Lufkin Industries, Inc. (LUFK)

Q3 2008 Earnings Call

October 15, 2008 10:00 am ET

Executives

Jack Lascar - DRG&E

John F. Glick - President, Chief Executive Officer, Director

Christopher L. Boone - Chief Financial Officer, Vice President, Treasurer

Angela McCarthy – Corporate Controller

Analysts

Collin Gerry - Raymond James

Byron Pope - Tudor Pickering & Co. Sec.

Terese Fabian - Sidoti & Company

Eric Mintz - Eagle Asset Management

Presentation

Operator

Welcome to the Lufkin Industries third quarter earnings conference call. (Operator Instructions) I would now like to turn the conference over to Jack Lascar of DRG&E.

Jack Lascar

With me this morning are Jay Glick, Lufkin’s President and CEO, Chris Boone, Vice President and CFO, and [Angela McCarthy], Corporate Controller. Before I turn the call over to Jay, I have a couple of housekeeping items. If you would like to be on our email distribution list to receive future news releases or if you experience a technical problem and didn’t get one this morning, please call us at 713-529-6600.

If you would like to listen to a replay of today’s call, it will be available via webcast by going to the earnings conference call section of Lufkin’s website at www.lufkin.com or via recorded replay until October 22. This information was also provided in this morning’s earnings release. The information reported on this call speaks only as of today, October 15, 2008 so be aware that time sensitive information may no longer be accurate as of the time of any replay.

Also please be aware that today’s conference call may contain certain forward-looking statements. The assumptions of from which these forward-looking statements are based are beyond the company’s ability to control or estimate precisely and may in some cases be subject to rough estimate material changes. Actual results may differ materially.

With that I will turn the call over to Jay Glick.

John F. Glick

As you saw in this morning’s news release we had a very good quarter particularly in the oilfield division and this was against the headwinds of Hurricane Ike which impacted our factory operations in Lufkin and Houston for several days in September.

For the third quarter we reported net earnings from continuing operations of $25 million or $1.66 per diluted share. This compares with $18.3 million or $1.21 per diluted share from continuing operations in the third quarter of 2007. Sequentially earnings from continuing operations increased by 17% from $1.42 per diluted share in the June quarter. Two items impacted this in the third quarter: Our LIFO inflation rate adjustment and the lost revenue due to Hurricane Ike. Together these items reduced earnings by approximately $0.20 per diluted share compared to our third quarter forecast. Chris will provide more details in a moment.

I want to give a lot of credit to our employees who worked very hard after the hurricane hit under some extremely trying circumstances to get us up and running again quickly. Many were without power or phones or even water at their homes for many days. In spite of their difficult personal circumstances, they returned to work to help the company fulfill its commitments to customers. The impact on Lufkin could have been more severe were it not for their dedication.

Despite the negative impact of the LIFO charge and the hurricane, we still came in a penny above our EPS guidance range of $1.55 to $1.65 per share, and as a result we have raised our full-year guidance from our previous range of $5.50 to $5.70 to a new range of $5.65 to $5.85. This would put our fourth quarter guidance in the range of $1.51 to $1.71 per diluted share.

The oilfield division was our biggest driver of the strong results this past quarter. Oilfield bookings increased by 135% year-over-year and by 28% sequentially to $256 million. International orders particularly Latin America were the main drivers of the sequential bookings growth with bookings up 62% while US bookings were up 17% sequentially.

We saw slightly lower bookings from our power transmission division, which I will discuss more in a moment.

Company-wide bookings at September 30 were up almost 20% sequentially. The total order backlog for Lufkin at September 30 was $413.9 million which is a 125% increase year-over-year and a more than 33% sequential increase. Most of the increase in backlog was in the oilfield division. Power transmission was off a little on a sequential basis but up year-over-year. I’ll come back to these in more detail in a minute.

We have ramped up production and shipments dramatically over the course of this year in response to strong energy prices and a surge in customer orders. Despite the pullback in oil and gas prices we saw in the third quarter, we expect our manufacturing plants to be very busy for the rest of this year and into 2009 based on our current backlog.

