Description
Xerium Tech Inc. 10% Owner ROBERT C RUOCCO bought 129500 shares on 5-17-2012 at $ 3.92
BUSINESS OVERVIEW
Company Overview
Our clothing and roll cover products are installed on pulp and paper-making machines and play key roles in the process by which raw materials are converted into finished paper. A fundamental characteristic of our products is that they are consumed in the paper production process and must be regularly replaced. This positions us to make recurring sales to our customers, and accordingly the number of paper machines in operation throughout the world and the amount of paper, pulp and board produced globally each year are primary drivers of the demand for our products. In addition, our products are also installed in other industrial applications such as nonwoven and fiber cement machines.
Paper-making machines utilize different processes and have different requirements depending on the design of the machine, the raw materials used, the type of paper being made and the preferences of individual production managers. We employ our broad portfolio of patented and proprietary product and manufacturing technologies, as well as our extensive industry experience, to provide our customers with tailored solutions designed to optimize the performance of their equipment and dramatically reduce the costs of their operations. We systematically track and report the impact of these customized solutions to our customers through our ValueResults program which quantifies the optimization process on their machines.
Our clothing products are highly engineered synthetic textile belts that transport and filter paper as it is processed in a paper-making machine. Clothing plays a significant role in the forming, pressing and drying stages of paper production. Our clothing segment represented 66% of our net sales for each of the years ended December 31, 2011, 2010 and 2009.
Roll cover products cover the rolls on a paper-making machine, which are the large steel cylinders over which clothing is mounted and between which the paper travels as it is processed. Our roll covers provide a surface with the mechanical properties necessary to process the paper in a cost-effective manner that delivers the sheet qualities desired by the paper producer. We currently use several hundred chemical compounds in our roll cover manufacturing process. Our roll cover segment represented 34% of our net sales for each of the years ended December 31, 2011, 2010 and 2009.
Our products are in constant contact with the paper during the manufacturing process. As a result, our products have a significant effect on paper quality and the ability of a paper producer to differentiate its products, two factors which are increasingly important to paper producers. In addition, while clothing and roll covers represent only approximately 3%, on average, of a paper producer’s production costs, they can help a paper producer improve productivity and reduce overall costs. Our clothing and roll covers facilitate the paper producer’s use of less expensive raw materials (including recycled fiber), their ability to run paper-making machines faster and with fewer interruptions, and their ability to decrease the amount of energy required in the expensive drying portion of the paper-making process. We have found that, in certain cases, our products and services provide paper producers with cost savings that substantially offset the costs of such products and services.
We estimate that there are approximately 7,000 paper-making machines worldwide, all of which require a regular supply of clothing and roll covers. Clothing and roll covers must be replaced regularly to sustain high quality paper output and operate efficiently. Roll covers also require regular refurbishment, a service that we provide to our customers. Paper producers typically replace clothing several times per year, replace roll covers every two to five years and refurbish roll covers several times between each replacement.
We have a reputation for technological innovation in the paper-making industry. In our clothing segment, in recent years we have focused our research and development efforts on higher value-added, technologically advanced products, such as forming fabrics and press felts, which offer paper producers greater potential for differentiating their products through quality improvements and increasing their operating efficiency. We pioneered a number of technologies that have become industry standards, including in our clothing business, synthetic forming fabrics (which replaced bronze wire technology), double-layer forming fabrics, laminated press felts and, most recently, triple-layer forming fabrics.
In our roll covers segment, we have introduced a number of innovations to our roll cover and spreader roll products in recent years, including SmartRoll™, the first continuous pressure sensing paper machine roll that enables the papermaker to maximize performance by knowing the pressure of the paper machine while the machine is running, shoe press belts which utilize our expertise in polyurethane material and manufacturing technologies, composite calender roll covers that use nanoparticle technology to improve roll cover durability and paper gloss, as well as covers that use an improved polyurethane to increase abrasion and moisture resistance as well as responsiveness and stability.
Our portfolio of patented and proprietary product and manufacturing technologies differentiates our product offerings from others in the market and allows us to deliver high value products and services to our customers. As of December 31, 2011, we had approximately 280 issued patents and approximately 105 pending patent applications. We currently license certain of our patents and technologies to some of our competitors, which we believe helps further demonstrate our technological leadership in the industry. We believe that the technological sophistication of our products and the capital-intensive nature of our business present significant challenges to any potential new competitors in our field.
Our business was organized in 1999 in connection with the acquisition of the paper technology group of Invensys plc. We completed our initial public offering on May 19, 2005.
Chapter 11 Filing, Emergence and Plan of Reorganization
On March 30, 2010, we and certain of our subsidiaries filed voluntary petitions for relief under Chapter 11 of Title 11 of the United States Code, 11 U.S.C. §§ 101-1532, in the United States Bankruptcy Court for the District of Delaware. On May 12, 2010, the Bankruptcy Court entered an order confirming the plan of reorganization (“the Plan”). On May 25, 2010, the Plan became effective and we and our subsidiaries emerged from Chapter 11. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Chapter 11 Filing, Emergence and Plan of Reorganization” for additional information regarding our Chapter 11 proceedings.
Recent Developments
Global Economic Environment
Our operations are highly dependent upon the pulp and paper production industry and the degree to which the paper industry is affected by global economic conditions and the availability of credit.
Beginning in 2008 and continuing through most of 2009, the global paper industry experienced a sharp reduction in production levels, caused by the general slowdown in economic activity and related paper consumption during the same period and the paper manufacturers’ reduction of excessive inventories. The slowdown of production was across most grades of paper production, but most notably in packaging and newsprint grades. For packaging grades, demand was directly related to broad manufacturing and transportation activity reduction, while newsprint demand has been declining over a number of years due to the greater prevalence of electronic media and was exacerbated during the recession by a reduction in print advertising. One of the results of this recession driven reduction in demand for paper products was that the paper manufacturers dramatically and quickly reduced production through curtailments of machines and complete mill shutdowns. These curtailments, which began in late 2008, served to reduce inventories and match output with demand. By early 2010, most mills and equipment not permanently shuttered had resumed production.
In the first half of 2011, global paper and board production continued the recovery that began in 2010, particularly in developing countries. As international shipments of manufactured goods increased, containerboard production recovered particularly strongly, contributing over 50% of the total global improvement. The paper and board production recovery stalled in the second half of 2011, particularly in Europe and South America. In the near term, we expect that global paper and board manufacturers’ operating rates will remain near their second half 2011 levels. As a result of these factors, pricing pressures increased as 2011 progressed. We have endevored to maintain our current pricing levels in both our clothing and rolls segments.
Business Strategy
The primary components of our business strategy are:
Fiscally Responsible Management. We are committed to improving our capital structure and creating sufficient financial flexibility. This will allow us to continue to invest in our operations where we can expect reasonable returns, expand into markets where our products and services will create value for our customers and support the global growth of the paper-making industry. As part of this strategy, our focus on the reduction of working capital, allocation of capital investments and elimination of loss-making businesses, customers and products will drive our activities. We may incur additional operational restructuring expenses in connection with pursuing cost-savings opportunities. We believe that our potential to improve productivity includes the opportunities to enhance our manufacturing efficiency by improving our process yields and reducing our cycle times.
New Product Development. We are committed to maximizing our margins and profitability in both our clothing and roll covers segments by focusing our production and marketing efforts on higher value-added, technologically advanced products that will benefit our customers by providing them with the cost savings and quality improvement characteristics they require to be competitive. We intend to continue to offer a full range of product offerings in order to meet our customers’ needs. We believe that the development and successful introduction of new products in a systematic and customer-focused manner will allow us to meet the expected demands of global market growth and our own sales growth and profitability projections. Simultaneous standardization and simplification will help us achieve significant cost reductions and competitiveness.
Workforce Engagement. We are committed to alignment of objectives for our entire workforce. We believe that communication, training, tools and incentives associated with this alignment are essential to meeting our business plans and objectives. Human resource management systems must be in place in support of this strategy, including retention of personnel to maintain and enhance the quality of the performance of our workforce, visibility to career opportunities to create job growth, and incentive systems that reward the workforce for achievement of critical objectives. Our approach includes the “high-grading” and “right-sizing” of our workforce to make certain those individuals most necessary for our success are in a position to positively contribute to goal achievement.
