Albany International Corp. (AIN) Q2 2012 Earnings Report, Transcript and Summary

Ladies and gentlemen, thank you for standing by. Welcome to the Second Quarter Earnings Call of Albany International. [Operator Instructions] Later, we will conduct a question-and-answer session. Instructions will be given at that time. At the request of Albany International, this conference call on Thursday, August 2, 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 particularly 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 will provide some opening remarks, before we go to Q&A. Joe?

Thanks, John. Good morning, everyone. Let me add my welcome to John's, and as always I'll make a few opening comments and then we'll go right to your questions. Q2 was an excellent quarter despite the economic uncertainties with adjusted EBITDA growing to $40 million, compared to $31 million a year ago and $26 million last quarter. In Machine Clothing, our sales came in pretty much as expected. We had suggested in Q1 that we would see a bounce back in Q2 revenues except in Europe and that's precisely what happened. Americas held firm, Asia held firm and West Europe weakened a little bit more, dropping below the already weak Q1 levels. Our margins in Machine Clothing were very strong, despite serious overcapacity issues in Europe. Ordinarily, gross margins in Machine clothing ranged from 42% to 44%, because of strong plant utilization in the Americas and favorable product mix, we came in at the high end of that range. AEC also performed as expected. Sales and EBITDA grew sharply compared last year and were consistent with Q1 2012 performance. The LEAP program ramp continue to progress very well, and on the commercial front, total orders enhanced for the LEAP engine now number nearly 4,000. At the recent Farnborough Air Show, at which Albany received a good deal of media attention, CFM disclosed that it expects our production to hit 32,000 fan blades per year by 2019. At 18 blades per engine that translates to nearly 1,800 chipsets per year rather than the 1,500 we had been assuming. At the same time, the pipeline of new product possibilities continues to strengthen the potential for additional content on LEAP, both on initial and future versions continues to grow and the potential for new products outside of LEAP also continues to grow. To take one prominent example, Boeing has now scheduled for this quarter a new ground test for the advanced engine nozzle that they are developing. The nozzle uses our ceramic matrix composite substructures. The other highlight in the quarter was the completion of the sale of PrimaLoft and of our debt and pension liability reduction efforts To summarize the impact, our net debt at the end of 2012 was about $260 million. Today, it is about $180 million. Our total unfunded pension liability at the end of 2012 was $100 million. Today, it is about $30 million. So net debt from $260 million to $180 million, unfunded pension liability from $100 million to $30 million, that's between end of 2011 and end of Q2. So in sum, our balance sheet is now in great shape. As for our outlook, obviously it hinges on the health of the economy, especially the European economy. Our expectation, given everything we see today, is that adjusted EBITDA for the overall company for the second half of the year should be roughly comparable to adjusted EBITDA for the second half of 2011. Now, this outlook is based on the following assumptions. First and most importantly, it assumes that the economies in the Americas and Asia hold firm. Second, it assumes some further deterioration in the European economy and paper industry. Third, it assumes that gross profit margins in Machine Clothing, which as I mentioned reached the high end of our normal range in Q2 will regress towards the mean. And one final assumption. You'll see in the discussion of STG&R in the earnings release that there was $1.5 million favorable impact in Q2 from normal adjustments to incentive compensation and other accruals. Our outlook assumes the absence of such favorable impacts in the second half of the year. But the key assumptions Asia and the Americas hold, Europe continues to deteriorate. In sum, what we see is very good performance in both businesses in Q2, except for Europe, with an outlook for similar performance in the second half of the year, again, except for Europe. Let me stop with that and turn to your questions. Operator?

[Operator Instructions] Our first question comes from the line of John Franzreb with Sidoti & Company.

Don't you just hate when they put out blade forecast sort of higher than yours? I guess, I want to start right there. Could you talk a little bit about your scheduling and what kind of maybe high watermarks we should look for in the year ahead for you as far as product ramps? What kind of targets you are looking for on the hiring front? Things of that nature, that maybe through the balance of this year and into early next year that, we should be visibly identifying to measure your progress?

John, I think that the dominant variable to monitor is the macroeconomic variables more than any internal announcements we would be making. So first and foremost keep your eye on Europe. I'll tell you what we are keeping our eye on. Europe historically, every year as it comes out of the summer shutdowns, there's a typically in our industry a big surge in orders and sales in September, if not September then October. We are watching very carefully to see if we get a normal surge this September or October or whether because of the economy there, that surge is seriously muted. That will have a big impact on the second half of the year and also on our thinking about what 2013 looks like. There are several important contracts in paper machine clothing in Europe that will be negotiated in that same timeframes, September, October, November. We will be watching those really carefully. Again, in many ways there, they will be heavily influenced by the economic outlook as well. So, to us it's those macroeconomic variables that are really, for us and everybody else I'm sure, that are really the big swinger in our outlook and they will dictate whether we are being too conservative or too optimistic in our outlook.

