Albany International Corp. (AIN) Q1 2012 Earnings Report, Transcript and Summary

Ladies and gentlemen, thank you for standing by. Welcome to the first quarter earnings call of Albany International. [Operator Instructions] At the request of Albany International, this conference call on Thursday, May 3, 2012, will be webcast and recorded. I would now like to turn the conference over to Chief Financial Officer and Treasurer, John Cozzolino, for introductory comments. Please go ahead.

Thank you, operator, and good morning, everyone. As a reminder for those listening on the call, please refer to our detailed press release issued last night, regarding our quarterly financial results with particular reference to the Safe Harbor notice contained in the text of the release about our forward-looking statements and the use of certain non-GAAP financial measures and associated reconciliation of GAAP. And for purposes of this conference call, those same statements also apply to our verbal remarks this morning. And for a full discussion, please refer to that earnings release as well as our SEC filings, including our 10-K. Now I will turn the call over to Joe Morone, our Chief Executive Officer, who’ll provide some opening remarks, before we go to Q&A. Joe?

Thanks, John. Good morning, everyone. Well, Q1 2012 was obviously a very disappointing quarter for us as sales in machine clothing particularly in Europe were much softer than we had anticipated and so what I would like to do at the beginning of this call before we get to your Q&A is discuss what happened in machine clothing in Q1, why we didn't see this coming and what it means for our outlook. As we discussed last quarter we had been expecting a slow seasonal start to the year and that did indeed occur. In fact the seasonality was a little more extreme than we were anticipating. But we were also expecting the slow start to be followed by a gradual ramp up in sales as the quarter progressed. And given the strong order trends right from the start of the quarter and increasing activities in our plants and strong shipments in the backend of the quarter, we kept expecting that ramp up in sales right through the end of March, but it never materialized. Revenue remained, stayed soft through the entire quarter. Now there were a number of positives in Q1, let me run through them quickly and then I will come back to the weak Q1 sales in machine clothing. So first just a minute on the positives in Q1. As I mentioned orders in machine clothing except for Europe were strong through the quarter. Our plants were busy in March and shipments flowing into Q2 from the end of the quarter and which will be recognized in Q2 were very high, unusually so. Considering the soft sales our margins in machine clothing were good. We made good progress on our efforts to strengthen the balance sheet with large reductions in net debt and pension liability. Net debt declined by $70 million, by the end of this month our total pension obligation will have been reduced by over $200 million and the unfunded portion of our remaining pension obligation will have declined to about $30 million. Yesterday we announced that we have entered into an agreement to sell PrimaLoft for $38 million which will further strengthen the balance sheet and as I discussed in some detail in the release, our composites business had a very encouraging quarter, 35% year-over-year growth, operating income breakeven, improving productivity, excellent progress towards the LEAP ramp, excellent progress in building up our R&D pipeline and the potential for annual EBITDA to grow to about $20 million in 2016 which is of course the starting point for that LEAP brand and the inflection point for sales and profitability. So there were a number of bright spots, but obviously the story in Q1 is the soft sales in machine clothing. So before we go to your questions, I would like to give you a sense of how we are thinking about the top line in machine clothing and what that Q1 performance means for the rest of the year. The average revenue per quarter in machine clothing for quarters 2 through 4 of last year was $184 million. So going into this year we thought that this $184 million average was a reasonable benchmark for quarterly sales in machine clothing. Now we knew we were going to have to deal with seasonal effects especially in Q1 but excluding seasonal effects we thought the $184 million average seemed like a good quarterly benchmark. Well as we now know our Machine Clothing sales in Q1 2012 were only $164 million, so $20 million below that quarterly benchmark. We think more than half of the missing $20 million is a matter of seasonality and timing and should bounce back right away in Q2 and for the rest of the year and beyond. So more than half of the $20 million bounces right back. But there is another portion of the $20 million roughly $5 million to $7 million that's related to weakness in Europe and that $5 million to $7 million per quarter is probably not going to bounce back. Given the weak and deteriorating European economy combined with the structural overcapacity in the European paper and paper machine clothing industries, we think that $5 million to $7 million per quarter is probably gone permanently, not just for the rest of this year but permanently. In other words that benchmark of $184 million per quarter of machine clothing revenue is now more like $178 million per quarter. Now we have been talking about overcapacity in Europe for some time and we had taken it into account in our long-term model of flat to 1% growth in machine clothing. But we have been expecting our sales in Europe to decline gradually over several years rather than all in one quarter. In hindsight one of the lessons we learned in late 2008 seems to apply directly to our European sales in Q1 2012. At the front end of a serious recession, which is what appears to be what Europe is heading into, when you're dealing with overcapacity as we are in the European paper industry, sales drop out in big chunks rather than gradually and they don't come back. We think that's what just happened to machine clothing sales in Europe in Q1. It hit all at once and it hit late and so a quarter that was already being dragged down by an unusually strong seasonal effect was made quite a bit worse by what is probably a more permanent structural effect. So what does this mean for the rest of the year? A $178 million run rate in machine clothing rather than $184 million puts us even with Q2 2011, but behind Q3 and Q4 which were at $188 million and a $183 million, respectively. However profitability in machine clothing has and should continue to improve as we keep reducing costs and improving productivity. At a $178 million run rate adjusted EBITDA in machine clothing for the rest of this year should be comparable to adjusted EBITDA in machine clothing for Q2 through Q4 of 2011. So assuming global economic conditions do not deteriorate significantly through the course of the year, our revised target for machine clothing for the rest of the year that is for Q2 through Q4 is for flat year over year adjusted EBITDA, lower sales but for Q2 through Q4 flat adjusted EBITDA. Now when you consider the entire company and add the improving performance in AEC and the positive impact of the pension liability reduction, total company adjusted EBITDA for Q2 through Q4 of 2012 should be slightly better than total adjusted EBITDA for Q2 through Q4 of 2011. As you know, there's a lot more material in the release about Albany Engineered Composites and the pension liability reduction but I hope I have given you enough here to give you a clear understanding of how we are viewing Q1 and the outlook for machine clothing. So I will stop here and let's go to your questions. Operator?