Products
We operate through two principal business segments, clothing and roll covers. Our clothing segment products include various types of industrial textiles used on paper-making machines and other industrial applications. Through our roll covers segment, we manufacture various types of roll covers, refurbish previously installed roll covers, provide mechanical services for the internal mechanisms of rolls used on paper-making machines and manufacture spreader rolls. For additional financial information about our clothing and roll covers segments, please see “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and Note 15 to the accompanying audited consolidated financial statements.
Clothing Products
Our clothing segment products are large, highly engineered synthetic textile belts that transport paper as it is processed in a paper-making machine from paper stock into finished paper. Clothing products must be tailored to each machine because all paper-making machines have different physical configurations and operating parameters. Clothing generally ranges in size from approximately 7 feet to over 30 feet wide and 24 feet to more than 460 feet long and operates on paper-making machines that run at speeds up to 7,500 feet per minute. We typically sell clothing products for between $13,000 and $45,000 per belt, although we sell some of our more sophisticated forming fabrics for up to $200,000 per unit.
We manufacture three general types of clothing products used on paper-making machines—forming fabrics, press felts and dryer fabrics—each of which is located in a different section of a machine. Forming fabrics and press felts are typically replaced several times a year, but replacement frequency varies significantly by the grade of paper being produced, the manner in which the paper-making machine is operated and the quality of raw materials used in the paper stock. Dryer fabrics are replaced less frequently, with replacement typically taking place no more than once per year.
Forming fabrics . Forming fabrics are used at the beginning of paper-making machines, where highly diluted paper stock is deposited on the forming fabric while the fabric is traveling at a very high speed. Forming fabrics allow water to drain from the paper stock, creating an initial wet sheet. Forming fabrics must be sufficiently porous to allow water to drain evenly and quickly, yet tight enough to retain and align the fiber and other materials that form the sheet of paper. They must also be strong enough to withstand high mechanical stresses. Forming fabrics are custom-manufactured in single, double, and triple layer designs in a variety of meshes to suit particular machines and paper grades. Customers are increasingly demanding the higher-priced triple layer designs that remove more moisture and produce higher quality paper. In 2011, forming fabrics accounted for approximately 41% of net sales in our clothing segment.
Press felts . Press felts are used to carry the paper sheet through a series of press rolls that mechanically press water from the sheet under high pressure. Press felts are designed to maximize water removal, which reduces the amount of water that must be removed during the expensive energy-intensive drying section of the production process. Press felts must maximize water removal while maintaining the orientation of the fibers and the consistency of the thickness of the paper, without removing chemicals or fillers from the paper.
Press felts differ from forming fabrics and dryer fabrics due to the addition of several layers of staple fiber that are needled into the fabric base. The staple fiber provides a smooth surface to meet the wet sheet of paper and creates a wicking effect to remove water from the paper sheet as it is pressed under high pressure between press rolls. Press felts are manufactured in a variety of designs, including lightweight single layer felts, multi-layer laminated endless felts and seamed felts that allow for reduced installation times. In 2011, press felts accounted for approximately 41% of net sales in our clothing segment.
Dryer fabrics . Dryer fabrics are used to transport the paper sheet through the drying section of paper-making machines, where high temperatures from large, steam-heated dryer cylinders evaporate the remaining moisture from the paper sheet. Dryer fabrics, which are less technically advanced than forming fabrics or press felts, are woven from heat-resistant yarns with a coarser mesh than forming fabrics. In 2011, dryer fabrics accounted for approximately 6% of net sales in our clothing segment.
Industrials and Other . We manufacture other fabrics used in other industrial applications, such as pulp, steel, plastics, leather and textiles manufacturing. In 2011, net sales for such industrial applications accounted for 11% of net sales in our clothing segment. We also manufacture auto-joining equipment used in clothing production. Net sales of auto-joining equipment accounted for less than 1% of net sales in our clothing segment in 2011.
New Clothing Products. In recent years, we have focused our research and development efforts on higher value-added, technologically advanced products, such as forming fabrics and press felts, which offer paper producers the greatest potential for differentiating their products through quality improvements and for increasing their operating efficiency. Our research and development efforts have resulted in several innovative new forming fabric and press felt products, including a number of high performance products, such as triple layer forming fabrics, for use on high performance paper-making machines. In addition, we have developed new clothing products aimed at segments of the paper-making process that we have not historically served, such as the growing market for shoe press belts and other clothing products designed for use in the technologically-advanced press section of a paper-making machine.
Roll Covers Products and Services
In our roll covers segment, the majority of our sales are generated through the manufacture of roll covers. We also refurbish previously installed roll covers, provide general mechanical maintenance and repair services for the internal mechanisms of rolls and manufacture spreader rolls.
Roll covers . We manufacture, refurbish and replace covers for three kinds of rolls on paper-making machines: working rolls (including vacuum rolls and press rolls), calendar rolls and coater rolls. There can be up to 200 such rolls in a typical paper-making machine. These metal rolls, which can be up to 39 feet long, 6 feet in diameter and weigh 500 to 140,000 pounds, are covered with an exterior layer of rubber, polyurethane, composite or ceramic, each of which is designed for use in a particular phase of the paper-making process. Roll covers operate in temperatures up to 400 degrees Fahrenheit, under pressures up to 1,400 pounds per square inch and at speeds up to 7,500 feet per minute. Roll covers are typically replaced every two to five years.
Roll cover replacement is performed at the manufacturing facility of the supplier, such as Xerium, which necessitates removing the roll from the paper-making machine, transporting it to the supplier’s site and using a spare roll in the interim. In general, each roll on a paper-making machine is unique due to its dimensions, specific design and cover material, and generally not interchangeable with other rolls. Because of their large size, paper producers generally maintain only one spare roll for each position on a paper-making machine. It is important that the roll cover replacement be completed quickly, because damage or a malfunction of the spare roll could render the paper-making machine inoperable.
Due to the large size and weight of a roll, transportation to and from a supplier’s site can be costly and is occasionally subject to regulations on road use that restrict available routes and times of travel, and that may require safety escorts. Round-trip transcontinental travel can take several weeks and intercontinental travel is rare. We offer an extensive network of manufacturing facilities worldwide, often in close proximity to our customers, which we believe is a significant competitive advantage.
CEO BACKGROUND
Stephen R. Light Mr. Light has served as our President, Chief Executive Officer and as a director since February 2008. Beginning in July 2008, Mr. Light has also served as Chairman. From September 2007 to May 2008, Mr. Light served as a director of Manitex International, Inc., formerly Veri-Tek International, Corp. Mr. Light was previously President and Chief Executive Officer of Flow International Corp., a publicly traded producer of industrial waterjet cutting and cleaning equipment from January 2003 to July 2007. Prior to Flow, Mr. Light was President and Chief Executive Officer of OmniQuip Textron from October 2000 to January 2003. Mr. Light has also held various management positions within General Electric Company, Emerson Electric Co. and Koninklijke Philips N.V. Mr. Light’s leadership skills and management experience, including serving as Chief Executive Officer for multiple companies, qualify him to serve on the Board. As our Chief Executive Officer, Mr. Light brings to the Board a critical perspective and understanding of our business strategy, and can provide the Board valuable insight into our management and operations.
