reliance steel & aluminum 2007_Q2_Conference_call_transcript

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FINAL TRANSCRIPT

Conference Call Transcript

RS - Q2 2007 Reliance Steel Earnings Conference Call

Event Date/Time: Jul. 19. 2007 / 10:00AM CT

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Jul. 19. 2007 / 10:00AM CT, RS - Q2 2007 Reliance Steel Earnings Conference Call



C O R P O R A T E P A R T I C I P A N T S David Hannah Reliance Steel & Aluminum Co. - CEO

Gregg Mollins Reliance Steel & Aluminum Co. - President and COO

Karla Lewis Reliance Steel & Aluminum Co. - EVP and CFO

C O N F E R E N C E C A L L P A R T I C I P A N T S Mark Parr KeyBanc Capital Markets - Analyst

Michelle Applebaum Michelle Applebaum Research - Analyst

Sal Tharani Goldman Sachs - Analyst

Timothy Hayes Davenport & Co. - Analyst

Michael Willemse CIBC World Markets - Analyst

Timna Tanners UBS - Analyst

Jonathan Goldberg Highline Capital - Analyst

Tony Rizzuto Bear, Stearns - Analyst

Luke Folta Longbow Research - Analyst

Yvonne Varano Jefferies & Co. - Analyst

Evan Steen Eos Partners - Analyst

Leo Larkin Standard & Poor's - Analyst

P R E S E N T A T I O N

Operator

Good morning, ladies and gentlemen, and welcome to the Reliance Steel & Aluminum 2007 second-quarter financial results conference call. At this time, all participants have been placed on a listen-only mode, and we will open the floor for your questions and comments following the presentation. It is now my pleasure to turn the floor over to your host, David Hannah, CEO of Reliance. Sir, the floor is yours.

David Hannah - Reliance Steel & Aluminum Co. - CEO

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Thank you. Good morning and thank you for taking the time to listen to our report and financial results conference call for the second quarter and six months ended June 30, 2007. Gregg Mollins, our President and Chief Operating Officer, and Karla Lewis, our Executive Vice President and CFO, are also here with me today. This conference call may contain forward-looking statements relating to future financial results. Actual results may differ materially as a result of factors over which Reliance Steel & Aluminum Co. has no control. These risk factors and additional information are included in the Company's Annual Report on Form 10-K for the year ended December 31, 2006, and other reports on file with the Securities and Exchange Commission. After the completion of this call, a printed transcript, including Regulation G reconciliations, will be posted on our website at www.rsac.com/investorinformation. We are very pleased to report our 2007 second-quarter results. Net income was a record $122.8 million, up 22% compared with net income of $100.5 million for the 2006 second quarter and also up 10% from the 2007 first quarter. Earnings per diluted share were a record $1.59 for the 2007 second quarter compared with $1.32 for the 2006 second quarter and $1.46 for the 2007 first quarter. 2007 second-quarter sales were $1.9 billion, an increase of 22% compared with 2006 second-quarter sales of $1.56 billion and up 3% compared to the 2007 first quarter. All share and per share amounts have been adjusted for our two-for-one stock split effective July 19, 2006. For the six months ended June 30, 2007, net income amounted to a record $234.5 million. That's up 36% compared with net income of $172.4 million for the same period in 2006. Earnings per diluted share were $3.06 for the six months ended June 30, 2007, compared with earnings of $2.41 per diluted share for the six months ended June 30, 2006. Sales for the 2007 year-to-date period were a record $3.7 billion, an increase of 47% compared with 2006 six-month sales of $2.5 billion. For the 2007 second quarter, our volume increased 8% and average pricing increased 13% compared to the 2006 second quarter. That was driven mainly by our acquisitions in both 2006 and 2007. Our volume was flat, and average pricing increased 3% compared to the 2007 first quarter. For the 2007 second quarter, carbon steel products were 46% of our revenues; aluminum was 18%; stainless steel was 22%; alloy was 6%; toll processing 3%; and the remaining 5% was miscellaneous, which includes titanium, copper and brass. Earlier this month, we completed the acquisition of the outstanding capital stock of Clayton Metals, Inc., headquartered in Wood Dale, Illinois. Clayton Metals was founded in 1976 and specializes primarily in the processing and distribution of aluminum, stainless steel and red metal flat-rolled products, custom extrusions and aluminum circles through its four metal service center locations. Clayton Metals' net sales for the 12 months ended December 31, 2006, were about $123 million. Clayton is operating as a wholly owned subsidiary of Reliance. The addition of Clayton Metals to our Reliance family provides further diversification of our business by bringing new products and customers to important geographic areas. We ended the quarter with a strong balance sheet and net debt to total capital of 37.6%(1) . Additionally, our operating cash flow in the second quarter was up 40% to $99.5 million compared with $70.8 million for the 2007 first quarter. Overall, business conditions during the second quarter were pretty much as we expected and were fairly steady with the 2007 first quarter. We expect that same environment to continue through the 2007 third quarter, except for the normal seasonal summer slowdown. Additionally, we anticipate that pressure on margins will continue as some metal costs soften further. We expect record sales and earnings for the year 2007, and we currently estimate earnings per diluted share for the 2007 third quarter in a range of $1.30 to $1.35. On April 18, 2007, our Board of Directors declared a regular quarterly cash dividend of $0.08 per share of common stock. The 2007 second-quarter dividend was paid on June 22 to shareholders of record June 1. The Company has paid regular quarterly dividends for 47 consecutive years. Customer demand and pricing for our products still remain at what we feel are relatively healthy levels in the markets where we operate, although because of a generally softer industrial economy, profit margins and growth rates are down slightly from last year's levels.

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We are proud of our performance and our leadership position in the industry, and we believe that our product, customer and geographic diversification and our proven ability to grow both internally and by successful, accretive acquisitions will result in continued strong operating results going forward. I will now turn the floor over to Gregg for some additional comments on our operations and market conditions. Thank you.

