in group. From our vantage point, after a long period of hunkering down by our customers, they're now looking for gradual improvement in 2021. While there's not yet a lot of firmness in demand, customer inventories are low.

Power generation market sales were $1.6 million or 4% of sales in the third quarter of 2020, down 25% from the $2.1 million or 4% of sales in the second quarter of 2020 and $2.9 million or 5% of sales in the third quarter of 2019. The continued shutdowns due to the coronavirus pandemic have sharply limited maintenance demand, which has been the major driver of our power generation sales. We expect maintenance to eventually return to more normal seasonal levels as states open and stay open. Additionally, rumors of forging work for power generation coming back to the states continue, but we've seen nothing tangible at this time.

Before I turn the call over to Chris Scanlon for his financial review, let me mention our new 5-year collective bargaining agreement with the hourly employees at our Titusville facility effective as of [October] (corrected by company after the call) 1. The new contract maintains the flexible work rules and profit-sharing incentives contained in the prior agreement. It also allows us to be competitive in the marketplace and attract skilled employees.

That concludes my review. Chris, let's have your financial report.

Great. Thank you, Denny, and good morning, everyone. Let's get started with the income statement. As Denny discussed, third quarter 2020 sales of $37.4 million were down 29% or $15 million from the 2020 second quarter and down 34% compared with the 2019 third quarter. Our aerospace sales were lower than second quarter 2020 by $12 million or 32% and $15.7 million or 38.5% lower than third quarter 2019. Our aerospace sales approximate 67% of our third quarter sales.

Sales for the balance of our end markets declined from the second quarter of 2020. Third quarter gross margin was a loss of $4.4 million compared to $1.9 million in the second quarter 2020 and $5.3 million in the 2019 third quarter. Our Q3 gross margin was unfavorably impacted by $4.3 million direct charge related to fixed cost absorption. This charge was a result of reduced third quarter operating levels. While we have aggressively reduced cost due to our reduced production levels, there is an amount of our fixed cost that is not absorbed in inventory and taken as a charge in the third quarter. We anticipate these fixed cost absorption charges to continue in the 2020 fourth quarter on continued lower activity levels.

Gross margin as adjusted for the $4.3 million fixed cost absorption direct charge was at a breakeven level. Gross margin also included $2.1 million of negative operating efficiency variances during the quarter, which were also expensed. These variances were associated with low activity levels.

Selling, general and administrative costs in the third quarter totaled $4.2 million or 11% of sales, a decrease of $1.2 million compared with the 2020 second quarter and $372,000 compared to the 2019 third quarter. Other income included $307,000 associated with the receipt of insurance proceeds. Specific to the third quarter, our income tax benefit was $1.9 million.

Net loss in the third quarter was $7 million or $0.79 per diluted share. Third quarter earnings per share adjusted for the $4.3 million fixed cost absorption direct charge and the $307,000 gain on insurance proceeds is a loss of $0.44 per share. Second quarter 2020 net loss totaled $3.3 million or $0.38 per diluted share, and 2019 third quarter net income totaled $800,000 or $0.09 per diluted share.

Our third quarter EBITDA totaled a loss of $3.6 million. Q3 EBITDA, as adjusted for noncash share compensation, fixed cost absorption direct charges in our insurance gain, totaled $636,000. The EBITDA and adjusted EBITDA calculations are provided in the tables to the press release.

Third quarter cash flow provided from operations was $13 million compared to our second quarter cash flow provided from operations of $7.4 million and third quarter 2019 cash flow provided by operations of $6.6 million.

Regarding the balance sheet, managed working capital totaled $135 million and decreased by $16.8 million compared with the second quarter of 2020. Accounts receivable decreased by $6.7 million, and inventory decreased by $14 million, while accounts payable decreased by $4.1 million. The decline in inventory is primarily due to reduced production activity to maintain an inventory level commensurate with our order backlog.

Third quarter 2020 backlog totaled $54.8 million and is down $17 million or 24% from the 2020 second quarter. Year-over-year, third quarter 2020 backlog decreased $63.5 million or 54% compared to the 2019 third quarter.

