Description
Unvl Stainless. 10% Owner MANAGEMENT, LL PENNANT CAPITAL bought 33339 shares on 4-11-2012 at $ 41.96
BUSINESS OVERVIEW
INDUSTRY OVERVIEW
The specialty steel industry is a relatively small but distinct segment of the overall steel industry. Specialty steels include stainless steels, high-speed and tool steels, electrical steels, high-temperature alloys, magnetic alloys and electronic alloys. Specialty steels are made with a high alloy content, which enables their use in environments that demand exceptional hardness, toughness, strength and resistance to heat, corrosion or abrasion, or combinations thereof. Specialty steels generally must conform to more demanding customer specifications for consistency, straightness and surface finish than carbon steels. According to the Specialty Steel Industry of North America (“SSINA”), annual domestic consumption of specialty steels approximated 2.1 million tons in 2010 compared with 1.6 million tons in 2009. Of the 2010 amount, approximately 1.3 million tons of specialty steels consumed domestically represented stainless steel sheet and strip and electrical alloy products which the Company does not produce. Also, according to SSINA data through October 31, 2011, U.S. consumption of total specialty steel products in 2011 increased 27% from 2010 levels. The consumption of those products in the Company’s addressable markets, comprising stainless steel bar, rod and wire products, increased by 23%, 12% and 5% in 2011, 2010 and 2009, respectively.
The Company primarily manufactures its products within the following product lines and, generally, in response to customer orders:
Stainless Steel. Stainless steel, which represents the largest part of the specialty steel market, contains elements such as nickel, chrome and molybdenum that give it the unique qualities of high strength, good wear characteristics, natural attractiveness, ease of maintenance and resistance to rust, corrosion and heat. Stainless steel is used, among other applications, in the automotive, aerospace, petrochemical and power generation industries, as well as in the manufacturing of food handling, health and medical, chemical processing and pollution control equipment. The increased number of applications for stainless steel has resulted in the development of a greater variety of stainless steel metallurgical grades than carbon steel.
Tool Steel. Tool steels contain elements of manganese, silicon, chrome and molybdenum to produce specific hardness characteristics that enable tool steels to form, cut, shape and shear other materials in the manufacturing process. Heating and cooling at precise rates in the heat-treating process bring out these hardness characteristics. Tool steels are utilized in the manufacturing of metals, plastics, paper and aluminum extrusions, pharmaceuticals, electronics and optics.
High-Strength Low Alloy Steel. High-strength low alloy steel is a relative term that refers to those steels that maintain alloying elements that range in versatility. The alloy element of nickel, chrome and molybdenum in such steels typically exceeds the alloy element of carbon steels but not that of high-temperature alloy steel. High-strength low alloy steels are manufactured for use generally in the aerospace industry.
High-Temperature Alloy Steel. These steels are designed to meet critical requirements of heat resistance and structural integrity. They generally have very high nickel content relative to other types of specialty steels. High-temperature alloy steels are manufactured for use generally in the aerospace industry.
RAW MATERIALS
The Company depends on the delivery of key raw materials for its day-to-day operations. These key raw materials are ferrous and non-ferrous scrap metal and alloys, primarily consisting of nickel, chrome, molybdenum, manganese and copper. Scrap metal is primarily generated by industrial sources and is purchased through a number of scrap brokers and dealers. The Company also recycles scrap metal generated from its own production operations as a source of metal for the melt shop. Alloys are generally purchased from domestic agents and originate in the United States, Australia, Canada, China, Russia, Brazil and South Africa. Political disruptions in countries such as these could cause supply interruptions and affect the availability and price of the raw materials purchased by the Company.
The Bridgeville facility currently supplies semi-finished specialty steel products as starting materials to the Company’s North Jackson, Titusville and Dunkirk facilities. Semi-finished specialty steel starting materials, not capable of being produced by the Company at a competitive cost, are purchased from other suppliers. The Company generally purchases these starting materials from steel strip coil suppliers, extruders, flat rolled producers and service centers. The Company believes that adequate supplies of starting material will continue to be available. In December 2011, the Company also began producing starting material in its new VIM furnace at its North Jackson facility.
The cost of raw materials represents more than 50% of the Company’s total cost of products sold in 2011, 2010 and 2009. Raw material costs can be impacted by significant price changes. Raw material prices vary based on numerous factors, including quality, and are subject to frequent market fluctuations. Future raw material prices cannot be predicted with any degree of certainty. The Company does not maintain any long-term agreements with any of its raw material suppliers.
The Company has implemented a sales price surcharge mechanism on its products to help offset the impact of raw material price fluctuations. For substantially all stainless semi-finished products, the surcharge is calculated at the time of order entry, based on current raw material prices or prices at the time of shipment. For substantially all finished products and tool steel plate, the surcharge is calculated based on the monthly average raw material prices two months prior to the promised ship date. While the material surcharge mechanism is designed to offset modest fluctuations in raw material prices, it cannot immediately absorb significant spikes in raw material prices. A material change in raw material prices within a short period of time could have a material effect on the financial results of the Company, and there can be no assurance that the raw material surcharge mechanism will completely offset immediate changes in the Company’s raw material costs.
ENERGY AGREEMENTS
The production of specialty steel requires the ready availability of substantial amounts of electricity and natural gas for which the Company negotiates competitive agreements for the supply of electricity and natural gas. While the Company believes that its energy agreements allow it to compete effectively within the specialty steel industry, the potential of curtailments exists as a result of decreased supplies during periods of increased demand for electricity and natural gas. These interruptions not only can adversely affect the operating performance of the Company, but also can lead to increased costs. The Company has a sales price surcharge mechanism on its products to help offset the impact of natural gas price fluctuations.
CUSTOMERS
The Company’s five largest customers in the aggregate accounted for approximately 45%, 45% and 38% of sales for the years ended December 31, 2011, 2010 and 2009, respectively. For the year ended December 31, 2011, sales to Carpenter Technology Corporation and Fry Steel Company accounted for 12% and 11% of the Company’s net sales, respectively, and 13% and 9% of its accounts receivable, respectively. No other customer accounted for more than 10% of the Company’s net sales for the year ended December 31, 2011. Sales outside of the United States approximated 4% of 2011, 5% of 2010 and 10% of 2009 net sales.
BACKLOG
The Company’s backlog of orders on hand, considered to be firm, as of December 31, 2011 was approximately $102.6 million as compared to approximately $69.3 million at the same time in 2010. The 48.0% increase in the backlog is primarily due to increased demand primarily caused by improving economic and credit conditions. The December 31, 2011 backlog has no promise dates beyond the year 2012. The Company’s backlog may not be indicative of actual sales because certain surcharges are not determinable until the order is shipped to the customer and therefore should not be used as a direct measure of future revenue.
COMPETITION
Competition in the Company’s markets is based upon product quality, delivery capability, customer service and price. Maintaining high standards of product quality, while responding quickly to customer needs and keeping production costs at competitive levels, is essential to the Company’s ability to compete in its markets.
Annual domestic U.S. consumption of specialty steel products of the type manufactured by the Company approximated 600,000 tons in 2010 compared with 400,000 tons in 2009. The Company chooses to restrict its participation in this market by limiting the volume of commodity stainless steel products it markets because of the highly competitive nature of the commodity business.
The Company believes that twelve companies that manufacture one or more similar specialty steel products are significant competitors. There are many smaller producing companies and material converters that are also considered to be competitors of the Company.