Gregg Mollins - Reliance Steel & Aluminum Co. - President and COO

Thank you, Dave, and good morning. We are very pleased with our record sales and earnings in the second quarter. Our managers once again did a terrific job managing through a very competitive market. Without a doubt, managing gross profit margins has been our biggest challenge in the first half of this year. Service centers have been focusing on reducing their inventories, and oftentimes this results in dumping inventory at extremely low margins. We were pleased to be able to improve our gross profit margins in the second quarter compared to the first quarter. Our pricing discipline pays dividends and is a key component to our success. Our acquisitions of IMS, Encore and Crest Steel earlier in the year are all doing well, with more upside potential going forward. Internal growth initiatives continue to get a great deal of attention at Reliance. Our plans to expand in the Midwest, Northeast and Southern regions are well on their way. Much of our 2007 capital expenditure budget is centered around these growth initiatives, and we are truly excited about our progress and future prospects. Internal growth doesn't get a lot of press, but it is an important component to our success, and we love it. Our inventory turn remained flat at 4.4 turns compared to the first quarter, but we have plans in place to improve our turn in the future. From a demand point of view, in spite of what you read in the papers, we felt demand was pretty good. We continued to see strength in our major markets, including aerospace, the energy sector, nonresidential construction, rail car, shipbuilding and infrastructure, as well as electronics and semiconductor. The weakest industries continue to be the domestic auto producers and appliance makers, where we have very little exposure. As for what lies ahead, in the carbon steel market, service center inventories continued to decline throughout the quarter. Import offerings have also declined from last year's levels, and import prices for most products are not attractive. With the weak dollar and the reduction of the VAT rebates in China, we see imports as less of a factor going forward. Here in North America, the big three domestic flat-rolled producers continue to demonstrate pricing discipline, which is benefiting the entire industry. As for aluminum, Midwest spot ingot pricing has dropped slightly the last few months. Aerospace plate is still in tight supply, and prices on this product remain stable at historical highs. Stainless steel prices, more importantly nickel surcharges, are headed south. Surcharges in August have fallen almost $0.40 a pound, and September's will fall another $0.30 plus. Although we never like the idea of prices going down, in this case we believe it is the right thing over the long haul because prices have just gotten out of hand. Demand is still pretty good and material is readily available. To summarize, demand in all our major product lines is still relatively healthy, and we expect that to continue. This time of year, demand gets a little softer due to the typical summer cycle, but we believe it will bounce back in the August/September timeframe. That concludes my report. I will turn the program over to Karla to review the financials.

Karla Lewis - Reliance Steel & Aluminum Co. - EVP and CFO

Thanks, Gregg. Good morning. As Dave mentioned, our 2007 second-quarter consolidated sales were a record at $1.9 billion, as were our 2007 six-month consolidated sales of $3.7 billion that were up 46.7% from the 2006 six-month period, with a 25.8% increase in tons sold and a 17.7% increase in our average selling price per ton sold. Please note that our tons sold and average selling price amounts exclude the sales of Precision Strip because of the toll processing nature of its business.

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Our 2006 and 2007 acquisitions contributed significantly to our increased sales levels. Same-store sales, which exclude the sales of our 2006 and 2007 acquisitions, were $1.1 billion in the 2007 second quarter, up 5.4% from the 2006 second quarter, with a 4.7% decrease in our tons sold and an 11.1% increase in our average selling price. For the 2007 six-month period, our same-store sales were $2.2 billion, up 7.7% from 2006, with a 2% decrease in our tons sold and a 10.5% increase in our average selling price. We believe that demand is still at healthy levels, although down somewhat from the 2006 period. Our average selling price increased mainly because of a shift in product mix from our 2006 and 2007 acquisitions to a greater percentage of stainless product that has experienced significant cost increases since the 2006 period. In addition, cost increases for carbon steel products in the 2007 second quarter also contributed to the increase in our average selling prices. On a same-store basis, our 2007 second-quarter sales increased 2.6% from the first quarter of 2007, with a 0.5% decrease in tons sold and a 3.5% increase in our average selling price. Our 2006 second-quarter gross profit was a record $497.5 million, up 18.5% from the 2006 second quarter. Our gross profit as a percentage of sales in the 2007 second quarter was 26.2% compared to 26.9% in the 2006 second quarter and 25.7% in the 2007 first quarter. We have experience some margin pressure in 2007 mainly due to competitive pressures resulting from excess inventories throughout the industry. Our 2007 second-quarter LIFO expense was $13.75 million or $0.11 per diluted share(2) compared to $18 million or $0.15 per diluted share(2) in the 2006 second quarter. In the 2007 six-month period, we reported LIFO expense of $32.5 million or $0.26 earnings per diluted share(2), up from our 2006 six-month LIFO expense of $23 million or $0.20 earnings per diluted share(2). The higher expense in 2007 is mainly due to increased costs for stainless steel products in 2007 as compared to 2006 levels. We reduced our full-year LIFO expense estimate to $65 million from $75 million based upon recent price declines for stainless products. Our LIFO expense is included in cost of sales. For 2007, warehouse, delivery, selling, general and administrative expenses increased mainly due to our 2006 and 2007 acquisitions. As a percent of sales, our 2007 second-quarter expenses were 14.0% compared to 14.5% in the 2006 second quarter, reflecting our continued diligence on cost control. Our 2007 six-month depreciation and amortization expense increased $9 million over 2006, mainly because of our 2006 and 2007 acquisitions. Operating profit for the 2007 six months was $417.3 million or 11.2%(3) compared to $302 million or 11.9%(3) in 2006. Our operating profit dollars increased because of our acquisitions. However, our operating profit margin declined mainly due to the somewhat lower gross profit margins in 2007. Interest expense for the 2007 six months increased $17.1 million, mainly due to increased borrowings to fund our 2006 and 2007 acquisitions. Our effective income tax rate for the 2007 periods was 37.5% compared to 37.6% in the 2006 second quarter and 38.0% for the 2006 six-month period. Our 2006 annual rate was 37.9%. The decrease in 2007 is mainly due to our increased international exposure and tax benefits from certain of our 2006 and 2007 acquisitions. Net of acquisitions, our accounts receivable balance increased $114.8 million and our inventory levels increased $95 million at June 30, 2007, from our year-end 2006 amounts. Our accounts receivables days sales outstanding rate was approximately 40 days at June 30, 2007, improved slightly from 41 days at year-end 2006. Our inventory turn rate of 4.4 times was equivalent to about 2.7 months on hand, consistent with our year-end 2006 rate. Our high earnings levels and effective working capital management produced cash flow from operations of $170.2 million in the 2007 six months. Our outstanding debt at June 30, 2007, was $1.3 billion, which included $392 million borrowed on our $1.1 billion revolving line of credit. Our net debt to total capital ratio was 37.6%(1) at June 30, 2007, consistent with our year-end 2006 rate. In the 2007 six months, we used our borrowings and cash flow to fund our increased working capital needs, capital expenditures of approximately $58.6 million and acquisitions of approximately $217.7 million. On July 2, 2007, we completed our acquisition of Clayton Metals that was funded with borrowings on our credit facility. Our pro forma net debt to total capital ratio after giving effect to this acquisition was 38.2%(1).