Capital expenditures for the third quarter were $1.2 million, while second quarter 2020 CapEx totaled $3.2 million, and third quarter 2019 capital expenditures totaled $3.9 million. Capital expenditures for the 9 months of 2020 totaled $8.5 million versus $13.3 million for the 9 months 2019. Capital expenditures are expected to approximate $9 million to $10 million for the year 2020.

Lastly, the company's total debt at September 30, 2020, was $60.6 million, a decrease of $11.9 million from the prior quarter. This reduction is consistent with our focus on working capital and debt reduction. The company's debt is primarily comprised of our revolving credit facility and term loan, which collectively totaled $35.7 million as of September 30, 2020, in our notes, which were issued in connection with the acquisition of our North Jackson facility in 2011. These notes totaled $15 million. We continue to include this $15 million in current debt as these notes are due and payable in March 2021. We intend to pay these notes off in the first quarter via utilization of our revolver. Due to the variance in interest rates between the 6% fixed rate of the North Jackson notes and the approximate 2% current interest rate on our revolver, we anticipate annual savings of approximately $600,000 in interest expense following the payoff of the North Jackson seller notes.

Additionally, the $10 million term note related to the Paycheck Protection Program is included in our long-term debt.

In the third quarter of 2020, the company applied for full loan forgiveness under the Paycheck Protection Program, and the PPP loan forgiveness process is currently underway.

As of September 30, 2020, we maintained revolver borrowing availability of $44.2 million. Our strong liquidity position, coupled with the solid creditworthiness of our customer base, provides the ability to continue to endure future uncertainties.

This concludes the financial update. And Denny, with that, I'll hand the call back over to you.

Thanks, Chris. In summary then, on our last call, we provided our outlook for the second half of 2020. The third quarter played out as expected with a step down in sales and activity levels but also and importantly, with tangible progress in flexing spending down and improving our liquidity. Total debt was reduced $12 million on an 11% decrease in managed working capital, including a $14 million reduction in inventory.

We ended the quarter with $44 million in liquidity, which positions us to successfully navigate through the current downturn and seize opportunities as business conditions recover.

We ended the third quarter with incoming business slowly improving in each month since the low point in July, and October bookings are currently running ahead of September. We will continue to diligently work our operating plan during the normally seasonally slower fourth quarter and expect results to closely parallel third quarter performance in terms of sales, activity levels and cash generation.

Longer term, we are actively focused on future growth opportunities, including our strategic investment in an additional vacuum arc remelt furnace and an 18-ton crucible for vacuum induction melting operations. These will reduce costs and expand our premium alloy capabilities. We are also pursuing new product and market opportunities to further diversify our revenue stream in future years.

Lastly, these times of lower production provide opportunities to really get after initiatives to debottleneck operations, increase first time through quality and continuously improve our safety processes.

In closing, I'd like to express my personal deep gratitude to our entire team, whose commitment and relentless effort are enabling us to navigate through these challenging times and to our customers, Board and shareholders for their continued support.

That concludes our formal remarks. Carmen, we're ready for any questions.

(Operator Instructions) Our first question is from Tyler Kenyon with Cowen.

Denny, you noted a steady improvement in order entry as the quarter grew to a close, and it sounds like that has continued here into October. Can you talk maybe a little bit about kind of where you're seeing that improvement across end markets or product-specific applications? I mean it sounds as though you're mostly seeing that in tool steel plate.

Plate is a component of that, and also defense in the aerospace side. And the last 6 weeks or so, we're starting to see some orders, which I would characterize as service centers, looking at their inventory and finding some holes as they destock, which I look at as a good sign because it says that inventory levels are starting to get to the point where people are getting surprised.

So 3 areas, basically tool, which is the plate business, largely the automotive and the new models coming back next year, which is going to require new jigs and fixtures and metal sales on our part this year and into the early part of next year. The defense end of the aerospace market and some holes in inventory on regular commercial aerospace products.

Got it. Okay. And are your cost reduction efforts that you have been pursuing here, call it, over the course of the past quarter, are they fully reflected in the third quarter? Or should we expect more benefits as we move into the fourth?

