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AZZ Inc. (NYSE:AZZ)
Q2 2019 Earnings Conference Call
Oct. 9, 2018, 11:00 a.m. ET

Contents:

  • Prepared Remarks
  • Questions and Answers
  • Call Participants

Prepared Remarks:

Operator

Good morning, ladies and gentlemen. Welcome to the AZZ Inc. Second Quarter Fiscal Year 2019 Financial Results Conference Call. All participants will be in listen-only mode. Should you need assistance, please signal a conference specialist by pressing * key followed by 0. After today's presentation, there will be an opportunity to ask questions. To ask a question, you may press * then 1 on your telephone keypad. To withdraw from the queue, please press * then 2. Please note, this event is being recorded.

At this time, I would like to turn the conference over to Joe Dorame of Lytham Partners. Please go ahead, sir.

Joe Dorame -- Managing Partner, Lytham Partners, LLC

Thank you, Denise. Good morning, and thank you for joining us today to review the financial results of AZZ Inc. for the second quarter of fiscal 2019, ended August 31, 2018. As Denise indicated, my name is Joe Dorame, Managing Partner of Lytham Partners. On the call representing the company are Mr. Tom Ferguson, Chief Executive Officer; and Mr. Paul Fehlman, Chief Financial Officer. After the conclusion of today's prepared remarks, we will open the call for a question and answer session. Please note there is a slide presentation for today's call, which can be found on AZZ's Investor Relations page under Financial Information at www.azz.com.

Before we begin with prepared remarks, I would like to remind everyone certain statements made by the management team of AZZ during this conference call constitute forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Except for the statements of historical fact, this conference call may contain forward-looking statements that involve risks and uncertainties, some of which are detailed from time to time in documents filed by AZZ with the United States Securities and Exchange Commission, including the Annual Report on Form 10-K for the fiscal year ended February 28, 2018.

Those risks and uncertainties include, but are not limited to, changes in customer demand and response to products and services offered by the company, including demand by the power generation markets, electrical transmission and distribution markets, the industrial markets and the metal coatings markets; prices and raw material costs, including zinc and natural gas, which are used in the hot-dip galvanizing process; changes in the political stability and economic conditions of the various markets that AZZ serves, foreign and domestic; customer-requested delays of shipments; acquisition opportunities; currency exchange rates; adequate financing; and availability of experienced management and employees to implement the company's growth strategies. The company can give no assurance that such forward-looking statements will prove to be correct. These statements are based on information as of the date hereof, and AZZ assumes no obligation to update any forward-looking statements, whether as a result of new information, future events or otherwise.

With that said, I'd like to turn the call over to Mr. Tom Ferguson, Chief Executive Officer of AZZ. Tom?

Tom Ferguson -- Chief Executive Officer

Thank you, Joe. Welcome to our Fiscal Year 2019 Second Quarter Earnings Call, and thank you for joining us this morning. As we had noted on the last call, we were hoping to maintain positive traction as we continued the 2019 fiscal year. We believe we've accomplished that with solid double-digit growth for both top and bottom lines versus Q2 fiscal 2018. While we still have several challenges, both within the business as well as outside, we have enough momentum to raise our guidance for the full year. We remain highly active on the M&A front, as we look to strengthen our core businesses and ensure our current businesses are focused on their core activities.

Metal coatings had a good second quarter with record sales, while it continues to gain traction on several operational, procurement improvement, and growth initiatives. Operating margins of 19% were negatively impacted by the high-cost zinc flowing through our kettles, the disruption of consolidating two plants, some impact from higher direct labor wages, and our efforts to regain market share in certain markets. We believe margins will show improvement at the balance of this year, and while 25% operating margin is still our target for galvanizing, all grown metal coatings will be somewhat less than that, as powder coating is likely to make up the growing portion of the revenues.

We continue to invest in digitizing our galvanizing plant so that we can improve our industry-leading customer service and drive improved productivity with real-time data. We call this initiative the Digital Galvanizing System, or DGS for short, and we now have DGS in all 40 of our galvanizing plants. We remain confident that continuous galvanized rebar and powder coating will continue to grow, and also improve their margins in the coming quarters.

The reorganization to improve our value-added selling efforts is allowing us to take back some market share and drive improved pricing. Due to the higher demand in the labor markets, we selectively increased wages at several plants to improve retention and hiring. In spite of a tight labor market, these changes allowed us to attract higher-skilled direct labor, which will help us improve volume throughput and will have a positive impact on productivity and efficiencies at these plants in the second half of the year.