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We did not repurchase any shares of our common stock during the 2007 six months. Book value per share was $26.29 at June 30, 2007, up from $23.07 per share at December 31, 2006. Thank you and we will now open the discussion for questions.

Regulation G Reconciliations

(1) Net debt-to-total capital is calculated as total debt (net of cash) divided by shareholders’ equity plus total debt (net of cash).

(2) LIFO expense is included in cost of sales. The per diluted share effect is calculated as follows (in thousands except for share and per share data):

(3) Operating profit is calculated as follows (in thousands):

This conference call may contain forward-looking statements relating to future financial results. Actual results may differ materially as a result of factors over which Reliance Steel & Aluminum Co. has no control. These risk factors and additional information are included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2006 and other reports on file with the Securities and Exchange Commission.

2007 2006 Three months ended June 30: LIFO expense/(income) $ 13,750 $ 18,000 Tax rate 37.5% 37.6% Net LIFO expense/(income) $ 8,594 $ 11,232 Weighted average shares outstanding – diluted

77,181,651

75,874,992 Per share effect $.11 $.15 Six months ended June 30: LIFO expense/(income) $ 32,500 $ 23,000 Tax rate 37.5% 38.0% Net LIFO expense/(income) $ 20,313 $ 14,260 Weighted average shares outstanding – diluted

76,691,529

71,431,880 Per share effect $.26 $.20

2007 2006 Six months ended June 30: Net sales $ 3,737,926 $ 2,547,208 Cost of sales 2,767,977 1,857,150 Gross margin 969,949 690,058 Warehouse, delivery, selling, general and administrative

expenses 520,101

362,447

Depreciation expense 32,598 25,636 Income from operations $ 417,250 $ 301,975

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Q U E S T I O N A N D A N S W E R

Operator

(OPERATOR INSTRUCTIONS). Mark Parr, KeyBanc Capital Markets.

Mark Parr - KeyBanc Capital Markets - Analyst

Congratulations -- great quarter. I had a couple of questions. First, I was wondering, Gregg, if you could help us perhaps get a little more color on the impact of lower nickel prices in the third quarter relative to the second quarter.


Well, nickel is down about $0.39 a pound in August. And we would expect it to be over $0.30 a pound surcharge in September, and it could go as high as $0.40 a pound, although those figures aren't out yet. That certainly impacts all of the stainless steel products that we have, which represent about 22% of our sales. So it has a pretty significant impact, Mark. But on the other hand, as high as nickel was, well over $2 a pound, at some point in time it's going to stifle demand. We really feel as though, as I said earlier, that it just got so far out of hand. So we are actually pleased to see the drop in nickel prices because, for the obvious reasons -- we think in the long haul it is better from a demand point of view.


I guess as far as the impact to your near-term earnings outlook, recognizing that longer term this is probably a positive development because it creates a more normal pricing environment, but how do you manage your way through this? It seems like there potentially could be more of an earnings impact than what you're indicating.


I think, Mark, what we try to do, as you know, is just manage our inventories very wisely and buy what we need when we need it. I think what helps us -- that helps us tremendously when you have a situation like this, where market prices start to level off and then decrease. So to the extent that we can actually turn over our higher-priced material that we have in inventory quicker than other people and replace it with lesser-cost material quicker, then certainly we are going to get bit, but we get bit a little less severely than we would had we had excess inventories on hand. So we are anticipating in our guidance two things because of the slowdown or the reduction in nickel prices. One is a slowdown in demand, because customers just naturally tend to buy less when they anticipate that prices are going to be decreasing. And then we also have the margin compression in addition to the reduction in demand that is coming through. But about the only thing you can really do is just turn your inventories, and that is what we preach, as you know, day after day after day.


And another thing, too, Mark, is because we are on LIFO, we've recorded some pretty significant LIFO expense amounts related to the stainless price increases over the last one-and-a-half to two years. And we will have a little bit -- should have a little bit of an offset to the margin pressure from reversal of LIFO charges. It certainly isn't a one for one.


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So that is really built into the $10 million reduction in the second half for your anticipated LIFO charges?


Yes.


Terrific. I will get back in queue. Thanks very much, though, for that color, and congratulations on all the progress.

Operator

Michelle Applebaum, Michelle Applebaum Research.

Michelle Applebaum - Michelle Applebaum Research - Analyst

Just the usual question, Dave and Gregg and Karla -- how is the pipeline looking? And what does Dave have on his piece of paper in his pocket today?


Well, there's a few more names than were on there a little while ago. But the pipeline is still there. There's a lot of activity out there. Some of it we like; some of it we don't. But there is a lot of opportunity, and we are probably as busy or busier than we have ever been, evaluating opportunities for acquisitions. And the size -- I know that is always something you ask about, what kind of size are you looking at -- I think Clayton is probably a good indicator of the type of transaction that is out there. Somewhere in that $100 million, $150 million range seems to be maybe the majority of the deals that are out. There are some that are smaller and some that are bigger. But by and large, I think the average size is probably in that $150 million range, give or take a little bit.