David A. Bloss, Sr. Mr. Bloss has served as a director since April 19, 2011. Mr. Bloss served as Chairman, President, and Chief Executive Officer of CIRCOR International, Inc., a supplier of valves and accessories, from December 1998 to March 2008. Mr. Bloss retired as Chairman of the Board of CIRCOR in February 2009. From June 1993 until December 1998, Mr. Bloss served as Executive Vice President and then President and Chief Operating Officer of Watts Industries, Inc., which spun off CIRCOR as of October 18, 1999. Earlier in his career, Mr. Bloss worked with the auditing firm of Price Waterhouse & Co. where he gained his certified public accountant credentials. Mr. Bloss currently serves on the Board of Directors of Magnetek, Inc., a provider of digital power and motion control systems. Mr. Bloss brings to the Board significant management experience and familiarity with reporting requirements of public companies, which gives him a valuable perspective in his role as a director. His qualifications to serve as a director also include his financial background and his manufacturing experience. 61 April 2011
Ambassador April H. Foley Ambassador Foley has served as a director since May 25, 2010. Ambassador Foley served as the United States Ambassador to Hungary from 2006 to 2009. Prior to serving as U.S. Ambassador to Hungary, she held several positions at the Export-Import Bank of the United States. After first serving as a Director of the Bank, she was appointed to be First Vice President and Vice Chairman in 2003. Ambassador Foley also previously held various positions with PepsiCo, Inc. She also serves on the Board of Directors of Alliant Techsystems Inc., an aerospace and defense company. Ambassador Foley’s financial background and international experience, including her public service for the federal government of the United States, qualify her to serve on the Board. Ambassador Foley’s extensive knowledge of international affairs, including the international financial system, enables her to offer valuable insight, judgment and perspectives in support of the Board’s oversight role and its other functions. 64 May 2010
Jay J. Gurandiano Mr. Gurandiano has served as a director since December 1, 2008. He has been the Managing Director of Stone House Investment Holdings Inc., an investment holdings company, since October 2000. He has served as a director of Eacom Timber Company since 2011 and he also served as the Chairman of the Board of Directors of Ainsworth Lumber Co. Ltd., a lumber and wood products company, until May 2010. Mr. Gurandiano brings to the Board significant management experience, particularly with respect to the paper industry, which gives him a valuable perspective in his role as a director. His qualifications to serve as a director also include his legal background and his private equity investment experience.
John F. McGovern Mr. McGovern has served as a director since May 25, 2010. Mr. McGovern is the founder, and since 1999 a partner, of Aurora Capital LLC, a private investment and consulting firm based in Atlanta, GA. Prior to founding Aurora Capital, Mr. McGovern served in a number of positions of increasing responsibility at Georgia-Pacific Corporation from 1981 to 1999, including Executive Vice President/Chief Financial Officer from 1994 to 1999. Mr. McGovern has served as a director of Collective Brands, Inc. since 2003 and as a director of Neenah Paper, Inc. since 2006. Mr. McGovern previously served as a director of GenTek, Inc. from 2003 to 2009 and currently serves on the board of its private successor, General Chemical. Mr. McGovern was formerly a director of ChanneLinx, Inc., where he also served as temporary Chief Executive Officer. ChanneLinx, Inc. filed for Chapter 11 protection in 2003, approximately one year after Mr. McGovern left the company. Mr. McGovern brings to the Board significant executive leadership and financial experience in the paper industry, including his experience as Chief Financial Officer of Georgia-Pacific Corporation. In addition, Mr. McGovern brings to the Board the experience of serving on the boards of multiple public and private companies and the views and judgment of a leader who is highly respected for his business expertise and acumen. 65 May 2010
James F. Wilson Mr. Wilson has served as a director since May 25, 2010. He has been a principal of Carl Marks Management Company, LLC since 2001, which manages investment partnerships focused on distressed securities. Mr. Wilson previously served as a director of Seneca Foods Corporation from 2008 to 2009. Mr. Wilson earned a B.A. in Economics from Dartmouth College, and an MBA from Harvard Graduate School of Business Administration. Mr. Wilson’s investment management and business experience qualify him to serve on the Board. In addition, we believe that given Mr. Wilson’s affiliation with Carl Marks, a significant former lender and stockholder of Xerium, he can serve as a valuable resource to the Board in understanding and interfacing with our stakeholders. 54 May 2010
MANAGEMENT DISCUSSION FROM LATEST 10K
Overview
We are a leading global manufacturer and supplier of two types of consumable products used primarily in the production of paper—clothing and roll covers. Our operations are strategically located in the major paper-producing regions of North America, Europe, South America and Asia-Pacific.
Our products play key roles in the formation and processing of paper along the length of a paper-making machine. Paper producers rely on our products and services to help improve the quality of their paper, differentiate their paper products, operate their paper-making machines more efficiently and reduce production costs. Our products and services typically represent only a small percentage of a paper producer’s overall production costs, yet they reduce costs by permitting the use of lower-cost raw materials and reducing energy consumption. Paper producers must replace clothing and refurbish or replace roll covers regularly as these products wear down during the paper production process. Our products are designed to withstand extreme temperature, chemical and pressure conditions, and are the result of a substantial investment in research and development and highly sophisticated manufacturing processes.
We operate in two principal business segments: clothing and roll covers. In our clothing segment, we manufacture and sell highly engineered synthetic textile belts that transport paper as it is processed on a paper-making machine. Clothing plays a significant role in the forming, pressing and drying stages of paper production.
Because paper-making processes and machine specifications vary widely, the clothing size, form, material and function is selected to fit each individual paper-making machine and process. In 2011, our clothing segment represented 66% of our net sales.
Our roll cover products provide a surface with the mechanical properties necessary to process the paper sheet in a cost-effective manner that delivers the sheet qualities desired by the paper producer. Roll covers are tailored to each individual paper-making machine and process, using different materials, treatments and finishings. In addition to manufacturing and selling new roll covers, we also provide refurbishment services for previously installed roll covers and manufacture spreader rolls. Additionally, we provide various related products and services to our customers, both directly and through third party providers, as a growing part of our overall product offering through our roll covers sales channels. In 2011, our roll cover segment represented 34% of our net sales.
Industry Trends and Outlook
Historically, demand for our products has been driven primarily by the volume of paper produced on a worldwide basis. We expect the growth of global paper production from 2012 to 2015 to be between 3% and 4% per annum. Generally, and over time, we expect growth in paper production to be greater in Asia-Pacific, South America and Eastern Europe than in the more mature North American and Western European regions where demand may potentially decline. Between 2008, especially the latter part of the year, and 2009, the global paper industry experienced a sharp reduction in production levels, caused by the general slowdown in economic activity and related paper consumption during the same period. In 2010 and 2011, global paper and board production began to recover from the economic recession and show growth, particularly in developing countries, although growth slowed in the second half of 2011. We believe that our increase in net sales volume in 2011 and 2010 as compared with 2009 reflects this recovery as well as the success of our new products.
The profitability of paper producers has historically been highly cyclical due to wide swings in the price of paper, driven to a high degree by the oversupply of paper during periods when paper producers have more aggregate capacity than the market requires. A sustained downturn in the paper industry, either globally or in a particular region, can cause paper manufacturers to reduce production or cease operations, which could adversely affect our net sales and profitability. Since 2000, paper producers have taken actions that seek to structurally improve the balance between the supply of and demand for paper. As part of these efforts, they have permanently shut down many paper-making machines or entire manufacturing facilities. Papermakers continue to experience low levels of profitability. We believe that further consolidation among papermakers, reduction in the number of paper producers, and shutdowns of paper-making machines or facilities will occur in Europe and North America until there is a better balance between supply and demand for paper and the profit levels of paper producers improve. This rebalancing has been accelerated since the most recent global economic recession. Over a number of years, paper consumption growth, particularly in South America and Asia-Pacific, is expected to drive an increase in the global production rates required to maintain balance between supply and demand. It is highly likely, however, that the recession-led consumption slow-down and related effect on global paper production will continue in the near term. Also affecting machine curtailments are structural productivity gains from improved products that we and our competitors supply.
Global paper production growth that does occur would be moderated by the level of industry consolidation and paper-machine shutdown activity that is a continuing underlying trend in North America and Western Europe. We also believe that, in addition to industry consolidation and paper machine shutdown activity in North America and Western Europe, the trend towards new paper machine designs with fewer rolls and market recognition of the extended life of our roll cover products has been and will continue to negatively impact demand for these products and their volume potential. However, we believe volume declines would be partially offset by our introduction of new products with the extended life qualities that our customers desire and increasing market share of proprietary products such as our SmartRoll™. Additionally, we are seeing a trend that paper producers are placing an increasing emphasis on maintenance cost reduction and, as a result, are extending the life of roll covers through additional maintenance cycles before replacing them.