High import penetration of specialty steel products, especially stainless and tool steels, also impacts the competitive nature within the United States. Unfair pricing practices by foreign producers have resulted in high import penetration into the U.S. markets in which the Company participates. According to SSINA, import penetration for the years ended December 31, 2010 and 2009 was 50% and 51%, respectively, for stainless bar, and 37% and 39%, respectively, for stainless rod. Import penetration during the first ten months of 2011 for stainless bar and rod was 55% and 38%, respectively, according to SSINA.
The Continued Dumping and Subsidy Offset Act of 2000 (the “CDSOA”) provides for payment of import duties collected by the U.S. Treasury to domestic companies injured by unfair foreign trade practices. The Company has joined other domestic producers in the filing of trade actions against foreign producers.
In 2011, 2010 and 2009, the Company received import duty net payments of $115,000, $32,000, $551,000, respectively. Benefits awarded from the CDSOA expired on September 30, 2007. Future benefits are dependent on the amount of undistributed import duties collected as of September 30, 2007 and the relationship of Dunkirk Specialty Steel’s claim in relation to claims filed by other domestic specialty steel producers. The Company expects minimal distributions in the future.
EMPLOYEE RELATIONS
The Company considers the maintenance of good relations with its employees to be important to the successful conduct of its business. The Company has profit-sharing plans for certain salaried employees and for all of its employees represented by United Steelworkers (the “USW”) and has equity ownership programs for all of its eligible employees, in an effort to forge an alliance between its employees’ interests and those of the Company’s stockholders. At December 31, 2011, the Company had 661 employees, of which 518 were USW members.
Employee Benefit Plans
The Company maintains a 401(k) retirement plan for its hourly and salaried employees. Pursuant to the 401(k) plan, participants may elect to make pre-tax and after-tax contributions, subject to certain limitations imposed under the Internal Revenue Code of 1986, as amended. In addition, the Company makes periodic contributions to the 401(k) plan for the hourly employees employed at the Dunkirk and Titusville facilities, based on service, and at the North Jackson facility based upon the employee’s age. The Company makes periodic contributions for the salaried employees at all locations, except for North Jackson, based upon their individual contribution to the 401(k) retirement plan. For North Jackson salaried employees, the Company makes periodic contributions based upon the employee’s age.
The Company participates in the Steelworkers Pension Trust (the “Trust”), a multi-employer defined-benefit pension plan that is open to all hourly and salaried employees associated with the Bridgeville facility. The Company makes periodic contributions to the Trust based on hours worked at a fixed rate for each hourly employee and a fixed monthly contribution on behalf of each salaried employee.
The Company also provides group life and health insurance plans for its hourly and salaried employees.
Employee Stock Purchase Plan
Under the 1996 Employee Stock Purchase Plan, as amended (the “Plan”), the Company is authorized to issue up to 150,000 shares of Common Stock to its full-time employees, nearly all of whom are eligible to participate. Under the terms of the Plan, employees can choose as of January 1 and July 1 of each year to have up to 10% of their total earnings withheld to purchase up to 100 shares of the Company’s Common Stock each six-month period. The purchase price of the stock is 85% of the lower of its beginning-of-the-period or end-of-the-period market prices. At December 31, 2011, the Company had issued 131,484 shares of Common Stock since the Plan’s inception.
ENVIRONMENTAL
The Company is subject to federal, state and local environmental laws and regulations (collectively, “Environmental Laws”), including those governing discharges of pollutants into the air and water, and the generation, handling and disposal of hazardous and non-hazardous substances. The Company monitors its compliance with applicable Environmental Laws and, accordingly, believes that it is currently in compliance with all laws and regulations in all material respects. The Company is subject periodically to environmental compliance reviews by various regulatory offices. The Company may be liable for the remediation of contamination associated with generation, handling and disposal activities. Environmental costs could be incurred, which may be significant, related to environmental compliance, at any time or from time to time in the future.
Dennis M. Oates has been President and Chief Executive Officer of the Company since January 2008. Mr. Oates was named to the Company’s Board of Directors in October 2007. Mr. Oates previously served as Senior Vice President of the Specialty Alloys Operations of Carpenter Technology Corporation from 2003 to July 2007. Mr. Oates also served as President and Chief Executive Officer of TW Metals, Inc. from 1998 to 2003. In May 2010, the Board of Directors elected Mr. Oates to the additional position of Chairman.
William W. Beible, Jr. has been Senior Vice President of Operations of the Company since February 2009. Mr. Beible was employed by Carpenter Technology Corporation from 2006 to 2008 and served in several positions, including Vice President of Manufacturing—Specialty Alloys Operations. Mr. Beible also served as Vice President of Business Improvement and of Information Technology at P.H. Glatfelter Company, a global supplier of specialty papers and engineered products, from 2003 to 2005. Prior to working at P.H. Glatfelter Company, Mr. Beible spent approximately 29 years in various managerial roles in the steel industry.
Paul A. McGrath has been Vice President of Administration of the Company since January 2007, General Counsel since 1995 and was appointed Secretary in 1996. Mr. McGrath served as Vice President of Operations from 2001 to December 2006. Previously, he was employed by Westinghouse Electric Corporation for approximately 24 years in various management positions.
Douglas M. McSorley has been Vice President of Finance, Chief Financial Officer and Treasurer since July 2010. Mr. McSorley was previously employed as Chief Financial Officer of PSC Metals, Inc. (“PSC”), an Icahn Enterprises L.P. scrap metal recycling company operating in the United States and Canada from 1999 to 2009. He joined a predecessor company to PSC as Controller in 1994, after serving five years with Deloitte & Touche LLP in Ontario, Canada, where he worked as a Chartered Accountant with a broad spectrum of industrial clients.
Christopher M. Zimmer has been Vice President of Sales and Marketing since April 2008. Mr. Zimmer previously served as Vice President of Sales and Marketing for Schmoltz+Bickenbach USA from 1995 to 2008. He held positions of increasing responsibility including inside sales, commercial manager—stainless bar, general manager—nickel alloy products, and National Sales Manager.
PATENTS AND TRADEMARKS
The Company does not consider its business to be materially dependent on patent or trademark protection, and believes it owns or maintains effective licenses covering all the intellectual property used in its business. The Company seeks to protect its proprietary information by use of confidentiality and non-competition agreements with certain employees.
AVAILABLE INFORMATION
Copies of the Company’s Annual Report on Form 10-K, Quarterly Reports on Form 10-Q, current reports on Form 8-K, and any amendments to those reports, as well as proxy and information statements that we file with the Securities and Exchange Commission (the “SEC”), are available free of charge on the Company’s website at www.univstainless.com as soon as reasonably practicable after such reports are filed with the SEC. The contents of our website are not part of this Form 10-K. Copies of these documents will be available to any shareholder upon request. Requests should be directed in writing to Investor Relations at 600 Mayer Street, Bridgeville, PA 15017. You also may read and copy any materials we file with the SEC at the SEC’s Public Reference Room at 100 F Street, NE, Washington, DC 20549. You may obtain information on the operation of the Public Reference Room by calling the SEC at 1-800-SEC-0330. The SEC maintains an Internet site at www.sec.gov that contains reports, proxy and information statements and other information regarding issuers, like the Company, that file electronically with the SEC.
CEO BACKGROUND
Dennis M. Oates, 58, has been a Director of Universal Stainless since October 2007. Mr. Oates has been President and Chief Executive Officer of the Company since January 2008. In May 2010, Mr. Oates was elected to the additional role of Chairman of the Board of Directors. Mr. Oates served as Senior Vice President of the Specialty Alloys Operations of Carpenter Technology Corporation, a manufacturer, fabricator and distributor of specialty metals and engineered products, from 2003 to July 2007. Prior to joining Carpenter in 2003, Mr. Oates served for five years as President and Chief Executive Officer of TW Metals, a distributor of metal products. Previously, he held the post of President and Chief Operating Officer for Connell Limited Partnership, a metals recycling and metal fabrication company. Mr. Oates began his career at Lukens Steel Company, a subsidiary of Lukens Inc., where he ultimately became President and Chief Operating Officer. Mr. Oates is past Chairman of the North American Specialty Metals Council and has served on the Metals Service Center Institute Board of Directors.