And I always ask you, on your list in your pocket, how many names are on it and what is the revenue base of all of those names? You are not going to get away with not answering.


I forgot what I told you the last time. I don't have it in my pocket; it is actually in my office. And there's probably now about 20 names on there, and I am guessing it's probably in the $6 to $7 billion range, something like that, in revenues.


It was 13 and $5 billion last time I asked. And then a new question is in terms of those 20 names, how many are names you hadn't heard of before?


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Oh, gosh. Help me out here, Gregg, maybe --


50%?


Yes, half of them.


Are just brand-new names?


Yes, names that just pop up that you don't know too much about.


And sorry, one more question -- how many of those names -- you know, everybody seems to look at the Purchasing magazine and Metal Center News lists, which are quite good, but then we always joke about who is not on the list, and these invisible service centers. So of the 20, are they all on that list, or how many of those names would not be on that list?


No, there is at least a handful that are not on that list. I haven't counted, Michelle, but no, they're not all on that list.


Great. Well, we expect -- we hope you can continue on the pace. It makes a lot of work for us, but it certainly does well for the stock.


It is a lot of work for us, too.


Is it?


Yes, but we enjoy it. So that is a good thing. And we fully intend to keep going in that regard as long as there's opportunities out there that look attractive to us. And there are.


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Well, it is good to see that somebody is consolidating the service center business.


We are trying.

Operator

Sal Tharani, Goldman Sachs.

Sal Tharani - Goldman Sachs - Analyst

A couple of quick questions. On the stainless steel, last time you mentioned that there was a significant liquidation by one of your competitors in the first quarter. Did you see a similar impact this quarter also?


Yes.


But it can't last anymore with prices holdings or rising. Probably this is the last of it you saw, do you think?


No, I don't, because of the reduction in the nickel surcharge. I think that trend is going to continue.


And spread to other service centers.


As Dave just pointed out, that trend is going to also spread to other service centers that are in the stainless steel business. But it is what it is. And we are just going to do the best we can to manage our margins and turn our inventory.


Now, you're still talking about improving your turns. We got service center data today -- the shipments were down year over year and month over month. Does it mean that service center industry in general is still continuing to shed inventory over the next couple of months?


That is what we are hearing from our suppliers, that that trend is still continuing. Certainly, our plans are to reduce our inventories in the third quarter, and the balance of the year, for that matter. So I would imagine we are not the only ones that are thinking in that direction. So I would expect that the service centers would continue to strive to reduce their inventories over the next few months at least.


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Also, we should see quite a bit of decline in inventory and some working capital relief with this nickel coming down in the third quarter. Would that be correct to assume?


Yes.


Yes.


Lastly, on titanium, what are you seeing on titanium right now?


Titanium prices as you know have been dropping. But demand is still very, very good. So we kind of -- I am looking over at Dave right now -- we kind of quit predicting exactly what is going to happen with certain of these high-nickel alloys and titanium products, because our best guesstimates have not been the greatest in the world over the past couple of years. And that is an understatement. But I will tell you this -- from a demand point of view, we are still selling a lot of titanium.


On the sheet side, have the prices stabilized or are they still continuing to fall?


What sheet?


Hot-rolled, cold-rolled, galvanized -- especially hot-rolled.


As far as from a demand point of view, it's not the greatest in the world on the flat-rolled side of the business.


It's our toughest area, I think.


No question about it. That particular product line is the most difficult, not only from a demand point of view, but from a competitive point of view as well.

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And the prices for the last, let's say, two, three weeks -- have they stabilized or they're still falling?


They're somewhere between the $500 and $540 a ton. If you threw out a real big tonnage thing, you might be able to get -- not from the big three, don't misunderstand me, but from one of the smaller independent companies you might get something a little bit less than that. But Reliance is paying in the ballpark of about $520 a ton.


And considering the demand you're seeing outside, lowering the price you think will increase demand? Or you don't think it matters anymore?


No, I think it is ridiculous for the mills to lower their prices, because demand is what demand is. And it's not going to stimulate purchases from them one way or the other.

Operator

Timothy Hayes, Davenport & Co.

Timothy Hayes - Davenport & Co. - Analyst

Just one question -- on your average daily sales for the second quarter, how did that trend in each of the three months?


April was flat with March, and then May was up about 1.5%, and then June was just basically flat with May. So overall, it was, from a quarter standpoint, it was up a little bit over the first quarter.


And any read so far on July? Is that coming off a little bit from June?


It is too early for us to tell. Right now, it looks like it is maintaining pretty much the same, maybe slightly below. We would expect July to be lower. More and more of our business now, Tim, is in the Eastern half of the country. And we have learned that -- which is contrary to what we grew up believing, because we were only a West Coast company for many, many years. And things didn't slow down in the summertime in the West. But we have learned that they do in the East, particularly in the month of July and maybe less so in August. But I think seasonally now we do have a larger percentage of our business in the Eastern half of the country. The Midwest also is -- we've put the Midwest in the Eastern half of the country there. I don't know if that is where it belongs or not, but that is where we refer to it.

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That is our story.


So yes, we have factored in some reduction. We truly expect that that is going to happen. And it could be anywhere -- what, Karla, from 3% to 5% --


Yes.


Is what our estimate -- that is traditionally what it's been.


That 3% to 5%, is that a sequential decline in sales from Q2 for that region?


The 3% to 5% is more from a tons basis, because then the other factor, obviously, is pricing. As Dave said, our historical trend -- but I will tell you we have to revisit our trend every year because of the mix of companies that we have as we grow and acquire companies in the Midwest and certain other areas, that those can be more of an impact to that trend.