We anticipate that pricing pressure for our products may continue with the consolidation among paper producers and as the shift of paper production growth in Asia-Pacific develops. In response to this pricing pressure, we expect to focus our research and development efforts on new products that our customers value. In addition, we will continue to enhance and deploy our value added selling approach as part of our strategy to differentiate our products, while at the same time we remain focused on cost reduction and efficiency programs. The negative paper industry trends described above are likely to continue. Although there appears to be a sustained, but slow recovery underway, we believe that the paper industry will experience increased emphasis on cost reduction, continued paper-machine shutdown activity, and reduced availability of credit than would have been the case in the absence of the economic downturn. These industry dynamics could negatively impact our business, results of operations and financial condition.
Net sales and Expenses
Net sales in both our clothing and roll covers segments are primarily driven by the following factors:
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The volume of worldwide paper production;
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Our ability to introduce new products that our customers value;
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Advances in the technology of our products, which can provide value to our customers by improving the efficiency of paper-making machines and reduce their manufacturing costs;
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Our ability to provide products and services which reduce paper-making machine downtime while at the same time allowing the manufacture of high quality paper products; and
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The impact of currency fluctuations.
Net sales in our roll covers segment include our mechanical services business. We have expanded this business in response to demand from paper producers that we perform work on the internal mechanisms of a roll while we refurbish or replace a roll cover. In our clothing segment, a small portion of our business has been conducted pursuant to consignment arrangements under which we do not recognize a sale of a product to a customer until the customer places the product into use, which typically occurs some period after the product is shipped to the customer or to a warehouse location near the customer’s facility. As part of the consignment agreement we deliver the goods to a location designated by the customer. In addition, the customer and we agree to a “sunset” date, which represents the date by which the customer must accept all risks and rewards of ownership of the product and payment terms begin. For consignment sales, revenue is recognized on the earlier of the actual product installation date or the “sunset” date.
Our operating cost levels are impacted by total sales volume, the impact of inflation, foreign currency fluctuations and the level and impact of cost reduction programs.
The level of our cost of products sold is primarily attributable to labor costs, raw material costs, product shipping costs, plant utilization and depreciation, with labor costs constituting the largest component. We invest in facilities and equipment that enable innovative product development and improve production efficiency and costs. Recent examples of capital spending for such purposes include faster weaving looms and seaming machines with accurate electronic controls, automated compound mixing equipment and computer-controlled lathes and mills.
The level of research and development spending is driven by market demand for technology enhancements, including both specific customer needs and general market requirements, as well as by our own analysis of applied technology opportunities. With the exception of purchases of equipment and similar capital items used in our research and development activities, all research and development is expensed as incurred. Research and development expenses were $12.1 million, $11.4 million and $11.3 million for the years ended December 31, 2011, 2010 and 2009, respectively.
Foreign Exchange
We have a geographically diverse customer base. In 2011, we generated approximately 36% of our net sales in North America, 34% in Europe, 9% in South America, 19% in Asia-Pacific and 2% in the rest of the world.
A substantial portion of our net sales is denominated in Euros or other currencies. As a result, changes in the relative values of U.S. Dollars, Euros and other currencies affect our reported levels of net sales and profitability as the amounts are translated into U.S. Dollars for reporting purposes. In particular, decreases in the value of the U.S. Dollar relative to the value of the Euro and these other currencies positively impact our levels of revenue and profitability because the translation of a certain number of Euros or units of such other currencies into U.S. Dollars for financial reporting purposes will represent fewer U.S. Dollars.
For certain transactions, our net sales are denominated in U.S. Dollars but all or a substantial portion of the associated costs are denominated in a different currency. As a result, changes in the relative values of U.S. Dollars, Euros and other currencies can affect the level of the profitability of these transactions. The largest proportion of such transactions consist of transactions in which the net sales are denominated in or indexed to U.S. Dollars and all or a substantial portion of the associated costs are denominated in Euros, Reals or other currencies.
Currency fluctuations have a greater effect on the level of our net sales than on the level of our income (loss) from operations. For example, in 2011 as compared to 2010, the change in the average value of the U.S. Dollar against most of the currencies we conduct our business in resulted in net increases of $16.6 million in net sales and net decreases of $1.6 million in income from operations. Although the 2011 results reflect a period in which the average value of the U.S. Dollar decreased against the Euro as compared to 2010, we would expect an opposite effect in a period in which the value of the U.S. Dollar increases.
Debt Refinancing
On May 26, 2011, we completed a refinancing transaction, which replaced certain of our then outstanding indebtedness with an offering of $240 million of our 8.875% senior unsecured notes due 2018 and a new approximately $278 million multi-currency senior secured credit facility, comprised of approximately $248 million of senior secured term loans and a committed $30 million senior secured revolving credit facility. The goal of the refinancing was to extend the maturity of, and fix the interest rate on, a portion of our debt, while providing lower interest rates and increased operational flexibility. See “Credit Facility and Notes” for a discussion of the notes and current credit facility.
Chapter 11 Filing, Emergence and Plan of Reorganization
On March 30, 2010, we and certain of our subsidiaries filed voluntary petitions for relief under Chapter 11 of Title 11 of the United States Code, 11 U.S.C. §§ 101-1532, and on April 1, 2010, following approval by the Bankruptcy Court, we entered into a debtor-in-possession financing facility consisting of a $20 million revolving credit facility and $60 million term loan (the “Exit Facility”). On May 25, 2010 (the “Effective Date”), our amended joint prepackaged plan of reorganization (the “Plan”) became effective, at which time we emerged from Chapter 11. Pursuant to the Plan, on the Effective Date:
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20 million shares of our new common stock, par value $0.001 were authorized, of which an aggregate of 14,970,050 shares were issued and outstanding, as described below. In addition, 1,000,000 shares of preferred stock, par value $0.001, were authorized, of which 20,000 shares were designated as Series A Junior Participating Preferred Stock;
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All of the shares of our common stock then outstanding, par value $0.01, or old common stock, were canceled and replaced with 2,566,150 shares of our new common stock, which was equivalent to a 20 to 1 reverse split of our old common stock;
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The lenders under our pre-petition credit facility and the interest rate swap termination counterparties received, among other things, their ratable shares of (a) $10 million in cash, (b) $410 million in principal amount of term notes, issued pursuant to our post-reorganization senior credit facility (the “Prior Credit Facility”), and (c) 12,403,900 shares of new common stock;
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Holders of our old common stock also received four-year warrants to purchase an aggregate of 1,663,760 shares of new common stock at an exercise price of $19.55 per share, representing approximately 0.0324108 warrants for each share of old common stock.
As previously disclosed in our filings with the SEC, we entered into a number of material agreements and engaged in a series of transactions on the Effective Date, including (i) the Prior Credit Facility (ii) an exit facility, which rolled over and replaced the DIP Facility (the “Exit Facility”) (iii) a Rights Agreement, (iv) a Registration Rights Agreement with certain of our stockholders, and (v) Director Nomination Agreements with certain of our stockholders.
Cost Reduction Programs
An important part of our strategy is to seek to reduce our overall costs and improve our competitiveness. As a part of this effort, we engage in cost reduction programs, which are designed to improve the cost structure of our global operations in response to changing market conditions. These cost reduction programs include headcount reductions throughout the world as well as plant closures that have rationalized production among our facilities to better enable us to meet customer demands. Cost savings have been realized in labor costs and other production overhead, other components of costs of products sold, general and administrative expenses and facility costs. The majority of the cost savings begin at the time of the headcount reductions and plant closure, with the remaining cost savings recognized over subsequent periods. Cost savings from headcount reductions have not been offset by related increases in other expenses. Cost savings related to plant closures have been partially offset by the reduction of revenues associated with those closed facilities in subsequent periods and additional costs incurred in the facilities that assumed the operations of the closed facility.
Our cost reduction efforts between 2002 and 2011 included the closing of 14 manufacturing facilities. During this same period, our headcount was lowered by almost 800 individuals as a result of these actions.
In 2009, we charged a total of $4.1 million to restructuring and impairments expense related to the continual streamlining of our operating structure and asset impairments, partially offset by a gain on sale of our rolls manufacturing facility in Sweden.
In 2010, we incurred restructuring expenses of approximately $10.0 million in the aggregate, primarily related to the North Bay, Ontario closure, the closure of a rolls plant in Germany, asset impairment charges in Vietnam and to headcount reductions resulting from the integration of the regional management structure in North America and Europe.