The Board believes that Mr. Oates’s qualifications include among other things: extensive knowledge of the specialty steel industry and aerospace markets, significant leadership experience and a detailed understanding of the Company’s operations.
Christopher L. Ayers, 44, has been a Director of Universal Stainless since April 2009. Mr. Ayers has been an Executive Vice President of Alcoa Inc. and Chief Operating Officer of its Global Primary Products Business since August 2010. Prior to that, Mr. Ayers served as the Chief Operating Officer of Alcoa Cast Forged and Extruded Products at Alcoa, Inc. from February 2010 to August 2010. From 1999 through December 2008, Mr. Ayers served in various management roles at Precision Castparts Corp., a manufacturer of metal components and products, including as Executive Vice President from May 2006 to July 2008, President – PCC Forgings Division from December 2006 to July 2008, President – Wyman Gordon Forgings from 2004 to December 2006 and Vice President/General Manager from 2003 to 2004. Mr. Ayers also previously served as Vice President of Operations at Quantum Laser Corporation, an operator of an aerospace repair facility, from 1998 to 1999.
The Board believes that Mr. Ayers’ qualifications include among other things: extensive knowledge of the specialty steel industry and a detailed understanding of the Company’s operations.
Douglas M. Dunn, 68, has been a Director of Universal Stainless since 1997. Mr. Dunn has been the managing partner of Dunn Associates, a partnership owning and managing real estate investments, since 1971. Since March 2011, Mr. Dunn has served on the board of directors of Umami Sustainable Seafood Inc., an owner and operator of aquaculture operations. Since May 2006, Mr. Dunn has served on the board of directors of Power Efficiency Corporation, a company which is involved with the design, development, marketing and sales of solid state electrical devices that reduce energy consumption. Mr. Dunn was Dean of the Graduate School of Industrial Administration (now the Tepper School of Business), Carnegie Mellon University, from 1996 to 2002. From 1999 until February 2006, Mr. Dunn served on the board of advisors of Solutions Consulting LLC, an enterprise software and e-commerce solutions company and a wholly owned subsidiary of Perot Systems Corporation. From 2000 until 2005, Mr. Dunn served on the board of directors of VocalTec Communications Ltd., a global provider of carrier-class multimedia and voice-over-IP solutions for communication service providers. Mr. Dunn has served on other boards of directors of companies and organizations in such fields as technology and consulting.
The Board believes that Mr. Dunn’s qualifications include among other things: his experience and education regarding senior leadership positions and his familiarity with the financial aspects of the Company’s business.
M. David Kornblatt, 51, has been a Director of Universal Stainless since April 2008. Since July 2009, Mr. Kornblatt has been Executive Vice President, Chief Financial Officer and Treasurer of Triumph Group, Inc. Prior to that, since June 2007, Mr. Kornblatt was Senior Vice President and Chief Financial Officer of Triumph Group, Inc., a New York Stock Exchange-listed manufacturer of aircraft components and accessories. Prior to joining Triumph, Mr. Kornblatt held the post of Senior Vice President and Chief Financial Officer of Carpenter Technology Corporation, a manufacturer, fabricator and distributor of specialty metals and engineered products, which he joined in July 2006. From 2002 until its acquisition by Johnson Controls, Inc. in 2005, Mr. Kornblatt was with York International Corporation, a supplier of heating, ventilation, air conditioning and refrigeration products, serving as Vice President Finance for York Americas and then as Vice President and Chief Financial Officer.
The Board believes that Mr. Kornblatt’s qualifications include among other things: extensive knowledge of the aerospace markets and a detailed understanding of the financial and accounting aspects of the Company’s business.
Udi Toledano, 60, has been a Director of Universal Stainless since its founding in 1994. In September 2010, Mr. Toledano was appointed Lead Director. Mr. Toledano has managed UTA Capital LLC, a special situation investment fund, since January 2010 and has been the President of AAT Capital, Inc., a private investment company, since June 2008. From 2000 until December 2009, Mr. Toledano was the President of Millennium 3 Capital, Inc., a private investment company, and he managed Millennium 3 Opportunity Fund, a venture capital fund. Mr. Toledano has served on boards of both public and private companies in various fields, including technology, software, real estate, energy and healthcare.
The Board believes that Mr. Toledano’s qualifications include among other things: extensive knowledge of the financial areas of the Company’s business and a detailed understanding of the accounting aspects of the Company.
MANAGEMENT DISCUSSION FROM LATEST 10K
Overview
The following Management Discussion and Analysis (“MD&A”) is intended to help the reader understand the results of operations and financial condition of Universal Stainless & Alloy Products, Inc. (“the “Company”). This MD&A is provided as a supplement to, and should be read in conjunction with, our consolidated financial statements and the accompanying notes to the financial statements.
We manufacture and market semi-finished and finished specialty steel products, including stainless steel, tool steel and certain other alloyed steels. Our manufacturing process involves melting, remelting, heat treating, hot and cold rolling, forging, machining and cold drawing of semi-finished and finished specialty steels. Our products are sold to rerollers, forgers, service centers, original equipment manufacturers and wire redrawers. Our customers further process our products for use in a variety of industries, including the aerospace, power generation, petrochemical and heavy equipment manufacturing industries. We also perform conversion services on materials supplied by customers that lack certain of our production capabilities or are subject to their own capacity constraints.
We recognized net income for the year ended December 31, 2011 of $18.1 million, or $2.56 per diluted share, compared with net income of $13.2 million, or $1.93 per diluted share, for 2010.
On August 18, 2011, we acquired substantially all the assets of Patriot Special Metals, Inc. and RSM Real Estate Holding, Inc., consisting of a new specialty steel manufacturing facility located in North Jackson, Ohio (the “North Jackson Facility”). We began forging and finishing operations at the North Jackson Facility in September 2011. In December 2011, we performed our first melts on the facility’s new vacuum induction melting (VIM) furnace and two vacuum arc remelting (VAR) furnaces. We believe the acquisition of the North Jackson Facility will broaden our production capabilities, expand our product range and market penetration, as well as benefit our future operating margins. The aggregate purchase price of the North Jackson Facility was $111.3 million, which was funded with the proceeds of a $40.0 million term note, $40.0 million in borrowings under a new revolving credit facility, $20.0 million in aggregate principal amount of convertible promissory notes issued to the sellers of the North Jackson Facility and the remainder from cash on-hand at the time of the acquisition. At the same time, we entered into an escrow agreement with the sellers, pursuant to which $2.5 million of the purchase price was placed in escrow. The escrow agreement expires on August 18, 2012. We assumed approximately $4.6 million of liabilities, primarily related to approved capital expenditure projects at the North Jackson Facility.
Our net sales increased from $189.4 million in 2010 to a record $252.6 million for the current year. This $63.2 million, or 33%, increase is largely due to increased volume recognized in the current year and favorable product mix. Tons shipped increased by 16% in the current year when compared to the prior year. Our net sales for the current year were also favorably affected by product mix. Our tool steel shipments as a percentage of total shipments decreased from 16% in 2010 to 11% in the current year, while our shipments as a percentage of total shipments for stainless steel and high-strength low alloy steel increased from 74% and 3%, respectively, during 2010 to 76% and 5%, respectively, in the current year. Our stainless steel and high-strength low alloy products have a higher content of nickel and typically have a higher selling price per pound than our tool steel products.