And this year, obviously with the guidance being a bit lower than the second-quarter actual results, we do have, in addition to that volume decrease, we are anticipating some pricing impact, some margin pressure on that, simply because -- and the fact that prices are going down can also make demand look like it is going down even more because customers do trim their buying. They are buying only what they need because they think tomorrow they can buy it for less. And it is the opposite on the other side. We see that when prices go up, customers tend to want to buy more because they think they can buy it at a better price today than tomorrow. So it's just the natural cycle. Like Gregg said, we can manage through this. This is what we do, and we are very comfortable with managing through fluctuating prices. The toughest market for us to operate in is one where customers don't want to buy inventory. And thank goodness that is not the case right now. So it is just a situation now where some prices are flat and some are coming down and some are stable. So all in all, things are pretty good from where we sit. We just have a situation where prices are cycling the other way for what we think will be a relatively brief period of time.


One last question. The nickel surcharge -- exactly how is that set? I know it is roughly a one-month average. But would that be the July average on the LME for nickel would set the surcharge for August? Is that how it works, or is it one day in time -- in July we set August?

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No, they take a monthly average over a 30-day period of time. And to be honest with you, I can't elaborate on that much more because my information is in my office. But it was determined for August a $0.39 a pound reduction, and that was established about two weeks ago.


Okay, so they are determining August surcharge without the full month of July data, clearly, so it's --


It's really based off of -- it is not a complete month. It is kind of like a partial part of one month versus the other. But it was basically based off of June.

Operator

Michael Willemse, CIBC.

Michael Willemse - CIBC World Markets - Analyst

Just going back to industry inventories, if you look at MSCI data, for the industry they are just under 14 million tons. And if you go back to 2005, when the industry started to come under 14 million and service centers were still talking about cutting inventory, then suddenly everyone got caught, in September/October they got caught short on inventory, and the prices started to come up. What do you think the chances are of that happening again in, say, September/October this year?


I think, actually, there is a pretty good chance of that happening again. And that is just one guy's opinion. So don't take that to the bank. But while I see the inventories falling consistently month over month over month over month, I would not be surprised at all if we saw an announcement sometime in August for a September price increase on carbon steel flat-rolled products.


Okay. Also, on the last conference calls, you've talked about eventually increasing inventory turnover of recent acquisitions. You've also mentioned eventually taking your gross margin target back up to 27%. Do they still look like reasonable targets?


Yes, we think so. We do not think that our inventory turn expectation of six turns is realistic now, primarily because of the acquisition of EMJ and Yarde Metals, which their inventories are not going to be able to turn at six turns. That is unrealistic. I will say that our inventory turn expectations at EMJ, we thought where they are today we thought would take us about two years to get there. And they did it in one. So we are very pleased with that, but our objective right now is to get to the five-turn level.


And going back to the acquisition side, are you seeing valuations of acquisition targets continuing to go up, or have they leveled off yet?

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As far as the way that we are looking at them, we are approaching valuations the same way that we always have, Michael. We have not changed our view or upped our pricing at all. There is more discussion, certainly, out there because of some transactions that have happened recently at the mill level, as well as at the service center level that have been at what appear to be pretty rich multiples. But right now, as far as we are concerned, that is discussion; it's not something we're going to buy into.


And just the last question -- as far as Reliance Steel financial capacity for more acquisitions, how much room would you suggest you have to do from a financial capacity standpoint?


Goodness. Our leverage is just around 38% debt to cap pro forma for the Clayton deal. Cash flow has been strong. We've got -- call it $400 million borrowed on our line. So we've got a lot of capacity. I don't want to put a number on it, but we can lever up. We are comfortable leveraging up to close to 50% debt to cap. If you do --


$500 to $600 million.


$500 to $600 million easy is there. We've got that much capacity, borrowing capacity on our lines. Also, from a leverage standpoint, we would be very, very comfortable with that. And as you know, when we had the opportunity to get together with EMJ, we used our stock in that transaction. And that was a way to do a large transaction and not leverage ourselves to the point where we thought it was risky should there be a downturn in the business environment. So we would certainly think about that again for larger transactions.

Operator

Timna Tanners, UBS.

Timna Tanners - UBS - Analyst

I wanted to ask -- most of my questions have been asked -- I think everybody is really understandably focused on the stainless side and also on the seasonality, to understand that. But just to follow up, I guess, I wanted to understand how much of the seasonal quarter-over-quarter decline that you are forecasting -- can you maybe give us a percent or an idea how much of that is stainless or nickel price decline and how much of that is seasonality? And part of the reason I asked that is last year at this time you talked about a seasonal decline and we actually didn't see it. So maybe if you could help us understand what might be different this year versus last.


Actually, Timna, I think we did see a seasonal downturn last year. But because of some of the acquisitions we made -- we brought Yarde in the third quarter that increased our consolidated numbers, you're not going to see it.

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As we said earlier, from a volume standpoint, it was probably in the 3% to 5% range last year, and that is what we are anticipating for this year. And then there's some additional pricing in there. As far as how much is specific to stainless, we're not going to go down to that level of detail. But it is factored in there. Probably pricing declines in total, probably somewhat consistent with the demand decline we are looking at.

Operator

Jonathan Goldberg, Highline Capital.

Jonathan Goldberg - Highline Capital - Analyst

Just a couple quick questions. First, is there a specific LIFO assumption in your Q3 guidance?


Yes, we make an annual estimate and then we book pro rata to that at the end of each quarter. We did bring it down to $65 million for the year, is our current estimate. It had previously been at $75 million for the year. So on the $65 million, we've got $32.5 million booked so far, another $32.5 million to book for the rest of the year, so it would be $16.25 million in the third quarter.


That is like $0.13 per diluted share.


Yes.


Of a charge?


Yes.


And then I was going to ask for a little bit more color on the stainless de-stocking process. Where are inventories now relative to what you would consider normal? And how long does that typically take for stainless relative to carbon, and then just stainless import offers relative to domestic prices?


When you say stainless inventories, are you referring to the mill level or service center levels?


Service center levels.