I would say 80% of it's reflected in the third quarter. We would expect to get some further benefits in the fourth quarter from a full quarter of spending reductions in certain categories. And also, I mean, obviously when you're running -- when you dip down to these low levels of activity, it is very challenging to run efficiently.

Out in the middle, think of a heat treat furnace that's going to run a load for 5 hours. Typically, if you have adequate volume, you can fill that furnace up with -- hypothetically with 20 large bars. Today's environment, we might only have 5. That's the efficiency issues. So as we go through the fourth quarter, we will get better and better at running at these lower activity levels. So I would expect some of those efficiency variances that we had in the third quarter, which were negative to be much smaller in the fourth quarter.

Got it. Okay. And Denny, in your closing comments, you talked about how this challenging time has kind of brought a fresh perspective in terms of pursuing debottlenecking efforts and enhancing sales through various channels. Just curious if maybe you could talk a little bit about some of those efforts you're undertaking or considering at this point?

We have a situation where -- when you're busy, there never seems to be -- you're always working on these kinds of things, basic blocking and tackling out in the shop. But you're also busy getting production, getting product to customers. And in the climate like we are in today, it does free up some time for us to focus on some other areas of process improvement. I'm not talking necessarily about capital projects here. So we're looking at maintenance practices in our remelt facility, which, in the past, has been a bottleneck for us.

We're also bringing a new furnace on as well, but I'm talking about process improvements, particularly on the maintenance side. We're going paperless in our -- on our shop floor, which will help significantly in terms of cycle times. We're looking at different chemistry modifications and heat treat modifications on some of the newer alloys, where we have approval, and the plan obviously would be that now we have the approval to see where we don't have fixed practices, what can we do to further reduce costs. So there's a whole range of items that I would categorize as debottlenecking, which is basically taking existing facilities and increasing their capacity, so that we can sell more and cycle things to our facilities faster when things recover over the next couple of years. And the other one would be continuous improvement on product quality. So as we have things going through our shop, they go through basically once we reduce rework and so forth when things recover.

And Chris, just one for you. It sounds like the working capital reduction targets in the second half as well as the debt reduction targets remain intact. On the $20 million reduction in debt, does that include some assumption around the forgiveness of the PPP loan? And then not sure if you made some specific comments in your remarks, but maybe if you could kind of talk about where you are in that process and kind of when you would expect that to be resolved?

Sure thing. So the $20 million debt reduction excluded any application of PPP forgiveness. So it's organic debt reduction associated with our revolving credit facility, coupled with our term note.

With regard to timing of the PPP application that was submitted in the third quarter, the bank has 60 days to review our application. Once they're complete that will get handed over to the SBA, who then has 90 days to conduct their review and make a conclusion on our application. So what we had originally went into this process is thinking that we would get forgiveness maybe in that Q3, Q4 time frame, obviously, we're in Q4 now. Depending on the timing of the review by both the bank and the SBA, it appears that, that application for a full forgiveness will most likely occur in, let's call it, the first quarter of 2021.

Our next question is from Phil Gibbs with KeyBanc Capital.

Denny, so if we surmise that revenues are between $35 million and $40 million for next quarter and let's just postulate they stay there in Q1. Should we expect that your gross margins will begin to improve, all else equal, as your own destocking efforts subside. Because I think it's an important point right now that I'm perceiving that you guys are getting hit with a double whammy, obviously lower sales, but you're taking your own inventories down. So I think that, that could be helpful to educate people on?

Yes. As you look at the -- first of all, with regard to the fourth quarter, the quarter we're in, I would look at the third quarter, and I expect performance to be very similar in the fourth quarter in terms of activity, top line, profitability as well as cash generation. As we get into the first quarter, I'm looking at bookings improving in the fourth quarter compared to the third quarter. We've seen now 4 -- well, 3 consecutive months, and it looks like we'll have a fourth consecutive month of improving bookings. So what that means as we get into the first quarter, our activity levels should rise. We'll be able to absorb more of those fixed costs that we're writing off currently, and we'll be able to run more efficiently.