Our cost of products sold increased from $155.7 million in 2010 to $205.1 million in 2011. This $49.4, million or 32% increase is primarily due to the aforementioned 33% increase in net sales. Our consolidated cost of products sold for 2011, includes $907,000 of costs from the start-up of the North Jackson Facility.
Our results for the current year were negatively affected by increased acquisition related expenses and general and administrative start-up costs associated with the North Jackson Facility, which are included within selling and administrative expenses. Selling and administrative expenses increased from $13.3 million in 2010 to $17.8 million in the current year. Increased acquisition related and start-up costs associated with the North Jackson Facility accounted for $2.8 million of this $4.5 million increase.
Interest expense increased from $0.5 million for 2010 to $1.4 million in 2011. This $0.9 million increase is primarily due to the higher debt balance maintained during the last five months of 2011 to finance the North Jackson Facility acquisition. In addition, during 2011 we settled our interest rate swap and wrote-off unamortized deferred financing costs related to our old term loan that was repaid in conjunction with the new financing arrangement entered into to acquire the North Jackson Facility. The write-off of these items in the current year increased interest expense by $0.3 million. We expect that our interest expense will increase from historical levels for the foreseeable future as a result of holding an increased amount of debt.
Our effective tax rate increased to 36.4% for 2011 from 34.0% recorded in 2010. The Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act, enacted in December 2010, provided for 100% bonus depreciation for qualified investments made during 2011, and 50% bonus depreciation for qualified investments made during 2012. As a result of the North Jackson Facility acquisition and the significant amount of machinery and equipment placed in service in 2011, we will claim the 100% bonus depreciation deduction on such equipment and, as a result, will generate a net operating loss (“NOL”) for the 2011 federal income tax return. As a consequence of generating a NOL, the benefit of the domestic production activities deduction will no longer be available, which is the primary reason for the increase in the effective tax rate. Prior to the acquisition of the North Jackson Facility, we paid federal estimated taxes of $4.5 million for 2011. We have recorded refundable income taxes in the amount of $4.8 million as of December 31, 2011, most of which represents the amount of federal estimated payments for 2011. In February 2012, we received a tax refund of $4.5 million. At December 31, 2011, we had a deferred tax asset of $15.1 million related to NOL carry forwards. We are currently evaluating whether to carry back a portion of this NOL to 2010 to obtain a refund of $5.4 million paid for federal income taxes for the 2010 tax year. If we choose to carry back the NOL to 2010, we would no longer benefit from certain deductions taken in 2010 that reduced our taxable income. These deductions would not be available which would have a negative impact on our 2012 effective tax rate. We expect to finalize the treatment of the NOL by the end of the second quarter of 2012. All remaining federal NOL’s can be carried forward until 2031.
2010 Results as Compared to 2009
Net sales for the year ended December 31, 2010 increased $64.5 million as compared to 2009. The increase was primarily due to a 54% increase in tonnage shipped as well as price increases realized in 2010. The year over year increase in net sales due to increased shipment volume was $52.7 million. The increase in shipments was attributed to improved economic conditions and market demand which continued to recover throughout 2010 as compared to 2009. During 2009, weaker economic conditions resulted in “destocking” in the service center industry to bring inventory levels in line with significantly lower end-user demand.
Cost of products sold as a percentage of net sales was 82.2% and 94.4% for 2010 and 2009, respectively. The results for 2010 and 2009 include a $1.0 million favorable inventory adjustment in 2010, as described above, and $3.9 million of 2009 unusual charges pertaining to inventory write-downs and restructuring charges stemming from the economic downturn, representing 0.5% and 3.1% of net sales, respectively. Excluding these adjustments, gross margin was 17.3% of sales in 2010 compared to 8.7% for 2009. The improved proportion of cost of sales to sales in 2010 is also attributable to fixed operating costs being spread over higher production volumes as a result of increased product orders.
Selling and administrative expenses increased in 2010 to $13.3 million, or 7.0% of sales, from $11.7 million, or 9.3% of sales, in 2009. The increased cost in 2010 was primarily due to a $2.1 million increase in accrued variable compensation, the $647,000 increase in stock option compensation, as described above, and by a $408,000 increase in salary and benefit expenses in 2010, which were partially offset by $2.1 million of bad debt and inventory write-down charges taken in 2009.
The effective income tax rate in 2010 was 34.0% as compared to a benefit of 27.0% for 2009. The effective income tax rate in 2010 reflects taxable income and benefits from the domestic manufacturing deduction, whereas 2009 reflected a net operating loss, benefits related to a federal loss carry back and state loss carry forwards. We had $2.0 million of state tax carry forwards at December 31, 2010 and $2.2 million at December 31, 2009 that represented New York Empire Zone tax credits with no expiration date and various state net operating loss carry forwards expiring in 2029. We believe we will generate sufficient taxable income to utilize these tax credits and losses.
In 2009, we recorded a $742,000 negative tax adjustment primarily for the reconciliation of tax balances to 2008 federal and state income tax returns. We determined that $370,000 of this adjustment related to prior periods and was not considered material to any prior period or to 2009 that would require the restatement of prior period financial statements. The remaining $172,000 of adjustments consisted of $48,000 relating to 2009 tax provision-to-tax return adjustments to properly report state tax credits, and the remaining $124,000 related to other timing differences, primarily state bonus depreciation adjustments.
Business Segment Results
We are comprised of four operating locations and a corporate headquarters. For segment reporting, the Bridgeville, North Jackson and Titusville facilities have been aggregated into one reportable segment, Universal Stainless & Alloy Products (“USAP”). The USAP manufacturing process involves melting, remelting, treating, forging and hot and cold rolling of semi-finished and finished specialty steels. The manufacturing process at Dunkirk Specialty Steel, our other reportable segment, involves hot rolling and finishing specialty steel bar, rod and wire products.
Management is currently evaluating the impact of the North Jackson Facility acquisition on our externally reported segments in accordance with Accounting Standards Codification (“ASC”) Topic 280, “Segment Reporting”. We have included the results of North Jackson in the USAP segment from the August 18, 2011 acquisition date through December 31, 2011. The North Jackson operating segment was included in the USAP reporting segment as a result of North Jackson having consistent characteristics as identified in ASC Topic 280 with the USAP segment. The USAP segment also includes acquisition related costs.
Net sales for 2011 increased by $52.0 million, or 30.0%, in comparison to 2010 primarily due to an 18.4% increase in tonnage shipped, base price increases realized in 2011 and product mix. Our intersegment sales as a percent of sales increased from the prior year to the current year to support the increased sales volume recognized by our Dunkirk segment. In addition, our 2011 net sales include $145,000 of external sales from the North Jackson operation, from August 18, 2011 through December 31, 2011. Shipments of aerospace products, petrochemical products, conversion services and power generation products increased 44.3%, 25.2%, 33.9% and 7.0%, respectively, over 2010. These increases were partially offset by a 20.6% reduction in service center plate shipments in 2011 when compared to 2010.
Net sales for 2010 increased by $65.0 million, or 60.0%, in comparison to 2009 primarily due to a 57.5% increase in tonnage shipped, and base price increases realized in 2010. The increase in shipments was attributed to improved economic conditions and market demands which recovered throughout 2010 as compared to 2009. During 2009, weaker economic conditions resulted in ‘destocking’ in the service center industry to bring inventory levels in line with significantly lower end-user demand. A 144% increase in reroller shipments was accompanied by a 111% increase in service center plate shipments, a 23.1% increase in service center long products shipments, and a 10.5% increase in forger shipments. Shipments of service center plate products, petrochemical products, aerospace products and power generation products increased 111%, 70%, 47% and 41%, respectively, over 2009.