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I would say if you had one pound of stainless steel inventory more than you could sell tomorrow, you're overinventoried. That is how we feel about it. But I think that stainless steel inventories -- people have been anticipating prices to decline for some time now, because they went up so high. So I would say that stainless steel inventories at the service center level are not way over by any stretch of the imagination. But everybody is just going to -- right now, nobody's going to be buying. Anybody that has got a brain in their head is not going to be buying, let's put it that way. So we anticipate -- the mills are going to be suffering quite a bit right now, because service centers are not going to be buying much. And I forget the second part of your question.


Just import offers on stainless relative to --


The import offerings -- they are out there, but they're not all that attractive. And because nickel is going down so much so fast, I don't think anybody is going to be buying any import, as you've got 90 days out for delivery. What is going to happen over the next 90 days with nickel surcharges? So I would say that --


Not a big factor.


I will tell you, as far as Reliance is concerned, if any of our guys are buying offshore, we're going to have a very difficult discussion about that, because it doesn't make any sense.


So what do you think is the risk, then, come Q4 or whenever people start buying stainless again, nickel comes back up, because everyone starts buying stainless again and the same thing happens?


Well, I am not sure that is going to happen.


I don’t know about that - when people start buying again -- you know, we will always be buying. We will be buying a little more cautiously and buying only what we need. But I think there was a fair amount of speculation and financial hedging and all kinds of things going on in the nickel market at the LME that drove a lot of those prices upward. So it wasn't just demand. And our feeling is that demand is going to continue, except for maybe you buy a little less because you can buy some tomorrow at a lesser price, demand is going to continue. And we are going to work through -- we, the service center industry, will work through our higher-cost inventory and replace it with lower-cost metal. But we don't think that buying is going to be driving the nickel surcharge back up again.

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Plus, as we are all cutting back at the service center level on our purchases from the mills, their inventories are going to grow. So when we get back into the buying mode, when nickel surcharges level off, there's going to be probably quite a bit of inventory at the mill level that they are going to want to sell. So raising their prices at that point in time probably won't be the smartest thing to do, especially given the fact of the fourth quarter anyway.

Operator

Tony Rizzuto, Bear, Stearns.

Tony Rizzuto - Bear, Stearns - Analyst

I've got several questions, actually. First of all, from a demand standpoint, on the margin, which end markets have softened since the first quarter from an end market perspective, guys?


The second-quarter end markets were all pretty consistent. As I said earlier, appliances and the domestic auto producers -- that is the weak market. The rest of the markets we're doing pretty well in. There wasn't much of a difference at all in our second quarter versus our first quarter as far as a demand point of view.


That is certainly encouraging. I wanted to make a point on the -- I noticed that some of the -- we saw an announcement come out of China with Baosteel that they are going to cut back on the purchase of the nickel pig iron. It is going to be very, I think, delicate in terms of the timing, trying to time when stainless is going to bottom out. Obviously, we are going to see some sharp declines. But I'm actually thinking that nickel may be finding possibly a level of support here because we have already got some curtailments -- I've got to think the mills are probably cutting back output too. So you want to be careful that you don't get whipsawed here, either. Obviously, you guys turning inventories more quickly, I think, is going to be very important in enabling you to certainly outpace your competitors. Just wanted to make that point, because we could see nickel maybe closer to finding a floor in here than further away from downside. Just a point. But I wanted to ask you guys about what you feel about all this M&A in aluminum. I know it has not fully played out yet, but do you see this impacting your business relationships in any way?


I am sorry, I missed that, Tony. Could you repeat that, please?


On aluminum and the M&A that we are seeing, the merger and acquisition activity, and I know we've got some distance to possibly see how this plays out, but do you have any thoughts, Gregg or Dave or Karla, on how this may impact your business overall?


We really don't think it is going to impact our business really at all. It may have some type of impact on primary, which could affect pricing maybe a little bit on the upside. With consolidation, especially when you are talking about a company as large as Alcan, it could have some

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positive impact with respect to ingot prices going from what they are today, which I think is around $1.26 a pound. It could drive those prices upward. But as far as we are concerned, ingot at $1.20, $1.30, $1.40 a pound -- as far as we're concerned, that is good for us.


We don't see any negative impact of -- if it all plays out as it looks like it might, and there is speculation about further consolidation at that aluminum producer level, we don't really see any negative impact of that on our business at all. If there is an impact, I think it leads to more stability in pricing and then maybe higher prices, which is positive for us.


I guess I was referring more to the heat-treat area.


On heat-treat, I think really on the heat-treat area, that is so much demand related. Boeing doing what Boeing is doing, which is selling a tremendous amount of commercial aircraft, I can't see that having any negative impact on our heat-treat market whatsoever.


I've got one final question, if I may. Your operation in Belgium -- are you guys seeing a pickup? I noticed in the past you've talked about some slowing in demand because of the A380 problems. What are you seeing there now?


I think things are picking up over there, Tony, as A380 gets back on course and their other products and other planes over there are -- they've got some more in development. I think we are seeing some improvement there.


Thank you very much. I appreciate your insights.

Operator

Luke Folta, Longbow Research.

Luke Folta - Longbow Research - Analyst

Not to beat the stainless issue to death further, but I just had a question. Are you seeing your end users' delay in purchasing on the 400 series stainless as much as you have been seeing on the 300 series -- higher nickel stuff?


We sell very little of the 400 series -- very little. So I really don't think we can comment on that, other than the fact that I have been told by guys in the field that there has been some inquiries on 400 series and that those are drying up now, that they are seeing the 304 prices go down because of the surcharge.

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From a 300 series -- yes, as Dave pointed out earlier, our customers are seeing the nickel prices go down and they are reducing their purchases of that product. They are still producing their own products, though. So they have to buy stainless. They are just not buying as much because their expectation is that tomorrow it's going to be a little bit less of a price than it is today. So it is not like our stainless sales have dried up; they haven't at all. We are still -- demand is still pretty darn good in stainless. But for obvious reasons, they are doing exactly what we're doing. They are just holding off their purchases until the day they need it.