[Operator Instructions] Your first question comes from the line of Mark Connelly from CLSA.

A couple of things Joe, can you talk about PMC regionally outside of Europe and the U.S.? We haven't really heard you talk much about Latin America lately, nor that much about China and we tend to think of China as a region where your margins are struggling to get up to the other, to the level of other regions obviously. If the other regions come down it’s easier, but I am just curious if you could give us a bit of a sense what's going on elsewhere.

Okay, let's start with China, and then go to Latin America. China had a very good Q1 and assuming nothing unusual happens in the economy in China…

I didn’t think my question was that hard.

No. We think China face strong and keep growing and there will be bounces as the growth rate modulates in China but we feel positive about China on the top line. Margins in China are actually comparable to a little bit better than margins in Europe. So even though prices are lower cost are low enough that we don’t see anything unusual in margin if anything we see an improvement in margins as sales from China and Asia replace sales from Europe. South America has been relatively flat but orders are very strong and margins are very good and North America is solid. The weakness we’re seeing if you leave aside the timing and seasonal effects, it really is concentrated in West Europe.

And then just a quick question with respect to PrimaLoft, can you give us a sense of how certain that sale is? Are there are a lot of conditions attached to it or is it just too early to know for sure?

Mark, there really are not a lot of conditions towards there. They are typical conditions to closing I think, but if there everything goes as expected, we would expect to close that transaction by the end of the quarter. So there is a very high probability of closing that transaction.

Okay. And then just one final question, maybe the harder one. When we see companies making contributions to pension plans, we know that the pension accounting can get just incredibly complex. Can you just give us a sense of how you thought about these contributions in terms of the return on doing this versus doing something else with that capital?

Yes, Mark. There are 2 primary alternatives. We are paying down our revolving credit agreement or putting a large amount of proceeds into our pension obligations. The pretax return on paying down the debt at current rate is about 2.5% and when we look at the pension plan, and really taking 2 key things into consideration, which is the interest charge on the unfunded liability which is essentially a formal debt as well as the administrative costs of these plans. We are looking at around 5% return on the pension plans. So there is a significant economic benefit to putting the money into the plans.

Now beyond the cash outflows that you’ve talked about in these next 2 quarters, is there anything meaningful beyond those 2?

There are still pension plans out there. We haven’t settled all the liabilities. The obligations or the total obligations that are out there that Joe talked about, go down $200 million which is a pretty big number. So we are not looking at a lot of cash requirements into those plans going forward probably less than $3 million or $4 million per year, compared to, close to $18 to $20 million per year now of required contributions, we look forward start of the strategy, So it’s a significant reduction and exposure.

Okay. And Sweden then is effectively done and Can -- the status of Canada?