In 2011, we incurred restructuring expenses of approximately $1.6 million, primarily related to the continued streamlining of our cost structure and operations. We expect to continue to review our business to determine if additional actions can be taken to further improve our cost structure. We currently estimate restructuring expenses of approximately $5.0 to $10.0 million during 2012, primarily related to a continuation of streamlining our operating structure. Actual restructuring costs for 2012 may differ substantially from our estimates at this time, depending on actual operating results in 2012 and the timing of any restructuring activity.
Selling Expenses. For the year ended December 31, 2011 selling expenses increased by $6.5 million, or 8.9%, to $79.4 million from $72.9 million compared to the prior year, primarily due to unfavorable currency effects of $3.1 million, $1.6 million increase in compensation and $1.5 million higher sales commissions due to higher sales volume and related costs.
General and Administrative Expenses. For the year ended December 31, 2011, general and administrative expenses decreased by $12.8 million, or 17.1%, to $62.0 million from $74.8 million compared to the prior year. The decrease is primarily due to (1) lower bank, consulting and legal fees of $9.9 million as a result of the reorganization in 2010, (2) a decrease of $4.2 million in management incentive compensation from 2010 to 2011, (3) a decrease of $3.1 million due to additional stock compensation expense recorded in 2010 as a result of the acceleration of certain performance restricted stock plans in connection with the reorganization in 2010 and a decrease in stock compensation related to various amendments to and the expected payout of certain performance stock compensation plans in 2011, (4) the reversal of $1.1 million in 2011 related to a previously accrued value added tax amount in South America as a result of a favorable ruling by the taxing authorities in 2011 and (5) a decrease of $0.8 million in environmental costs in 2011. These decreases were partially offset by unfavorable currency effects of $2.5 million and an increase in bad debt expense of $2.5 million, primarily related to a reduction in the required reserve in 2010 and specific losses related to the bankruptcies of certain customers in 2011.
Restructuring and Impairment Expenses. For the year ended December 31, 2011, restructuring and impairment expenses decreased by $8.4 million, or 84.0%, to $1.6 million from $10.0 million for the year ended December 31, 2010. For the most part, restructuring expenses in 2011 and 2010 resulted from our long-term strategy to reduce production costs and improve long-term competitiveness as described above under “Cost Reduction Programs” by closing and/or transferring production from certain of our manufacturing facilities and through headcount reductions. For the year ended December 31, 2011, restructuring expenses included $1.1 million related to the relocation of equipment and the wind up of the North Bay, Canada pension plan, as this facility was closed and sold in 2010 and approximately $0.8 million in various other restructuring expenses. Partially offsetting these charges was a $0.3 million gain recorded as a result of the sale of the Sherbrooke, Canada facility.
Interest Expense, Net. Net interest expense for the year ended December 31, 2011 decreased by $17.6 million or 31.0%, to $39.2 million from $56.8 million for the year ended December 31, 2010. The decrease was primarily attributable to $9.7 million of interest rate swaps being fully amortized at December 31, 2010, a $5.9 million lower interest expense due to lower debt balances and interest rates from 2010 to 2011, and $3.6 million lower amortization of deferred financing costs in 2011, primarily as a result of $3.9 million in amortization of the Debtor in Possession deferred financing fees in 2010 prior to the refinancing in 2010. These decreases were partially offset by unfavorable currency effects of $0.9 million and a decrease in interest income of $0.7 million, primarily as a result of lower balances in high-yield cash accounts in 2011.
Loss on Debt Extinguishment. The loss on debt extinguishment of $2.9 million in the year ended December 31, 2011 resulted from the refinancing of debt that closed on May 26, 2011. (See Note 6 of the Condensed Consolidated Financial Statements and “Credit Facility and Notes” below for further discussion on the refinancing). In 2010, as part of the reorganization, $14.4 million represented loss on debt extinguishment, and is included in reorganization expenses on the Condensed Consolidated Statements of Operations. See below for further discussion.
MANAGEMENT DISCUSSION FOR LATEST QUARTER
Company Overview
We are a leading global manufacturer and supplier of two types of consumable products used primarily in the production of paper—clothing and roll covers. Our operations are strategically located in the major paper-producing regions of North America, Europe, South America and Asia-Pacific.
Our products play key roles in the formation and processing of paper along the length of a paper-making machine. Paper producers rely on our products and services to help improve the quality of their paper, differentiate their paper products, operate their paper-making machines more efficiently and reduce production costs. Our products and services typically represent only a small percentage of a paper producer’s overall production costs, yet they can reduce costs by permitting the use of lower-cost raw materials and by reducing energy consumption. Paper producers must replace clothing and refurbish or replace roll covers periodically as these products wear down during the paper production process. Our products are designed to withstand high temperatures, chemical and pressure conditions, and are the result of a substantial investment in research and development and highly sophisticated manufacturing processes.
We operate in two principal business segments: clothing and roll covers. In our clothing segment, we manufacture and sell highly engineered synthetic textile belts that transport paper as it is processed on a paper-making machine. Clothing plays a significant role in the forming, pressing and drying stages of paper production. Because paper-making processes and machine specifications vary widely, the clothing size, form, material and function is custom engineered to fit each individual paper-making machine and process. For the quarter ended March 31, 2012, our clothing segment represented 66% of our net sales.
Our roll cover products provide a surface with the mechanical properties necessary to process the paper sheet in a cost-effective manner that delivers the sheet qualities desired by the paper producer. Roll covers are tailored to each individual paper-making machine and process, using different materials, treatments and finishings. In addition to manufacturing and selling new roll covers, we also provide refurbishment services for previously installed roll covers and manufacture spreader rolls. We also provide various related products and services to our customers, both directly and through third party providers, as a growing part of our overall product offering through our roll covers sales channels. For the quarter ended March 31, 2012, our roll cover segment represented 34% of our net sales.
Industry Trends and Outlook
Historically, demand for our products has been driven primarily by the volume (tonnage) of paper produced on a worldwide basis. We expect the growth of global paper production from 2012 to 2015 to be between 3% and 4% per annum. Generally, and over time, we expect growth in paper production to be greater in Asia-Pacific, South America and Eastern Europe than in the more mature North American and Western European regions where demand may decline. Between the second half of 2008 and 2009, the global paper industry experienced a sharp reduction in production levels, caused by the general slowdown in economic activity and related paper consumption during the same period. In 2010 and 2011, global paper and board production began to recover from the economic recession and show growth, particularly in developing countries, although growth slowed in the second half of 2011. We believe that our increase in net sales volume in 2011 and 2010 as compared with 2009 reflects this recovery as well as the success of our new products.
The profitability of paper producers has historically been highly cyclical due to wide swings in the price of paper, driven to a high degree by the oversupply of paper during periods when paper producers have more aggregate capacity than the market requires. A sustained downturn in the paper industry, either globally or in a particular region, can cause paper manufacturers to reduce production or cease operations, which could adversely affect our net sales and profitability. Since 2000, paper producers have taken actions that seek to structurally improve the balance between the supply of and demand for paper. As part of these efforts, they have permanently shut down many paper-making machines or entire manufacturing facilities. Many paper producers continue to experience low levels of profitability. We believe that further consolidation among papermakers, reduction in the number of paper producers, and shutdowns of paper-making machines or facilities will occur in Europe and North America until there is a better balance between supply and demand for paper and the profit levels of paper producers improve. This rebalancing has been accelerated since the most recent global economic recession. Over a number of years, paper consumption growth, particularly in South America and Asia-Pacific, is expected to drive an increase in the global production rates required to maintain balance between supply and demand. It is highly likely, however, that the recession-led consumption slow-down and related effect on global paper production will continue in the near term. Also affecting machine curtailments are structural productivity gains from improved products that we and our competitors supply that enable paper producers to manufacture more paper with fewer machines.