You had mentioned that you expect mill inventory to increase. Do you think that there is a possibility they could be lowering base prices moving forward?


I don't think -- that's a certainly a possibility. It is not something that I think that, frankly, they should do, because the surcharges are more than twice what the base price of stainless is.


And really, we don't think it would have an impact on demand.


Yes, it wouldn't have any impact on demand.


The surcharge adjustments would be more.


If it goes down another $0.30 or more in September, following a $0.39 a pound reduction in August, and it can possibly go down in October, we are looking at $1. So I don't think it's likely that they will lower the base prices. I think they will just float the surcharge.


And just a final question on titanium. You had mentioned that you were seeing prices come down in titanium. Can you talk about to the extent of which they are falling and if you are seeing the weakness in sheet products and flat products, as well as the bars?


We do very little in sheet products. As a matter of fact, it is not even a blip on the radar screen. As far as the prices on titanium products -- I wish I had the information in front of me, but I think ingot prices were as high as $27 a pound. And I believe currently -- I hate to even make a comment -- I think it is around $22. But it may be -- I hate to tell you something that I don't have paperwork in front of me to substantiate.

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It has come down. It is really similar to what was going on in the stainless with the nickel surcharges. The price had climbed up so high, and I think everyone out there -- we all anticipated that the prices would be coming down. And it has this year. So as Gregg pointed out earlier, I think the demand level is still very, very strong for the titanium products. And that is a good market for us right now.


Using the ingot as a benchmark, what do you think the stabilizations point is? Do you think we are going to hover around a $20, $22 a pound range?


We really can't comment on that. We never thought it would go to $27 a pound. A couple of years ago, it was at $7 to $9 a pound. So we just don't know.

Operator

Mark Parr.


My questions have been all taken care of. So thanks again.


Do you have any answers to some of these other questions that we didn't have any answers to?


Well, if I did, I would only be sharing them with you on private.


Call us back and tell us.

Operator

Michelle Applebaum.


I was asking for a follow-up on your comments about sheet prices bottoming. It doesn't seem -- if you look at the AISI operating rate, we hit a new high in production last week. And Mittal finally did bring down Cleveland, but Burns Harbor is coming back up. If Mittal thought that we were near a bottom, they wouldn't be cutting production now, would they?

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We don't run Mittal, but to answer your question, I would think they would be cutting back production. They certainly have been doing that the last few years.


I was kind of curious about -- we have a new industry model and prices won't be as volatile. And yet here we are, another cycle -- in six months we went from $600 to $500 and nobody has really cut production.


You know, Michelle, though, I think that you are right -- we are in another cycle. But a $100 swing, especially when you are going from $600 to $500 or $500 to $600 -- that's not really that big of a deal. And if that is the kind of fluctuations -- and we really believe that we are always going to have some pricing swings. It is still going to be a cyclical type of an industry. But we truly believe that the bandwidth of the fluctuation is going to be much tighter. If you look at years ago -- probably wasn't too awfully many years ago, when if we could have signed up for hot-rolled for $400 or $450 a ton for the rest of our living days, we would have done it. And now in hindsight, that would have been a bad choice. But the fluctuations as a percent of the base price were quite a bit higher then. If we are $550, give or take $50, kind of on an ongoing basis, that is a pretty good market for us to operate in.


Yes, I guess I do see your point. Do you think there is a particular catalyst that would cause prices to go up in August or September?


I think if there is, it is because people have reduced their inventories so much. If they get back into the market, which frankly, I think is a good possibility if service centers begin to buy more, in the August timeframe -- that is why I think it's a good possibility that there could be a price increase announcement in August for September, because I think people are just going to have their inventories down as low as they have been in a long time, and they are going to get back in the market to buy some steel.


Cool. I hope you are right.


Me too.

Operator

Sal Tharani.


Is Clayton Metals going to be accretive in the third quarter?

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Yes.


And Karla, the LIFO assumption and LIFO decline -- is that primarily from the stainless steel side, you have reworked your prices, or is carbon in there also?


It is primarily stainless.


There was an announcement by one of the mills that there was some pre-buying on bar products in the first quarter, which resulted in lower volume in the second quarter. Did you guys see any slowdown in your shipments out of, let's say, Jorgensen or anywhere else?


No. The only exception to that would be there is cold-finished bar that goes into the automotive drive train business that has slowed with the domestic auto producers. And that has affected EMJ. In the whole scheme of things, it is very, very small. But their business has been impacted on the cold-finished bar because of that.


From a volume standpoint, really in pretty much all the markets we are in, it has just been pretty steady through the six months, and looks like it is going to be steady with just some seasonal adjustment here.


If I look at your percentage of sales from the tolling business, it has remained steady at 3% over the last three quarters, even though your overall revenue has ticked up. So it goes to show that, for the last two quarters, it goes to show that you're still getting enough business in that, even though it is very much tied to the auto industry.


It is. Our folks at Precision Strip -- that is who you are referring to -- our people there have done an outstanding job. And they have grown, and they are processing more metal and they are making more money than they were a year ago, despite the fact that the domestic autos and some of the appliance business might be down a bit. But they do a real fine job.


Have you seen a shift in Precision Strip towards more transplants on your domestics?


Yes, they have always had a bigger position with the transplants or the new domestics, as I guess we say now, but compared to the Big 3 in Detroit. So that has also helped them, obviously.

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So you are saying the bigger percentage of your sales over there is from the new domestics?


From the transplants.

Operator

Yvonne Varano, Jefferies & Co.

Yvonne Varano - Jefferies & Co. - Analyst

Gregg, I was wondering if you could just give us your outlook for pricing trends in long products and maybe plate. I think those are the areas we haven't touched on.


On long products, we think it is pretty flat. It has been for the past four or five months, and we don't really see any change in that. And I am referring to mini-mill product as well as beams. As far as the plate, plate has dropped about $44 a ton over the past couple of months. But the basic industries that support that, the plate market, they're all strong. So I would expect that plate is hovering somewhere around a little over $800 a ton for discrete. And we really don't look for that to go anywhere south of $800 a ton, and if anything, I think it is just going to maintain itself pretty well. Plate and the long products have been the more stable of all of the carbon steel products, as you know, Yvonne, over the past few years.