Canada, we are in the process of fully funding and purchasing annuities for a portion of that plan, about half of that plan.

Half of the plan. Okay.

And for the U.S., we have actually, after the end of Q1, towards the end of April; we actually purchased annuities for 2/3 of that population of that plant.

Okay. So we are presumably not going to see a lot of additional charges in items related to this after the next quarter. Is that right?

Correct. Q2 we will see the large $100 million plus charge that will come through in selling those liabilities and then after that we shouldn’t have anything assuming we get the Canadian plan done this quarter as expected.

Okay, and just one last question on composites and I apologize for asking so many but we know how lumpy it is for new project approvals to come through and you’ve always been good about giving us updates where you can. Is 2012 likely to be a light year for those kind of announcements? I think 2011 is a pretty heavy year.

Yes, 2011 was a big year for announcing big new programs. What’s happening in 2012 in addition to the progress toward the ramp up of LEAP is the number of projects that we are building up in our R&D pipeline is growing. They have an impact, positive potential impact on revenue in the second half of the decade after 2016. We are not able to talk about them yet until our customers talk about them. It is possible, there is a fair possibility that by the time of the Farnborough Air Show, some of our customers will be talking openly, more openly about some of the things we’re working on and if they are then we will be able disclose more but that would be pipeline projects and the pipeline that have revenue potential after 2016.

Your next question comes from the line of John Franzreb from Sidoti & Company.

Firstly, in the press release you’ve provided some EBITDA guidance on the Engineered Composites segment, based on what your expectations were for 2016, I was just wondering if you want to provide a little bit more color on what your thought process is, a, providing at this point any incremental data that you are comfortable with providing that number at this point?

We have been saying that, we weren't expecting any improvement in EBITDA in AEC this year particularly because of one-time charges. And that a year ago we had offered Q2 2012 as a target of hitting $60 million run rate and breakeven operating income and then we backed away from that. When we got to the level that we have backed away from earlier in Q1 and so we thought it was a significant development and enough of a development that we are to explain what the implications of hitting that revenue run rate and operating income breakeven sooner rather than later. It basically leads us to the conclusion that we are going to see more profitability from this business sooner and that's why we laid it out. As I lay out in the earnings release, there is still the potential for lumpiness here and we will get some of these charges associated with -- moving cost associated with buyers, but we think that underlying run rate of about $5 million of EBITDA and $60 million of revenue, that's a good baseline, sustainable.

With regards to Europe, you’ve kind of spent some time earlier about, we’ll call it deteriorating market conditions. I wonder if you could address the competitive landscape against that backdrop and what are you seeing out there and I guess as a subset of that, are there any material new contracts that are coming out for bid in the coming year?

Well, there I believe is an important contract at the back end of the year, with Stora Enso. I am not quite positive, I am pretty sure, but look we know there's over capacity in the paper industry, we know there's over capacity in paper machine clothing and so we expect the competitive environment, the pricing environment to get worse as the sales environment gets worse. That's one of the reasons that we are saying that $5 million to $7 million of revenue, we’re assuming that's gone permanently. We are building into that a presumption of declining revenue from both declining volume and growing price pressure there. There isn't any reason to be optimistic right now about what’s going on in Europe and it’s a combination of what looks to us like a bad macroeconomic environment coupled with over-capacity that didn't get taken out in the last recession, the way it did get taken out in North America.

Joe, how do you think that resolves itself?

I think the only way that it resolves itself and if I can quote the CEO of UPM, the #1 papermaker in Europe, the only way it resolves itself is through consolidation of capacity and it keeps pounding the drum for this and the only way the European paper industry gets healthy is if it consolidates, if it shuts down capacity. And he has done his part he keeps saying he is waiting for everybody else to do their part. It’s very instructive to compare how international paper is feeling about itself having gone through great pain in 2008 and 2009 and how the European paper makers are feeling about themselves have been delayed taking the pain; it feels like it’s coming home to roost now.

And one last question, as you divest operations and you soon generate relatively strong and of course healthy cash flows from machine clothing; would there be a point in this process that you’ll move away from balance sheet improvements and potentially moving to a more inquisitive stance maybe just kind of broaden the product line again or readjust the product line offerings?