Global paper production growth would be moderated by the level of industry consolidation and paper-machine shutdown activity that is a continuing underlying trend in North America and Western Europe. We also believe that, in addition to industry consolidation and paper machine shutdown activity in North America and Western Europe, the trend towards new paper machine designs which have fewer rolls and market recognition of the extended life of our roll cover products has been and will continue to negatively impact demand for these products and their volume potential. Additionally, we are seeing a trend that paper producers are placing an increasing emphasis on maintenance cost reduction and, as a result, are extending the life of roll covers through additional maintenance cycles before replacing them. However, we believe volume declines would be at least partially offset by our introduction of new products with the extended life qualities that our customer’s desire and increasing market share of proprietary products such as our SmartRoll™. Additionally, we are seeing a trend that paper producers are placing an increasing emphasis on maintenance cost reduction and, as a result, are extending the life of roll covers through additional maintenance cycles before replacing them.
We anticipate that pricing pressure for our products may continue with the consolidation among paper producers and as the shift of paper production growth in Asia-Pacific develops. In response to this pricing pressure, we expect to focus our research and development efforts on new products that deliver increased value to our customers and for which they will pay increased prices. In addition, we will continue to enhance and deploy our value added selling approach as part of our strategy to differentiate our products, while at the same time we remain focused on cost reduction and efficiency programs.
The negative paper industry trends described above are likely to continue. Although there appears to be a sustained, but slow global recovery underway, we believe that the paper industry will experience increased emphasis on cost reduction, continued paper-machine shutdown activity, and reduced availability of credit than would have been the case in the absence of the economic downturn. These industry dynamics could negatively impact our business, results of operations and financial condition.
Net sales and Expenses
Net sales in both our clothing and roll covers segments are primarily driven by the following factors:
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The volume (tonnage) of worldwide paper production;
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Our ability to introduce new products that our customers value and will pay for;
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Advances in the technology of our products, which can provide value to our customers by improving the efficiency of paper-making machines and reduce their manufacturing costs;
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Our ability to provide products and services which reduce paper-making machine downtime while at the same time allowing the manufacture of high quality paper products; and
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The impact of currency fluctuations.
Net sales in our roll covers segment include our mechanical services business. We have expanded this business in response to demand from paper producers that we perform work on the internal mechanisms of a roll while we refurbish or replace a roll cover. In our clothing segment, a small portion of our business has been conducted pursuant to consignment arrangements under which we do not recognize a sale of a product to a customer until the customer places the product into use, which typically occurs some period after the product is shipped to the customer or to a warehouse location near the customer’s facility. As part of the consignment agreement we deliver the goods to a location designated by the customer. In addition, the customer and we agree to a “sunset” date, which represents the date by which the customer must accept all risks and rewards of ownership of the product and payment terms begin. For consignment sales, revenue is recognized on the earlier of the actual product installation date or the “sunset” date.
Our operating cost levels are impacted by total sales volume, raw material costs, the impact of inflation, foreign currency fluctuations and the success of cost reduction programs.
The level of our cost of products sold is primarily attributable to labor costs, raw material costs, product shipping costs, plant utilization and depreciation, with labor costs constituting the largest component. We invest in facilities and equipment that enable innovative product development and improve production efficiency and costs. Recent examples of capital spending for such purposes include faster weaving looms and seaming machines with accurate electronic controls, automated compound mixing equipment and computer-controlled lathes and mills.
The level of research and development spending is driven by market demand for technology enhancements, including both specific customer needs and general market requirements, as well as by our own analysis of applied technology opportunities. With the exception of purchases of equipment and similar capital items used in our research and development activities, all research and development is expensed as incurred. Research and development expenses were $3.0 million and $3.1 million for the three months ended March 31, 2012 and 2011, respectively.
Foreign Exchange
We have a geographically diverse customer base. In the three months ended March 31, 2012, we generated approximately 38% of our net sales in North America, 32% in Europe, 10% in South America, 19% in Asia-Pacific and 1% in the rest of the world.
A substantial portion of our net sales is denominated in Euros or other currencies. As a result, changes in the relative values of U.S. Dollars, Euros and other currencies affect our reported levels of net sales and profitability as the results are translated into U.S. Dollars for reporting purposes. In particular, decreases in the value of the U.S. Dollar relative to the value of the Euro and these other currencies positively impact our levels of revenue and profitability because the translation of a certain number of Euros or units of such other currencies into U.S. Dollars for financial reporting purposes will represent more U.S. Dollars than it would have prior to the relative decrease in the value of the U.S. Dollar.
For certain transactions, our net sales are denominated in U.S. Dollars but all or a substantial portion of the associated costs are denominated in a different currency. As a result, changes in the relative values of U.S. Dollars, Euros and other currencies can affect the level of the profitability of these transactions. The largest proportion of such transactions consist of transactions in which the net sales are denominated in or indexed to the U.S. Dollar and all or a substantial portion of the associated costs are denominated in Brazilian Reals or other currencies.
Currency fluctuations have a greater effect on the level of our net sales than on the level of our income (loss) from operations. For example, in the three months ended March 31, 2012 as compared to the three months ended March 31, 2011, the change in the value of the U.S. Dollar against most of the currencies we conduct our business in resulted in net currency decreases in net sales of $2.6 million, yet only impacted income from operations by a nominal amount. Although the first quarter of 2012 results reflect a period in which the value of the U.S. Dollar increased against the Euro as compared to the first quarter of 2011, we would expect an opposite effect in a period in which the value of the U.S. Dollar decreases.
Debt Refinancing
On May 26, 2011, we completed a refinancing transaction, which replaced certain of our then outstanding indebtedness with a private placement of $240 million of our 8.875% senior unsecured notes due 2018 (the “Notes”) and a new approximately $278 million multi-currency senior secured credit facility (the “Credit Facility”), comprised of approximately $248 million of senior secured term loans and a $30 million senior secured revolving credit facility. The goal of the refinancing was to extend the maturity of, and fix the interest rate on, a portion of our debt, while providing increased operational flexibility. See “Liquidity and Capital Resources-Credit Facility and Notes” for a discussion of the Notes and Credit Facility.
Cost Reduction Programs
An important part of our strategy is to seek to reduce our overall costs and improve our competitiveness. As a part of this effort, we engage in cost reduction programs, which are designed to improve the cost structure of our global operations in response to changing market conditions. These cost reduction programs include headcount reductions throughout the world as well as plant closures that have rationalized production among our facilities to better enable us to meet customer demands. Cost savings have been realized in labor costs and other production overhead, other components of costs of products sold, general and administrative expenses and facility costs. The majority of the cost savings were recognized at the time of the headcount reductions and plant closure, with the remaining cost savings recognized over subsequent periods. Cost savings from headcount reductions have not been offset by related increases in other expenses. Cost savings related to plant closures have been partially offset by the reduction of revenues associated with those closed facilities in subsequent periods and additional costs incurred in the facilities that assumed the operations of the closed facility. During the three months ended March 31, 2012, we recorded restructuring expenses of approximately $4.0 million, primarily related to $3.6 million of costs to terminate a sales agency arrangement in Europe, of which $3.0 million will be paid in the second quarter of 2012 and $0.6 million will be paid in the third quarter of 2012. After accounting for ongoing personnel costs associated with directly employing these former independent sales agents, termination of this agreement is expected to result in annual cost savings of approximately $1.4 million.
Three Months Ended March 31, 2012 Compared to the Three Months Ended March 31, 2011
Net Sales. Net sales for the three months ended March 31, 2012 decreased by $8.8 million, or 6.1%, to $134.4 million from $143.2 million for the three months ended March 31, 2011. For the three months ended March 31, 2012, approximately 66% of our net sales were in our clothing segment and approximately 34% were in our roll covers segment.
In our clothing segment, net sales for the three months ended March 31, 2012 decreased by $5.2 million, or 5.5%, to $88.7 million from $93.9 million for the three months ended March 31, 2011, primarily due to decreased sales volume of $3.6 million in Europe and $0.6 million in North America and unfavorable currency effects of $1.6 million. These decreases were partially offset by an increase in sales volume of $0.6 in Asia Pacific and South America.
In our roll covers segment, net sales for the three months ended March 31, 2012 decreased by $3.5 million or 7.1%, to $45.7 million from $49.2 million for the three months ended March 31, 2011. The decrease is primarily due to decreased sales volume of $4.3 million in Europe and unfavorable currency effects of $0.9 million, partially offset by an increase in sales volume of $1.7 million in Asia Pacific.