So right now, it's dicey because I don't know how much things are going to improve during the fourth quarter for first quarter production, but I do expect higher production levels. So I would expect to see margins improving with lower fixed cost write-offs and lower negative variances as we get later in the second quarter, the latter part of the first half of next year. If things continue to tracking the way we see them tracking, we should be working our way out of this requirement to book unabsorbed fixed costs and so forth.

So to answer your question, fourth quarter, pretty much the same as the third quarter, improvement in the first quarter, and some of these unusual things should disappear as we get into the second quarter of next year if things play out the way we are projecting them. That doesn't require a return to 2019 aerospace markets. That's not what I'm saying.

Right now, we got, from a commercial standpoint, kind of a triple whammy, right? We got lower demand in the supply chain driven by COVID. We've got our customers also very quickly trying to get their inventories down. So you get the bullwhip effect on the mill. And then I would throw into that the fact that lead times are so short, people know they can get product in fairly short order from the mills right now. So there's no need to really lay in orders for the first quarter. I mean we're still selling into our fourth quarter on many products. So you put those 3 things together, and that's what which makes things very sporting currently in the market.

I get all that. I'm just trying to understand if, let's just say, this quarter, you did $37 million; next quarter, you did $37 million. And I'm just saying if you do $37 million in Q1 next year, you may anticipate a pickup or a decline, probably a pickup. But just saying, let's just assume revenues are flat, should your margins improve alone just on the fact that by Q1, you won't be taking out as much inventory?

Yes, they will. They will, we'll be running slightly higher. We would expect production to be coming up. So you must have to delink the top line from what we see in production based upon the timing of incoming business. Yes.

Because I think you said in the third quarter that your own internal production was down something like 50%, correct me if I'm wrong there, but your revenues were not down that much sequentially.

Correct. Yes. We are producing at a much lower level than we're selling. So the selling is depressed, but we're producing at an even lower level, and you're seeing in that our reduced inventory levels. And that will continue in the fourth quarter. We expect that to start to turn around here as we exit this year and go into next year, which will result in lower fixed costs being written off and better performance out in the shop with higher volumes to better plan, schedule our operations.

Do you expect to take out more inventory in the fourth quarter than you did in the third, just absolute dollar basis or similar?

It will be about the same, maybe a little bit less currently. But overall, if you look at managed working capital and cash generation, it should be very close to what you saw in the third quarter.

So if I look at the $4.3 million fixed cost charge that you took this quarter, how much of that is due to the fact that your production -- let's just say, how much is due to the fact that you took out inventory?

100% of it is due to the reduction in inventory, which is being accomplished by lower production. If you look at the elements of fixed cost, nondepreciation fixed cost, they've been reduced 30% to 35% over the last 3 or 4 months. So we've taken a fair amount -- what we can control in the fixed category, like longer-term maintenance items and things like that, they have been reduced. But we have something like depreciation that is truly fixed, that's going to be there.

So if you guys didn't take out any inventory in the third quarter, your gross margins would have been around 0.

It would have been higher than that. If you add back just the $4.3 million, that would get you to 0. Yes. But you also can't minimize the impact on operations from an efficiency standpoint. As what I described in my heat treat example, I could give you an example of virtually peeler, for example, we've got decent volume flowing through the shop. You can schedule things by size, so you can run fairly efficiently. In today's climate, you've got a lot of onesies and twosies, which require you to take the machine apart, basically set it up again. So your setups increase and your throughput per hour goes down, even though you're spending per hour goes down, that makes sense to you. So as volume picks up, we'll be getting more productive. So some of those efficiency variances will also turn around. And I would expect that to add further improvement to gross profit margins.

(Operator Instructions)

All right. I will turn the call back to Mr. Oates for his final remarks.

Thank you, Carmen. That concludes our formal remarks. Once again, thank you for joining us this morning. We truly appreciate your ongoing support and interest in Universal, and we look forward to updating you on our next call in January. Continue to be well, stay safe, enjoy the holidays, and have a great day.

And with that, ladies and gentlemen, we thank you for participating in today's program. You may now disconnect. Have a wonderful day.