Do you think there's any potential for price increases in the plate side?


I don't know. I guess if it has dropped $40 and business conditions improve a little bit, then it could probably go up $40. So I really don't know. When I look at plate, I am just pleased with the fact that it has been able to maintain a range of somewhere between $800 a ton plus or minus $30 or $40. But that is good news for us.


It really depends more on demand in that area. We don't see any big changes in demand. So as a result, we really don't have much expectation for any significant price changes, either.


We have some increases in -- Mittal's bringing on a little bit more plate production at the Gary plant. And that is coming on in September. Hopefully, the demand will be able to suck that up. That is about 600,000 to 900,000 tons. So there is a little bit of concern there about price erosion because of that particular production coming on board. But overall, the plate market industries that support that are doing well. So hopefully, we will be able to suck that up.

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Right. Well, that's what I figure -- your markets there have been extremely strong.


Yes, they have. So I feel pretty good about plate and long products, period.

Operator

(OPERATOR INSTRUCTIONS). Evan Steen, Eos Partners.

Evan Steen - Eos Partners - Analyst

My questions are more strategic than, like, what is going to happen next quarter or whatever. You guys are becoming by far and away not only the biggest, but the best operator. As you look out over the next two, three, four years, how important do you feel it is to keep up this pace of acquisitions and growing as your suppliers have become really concentrated? And what advantages or disadvantages are there -- I know it is a very regional business, but is there anything -- I guess what I am asking is, is there an inflection point where, when you reach and continue to grow, that something clicks that changes as opposed to, in the past, it's been very fragmented and very regional, and vis-a-vis how that ties in with some of the consolidation going on with your suppliers? And in addition, there have been numerous rumors -- and I know in Europe it is different -- where the suppliers actually go downstream and own distributors. And obviously, that has happened in the past here in the U.S. It is not really currently the way it is structured, but in the past, some companies were managed like that. And in Europe, there are companies that manage their processes like that. And I'm curious what your feelings are with regards to that.


First off, I think the first part of your question had to do with the importance of continuing to grow at some pace. You referred to a pace. We believe that we will continue to grow and it is important for us to continue to grow. But we don't have any real pace that we've set for ourselves or plan for. Our growth is really based upon the opportunity that is out there. We will continue to grow. We will continue to grow internally and we will continue to do acquisitions. But in terms of referring to some rate of growth, that is a tough call for us, because sometimes you do a bigger deal and sometimes you don't do any for a little while. So I think that we will continue to grow. The pace is less important to us. It is just about doing the right things, which is the most important thing for us. With respect to growing so we could maintain relationships with our suppliers as they consolidate, I think we are of a sufficient size currently that we are not worried about supplier consolidation having an impact on our ability to work with them. So I think we are -- we are okay with respect to that. We don't have to force ourselves to grow because our suppliers are growing. Our growth is going to be because it is the right thing for us. With respect to mills and service centers, yes, that question has been battered about. We don't know what is going to happen there. We happen to think that the way we are structured here in the U.S. is the best way. There is some discussion out there about the so-called European model and how good it is. But none of us, or at least we have not been able to find any information about how good the European model really is, because a lot of that is not broken out, or we haven't seen any of it broken out. So we don't know that it is a better model or not, just from a financial/operating success point of view. So we happen to think that this is a better way to do it. Here in this country, as you referred to, there were many of the producers that had their own distribution networks in the past, and it didn't work out. And that is kind of how our industry evolved.

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So I think the best thing for us is to just keep doing what we have been doing. Whether or not somebody is going to -- a mill is going to want to own a distribution chain, who knows? I wouldn't be surprised if it did happen. You have some now already. Certainly, Thyssen is out there, and they have distribution not only in Europe, but here in the U.S. So it is not a concept that is unknown here. But I think it is going to be -- we just don't know what to expect. And we are not dwelling on it. But we do believe that the way that we're doing it now is probably the most efficient way. There's a lot of concerns that the mills would have because none of us in the service center business are really big enough to fill up a mills order book. So they’re still going to be --


Maybe someday you will be there.


So there's some risk involved too.


The only other question, with regards to volume, what would you say, and obviously you don't traffic really very much in appliance or auto, but trying to get a sense of tying in GDP versus what would be a quote/unquote normal volume year for you based on that GDP if it grew 2%, 3%, and then adding in you growing and organically growing and taking market share in different areas. Is there any metric that you tie in so that I can get some sense of how that might look?


That is a tough thing to do, because there are so many components to GDP. Some use more metal and some use less. But we believe that we should be able to grow our Company organically at 2% to 3% more than whatever GDP -- the growth rate of GDP is.


On a tons basis.


Organically on a volume basis, yes. And then pricing -- it can be more or less, depending upon what the impact of prices is going to do. But we have been able to do that historically, and we think that we can continue to do that at a minimum.


Okay, sounds good. Okay, nice quarter, and thanks for the response to those questions.

Operator

Leo Larkin, Standard & Poor's.

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Leo Larkin - Standard & Poor's - Analyst

Could you give us a CapEx and DD&A for this year and for '08, if that is available?


For 2007, CapEx is about $145 million, is our budget. Our depreciation for the year probably will be around a $70 million number. So we've got a lot of growth initiatives built in. D&A would be about $80 million. So there's a lot of growth initiatives built into the CapEx budget this year. And 2008, we have not come up with numbers yet. Potentially, the CapEx number might be less than the current-year number, but not significantly.

Operator

Ladies and gentlemen, there are no further questions in the queue at this time.

Ladies and gentlemen, this does conclude today's conference call. You may disconnect your phone lines at this time, and have a wonderful day. Thank you for your participation.

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reliance steel & aluminum 2007_Q2_Conference_call_transcript

Economy & Finance