Cost of Products Sold. Cost of products sold for the three months ended March 31, 2012 decreased by $1.4 million, or 1.6%, to $87.9 million from $89.3 million for the three months ended March 31, 2011.
In our clothing segment, cost of products sold decreased $1.4 million in the current quarter compared to the first quarter of 2011 as a result of favorable currency effects and lower sales volume partially offset by higher cost of products sold as a percentage of sales. Cost of products sold, as a percentage of revenue increased by 2.2% to 64.0% in the three months ended March 31, 2012 from 61.8% in the three months ended March 31, 2011. The increase was primarily due to unfavorable factory overhead absorption and unfavorable regional mix due to reduced volumes in Europe.
In our roll covers segment, cost of products sold in the current quarter was slightly below cost of products sold in the first quarter of 2011 as a result of favorable currency effects and lower sales volume partially offset by higher cost of products sold as a percentage of sales. Cost of products sold, as a percentage of revenue increased by 4.8% to 69.3% from 64.5% in the first quarter of 2011. The increase was due to unfavorable absorption of production costs and higher sales of products with lower margins, including mechanical services and new roll core sales, which include costs related to steel cores that are billed as a pass through item to the customer.
General and Administrative Expenses. For the three months ended March 31, 2012, general and administrative expenses increased by $0.4 million, or 2.3% to $17.8 million for the three months ended March 31, 2012 from $17.4 million for the three months ended March 31, 2011. The increase was primarily due to the accrual of a portion of the incentive bonus for the retiring CEO and the related recruiting efforts for a replacement and an increase of $0.5 million in costs incurred to relocate an office facility in Japan and severance costs incurred in Brazil. These increases were partially offset by a gain of $0.4 million on the sale of land in Brazil and favorable currency effects of $0.3 million.
CONF CALL
Kevin McDougall
Thank you, and welcome to the Xerium Technologies first quarter 2012 financial results conference call. Joining me this morning are Stephen Light, the CEO, Chairman and President of Xerium Technologies; and Cliff Pietrafitta, Executive Vice President and Chief Financial Officer. Stephen will start the discussion this morning with an update on our progress, and then we'll provide further financial details with respect to the quarter. Subsequently, we will open the line for questions. The Xerium Technologies financial results for the quarter were announced in the press release after market closed on Tuesday, May 8, 2012. Notification of this call was broadly disclosed, and this conference call is being webcast using the link on the Investor Relations homepage on our website at www.xerium.com. We have also posted a slide presentation on our website, which we will refer to during this conference call.
I'd also note that we'll make comments today about future expectations, plans and prospects of the company such as our general expectations for 2012. These statements constitute forward-looking statements for purposes of the Safe Harbor provisions under the Private Securities Litigation Reform Act of 1995.
Our actual results may differ materially from those indicated by these forward-looking statements as a result of various important factors, including those described in Tuesday's press release, in our slide presentation and in our SEC filings. The forward-looking statements represents our view as of today, May 9, 2012, and we specifically disclaim any obligation to update these forward-looking statements.
Lastly, on this call, we plan to discuss supplementary non-GAAP financial measures, such as adjusted EBITDA that are key metrics for our credit facility covenants and that we use internally to assess liquidity and financial performance, and therefore, we believe will assist you in better understanding our company. Reconciliations of these measures to the comparable GAAP numbers are available in our press release and in our materials, which are each posted in the Investor Relations section of our website at www.xerium.com.
With that, I'd like to turn the call over to Stephen.
Stephen R. Light
Thanks, Kevin. Good morning, ladies and gentlemen. Thanks for joining us this morning. Generally, little has changed since our 2011 annual earnings call just 8 weeks ago as conditions in the global paper industry continue to be significantly differentiated by region and paper grade. Our chief concern continues to be our largest market, Europe, where paper production remains depressed as a result of the region's overall poor economic health. The most recent paper producer association data from the Confederation of European Paper Industries, or CEPI, report in February shows cumulative production tonnage to be about 3.6% below last year and 3.7% below January of 2012. The hardest hit segment of the European market has been graphic upgrades, where year-to-date production is 6.3% below last year's cumulative output, while the best area, sanitary products, or what we would typically call the tissue segment in North America, experienced growth of just 2.7%. However, in what we consider a positive turn as the first quarter developed, our European customers increased orders steadily throughout the quarter to a level substantially above the end of 2011.
We view this pattern as indicative of their slowly increasing optimism about the future. Each month of the quarter showed sequential increases in orders and while it is obviously too early to declare that the European market has turned, we're more optimistic than we were just 3 months ago.
Meanwhile, paper production tonnage in North America decreased just slightly, but our orders remain well ahead of a good 2011 fourth quarter for both Rolled and Paper Machine Clothing. In North America, PMC orders increased more than 30% and roll orders increased 14.5% from the fourth quarter of 2011.
In South America, our deliveries remain subdued due to low backlogs for domestic consumption. However, once again, new orders for Paper Machine Clothing improved more than 20% from the fourth quarter of 2011 while Rolls remained flat. We believe this market behavior is consistent with our internal outlook for the second half of 2012 being much better than the first half of the year.
Sales continue to be solid in Asia. Rolls were strong, but PMC was a little softer than expected as China's slowing growth rate made itself evident. This actually helped our margins as we earn more on Asian rolls produced and sold than Asian PMC. Meanwhile, Asian PMC orders increased month-over-month throughout the quarter. Of course, orders were also slowed in the first quarter of 2012 as China celebrated its New Year's holiday. And also as a consequence of our major Japanese customers who pre-ordered in last year's fourth quarter for the resumption of production in mills damaged by the tsunami last year.
On a consolidated basis, Rolls segment orders increased 5.2% over the previous quarter, while consolidated paper machine clothing orders increased 6%. While I'm pleased with this initial indication of an upturn beginning, our bookings are still about 13% below 2011's first quarter bookings rate. So there's a lot of room for growth. Meanwhile, paper machine clothing inventories, as measured by our various industry associations data, and also our own direct piece count of a large sample of our customers remains in the mid-90% level as compared to January 2007, the benchmark period we use. This is more than 20% below the peak reached in November 2008. I consider this a healthy level and I'm not concerned about experience that repeat of the protracted delays in demand for our products as a result of gorged customer inventories when the paper production resumes in earnest.
As Cliff will share with you very shortly, the quarterly results were about what we expected them to be coming off softened orders in the fourth quarter of last year and our outlook for 2012's market. Now, Cliff will provide you the specific details regarding our Q1 performance.
Clifford E. Pietrafitta
Thank you, Stephen. I'd like to start off by referring you to the sales chart on Page 9 of the slides. Sales for the quarter decreased 6.1% to $134.4 million from $143.2 million in the first quarter of 2011. Currency exchange rate differences accounted for 1.7% of the decline, while sales decreased 4.4% from an operational standpoint compared to the first quarter of 2011. This operational decline was comprised of a 3.9% decline in our clothing business and a decline of 5.3% in our Rolls business.
From a regional standpoint, more than the entire operating sales decline was directly attributable to weakness in the European paper market. On a sequential basis, sales for the first quarter decreased 7.5% compared to the fourth quarter of 2011 as currency exchange differences accounted for half-a-point of decline in sales while sales volume decreased 7%. Once again, the decline in volumes was more than entirely due to weakness in European markets.
Gross margin as a percentage of sales declined to 34.6% of sales in the first quarter of 2012 from 37.7% of sales in the first quarter of 2011, largely as a result of unfavorable absorption of production costs in the first quarter of 2012 related to reduced European market demand. And two, unfavorable margins as a result of disproportionately higher sales of lower margin products in our Rolls business. Specifically, our North American Rolls business experienced higher sales in mechanical services and new roll cores which include costs related to steel cores that are billed as a pass-through item to the customer. These mechanical products and services earn lower margins than our traditional roll covered products, but we accept them as a means to secure the more profitable cover work they accompany. The growth in our mechanical services business within the Rolls segment has been spurred by our customers increasing amount of maintenance work they outsource. Compared to the fourth quarter of 2011, gross margin dollars declined 7.5%, while gross margin as a percentage of sales remained flat at 34.6% of sales as volume related unfavorable factory overhead in our operations in the first quarter of 2012 effectively matched the unfavorable factory overhead related to the inventory reduction efforts we initiated in the fourth quarter of 2011.