Our cash flow was strong in the third quarter and we continue to maintain a strong balance sheet. With so much trauma in the credit markets today the choices we have made over the years in terms of capital structure and liquidity were clearly the right ones for Lufkin.

We can’t predict what the financial markets are going to do or how that will affect our customers’ access to credit or how a deep downturn in the broad economy will impact energy prices. We will continue to watch the markets very carefully and stay close to our customers. Based on current feedback from those customers, the current oil price levels will support continued E&P CapEx.

Our poll of customers suggests that most 2009 budgets that they’re developing are assuming an economic hurdle rate on a per barrel basis in the range of $60 to $70 and somewhat lower in more mature basins. However we recognize that if events in the broader economy affect either energy demand or access to credit might well alter this picture. Based on information we are getting we believe that the majors and large independents will have a strong cash flow and will be well positioned to maintain their development programs into 2009. We will monitor the pulse of the small and medium independents carefully.

We also expect that a few of the resource plays may come under greater scrutiny at gas prices under $7.00 per mcf. Fortunately we’re strongly leveraged to oil. Last quarter for example about 4/5 of our new bookings in the oilfield division were oil projects and 1/5 natural gas projects. So on a company-wide basis we are less sensitive to changes in gas-related activity than oil.

In addition it’s worth noting that many of the natural gas wells we supply and service are shallow US onshore gas projects, and since these wells are low-cost development wells that don’t require the large upfront capital commitments necessary for a deep water gas project, we believe these projects will proceed because of the incrementally lower risk profile and the flexibility to quickly scale up or down should the energy price environment suddenly shift.

How much the credit crunch could impact some of our customers’ plans is unknown. My hunch is that the strong cash flows that our larger E&P customers are realizing today should sustain continued capital investment in any MP projects if the global energy demand forecast remains strong.

In power transmission where most of our customers are original equipment manufacturers as opposed to end users, we could be a little bit more exposed but so far we have seen no indications of credit-related interruptions.

The equity markets have steeply discounted the oil services stocks because of commodity price declines in recent weeks and it could be argued that those discounts are overdone, although we will leave the forecasting of share price moves to those of you on the other end of this call.

Our M&A efforts however may benefit from the reduction in valuations. We spent a good bit of time looking for attractive acquisitions over the last couple of quarters but we were unable to close any of those due to what we believe were unrealistically high expectations by the sellers, which we believe subsequent events have borne out.

A couple of more items before I get into the detailed operations discussions. Last week we signed a new three-year labor agreement with our three unions. The new contract is not expected to impact our guidance for the remainder of the year which we have raised this morning and the terms are in line with our expectations over the life of the contract.

Now let’s look at the divisions in a little bit more detail, starting with oilfield. No matter how you look at it we had a great quarter, not only in the pumping side of the business but automation was also extremely strong last quarter. New orders for the oilfield division totaled $256 million which is up 135% versus the third quarter of last year and up 28% from the second quarter of 2008. Of that, 69% was domestic and 31% was international.

Domestically we saw continuing strong orders from customers operating in the Bakken Shale in North Dakota and from heavy oil areas in California and the Permian Basin in West Texas. We also had very strong activities from both Latin America and Canada. Our oilfield backlog at September 30 was $279.8 million which was up 64% from the second quarter and up 335% year-over-year. The US backlog was up 66% versus 60% for international.

As I mentioned a moment ago, we have ramped up production dramatically in oilfield and our third quarter shipment rate was up 45% from the first quarter rate. We are continuing to optimize our manufacturing through the applications of lean processes and new capital equipment to keep up with customers’ demand and maintain the short lead times that have been a competitive advantage for us for many years.

Looking at the fourth quarter, which is typically a strong revenue quarter but can be a weak quarter for bookings, we are projecting a moderating level of new orders for the division. Both the second and third quarters were marked by large international project bookings that are not assumed in our fourth quarter projections.

Last quarter we highlighted a big upward spike that we’ve seen in steel prices. Efforts to offset those increases through price adjustments and aggressive supply chain management have prevented the erosion of our margins. We continue to keep a watchful eye on commodity prices and believe that steel price increases have moderated for the moment.