I'm sorry. My real question was actually directed towards LEAP development. That's where I was kind of looking for what kind of near-term production or development targets, where are you in that timeline is really what I was looking for. Let's put that aside, John, and stick with what you are talking about right now. So given that outlook, is that why your gross margin expectation has been dropped from being above 44% threshold to that lower, that mid-range is that the primary driver there?

No. We're just assuming regression towards the mean, normal variability. There is always for a variety of reasons, there will be some fluctuation within the normal range in gross margin and we just think it's statistically improbable that you always stay at the high end of that range. If we stay at the high end of that range, that means our range has changed and we are not prepared to say that yet.

So the current volumes don't support that kind of a mix or margin profile?

Let's try to do a number this way. Let's assume we had the identical sales profile, so start with the $40.5 million of adjusted EBITDA we had this quarter. Take out $1.5 million for those normal incentive compensation accruals, so now you are at $39 million, $38.5 million. We think it's more likely that gross margins will fall back to the normal range of 43%, 42.5%, 43%, so that would take the $38.5 million, $39 million of adjusted EBITDA down another $2 million or so. So now you are in the $36 million range and that's still above the average for the second half of last year. But then we're putting in an assumption that there was further deterioration in the European paper industry, because of deterioration in the European economy and that accounts for another $1 million to $2 million of EBITDA. So that's how we do the math.

I got you. I'll ask one last question then let somebody get in. How much more rebalancing of the pension remains based on your current cash position? How much more is left to be done?

Yes, John. As Joe mentioned, we're looking at underfunded position of about $30 million, so there are parts of our U.S. plan, of our Canadian plan that still remain and are ongoing. We don't have plans really to look at that in the near future. We also have a couple of plans outside the U.S. that also carry some of that liability. I think right now, for the stage that we have talked about, we're pretty much done. We'll keep looking if there are further opportunities in the future, but that would be over the next few years, but we'll continue to monitor it. So I would say based on the plan that we have outlined that we are done.

We'll come back to your LEAP question, John, once you get back in queue.

Our next question comes from the line of Jason Ursaner with CJS Securities.

Congratulations on a very strong quarter, completion of the various sales, pension stuff, should be a lot simpler going through these releases going forward hopefully.

Let us hope. We think so too.

Just first on Machine Clothing. I want to try and dig a little deeper on the gross margin there. Were you saying it's more mix and new products in holding your cost where it could be sustainable but conservatively you are assuming that's regression? Or did it have more to do with the extra sales that kind of slid out of weak Q1 due to timing, where it was more just a utilization benefit but you're fairly sure you don't see that every quarter?

The gross margin is made up of so many moving parts and sales volumes, sales mix geographic mix, plant utilization, seasonality. So we think it's an exercise and false precision to put a number on it. You really want to look at what's a reasonable range. If we hit 43.5%, 44%, for a couple more quarters, then you could say all right, our range for all the productivity moves that we've been trying to make, our range is higher than it had been. But one quarter in a row is not sufficient to say that the range has changed. It looks to us like if the range is 42% to 44%, we came in at 44%. A reasonable forecast would be to assume regression toward the mean. That's all that's going on. It is nothing more complicated than that.

In terms of the outlook there, within the industry what are the general expectations in terms of consumption trends around the world? Has production been matching that outlook, I guess especially in Europe? And then would your orders be matching current production or are you seeing any variances in terms of customer inventory levels?

The consumption in production patterns around the world have been remarkably consistent with the outlook that we tried to lay out in Q1, and that we saw in Q2, which is America's consumption, production and our sales and orders held firm. And, Asia has a little - there are occasional blips of warning signs, but on balance it appears to be holding firm. So the story is Europe. When you look at all the variables you just mentioned, paper industry, production trends and what the major paper makers are saying about their outlook. Paper consumption, trends and the overall paper machine industry order patterns and our sales and order patterns, we and you add on top of that the macroeconomic outlook that we see from the bottom up, we think that industry has not, and therefore our sales in Europe have not yet hit bottom. We can't find a piece of counterevidence to suggest that it has hit bottom.

Is that more before because there's an expectation consumption is going to continue declining or the current consumption still there's still this overcapacity a little bit?

If you just step back and think about what drives the overall climate for the paper industry and therefore paper machine clothing. It's a G&P-driven industry, so all the modeling that's done about forecasting paper industry consumption and production is first approximation, driven by projections about G&P, and you just take it step-by-step. The G&P moves that is made up of consumption and consumption in retail markets and industrial markets and paper production is driven by consumption of printing and writing, tissue, packaging, all that's driven by how strong the economy is, so it really is a G&P-driven industry.