Moving on to the chart on Slide 10. Selling, general and administrative expenses and research and development costs increased 0.8% to $40.3 million for the first quarter of 2012 from $40 million in the first quarter of 2011. Foreign currency exchange rates provided a favorable variance of 1.6% compared to the first quarter of 2011. The remaining unfavorable variance to the prior year's first quarter is primarily related to onetime costs associated with our CEO's impending retirement and the ongoing search for his replacement and the relocation of our Japanese sales office. These onetime costs were partially offset by a gain on the sale of land in Brazil.
Restructuring cost increased to $4 million in the first quarter of 2012 from $0.2 million in the first quarter of 2011. The increase was largely attributable to a termination of a sales agency agreement in Europe. The cost incurred to terminate the sales agency arrangement were $3.6 million, of which $3 million was paid in the second quarter of 2012 and $0.6 million will be paid in the third quarter of 2012. The termination of this agreement will result in annual net savings of $1.4 million after consideration of ongoing personnel costs to augment our in-house sales force.
Income from operations declined in the first quarter of 2012, $2.2 million from $13.8 million in the first quarter of 2011. Lower European sales volume and gross margins and increased restructuring costs drove the unfavorable earnings results. Net interest expense improved 2.6% to $9.6 million in the first quarter of 2012 from $9.9 million in the first quarter of 2011. This decline in interest expense reflects lower current interest rates and debt balances, net of higher deferred financing cost amortization in the current year's first quarter. The decrease in interest rates and the increase in deferred financing cost amortization are the result of the refinancing in May 2011. Cash interest expense in the first quarter of 2012 was $8.6 million, compared to $9.7 million in the first quarter of 2011.
Income tax expense declined to $0.7 million in the first quarter of 2012 from $3.4 million in the first quarter of 2011. The reduction in income taxes reflects the reduction in our pretax results from income of $4.1 million in the first quarter of 2011 to a pretax loss of $6.9 million in the first quarter of 2012. Our overall effective tax rate for the period presented reflects the fact that we have losses in certain jurisdictions such as the United States where we receive no tax benefit.
Net income and diluted earnings per share decreased to a net loss of $7.5 million, or $0.50 per diluted share in the first quarter of 2012, from net income of $0.6 million or $0.04 per diluted share in the first quarter of 2011.
Page 11 of our slide deck displays our adjusted EBITDA results for the first quarter of 2012. Adjusted EBITDA is a non-GAAP measure by which we manage compliance with our existing financing agreements and provides us with the liquidity and financial performance measure of the business. Adjusted EBITDA in the first quarter of 2012 decreased to $18.8 million from $26.1 million in the first quarter of 2011. The data on Slide 12 shows the minor improvement in trade working capital to $145 million in the first quarter 2012 from $145.2 million in the fourth quarter of 2011. The slight improvement reflects $2.4 million of lower accounts receivable as days sales outstanding improved to 55 days from 57 days. And a $1.2 million of increased accounts payable as days costs outstanding improved to 58 days from 52 days. These improvements were largely offset by increased inventory of $3.4 million.
Capital expenditures for the year-to-date period ended March 31, 2012, totaled $3.3 million. We currently expect 2012 capital expenditures to be approximately $30 million. Net cash from operating activities totaled $10.2 million in the first quarter of 2012. During the first quarter of 2012, we repaid $13.2 million of our bank term loans. At quarter end, we had $38.3 million of cash on hand and $21.9 million of borrowing availability under our revolving credit and other facilities.
Stephen R. Light
Thanks, Cliff. As we announced during our 2011 earnings call, we expect that customer demand in 2012 to resemble that of 2011 only in reverse with the first portion of the year slow and the second half increasing. The gradual recovery in order bookings in PMC and Rolls we've already seen in the first quarter of 2012, and the most recent communications from our economic forecasters gives us confidence that we have the correct outlook for the year, barring any unforeseen events.
Consequently, the immediate challenge we face in 2012, while we drive to increase revenues ahead of the recovery of customer demand in the second half, is how to further reduce our cost structure. As we consider the 4 largest cost increase drivers of 2011, which were, one, raw material inflation; two, currency swings; three, regional mix swings toward Asia, and four, products mix changes, we see a similar pattern emerging this year. We all know that oil prices have risen again and these increases will filter through our supply chain into yarn pricing within the next 6 months. Consequently, as we progress in 2012, our operating teams have redoubled their efforts to improve production yield in our PMC manufacturing plants even further.
We're working closely right now with our yarn providers to find means to reduce the prices we pay by examining their value streams, and where non oil related costs creep into their processes, such us their scrap and yield rates. To the extent we can collaborate with them to improve their yields, we should see an immediate benefit in reduced purchase prices.
Our regional sales expectation foresee further ships into Asia as growth there is forecasted to be in the range of 4% to 6%, or higher, depending on the specific type of paper being sold. To further improve the profitability of our Asian operation, we are increasing the number of different product offerings in our Asian Rolls segment, and in particular, accelerating the penetration of spreader rolls and SMART Roll into that region. You may recall from our last call that we established the spreader roll rebuilding facility in China inside one of our 2 existing roll plants. This facility has been well accepted by local customers as an alternative to other local and less reliable suppliers.
Now that we've demonstrated excellent SMART Roll performance at tissue mills in China, our SMART Rolls have established the good reference installations we needed to promote the product in that region. As a consequence, our first order for our SMART Roll in Australia has been received. I'm quite optimistic that this product will take off in Asia in 2012.
As shown on our new product charts, our new product sales continue their steady growth with Q1 2012 setting yet another new record of 53.4% of our revenue derived from products developed in the prior 5 years. Monthly results within the quarter showed March at 56.1%, nearly achieving our goal of 60%, which we set way back in 2008. We've recently conducted an internal review of a sample of new products with real market experience to verify the contribution of these new products to our profit margins. And I'm pleased to announce that approximately 75% of the sample we analyzed showed a materially significant increase in gross margins versus the product they replaced. The one product that did not increase its gross margin versus the product it replaced was heavily influenced by the rise in raw material costs we endured in 2011.
Over the last 4 years, we've substantially reduced variable operating costs through greatly increased material yields in our weaving facilities, which were up nearly 30% in our dryer business and trending similarly in our forming product line. We've simplified and sped up old processes. We now share capacity across divisions and ocean, we reduced cost by shortening work change downtime by as much as 75% through product standardization, which dramatically increased our weaving capacity with negligible CapEx. We've reduced total working capital by 25.4% since 2008 and we've substantially reduced headcount. We've closed several facilities we no longer needed and transferred the work areas where we could do it less expensively. Notably, we've changed the paradigm that a roll plant needs to be closed to its customers by streamlining our role servicing processes and management. We've consolidated many back-office functions to reduce regional duplication. But now that so much of our remaining addressable costs are fixed and are related to buildings and geographic dispersion resulting in organization duplication, we must aggressively reduce these fixed costs to achieve a step function improvement in Xerium's results.
As we've examined the paper industry's production forecast for the next several years, we see the gradual migration toward Asia continuing. While we've carefully considered and will continue to consider alternatives to develop the appropriate manufacturing capacity in Asia to add to our existing Japanese and Australian facilities, none that we've analyzed as of today will help us restore our historical margin within an acceptable timeframe, or is a better use of cash than reducing our leverage. So we've concluded that we will continue to use our existing plant assets to satisfy Asia's growing market requirements for the foreseeable future. As a result, we've launched a cross functional team aimed at significantly reducing our fixed costs to restore historical margins and further simplify our business processes. One challenge the team is addressing is to determine the optimal number and location of facilities we currently occupy relative to our customer needs and capacity requirements and their future expectations. Another work element will be defining and implementing how we improve our information management processes to reduce the aforesaid duplication. More details about these significant initiatives will be provided over the next few months and in subsequent earnings calls and filings as detailed work plans are prepared. Our modeling shows that our operating cash flows can fund the activities we are reviewing and considering. While we continue to repay our debt as it is scheduled. That concludes our prepared remarks, and we're now ready for questions. Stacy, may we have the first question please?
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Fund Letters