Future raw material pricing will depend on the steel producers’ ability to reduce or maintain prices by reducing output. In any event we will continue our efforts to improve our steel sourcing and procurement practices to minimize our costs and manage the volatility in our raw material cost structure.

The real driver of improved gross margins came from greater leverage on our fixed assets associated with the higher factory utilization which was driven by the ramp up in manufacturing activity to meet the higher levels of demand. Chris will speak to the margins in more detail in just a moment.

Looking now at the power transmission division, [lead orders] totaled $43 million which is down 10% from the third quarter a year ago and 12% versus the second quarter of this year. This decline is mainly related to capacity and scheduling issues with our marine customers based on shipyard capacities. Also some new orders that we expected to book have slipped from the third quarter into the fourth quarter.

Timing issues also affected power transmission’s revenue in the quarter. Shipyards delayed in taking delivery of new equipment that was scheduled for completion in the third quarter. In addition we experienced similar delays on several large oil and gas and power generation projects that involved high-speed units. In those cases customers did not want to take delivery until the fourth quarter.

Backlog in power transmission increased by 12% from a year ago to $134.1 million but declined 3% from the second quarter. Oil and gas and power generation projects continued to be the most active sectors for the business in power transmission. Demand from those sectors is expected to remain strong in the fourth quarter and into next year.

Hurricane Ike has also created some business opportunities for us from the petrochemical and refining sector along the Gulf Coast. Our after-market group is inspecting and reconditioning gear boxes damaged during the storm. We expect that work to continue into 2009.

We are expecting a slight increase in revenue during the fourth quarter and a recovery in the rate of bookings as projects delayed from the third quarter are placed during the fourth quarter.

Looking ahead we see continuing growth opportunities in oil and gas, power generation and the marine business. One of the benefits of the power transmission side of our business is the greater market diversification that that division offers. We are not so linked to the volatility of oil and gas prices and it offers opportunities in general industrial applications as well as alternative energy plays.

To sum it up again, a great quarter. Our growing backlog combined with the continued strength in demand in both segments of our business and the ongoing improvements we’re making in our manufacturing operations have increased our full year earnings outlook for 2008. We remain cautiously optimistic as the impact of the economic situation is tough to call, but early indications would suggest a solid 2009.

Now I’ll ask Chris to give you a more detailed review of Lufkin’s financial performance during the third quarter.

Christopher L. Boone

Just a quick reminder that we’re providing results from continuing operations in our financial statements because we closed our trailer operations in the second quarter. All of our prior period financial information has been restated to reflect this change.

To briefly recap third quarter financial results, third quarter net income from continuing operations was $30 million or $1.66 per diluted share. This compares to $18.3 million or $1.21 per diluted share a year ago and to $21.2 million or $1.42 a share in the second quarter of this year.

For the third quarter we saw a $0.20 per share impact from non-cash additions we made to LIFO reserves for continuing operations, about $4.5 million compared to the third quarter last year. These LIFO reserves were about $2.5 million greater than originally forecasted for the third quarter or $0.11 per share higher than expected. This was due to continued inflationary impact of raw material prices versus a year ago.

Hurricane Ike cost us about a dime of EPS for missed shipments and plant downtime.

Looking at sales and gross margin results by division. Starting with oilfield, third quarter revenues increased $147.1 million which was a 52% increase year-over-year.

Breaking those revenues down by product line: $92.9 million was from new pumping units, which is up almost 70% from the third quarter of ’07. Services contributed $27.4 million, up over 26% from a year ago. Automation contributed $19.2 million, which is up nearly 54% year-over-year. Commercial castings generated $7.5 million, which was off just a little, 1.6% from a year ago.

Comparing those same numbers to the second quarter of 2008, revenue from new pumping units was up more than 17%. Services revenues were up over 14% sequentially. Automation sales increased 9% and founder revenues were up 31% from higher raw material surcharges.

Gross margin for the oilfield division was 28% in the third quarter versus 26.1% in the second quarter of 2008 and 26.9% a year ago. This increase reflects the combination of higher volumes and the catch-up we’ve been able to achieve following a rise earlier this year in steel costs. The non-cash additions we made to LIFO reserves were $3.2 million higher in the third quarter of this year than they were in the same quarter last year. That reduced gross margin for oilfield by 2.2% points.