Our operating income for 2011 increased by $2.9 million when compared to 2010, however as a percentage of sales operating income decreased from 10.0% in 2010 to 9.0% in 2011. North Jackson acquisition and start-up costs negatively affected our 2011 operating income by $3.5 million when compared to 2010. In addition, our 2010 operating income benefited from the $1.0 million favorable inventory adjustment described above. Excluding the impact of North Jackson on the current year and the inventory adjustment on 2010, our operating income as a percentage of sales, increased to 10.5% in 2011 from 9.4% in the prior year. The improved proportion of operating income to sales in 2011 is largely attributable to fixed operating costs being spread over higher production volumes as a result of increased product orders.
Operating income for 2010 increased by $19.7 million compared to 2009. The 2010 results include the $1.0 million favorable inventory adjustment described above, and $5.0 million of 2009 unusual charges pertaining to inventory write-downs, restructuring and bad debt expenses stemming from the economic slowdown in 2009, representing 0.6% and 4.6% of net sales, respectively. Excluding the impact of the unusual charges, material costs, as a percentage of sales, increased to 49.9% from 43.7% for the years ended December 31, 2010 and 2009, respectively, as a result of higher material costs in 2010, and operation costs, as a percentage of sales, decreased to 35.4% from 48.0% for the same years, respectively. The improved proportion of cost of sales to sales in 2010 is also attributable to fixed operating costs being spread over higher production volumes as a result of increased product orders.
Liquidity and Capital Resources
We have financed our operating activities through cash on hand at the beginning of the period, cash provided by operations and cash provided through our credit facilities. Working capital increased $3.9 million to $114.0 million at December 31, 2011 compared to $110.1 million at December 31, 2010. Accounts receivable increased $5.3 million as a result of a 20.5% increase in sales for the three-month period ended December 31, 2011 in comparison to the three-month period ended December 31, 2010. The $15.4 million increase in inventory at ember 31, 2011 compared to December 31, 2010 is due principally to a 26% increase in our work-in-process inventory in response to the rise in our backlog. The backlog increased from $69.3 million at December 31, 2010 to $102.6 million at December 31, 2011, an increase of 48.1%.
MANAGEMENT DISCUSSION FOR LATEST QUARTER
Overview
The following Management Discussion and Analysis (“MD&A”) is intended to help the reader understand the results of operations and financial condition of Universal Stainless & Alloy Products, Inc. (the “Company”). This MD&A is provided as a supplement to, and should be read in conjunction with, our condensed consolidated financial statements and the accompanying notes to the financial statements.
We manufacture and market semi-finished and finished specialty steel products, including stainless steel, tool steel and certain other alloyed steels. Our manufacturing process involves melting, remelting, heat treating, hot and cold rolling, forging, machining and cold drawing of semi-finished and finished specialty steels. Our products are sold to rerollers, forgers, service centers, original equipment manufacturers and wire redrawers. Our customers further process our products for use in a variety of industries, including the aerospace, power generation, petrochemical and heavy equipment manufacturing industries. We also perform conversion services on materials supplied by customers that lack certain of our production capabilities or that are subject to their own capacity constraints.
We recognized net income for the quarter ended September 30, 2011 of $3.9 million, or $0.55 per diluted share, compared with net income of $4.1 million, or $0.60 per diluted share, for the third quarter of 2010.
During the third quarter of 2011, we acquired substantially all the assets of Patriot Special Metals, Inc. and RSM Real Estate Holding, Inc., consisting of a new specialty steel manufacturing facility located in North Jackson, Ohio (the “North Jackson Site”). We began forging and finishing operations at the North Jackson Site in September and will have vacuum induction melting, remelting and thermal treatment capabilities once the facility is fully operational. We expect that the assets acquired in the North Jackson Site acquisition will be operational prior to the end of the first quarter of 2012. We believe that the acquisition of the North Jackson Site will broaden our production capabilities and expand our product range and market penetration. The aggregate purchase price of the North Jackson Site was $111.3 million, which was funded with the proceeds of a $40.0 million term note under a new term loan facility, $40.0 million in borrowings under a new revolving credit facility, $20.0 million in aggregate principal amount of convertible promissory notes issued to the sellers of the North Jackson Site and the remainder from cash on-hand prior to the acquisition. At the same time, we entered into an escrow agreement with the sellers, pursuant to which $2.5 million of the purchase price was placed in escrow. The escrow agreement expires one year after the closing date. We assumed approximately $4.6 million of liabilities, primarily related to approved capital expenditure projects at the North Jackson Site.
Our net sales increased from $51.9 million in the third quarter of 2010 to a record $67.3 million for the current quarter. This $15.4 million, or 30%, increase is partially due to increased volume recognized in the current quarter. Tons shipped increased by 9% in the current quarter when compared to the prior year third quarter. Our net sales for the current quarter were also favorably affected by product mix. Our tool steel shipments as a percentage of total shipments decreased from 17% for the third quarter of 2010 to 11% in current quarter, while our shipments as a percentage of total shipments for stainless steel and high-strength low alloy steel increased from 74% and 3%, respectively, during the quarter ended September 30, 2010 to 77% and 5%, respectively, in the current quarter. Our stainless steel and high-strength low alloy products have a higher content of nickel and typically have a higher price per pound than our tool steel products.
Our results for the current quarter were negatively affected by increased acquisition related expenses, which are included within selling and administrative expenses. Selling and administrative expenses increased from $4.0 million for the third quarter of 2010 to $5.3 million in the current quarter. Increased acquisition related costs accounted for $1.1 million of this $1.3 million increase.
Interest expense increased from $0.1 million for the quarter ended September 30, 2010 to $0.6 million during the current quarter. This $0.5 million increase is primarily due to the settlement of our interest rate swap and the write-off of unamortized deferred financing costs related to our term loan that was repaid in conjunction with the new financing arrangement entered into to acquire the North Jackson Site. The write-off of these items in the current quarter, increased interest expense by $0.3 million. In addition, interest expense increased as a result of having significantly more debt during the current quarter than we did in the prior year third quarter.
Our estimated annual effective tax rate increased to 37% in the quarter ended September 30, 2011 from 35% recorded in prior 2011 periods and 34% recorded during the quarter ended September 30, 2010. The entire incremental change for the nine months ended September 30, 2011 resulting from the increase in the estimated annual effective tax rate is included in our current quarter results. This increase resulted in an effective tax rate of 42% for the current quarter. As a result of the North Jackson Site acquisition and the significant amount of machinery and equipment that has been placed in service in 2011, we will benefit from the 100% bonus depreciation deduction on such equipment. As a result, we expect to generate a net operating loss for the 2011 federal income tax return. As a consequence of generating a net operating tax loss, the benefit of the domestic production activities deduction will no longer be available to us, resulting in our estimated annual effective tax rate increasing to 37%.
Cost of products sold, as a percentage of net sales, was 81% and 80% for the quarters ended September 30, 2011 and 2010, respectively. This increase is primarily due to the acquisition of the North Jackson Site. During the current quarter, the North Jackson Site incurred operating costs of $0.6 million, primarily in the form of fixed costs such as depreciation expense, but only recognized $6,000 in external sales. Although the North Jackson Site had minimal external sales in the current quarter, the facility provided conversion services for our Bridgeville facility.