Okay. Then AEC on a…

And, so if you believe the economy in the Americas is going sideways, the economy in Asia is slowing down, but still had some growth in it and the economy in Europe is going to continue to slide then that's what gets to the outlook - that's what gets to our outlook.

Got it, but it's not gap in overcapacity still, or there is a clear gap relative to what the current consumption is? I think that was more the question.

Yes. We talked about. The reason that we felt that the big 15% drop in European sales in Q1 would not come back. And that the smaller drop in Q2 will not come back is because, I think we talked about is it mirrors the magnitude of the structural overcapacity in the European paper industry. That is for the European paper industry to get healthy, that's what needs to one way or another that kind of capacity needs to be taken out. If you listen to the CEOs of the major paper makers in Europe, they are saying precisely that. When they think about their planning, they look at the paper industry in Europe, they say that point number 1, 2, and 3 is we've got to take capacity out. So, that's the only place that there is a mismatch between capacity and consumption. And that's why we project PMC revenue going down more than the economic decline, because of that overcapacity factor. We don't see that as much in the Americas, because we are overexposed to the segments of the paper industry that are growing and under-exposed to the segments that are shrinking. The segments that are shrinking like newsprint do have overcapacity. Did that answer…

Yes. That definitely covered it. In AEC, on the nozzle program, what do you think the long-term opportunity is in terms of your content? Do you still see any potential retrofit opportunity on that program or it's going to be for new engines?

This is a very important ground test that Boeing is running in Q3 that we prefer to unreleased. There is a flight test scheduled for next year, I think, Q3, but really the ground test is the critical test. Assuming it succeeds, another reason they do the test is, because it may not, but assuming it succeeds what the heart of the opportunity here is nozzles for engines that run hot and the larger engines, particularly the more advanced versions of large engines are the ones where they have the highest temperature issues. The most obvious initial application or platform for these nozzles would be on new engines for larger planes. So if you're thinking the new version of the 777, upgrades on the 787, that's the natural market. Now, could it spread too in the long run? Now we're out at the end of the decade, early next decade. Is it theoretical? Is it conceivable that the same nozzles would apply to single-aisle over new generation of single-aisle will be running hotter, so it's possible. And it is also theoretically possible that there will be a retrofit market eventually? Yes. The whole point here is that these nozzles' current version need to get replaced 3 or 4 times in the life of the engine for the larger engines that run hot. So, yes, it's a very interesting potential application. But like all of these interesting potential applications, they really speak to the growth potential AEC beyond the after that is, after the introduction of the LEAP. It won't materially affect revenues before the introduction of LEAP.

Okay. And long-term, the opportunity. It's comparable to LEAP, 1/2 LEAP? I mean you used the baseball references before. If LEAP is the home run, where does the nozzle fit in that?

Yes. The LEAP benchmark is itself changing. So a year ago when we were thinking LEAP was 1,500 engines at a 100,000 per chipset then long-term this opportunity is potentially somewhere between 1/3 to 1/2. Third to 40% of the LEAP. The LEAP opportunity is growing, so now maybe this looks a little smaller compared to LEAP.

So, this is a double and LEAP is a grand slam then?

Well, one of the variables here that is hard for people to understand is how the volume on the single-aisle aircraft is so large compared to other aircraft. That, yes, if you can get a major position on the single-aisle aircraft, that's a big opportunity and that's what we have with LEAP. Everything pales by comparison to that, just because of volume.

I guess the last question for John. Where do you expect the full rate benefit to be on the STG&R on the pension contribution side? Is the $1 million per quarter sort of where we should expect it to final out or that should grow given the timing of when you did some of these initiatives?

Yes. We about $900,000 of benefit that we reported there. There's probably $200,000 or $300,000 more just based on the timing of when we finish that per quarter. So it's probably little over $1 million per quarter on STG&R, and to get the full benefit that we talked about the $7 million to $8 million the remaining benefit is in our manufacturing cost, and that's related to our non-U.S. plans. That's another $0.5 million per quarter. And some of that came through in Q2. Maybe about 1/2 of it or probably little less than that, but we'll have a full benefit in Q3.

[Operator Instructions] Next we have Mark Connelly from CLSA.

This is Kurt Schoen filling in for Mark. Just following up on the engine nozzle. If that test, the ground test does fail, does that kind of kill the whole opportunity for the nozzle?

No. It usually means, you got to go back and do more research and make some adjustments. I would say no. It doesn't kill. You got to go back and do more work. It's rarely are things black and white. If it passes all the tests that's black, but if they get more vibration than they thought or runs noisier than they thought then you go back and do some design modification.

But you do think they are committed to composites longer term?

Boeing has talked a lot about the appeal of a lighter, quieter, more high-temperature-resistant nozzle, so this would have a big impact for them it will succeed, so I think it's fair to say that if there's encouraging results from the test, they will move forward too. But if the tests aren't fully successful. They will keep working at this.