Turning to power transmission. Revenue was $48 million for the third quarter, which is up over 17% from a year ago and roughly flat with the second quarter of 2008.

Breaking that down by product line: New units contributed $36 million, which is up almost 16% versus the third quarter of last year and down about 3% from the second quarter. Repair contributed $12.1 million, which is up more than 22% versus a year ago and about 11% from the second quarter of this year.

Gross margin of power transmission was 30.4% versus 34.2% a year ago and 30.8% in the second quarter of 2008. Non-cash additions to LIFO reserves were $1.3 million higher than they were in the third quarter of last year. This reduced our margin by 2.8% points.

On a consolidated basis, overall gross margin for the third quarter was 28.6% versus 27.4% in the second quarter and 29.2% a year ago.

Looking at some of our expense items for the third quarter. Third quarter SG&A expenses from continuing operations increased to $17 million, which is up 24% from a year ago but flat sequentially. We expect SG&A for the fourth quarter to be on trend with the third quarter. As a percent of revenues third quarter 2008 SG&A expenses decreased to 8.7% compared to 9.7% in the second quarter.

Depreciation and amortization from continuing operations in the third quarter was $3.9 million. We expect D&A in the fourth quarter to be about the same or slightly higher.

EBITDA from continuing operations in the third quarter was $43.2 million or 22.2% of revenue as compared with $32.4 million or 23.5% for the third quarter of 2007.

We ended the third quarter with $110.2 million in cash and cash equivalents versus $95.7 million at December 31, 2007, up $15 million. Working capital for accounts receivable and inventory net of accounts payable was $209.1 million, an increase of about $49 million during 2008 due to higher sales volumes and strategic steel purchases.

Capital expenditures from continuing operations in the third quarter were $7.6 million. Year-to-date we spent about $18 million and we expect capital spending in the $25 million to $30 million range for the full year of 2008. This slightly lower range than previously provided reflects the fact that the approval of certain large capital projects took a few months longer than previously planned and we’re also seeing longer lead times in getting delivery of new machine tools. That will push some of the expected 2008 spending into 2009.

Also during the third quarter of 2008 the company paid dividends of $3.7 million or $0.25 per share.

In early October we bought $3.5 million worth of Lufkin common shares, which completed the outstanding repurchase authorization. We bought about 52,000 shares at an average price of $67.53.

The company ended the quarter with no short or long-term debt and we continue to have access to a $40 million credit facility with J.P. Morgan Chase that is scheduled to retire on December 31, 2010.

The third quarter tax rate from continuing operations was 35.8% which was in the range of what we had expected, and we expect a tax rate of 35% to 36% for the fourth quarter.

That concludes the financial overview, so I’ll turn it back to Jay.

John F. Glick

We’re now ready for questions.

Question-and-Answer Session

Operator

(Operator Instructions) Our first question comes from Collin Gerry - Raymond James.

Collin Gerry - Raymond James

In the past we’ve talked about lead times being one of your competitive advantages and being closer to the customer. Are there any capacity constraints that you all are running into as this demand really exceeds what we’ve seen in the past?

John F. Glick

Our lead times have gone out by more than we’d like to see them go out, which reflects the fact that we’re not able to ramp up the output as rapidly as we would like.

I would point out we’re continuing to bring on more resources from both the power transmission division domestically as well as activating some resources with our operation in France to supplement the domestic capacity. The capital investments that we have coming in will also let us get back to lead times that are more in the range of what we would like to see, which would be something more like four to six weeks on units. We are bumping up against capacity constraints temporarily but I think we’re going to be able to deal with those going forward.

One of the other things that we continue to see with the bookings though is that customers are actually reserving capacity further out. So while we had the glut of business come in in both Q2 and Q3, which we were delighted to see, it wasn’t all requesting immediate delivery. A lot of this extends out into the first part of next year. We clearly have the fourth quarter covered for oilfield and PT with backlog matching the revenue projections we’re giving; perhaps more than matching them. But we have oilfield backlog extending out into next year because again customers requested dates were out that far.