Selling and administrative expenses increased by $1.3 million for the quarter ended September 30, 2011, as compared to the similar period in 2010. Selling and administrative expenses as a percentage of net sales was 8% for the quarters ended September 30, 2011 and 2010. The dollar increase largely relates to $1.1 million of expenses related to the acquisition of the North Jackson Site. We do not expect to incur any additional significant acquisition related expenses.
On December 17, 2010, the Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act of 2010 was signed into law and extended 100% bonus depreciation on purchases of qualified business property through December 2011. Our effective income tax rate in the quarter ended September 30, 2011 increased to 42% from 35% recorded in the prior 2011 periods and 34% recorded during the quarter ended September 30, 2010. The entire incremental change for the nine months ended September 30, 2011, resulting from the increase in the estimated annual effective tax rate, is included in our current quarter results. As a result of the North Jackson Site acquisition and the significant amount of machinery and equipment that has been placed in service in 2011, we will claim the 100% bonus depreciation deduction on such equipment. As a result, we expect to generate a net operating loss for the 2011 federal income tax return. As a consequence of generating a net operating tax loss, the benefit of the domestic production activities deduction will no longer be available to us, resulting in our year-to-date and estimated annual effective tax rate increasing to 37%.
Business Segment Results
We are comprised of two reportable business segments: Universal Stainless & Alloy Products (“USAP”), which consists of the Bridgeville, North Jackson and Titusville facilities, and the Dunkirk Specialty Steel facility. The USAP manufacturing process involves melting, remelting, heat treating, forging and hot and cold rolling of semi-finished and finished specialty steels. Dunkirk Specialty Steel’s manufacturing process involves hot rolling, heat treating and finishing of specialty steel bar, rod and wire products.
Our USAP segments net sales for the quarter ended September 30, 2011 increased by $14.4 million, or 31%, in comparison to the quarter ended September 30, 2010. This increase reflects an 11% increase in shipments for the three months ended September 30, 2011, as well as pricing increases and a change in product mix. Increases in shipments of aerospace products, petrochemical, power generation, conversion services and general industrial products of 36%, 14%, 9%, 14% and 6%, respectively, were partially offset by a decrease in service center plate products of 29%, for the quarter ended September 30, 2011, when compared to the prior year third quarter.
Operating income increased by $0.4 million during the quarter ended September 30, 2011 when compared to the prior year third quarter. Cost of goods sold as a percentage of net sales remained consistent at 85% for both the current and prior year third quarter. Selling and administrative expenses as a percentage of net sales increased from 6% for the quarter ended September 30, 2010 to 7% in the current quarter. The increase in selling and administrative expenses is primarily due to the inclusion of acquisition related costs within the USAP segment. The USAP segment’s results include acquisition related costs of $1.1 million and $52,000 incurred during the quarters ended September 30, 2011 and 2010, respectively.
Net sales for the nine-month period ended September 30, 2011 for the Dunkirk Specialty Steel segment increased by $33.4 million, or 85%, in comparison to the nine-month period ended September 30, 2010. This increase reflects a 67% increase in shipments for the nine-month period ended September 30, 2011, as well as pricing increases and a change in product mix. We benefited from increased shipment of aerospace, petrochemical, general industrial, conversion services and power generation products of 82%, 109%, 20%, 18% and 26%, respectively, during the nine months ended September 30, 2011.
Operating income for the nine-month period ended September 30, 2011 increased by $4.9 million, as compared to the similar period in 2010. The increase is primarily due to the significant increase in sales volume. Operating income further benefited from a decrease in operation costs per sales dollar from 27% for the nine-month period ended September 30, 2010 to 22% for the nine-month period ended September 30, 2011, partially offset by higher raw material costs in relation to net sales. Operation costs per sales dollar decreased primarily as a result of increased production volumes incurred during the current periods. Material cost of sales, as a percentage of net sales, increased from 57% for the nine-month period ended September 30, 2010 to 62% for the nine-month period ended September 30, 2011. Many of the prices of the commodities that we consume decreased in price during the nine months ended September 30, 2011. As these prices decreased, we have reduced our surcharges. Our surcharge mechanism is based on raw material prices two months in arrears of the month the product is sold. At times when raw materials and surcharges are decreasing, our material cost as a percentage of net sales generally increases to the extent our inventory turnover period exceeds two months.
Liquidity and Capital Resources
We have financed our operating activities through cash on hand at the beginning of the period, cash provided by operations and cash provided through our credit facilities. Working capital increased $1.4 million to $111.5 million at September 30, 2011 compared to $110.1 million at December 31, 2010. Net accounts receivable increased $10.3 million as a result of increased sales for the quarter ended September 30, 2011 in comparison to the quarter ended December 31, 2010. The $9.6 million increase in net inventory at September 30, 2011 compared to December 31, 2010 is due primarily to an 18% increase in our work-in-process inventory in response to the rise in the Company’s backlog offset by lower material purchase prices. The backlog increased from $69.3 million at December 31, 2010 to $92.2 million at September 30, 2011, an increase of 33%. Excluding North Jackson, our accounts payable balance at September 30, 2011 decreased by approximately $1.9 million from our prior year-end. This reduction is primarily related to carrying a $1.4 million lower raw material inventory balance at September 30, 2011 when compared to December 31, 2010.
Increased employment costs are primarily due to the aforementioned higher profitability, which added increased payout under our incentive plans. Taxes paid and tax refunds received are included within “other” uses of cash. We paid net taxes for the quarter and nine months ended September 30, 2010 of $2.8 million and $0.3 million, respectively. The nine month net amount includes a $4.1 million tax refund, as a result of being able to carry our 2009 net operating loss back to earlier years and recover previous taxes paid. Prior to the acquisition of the North Jackson Site, we paid taxes of $4.8 million in 2011. As a result of the acquisition and the significant amount of machinery and equipment that has been placed in service in 2011, we will claim the 100% bonus depreciation deduction on such equipment and, as a result, expect to generate a net operating loss for the 2011 federal income tax return. We have recorded refundable income taxes in the amount of $10.5 million as of September 30, 2011, which represents the amount paid in federal taxes during 2011 and a refund of all federal taxes paid for the 2010 tax year. Other uses of cash, the majority of which was cash for production supplies and maintenance, selling and administrative expenses, insurance, outside conversion services and freight, increased primarily as a result of higher production levels in the current period.
The Company had capital expenditures for the nine-month period ended September 30, 2011 of $7.9 million compared with $5.1 million for the same period in 2010. The most significant capital expenditures incurred during the nine months ended September 30, 2011 related to the Bridgeville remelt and laboratory upgrades, which collectively were $1.9 million. There were no capital expenditures related to these projects during the nine months ended September 30, 2010. The Bridgeville melt shop upgrade accounted for $0.4 million of the 2011 expenditures and $2.1 million of the 2010 expenditures. During the nine months ended September 30, 2011, our Titusville facility began upgrading the furnace controls and power supplies of its VAR furnaces. We have incurred $1.1 million in 2011 related to this project. The remainder of the increase in capital expenditures during the current period related to various individually less significant additions at both of the Company’s operating segments. Capital expenditures are expected to increase from historical levels as a result of the approved addition of two VAR furnaces for $7.6 million and a $6.8 million electro slag remelt furnace. We expect to begin installation of these furnaces at our North Jackson facility in 2012. In addition, the Company expects to incur approximately $26.0 million related to the completion of equipment installation at the North Jackson facility.