Well, so far what we have -- where we would the acquisition is pretty clear; we’re a 2 business company, where we would do the acquisition is on the composite side. That on the paper machine closing side, we have such high share that any acquisition we’re going to wind up paying for the acquisition, paying for the consolidation cost associated with the acquisition and then probably losing share to competitors, because our combined share will be so higher, customers will inevitably lose some shareholders, so it doesn’t make sense. When you add on top of that flat to 1% growth you just don’t get the return. So the acquisition activity is almost certainly, if there is any going to be on the composite side; what we are seeing so far and we revisit this question repeatedly, is the organic growth opportunities are so significant that they far outweigh anything that we’re seeing in attractiveness on the acquisition front. So a strengthening balance sheet, if it’s going to get reinvested into composites will be, almost the way it looks like now is more likely to go to funding organic growth than funding acquisition, of course that’s always subject to change and that’s how it looks to us today.

I guess just one last question; will your R&D spend will be going up materially to fund those investments over the next couple of years?

Well, it has been going up and I don’t think it will have a material effect on the story, no.

[Operator Instructions] Your next question comes from the line Jason Ursaner from CJS Securities.

Joe, I just want to try and reconcile this area that played out in the quarter that you had previously talked about with a relatively flat outlook. If Europe hadn’t sort of dropped out in one quarter, is there anything that changed about your outlook given the growth you are seeing in China, the growth in South America. Would it still been that sort of gradual covering of it, if it hadn’t come out in the quarter?

Correct. We would be talking about; the only thing we would be talking about is timing affects that, we have these strong shipments at the end of the quarter that won’t get recognized till next quarter. We had expected them to get recognized in Q1 and we would be mostly talking about that. There wouldn’t be anything structural. North America looks the way we are expecting South America does, Asia does. There is obviously ups and downs with the G&P in this industry, but the structural change here is Europe and it's not -- 5 years from now it will look -- 3 years from now Europe will look like what we thought it would look like, it just all came out in one quarter. That's how it's looking to us right now.

Got it, so if we assuming that the seasonal and timing affects taking that out sort of a Q1 blip, if we just concentrate on Europe, the permanent part I guess you have been talking about overcapacity for a long time and no one really seemed to care because demand had been pretty flat, as demand softened and now you see these shutdowns. Assuming that they are permanent capacity reductions, is it matching, is production matching demand at the current level or is there still overcapacity issue?

Well, we have been I think we have mentioned and we have been thinking that overcapacity in Europe in paper is about 15%. So and $5 million to $6 million per quarter is about 15%. So now there will still be those sectoral trends with printing and writing declining every year offset somewhat but we think this chunk is a pretty good, pretty good reflection of what the overcapacity was.

Okay and I mean can you talk anymore about share in the region, how your customers may be different than what some of the other customers are doing and the grades that you’re most tied to in the region, so?

Well I don't want to talk too much about share but our thinking is very clear there will be winners and losers in any industry consolidation and our strategy for the past 5 years is to try to align ourselves with the companies and the machines that are the long-term survivors in the industry. So the highest speed, most modern machines in Europe, they are not going to go away, the ones that will get shuttered in the consolidation will be the less efficient machines. So we've been working very deliberately to strengthen our position on the machines that are going to survive and that's where that you are able to differentiate, we are able to differentiate ourselves on products and service and that's where there's less likely to be a commoditization of pricing commodity like pricing of paper machine clothing.

And on the cost side you mentioned pretty solid margins still in the machine clothing segment, were you still selling out of inventory at all as you came out of the shutdown from December, or had the shutdown really matched -- gotten your inventory to where it needed to be for utilization in the quarter?

A lot of the sales now and our growing percent, we recall making a shift, so they are manufactured and shipped and recognized during the quarter. So there is certainly a large piece of that. There is still inventory, there's still inventory that was also sold during the quarter that was made in the previous quarter and I think the indications to that with the margins holding firm, even with that level of decline in sales to us is indicative of just the continuation of the improved cost structure that we have in that business.

And on composites you got asked a little bit about R&D and you mentioned the strong pipeline for after 2016, is there anything you could add about, will there be different capital requirements sort of on the out programs later in the decade where you don’t have the process as said as you do already on some of the weak bags and some of the other shorter term ones. And then there is also anything you could add on the programs in terms of where it is, is it still coming from the private sector or public sector. You mentioned Farnborough, is it still aerospace or are these other applications?