Collin Gerry - Raymond James

Visibility now with the backlog goes out six months or maybe even nine months in some cases?

John F. Glick

That in PT. It’s probably more like four to five months in oilfield.

Collin Gerry - Raymond James

Just to follow up on some of the drivers that we’re seeing in terms of demand, internationally I saw that bookings really picked up. Could you just speak to regionally where that’s coming from, what specifically is driving that, and what’s changed over the last year in those particular regions?

John J. Glick

We picked up some share in certain markets in Latin America and I think part of that’s due to the fact that we now have a station fully equipped to support the [Mur Cuissure]. We’re seeing some benefits from that. We’ve also seen customers expanding field developments in that part of the world in ways that were not in place a year ago so clearly that’s been a big driver year-on-year. We’re seeing Canada pick back up a little bit. The [Nivaucan] development is clearly a major issue domestically. It was a big source of where our new bookings came from on the US side.

Operator

Our next question comes from Byron Pope - Tudor Pickering & Co. Sec.

Byron Pope - Tudor Pickering & Co. Sec.

I wanted to get your thoughts. You talked about based on your customer feedback $60 to $70 per barrel being the pain threshold if you will. As we look at some of these plays domestically, you mentioned the Bakken and you mentioned West Texas and California for the heavier oil, are those the three primary reasons we should be looking at from a rig count point of view in terms of thinking about when we might start to see some softness in the oil directed rig count as it relates to demand for pump jacks for you guys?

John F. Glick

Yes, I think so. Those are the areas we’re clearly watching. Mid-Continent is another area we’re fairly busy in but if you look at Permian and you look at California and you look at the Bakken, so far as our domestic US business goes those are the areas. Barnett Shale we’re seeing some business pick up there recently and Haynesville we’re all kind of holding our breath to see what happens there as oil prices weaken a little bit.

Byron Pope - Tudor Pickering & Co. Sec.

Based on your commentary, it sounded like you’re fairly confident that among your customer base that the oil majors and the large independents will probably power through in terms of demand for pump jacks, but is it fair to think about watching the private E&P operators as kind of the X factor in this whole equation?

John F. Glick

I think that’s fair. That’s certainly what we’re going to do. Again we’re getting ready to go to our sales meeting this afternoon. Chris and I are leaving for that. We’ll know a little bit more after that but we had a discussion last week and the feedback we’re getting from most of our major customers suggests that they’re going to power through as you said. It’s the small independents we’ll keep an eye on just to be sure they have the cash flow to carry on with the plans they gave us.

Byron Pope - Tudor Pickering & Co. Sec.

On the power transmission side, historically that mix has been fairly balanced between oilfield and non-oilfield. Has that mix shifted much? I recall one of the drivers there is general industrial plant and utilization is something we should be watching for on that side. Is that a fair way to characterize it?

John F. Glick

65% or so of what PT does is typically energy related and in that group we have the power generation sector as well as the oil and gas sector and the refining sector. We’re not seeing the weakening in the industrial part of that business which would be the 35% that’s left over. That is still there to come. What we are seeing is a pretty significant pick up in the power gen area so we’re counting on that. We’ll be talking about that probably at the end of our fourth quarter call. So far PT seems to be, from an order intake perspective, staying kind of in the same mix that we’ve seen the last several years.

Operator

Our next question comes from Terese Fabian - Sidoti & Company.

Terese Fabian - Sidoti & Company

You had a nice pick up in your oilfield service segment revenue growth. Can you talk a little bit about that? Where is that coming from? Is that because of new additions to your service facilities or expansion thereof?

John F. Glick

A lot of it was domestic pick up in service. Our international service continues to grow as well. California was clearly busy; the same areas we just spoke to Byron about. West Texas was busy. We had good weather in spite of the hurricane in this part of Texas. West Texas had pretty good weather, which is a factor. We’ve tried to ramp up the capacity of that group and will continue to build that going forward. So I think it’s just a combination of active markets in areas that we traditionally are strong in and no weather interruptions. Canada came back recently strong as well.