On August 18, 2011, we and our wholly owned subsidiaries entered into a Credit Agreement (the “Credit Agreement”) which provides for a senior secured revolving credit facility in an aggregate principal amount not to exceed $75.0 million (the “Revolver”) and a $40.0 million senior secured term loan facility (the “Term Loan” and together with the Revolver, the “Facilities”). PNC Bank, National Association (“PNC”) serves as Administrative Agent with respect to the Facilities. The Facilities, which expire in August 2016, are collateralized by substantially all of the assets of the Company and its subsidiaries, except that no real property other than the North Jackson Site is collateral under the Facilities. The Company, Dunkirk Specialty Steel, LLC and North Jackson Specialty Steel, LLC are co-borrowers under the Facilities. The co-borrowers’ obligations under the Facilities have been guaranteed by USAP Holdings, Inc.
Availability under the Revolver is based on eligible accounts receivable and inventory, less outstanding letters of credit issued under the Revolver, which may not exceed $10.0 million at any given time. At September 30, 2011, we had borrowing capacity under the Revolver of $72.9 million. At any time prior to August 18, 2015, we may make up to two requests to increase the maximum aggregate principal amount of borrowings under the Revolver by at least $10.0 million, with the maximum aggregate principal amount of borrowings under the Revolver not to exceed $100.0 million in any event. We are required to pay a commitment fee based on the daily unused portion of the Revolver. At September 30, 2011, the commitment fee under the Revolver was 0.375%. The Revolver also provides for up to $7.0 million of swing loans so long as the sum of the outstanding swing loans and the outstanding borrowings under the Revolver does not exceed the aggregate borrowing capacity under the Revolver at any given time. The Term Loan is payable in quarterly installments in the principal amount of $1.5 million beginning on July 1, 2012, with the balance of the Term Loan payable in full on August 18, 2016.
Amounts outstanding under the Facilities other than swing loans under the Revolver, at our option, will bear interest at either a base rate (the “Base Rate Option”) or a LIBOR-based rate (the “LIBOR Option”), in either case calculated in accordance with the terms of the Credit Agreement. We elected to use the LIBOR Option during the period from the entrance into the Credit Agreement through September 30, 2011, which was 2.49% at September 30, 2011. Interest on swing loans under the Revolver is calculated using the Base Rate Option, which was 4.50% at September 30, 2011. Interest on both the Facilities and the swing loans is payable monthly.
The Credit Agreement requires that we maintain a leverage ratio not less than a ratio decreasing from 3.25 to 1.00 to 2.50 to 1.00 during the term of the Facilities and a fixed charge coverage ratio not less than 1.20 to 1.00. At September 30, 2011, we were obligated to maintain a leverage ratio of not less than 3.25 to 1.00. We were in compliance with all covenants contained in the Credit Agreement at September 30, 2011.
As a result of our entrance into the Credit Agreement, we recorded deferred finance costs of $1.4 million in the Condensed Consolidated Balance Sheet as a component of other long-term assets as of September 30, 2011. These costs are being amortized to interest expense over the life of the Credit Agreement.
In connection with the acquisition of the North Jackson Site on August 18, 2011, we issued $20.0 million in convertible notes (the “Notes”) to the sellers of the North Jackson Site as partial consideration of the acquisition. The Notes are subordinated obligations and rank junior to the Facilities. The Notes bear interest at a fixed rate of 4.0% per annum, payable in cash semi-annually in arrears on each June 18 and December 18, beginning on December 18, 2011. Unless earlier converted, the Notes mature and the unpaid principal balance is due on August 17, 2017. The Notes and any accrued and unpaid interest are convertible into shares of our Common Stock at the option of the holder at an initial conversion price of $47.1675 per share of Common Stock. The conversion price associated with the Notes may be adjusted in certain circumstances. We may prepay any outstanding Notes, in whole or in part after August 17, 2014 during a fiscal quarter if our share price is greater than 140% of the current conversion price for at least twenty of the trading days in the thirty consecutive trading day period ending on the last trading day of the immediately preceding quarter. We evaluated the conversion feature of the Notes and determined that no beneficial conversion feature exists.
As a result of our increased debt load, we expect that our interest expense and interest payments will increase from historical levels.
Prior to our entrance into the Credit Agreement, we had a credit agreement with PNC which provided for an unsecured $12.0 million term loan (“Old Term Loan”) and an unsecured $15.0 million revolving credit facility. We used a portion of our cash balance prior to the acquisition of the North Jackson Site to repay the Old Term Loan during the quarter ended September 30, 2011. There were no borrowings on this revolving credit facility and it was extinguished with our entrance into the Credit Agreement. During the nine months ended September, 2011, we also repaid all of our governmental debt in the amount of $0.6 million.
We had an interest rate swap with PNC to convert the LIBOR floating rate under the Old Term Loan to a fixed interest rate for the life of the loan. Under the agreement, our interest rate was fixed at 4.515%. The effective portion of the change in the fair value of the interest rate swap was recorded net of tax in accumulated other comprehensive loss (within stockholders’ equity) prior to extinguishing the Old Term Loan. We recorded a charge of $0.3 million during the quarter ended September 30, 2011 as a component of interest expense on the Condensed Consolidated Statement of Operations to terminate the interest rate swap.
We expect to meet all of our short-term liquidity requirements resulting from operations and current capital investment plans with internally generated funds and borrowings under the Revolver. At September 30, 2011, we had $37.3 million in availability under the Revolver.
CONF CALL
June Filingeri
Thank you, Mary. Good morning, this is June Filingeri. And I’d also would like to welcome you to the Universal Stainless & Alloy Products conference call. We are here to discuss the company's third quarter results, which were reported this morning. With us from management are Denny Oates, Chairman, President and Chief Executive Officer; Bill Beible, Senior Vice President of Operations; Paul McGrath, Vice President of Administration and General Counsel; and Doug McSorley, Vice President of Finance and Chief Financial Officer.
Before I turn the call over to management let me quickly review procedures. As Mary said after management will makes their formal remarks they will take your questions. The conference operate will instruct you on the 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 risk 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 the formalities out of the way, I would now like to turn the call over to Denny Oates. Denny, we are ready to begin.
Denny Oates
Okay, June. Thank you very much. Good morning everyone. Thanks for joining us today. Our third quarter performance reflects modest sales growth, solid profit margins, positive cash flows and a 28% increase in our backlog.
Third quarter sales of $51.9 million doubled those of the same quarter last year and about 1% ahead of the second quarter.
With supply chain re-stocking mostly completed in the first half of the year. Third quarter sales mainly reflected end used demand, as well as our progress in market and product expansion initiatives. From an end market standpoint positive momentum in aerospace was the major positive driver of our sales in the third quarter. Our operating margin remained above 12% of sales in the third quarter, despite the recent price fluctuations in nickel and other raw materials.
We continue to drive improvements in operating performance. The increase in inventory returns achieved thus far is less than the impact of nickel volatility. The melt shop upgrade and other recently completed capital projects along with process improvements are reducing costs and increasing yields. By way of update on our Melt shop projects daily melt productivity has increased 33%, materials are up more than 2% and work in process inventory returns are 50% higher.
In total our Melt shop production in the first nine months of 2010, was 50% greater than its production for all of 2009.
As I said on our last call, the operational improvements achieved to date are sustainable and there is still more we can do.
Cash flow from operations was a positive $8.8 million in the third quarter and managed working capital per dollar a sales is consistently improved over year.
Let me turn to our end markets, aerospace remained our largest market growing up to 37% of sales in the third quarter compared to 32% of sales in the second quarter of this year and 31% in the third quarter of 2009.
Aerospace sales rose 20% sequentially and were 150% greater than the 2009 third quarter. Boeing’s earnings report last week shows the positive momentum in the market.