We’ve been pretty consistent about saying that our expectation is total CapEx for the company for the next 5 years, which includes the ramp for LEAP, the new plants for LEAP, will be at or slightly below on average amortization and depreciation. So that has not changed and that’s as we get closer to LEAP, those numbers are still holding firm. So now if there is a new, if we’re on a new program or if there are enhancements to existing programs that require more productivity capacity that would lead to both an increase in capital expending and an increase in revenue income. The capital spending does not lag the revenue on income by that much. We start loading up, start equipping the plant, production starts pretty shortly thereafter. So yes there is the potential for more, for a requirement for more capital spending as some of these new programs and enhancements to programs turn into new revenue potential. We don’t see anything immediately. Our estimate for capital spending for the next 4 to 5 years, we are not adjusting at this point. If we did, it would mean that we would be adjusting our revenue and income potential upward.

Your next question comes from the line of Rick D'Auteuil from Columbia Management.

Just a couple of, so on the composites, just following through on that, little more bullish tone, can you get into the granularity on what the upgrade to your thoughts are, both on the $60 million and $5 million in EBITDA, sooner rather than later. What specifically contributed there?

Revenue was hitting sooner. Productivity is improving and the current run rate. What was interesting about Q1 is that you saw the run rate without these one-time charges that we think we are going to get, it was a unique snapshot. And that’s why we thought it was worth talking about it. So at this run rate, we have been loading up on fixed cost. We are essentially creating an additional layer of organizational infrastructure because we know this big ramp in revenue is coming. So if this is the run rate at this level of revenue, this run rate of EBITDA, that profitability should improve. So that EBITDA should grow faster substantially than sales growth from here on because the amount of investment we are making in fixed costs is going to decline as a percentage of every incremental piece of revenue. So this is a good snapshot of what our profit potential is at this level of sales and as sales nearly double over the next 4 years, we will expect EBITDA to quadruple. Always remembering that in this kind of young business, there will be some volatility with those one-timers every once in a while, but that run rate is, we are pulling it in, it’s coming sooner than we thought.

Is this New Hampshire business or where was your acquisitions, was it Texas or…

Well, the productivity in Texas is definitely improving. And the revenue, especially in Rochester is definitely increasing. So you take the combination of both of those and again at some point of slowing down and the increase in fixed cost and that puts us in a better place sooner than we were anticipating. I am always with the caveat that it will be choppy for a few quarters.

On the revenue side or…

More on the cost side because of onetimers.

That’s my sort of my second question, the reference to charges on the composite side?

Well, here is what we know, and what we don’t know; what we know is we are recruiting people from all over the country and they are senior engineers, managers of quality, heads of operations and actually all of their houses are under water. And so in order to recruit them we've put together relocation packages and the relocation packages will include help with their houses, that's the only way we can recruit them. So after they sell their houses we will help them with real estate charges or the closing costs or something like that. And so we know those are coming and we think its somewhere between $1.5 million and $2 million, it’s not quite as high as we thought it was going to be, because we've been more successful recruiting locally than we thought we would be. But there is a known $1.5 million to $2 million of relocation costs that are still to come, even though some of the people are already here that haven’t sold their house yet, so we don’t know exactly what that support for them would be. The unknown onetimer is more of generalized caveat, anytime you are in a business, in aerospace business with a lot of program development. Sometimes those programs get canceled or you are not successful in developing the program and you've got to write off that program investment. We had about $2 million of write offs or $1.5 million to $2 million of program write-offs at the last recession when investments in R&D we were making in developing parts for jets, for business, engines for business jets, those business jets and those engine programs got canceled. So we had to write off that program investment. That's always lingering out there and right now we don't see anything on the horizon, but it’s always there, at least until we are large enough that those write-offs then are in the noise and you don't see them.

You have a follow up from the line of John Franzreb from Sidoti & Company.

Actually, Rick picked off a lot of my follow-ups. The $1.5 million to $2 million that’s a total gross number, that’s not on a quarterly basis, just to clarify real quick?

Yes, I think if you assume $0.5 million a quarter for the next 3 to 4 quarters that’s a pretty good assumption.

And when are you going to break ground on the new facility, Joe?

The ground is broken.

How far along are we in the process there?

Well, I think by this time next year the building will be complete and we will start equipping the building.

And at this time, there are no further questions.

Okay, thank you everyone and we’ll do our best to be in touch with you during the quarter and if not, we’ll talk to you next quarter. Thank you for participating in this call.

Ladies and gentlemen, a replay of this conference call will be available at the Albany International website beginning at approximately noon Eastern Time today. That does conclude your conference for today. Thank you for your participation and for using AT&T Executive Teleconference Service. You may now disconnect.