Terese Fabian - Sidoti & Company

Getting back to your backlog, you say that you sort of see a breakdown between the majors and large independents with access to cash than the smaller independents. Do you have any breakdown on who your customers are between those two groups?

John F. Glick

Yes. That was a question we anticipated. If you look at our oilfield backlog at $270 million or $280 million, the $90 million that is international is all either majors or very large independents. Of the $180 million that is the domestic market, probably 15% to 20% would be small independents in that group.

Terese Fabian - Sidoti & Company

Another question you may have anticipated is in your pump jack backlog, can those orders be canceled probably for the international for the most part, but what about the others?

John F. Glick

We’ve beefed up our cancellations going back a couple quarters ago in anticipation of what things would be like if they weakened, and essentially we’ve not seen any significant cancellations come through. Our cancellation policy gets more onerous as we approach the delivery date.

The other thing we’re trying to do is if we have something that we’re concerned about, we’re trying to check with people before we commit materials to the shop to be sure we’re working on the right things. Part of that’s in response to making sure our capacity supply to the customers that need the equipment most, but it also has the additional advantage of checking against customers who may be reconsidering their development work.

Terese Fabian - Sidoti & Company

I know it’s hard to see into the future, but going back into the fast maybe I think you were somewhat surprised by the level of your backlog numbers in oilfield services. Did the third quarter numbers sort of come as a surprise to you also, and what do you see going forward?

John F. Glick

If you remember our second quarter call, our bookings in oilfield were about $200 million in Q2 and I made the comment that we didn’t expect that to repeat at that level, and lo and behold we booked $250 million or something in Q3. We were surprised. I think the biggest issue though was several large international projects came in that we had not expected timing wise to book in Q3 and in addition to that we saw some strength in our domestic markets that I think came as a little bit of a surprise in the US markets.

Terese Fabian - Sidoti & Company

Your diluted share count at the end of the quarter?

Christopher L. Boone

Right around 15 million to slightly over 15 million.

Operator

Our next question comes from Eric Mintz - Eagle Asset Management.

Eric Mintz - Eagle Asset Management

Last quarter we talked a little bit about operating efficiencies and getting more out of the plants. I’m just wondering where we are in the phases and obviously you had some good op margin expansion this quarter. I guess there’s more to come in Q4 and should we expect to see continued margin expansion in ’09?

John F. Glick

I don’t want to project too much into ’09 at this stage. We’re hoping that we can see some pullback in raw material prices. I would hasten to add we have not seen that yet and I think that’s going to be a challenge to forge through but our sourcing group will be working hard on that.

The labor efficiency issues and just kind of the lean payback on investment in training and other things that we’re doing, I would hope we’ll see more of that in ’09 for sure. We put a lot of effort into that. We found a lot of seeds, and overall the workforce has embraced the concepts. So I think we will see some improvements there. I’m not sure I could quantify those this morning but certainly that’s where the push is going to be.

Eric Mintz - Eagle Asset Management

Just to use a baseball analogy, is it fair to characterize it as still early innings on those initiatives?

John F. Glick

Yes. It clearly is early innings but again there’s a lot of momentum. It’s one of these things that has snowball downhill characteristics that once you get the thing rolling and success is visible to other areas of the factory, the momentum increases and more people want to jump on board.

Eric Mintz - Eagle Asset Management

You mentioned I think you said a significant pick up in power gen. Would that be related to wind energy?

John F. Glick

A lot of what we’re seeing right now is related to gas turbine power gen, but we are working on some things that we may want to talk about in future calls on wind energy both in our operations in Europe and our operations here. We’re making some capital investments to position ourselves a little bit more strongly for those sectors. There is going to be that in the future but my reference was more to the gas turbine sector.

Operator

Management, I’m showing that there are no further questions. I’ll turn it back to you for closing comments.

John F. Glick

Again we are very pleased with our third quarter results and we expect a strong fourth quarter as well. We think we’re well positioned to manage our business through this uncertain economic period. We appreciate you joining us this morning. If you have any follow-up questions, please talk to either Chris or Jack by phone. Thanks very much.

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