For the third quarter Boeing reported booking at net 221 commercial airplane orders compared with 68 net orders in the 2010 second quarter and 79 in the third quarter of last year.
They also have raised the production level for the 737 for the third time, starting the resurgence in air travel and strong demand from their customers. The current backlog includes over 2000, 737s and they are optimistic that number is going to increase, based on existing customer options and their sales efforts.
Boeing also [have set] the demand for a 777, 787 and the stretch (inaudible) rather supports their current production schedule and they anticipate prolonged market recovery overall.
The Petrochemical market was our second largest market in the third quarter, representing 21% of sales essential even over the second quarter of 2010 and the same period last year.
Our potential chemical sales which are primarily for the oil and gas exploration market, were up 2% sequentially or being nearly double the level the third quarter of 2009. As noted on the last call, some excess inventory remains in the distribution supply chain, which we expect to come into balance by year end.
For the third quarter Halliburton and Schlumberger both reported sequentially flat international sales with strong growth in North America with a shift to more land based fields from offshore drilling. Both companies are forecasting further recovery in 2011. The good news from our standpoint is that our customers have started adding to payroll and our coding activity has picked up in recent weeks.
Power generation represented 17% of third quarter sales, compared with 19% in the second quarter of 2010 and 32% of sales in the third quarter of 2009. Our Power Generation sales were down 10% sequentially, but up 9% from the third quarter of 2009.
Our customers continue to expect significant market recovery in 2012 which implies a pick up in Power Gen business for us as we move to 2011. Their expectation seem to be in sync with what we are hearing on the end market.
On the third quarter call GE reported a total of 15 new orders for turbines in the quarter compared with 23 in the third quarter of 2009. It was good to see the announcement earlier this week that GE won a large deal for natural gas and steam turbines from Reliance Power of India.
Until the market recovery gains traction we are focusing on continuing to capture maintenance business as it becomes available based on shortly times and quick turn around. We are also upgrading our re-melt facilities to meet our customers’ needs and what we feel will be a very robust market in the future.
Our service center plate sales represent 14% of third quarter sales versus 17% of sales in the second quarter of 2010. But just 5% in the 2009 third quarter, our service center plate sales were 16% lower sequentially, but six times higher than on the same quarter a year ago.
The current sales level seems stable, now that restocking has been completed in a channel. Domestic auto sales appeared to be selling in at around 12 million units annually and the offer equipment manufacturers continue report healthy backlogs and strong bookings.
Let me turn the call to Dough at this point for report on third quarter financial results.
Doug McSorley
Thank you Danny, our third quarter sales of $51.9 million and volumes shipped of to 11,800 tons more than doubled from the same quarter in 2009 to the stronger open shipments to all end markets. Sequentially our sales increased 1.1%, while our tonnes shipped were essentially flat. The sales increase was due to the improved shipments to aerospace and our pricing levels on those products that offset the volume variability and our other end markets.
For the first nine months 2010, our sales of $137.8 million were up 40.3% from the same period of 2009 with an increase of 45.4% in our tonne shipped.
Our third quarter gross margin of $10.3 million was 19.1% of sales compared to 10.7 and then 2009 third quarter an 18.9 in the 2010 second quarter. Our cost of sales can include book the physical inventory adjustments, our third quarter of 2010 included a favorable adjustment of $1 million for the additional metal recovery as a result of a capital project in streamlining our scrap loading area. Excluding this adjustment, our gross margin was 17.9% of sales for the quarter. For the first nine months of 2010 our gross margin of 24.9 million was 18 .1% of sales, compared to 3.8% in the same period of 2009.
Our selling general administration expenses of the third quarter with $4 million for 7.7% of sales compared to 8.9% in the 2009 third quarter and 6.4% in the 2010 second quarter. There was a $700,000 increase in our SG&A from the 2010 second quarter. This increase is primarily due to an unfavorable adjustment for increase stock option compensation expense. The adjustment was accumulative non-cash adjustment require to fully expense that productions and change the estimated forfeiture rates of current and invested options.
Our third quarter operating income of $6.3 million was 12.2% of sales compared to 1.8% in the third quarter of 2009 and 12.5% in the 2010 second quarter. Our operating income for the first nine months of 2010 was $15 million over 10.9% of our sales. The company’s cash position at the close of 2010 third quarter $15millionor the 2010 third quarter was 41.2 million an increase of 6.6 million from the second quarter.
Our managed working capital which includes receivables and inventory less accounts payables improved rather the 33.1% of sales in the third quarter from the second quarter level of 34.7% of sales.
Capital expenditures for the third quarter was 1.7 million bringing our year-to-date spending to 5.1 million. Total debt at the end of the third quarter was 11.5 million; this debt includes a term loan with DMC against which we are making quarterly principle payments of $600,000.
That concluded my report Denny I'll turn the call back to you for final remarks.
Denny Oates
Okay. Thanks, Doug. In summary then sales remained at strong levels in the third quarter as the market shifted from restocking to end user demand, and we continue to execute on market and product expansion initiatives. Our backlog grows 28% and order entry increased in the quarter. Manufacturing improvements and targeted capital spending programs contributed to profitability and our margins remained strong in the third quarter despite the fluctuations in nickel.
Our balance sheet remains very strong. For the balance of 2010 beyond we will continue to focus on high service levels, process improvements and lower cost, while investing in our operations all which are aimed to driving growth and profitability.
That concludes our formal remarks, we are now ready to take your questions.
Question-and-Answer Session
Operator
(Operator Instructions). And our first question comes from the line of Michael Gallo from CL King.
Michael Gallo - CL King
Good. How are you doing? Just one, thinking a little bit on the SG&A question, I think that it was the whole increase Q2 to Q3 EBITDA stock option adjustment, the total increase over the prior quarter nickel was 700,000; 640 of that was the adjusted stock options. Okay and just what we feel a little bit how that came up there is something I presume shouldn’t reoccur here would be expected to reoccur?
Doug McSorley
No, it shouldn’t and won’t reoccur. It’s a change in our estimated perpetual rates of the different pools of options that are currently vesting in it was a full expense of options invested with an August anniversary date and some prior to that.
Michael Gallo - CL King
Just to change the way you did things, going forward you would expect that to be more inline with probably where it was in the second quarter. Expectation for a level with sales?
Doug McSorley
What will happen is some of the expense will be the quarter earlier, it’s a little more current with more appropriate rates. I would say compared to the second quarter you would see an increase related to stock options of $100,000.
Michael Gallo - CL King
And then just commentary Denny just on the overall supply chains for petrochemical and Power-Gen I know you indicated you expect us to improve in 2011. but just if you can comment I think on the supply chains of those two areas that’d be great? Thank you.
Denny Oates
Okay, toward the supply chains in the oil and gas area which is most of our petrochem business. A lot of that business that we sell goes to distribution. We still see some excess inventory along the supply chain which as I mentioned we expect to go in the balance.
On the Power-Gen side its not the same case I think inventory is there I would characterize as lean which means the timing of return in the market is going to be critical. You have been around this market long time, like so you know it tends to turns very quickly and I think when it does there will be a mad rush to get metal.
So there are two different markets, two different situations as the supply chain from an inventory standpoint as I say.
Operator
Our next question comes from the line of David Woodyatt from Keeley Asset Management
David Woodyatt - Keeley Asset Management
Yes, could you give us at least a rough estimate of where you think the overall company operating rate stands at the moment?
Denny Oates
Usually the operating rate is based offer, your melt capacity and your utilization re-melt shop today we are running in about 55% of capacity based upon that measure.
|
|
Fund Letters