Okay. Then going to PMC, I know you said the bottom really isn't in yet.

In Europe.

In Europe, yes, so you don't see that in yet. In terms of market share shifts. Have you been seeing anything there, and if there is any market share shift in Europe, do you think other markets will be pressured as a result either positively or negatively for you guys?

Market share is a tricky issue. If you look at the aggregate market share for us around the world, we had not seen any shifts, but that's not a very important variable for us. What we look at is our share among the most important paper makers and the most important grades that is the growth grades in each region of the world. And the market share shifts that we see there are positive and encouraging. I think a version of your question is, if Europe has not hit bottom and there is overcapacity in paper machine clothing industry in Europe, are we going to see share pressures due to price? And yes we think the conditions for price erosion in Europe as we've been saying now for few quarters are heightened, because of the decline in demand, in Europe coupled with several contract negotiations coming up. We've tried to build that into our model.

Okay. Then in Asia, your baseline assumption is that Asia remained firm. If it does decrease, where do you see that downside? How much downside is there?

We tend to lose sight of when we say Asia is softening, we are talking about, if China goes from 9% growth to 6%, we view that as a significant economic crisis. Right now, we're not seeing and we haven't been thinking about it. The downside in Asia, the question in our minds is what's the latest growth going to be. The number of new machines going in tends to ebb and flow, and right now it's in an ebb, and the number of new machines starting up does have an impact on our PMC orders and sales. For us the question in Asia is more is it stable, or we going to see growth? That's the uncertainty. In Europe the uncertainty is, where is the bottom, and in the Americas, the primary uncertainty is, will the economy continue to run sideways? And, if the answer is yes, then what we've been performing should be what we guess. If we starting see a pick-up in economic activity that will be good, and if we see a contagion effect from Europe and G&P really starts to drop, then we have some downside. Right now we think we have adequately taken into account the downside in Europe. But as I was describing, that's the real uncertainty. That's the real risk factor that we see. As I try to describe to an earlier question, September and October will tell us an awful lot about the outlook over the next few quarters in Europe, because there's a very well-defined seasonal pattern in orders in particular, but also sales in PMC and in paper in Europe. Which as you go, everything slows down in July, and then it comes back hard sometimes in August, usually in September but it could even be delayed until October. In our mind, the size of the bounce-back will tell us a lot about the depth of the, call it the paper recession in Europe. There likely will be some bounce-back, but is it a muted bounce-back, which says we still haven't hit bottom or is it a sharp bounce-back the way we like nearly see that says we did hit bottom at the end of Q2 and in July. You just don't know until you go through it. We should have pretty clear picture of it in our Q3 call.

Our next question comes from Mr. John Franzreb with Sidoti & Company.

Joe, just a follow-up on that last point that you just made. Could there be a scenario that plays out where your European customers reset delivery times? Or is there a fundamental reason why they have to get the orders out the door quickly in September?

Well, there's the holiday season and they are coming back and starting back up, so I don't think it would be a reset in delivery time.

You can't elongate it any way or something?

Well, I think the elongation or truncating that's going on really affects us in their treatment of inventory. So if they are pessimistic about the economy, they will run down their clothing inventory before putting in new orders, and so you might see delays, but they are going to need. The seasonal pattern is what it is, because of the need for paper production towards the backend of the year for their customers, so that's why the scale of the balance tell us an awful lot about what paper makers are seeing in the demand from their end users.

It was just a curious thought I just wanted to throw out there. Then back to my question from before. Just if you could update us on what kind of capital outlays you have coming up as far as ramping up production or where you are in the process of hiring as far as LEAP is concerned. And any other color along those lines, if you could provide that would be great.

We had been saying that between 2012 and 2017, we'd expect total CapEx for the company to be on average at our slightly below $70 million, which is through amortization, depreciation. That's looking more like for '12, '13, '14, '15, we'll be closer to averaging $55 million. Then, $16 million, $17 million, which is where the surge in CapEx will be as there's a surge in production in LEAP. It will go to $70 million, $75 million. Now, there is a chance that out there in $16 million, $17 million, the $75 million goes higher, but that's because some of these new product possibilities have kicked, we've gotten contracts and we have to build more capacity, so it's possible that out of the very end of the investment horizon, '17, '18, '19, we see more capital expenditure than $70 million a year and that would be because we are seeing another wave of revenue potential on top of the LEAP potential. That everybody talked about.

Any significant capital outlays in the near-term that we should be eyeballing?

No. Not beyond what we've already talked about.

Thank you. We have no more questions in queue.

Thank you, everyone for participating on the call and we'll be seeing many of you at several investor conferences coming up in August and early September. If I don't talk to you, or John doesn't talk to before then, we'll talk to you at end of Q3. Thank you.

Thank you. 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 our conference for today. Thank you for your participation and for using AT&T Executive TeleConfernce service. You may now disconnect.