The energy segment's Welding Solutions business experience a normal weak summer season for turnarounds and outages. The nuclear sector continues to be challenging, but we have right-sized our operations to work through this environment, and believe this market is poised for some improvement the balance of the year and into next year, particularly with our greater focus on the international nuclear opportunities.

The electrical platform continues to see improvement and opportunities for electrical enclosures, switch gear, and our oil field-related products. We have a large backlog for high voltage bus, but have not been able to replace the large nuclear projects from medium voltage bus. Tariffs had only a minor impact on this segment in the second quarter. We are in the process of converting our Chinese joint venture to a wholly owned operation to give us better control and more flexibility in responding to any new tariffs or trade actions.

Overall, we are seeing improved demand in most of our energy segment businesses as we enter the third quarter. As we look forward, we see solid demand in most of our metal coatings plants, as fabricators are busy in most regions, and infrastructure span continues to grow. While we have increased prices, we have not been able to offset the majority of the impact from higher zinc and labor cost. We are focused on improving productivity and efficiency, while also continuing to improve price realization to offset these increased costs.

We did consolidate two Louisiana plants into the Baton Rouge facility, and are upgrading that facility to provide outstanding customer service to the marketplace. On the other hand, we are also more aggressively defending some markets where competitors have attempted to take market share by focusing more on customer satisfaction while competing at the market price level.

As the year progresses, we are beginning to see increased demand for GalvaBar, and have begun looking for a site to build our second facilities for future growth, probably in the East Coast area. We may look at a fully integrated hot dipping GalvaBar plant, which would be unique. Powder coating demand is growing for both of our plants, helped by our improved selling efforts. Our energy segment's full year outlook is solid, and Q3 is seasonally a strong quarter for turnaround and outage activity. We are currently experiencing very strong turnaround activity this fall. In summary, these positive developments are giving us confidence in a strong second half of the year.

With that, I'll turn it over to Paul Fehlman to discuss the financials in more detail.

Paul Fehlman -- Chief Financial Officer

Thank you, Tom. For the second quarter of fiscal year 2019, we reported net sales of $222.8 million, a $26.5 million increase, which was 13.5% higher than the second quarter of fiscal 2018. Operating income for the second quarter of fiscal 2019 was $17.1 million, which included a $1.3 million charge to consolidate two galvanizing plants on the Gulf Coast. This drove a slight decrease to operating income of $300,000.00, or 1.6%.

Reported fully diluted EPS grew 13.2% to $0.43, compared to $0.38 last year, and our backlog finished at $336 million, up 12% versus the second quarter last year. Our book to revenue ratio finished the second quarter at 1.14, compared for 0.97 in the second quarter last year. We expect to shift 54% of the backlog outside of the U.S., compared to 42% in the same quarter last year. Gross margins for the quarter were 21.1%, 120 basis points lower than the 22.3% margin for the second quarter of last year, as we experienced the continued headwinds of realized zinc prices, increasing labor costs, and the charges we took to consolidate the two galvanized plants.

SG&A finished at 13.4% of total sales compared to 13.5% from second quarter last year, and as a result, we generated second quarter operating margins of 7.7%, compared to 8.9% in the second quarter of fiscal 2018. On a comparative, our quarterly interest expense rose 17% year-over-year, or $580,000.00, mainly as a result of rising interest rates. Our effective tax rate improved to 19.6% compared to the second quarter rate last year of 28.7%, driven by the Tax Cuts and Jobs Act of 2017. Cash flows from operations improved by $14.7 million, or 527% in the first half of fiscal 2019 compared to the performance in the first half a year ago on higher net income.

As for our second quarter segment results, second quarter revenues in our energy segment were up 9.5% to $106.5 million compared to the second quarter of the prior year, while operating income rose 80.8% to $4.3 million compared to the prior year second quarter, as gross margins in the segment grew to 19.9% compared to the 17.8% in the second quarter last year. Operating margins for the second quarter were 4% compared to 2.4% in the second quarter last year.

In our AZZ Metals Coatings business, second quarter revenues grew to $116.3 million, a 17.4% increase compared to the second quarter of last year, which was, for the second consecutive time, a new quarterly record for the metal coatings segment. Operating income fell 5.7% to $22.1 million compared to the $23.4 million in the same period last year, generating an operating income margin of 19% compared to the 23.6% in the second quarter last year, as we took the $1.3 million in charges to consolidate the plants on the Gulf Coast and continued to experience the headwinds of higher realized zinc prices and growing labor costs.

With that, I'll turn it back over to Tom for his concluding remarks. Tom?

Tom Ferguson -- Chief Executive Officer

Thank you, Paul. We remain cautiously optimistic about fiscal year 2019, and are gaining confidence in our outlook after two solid quarters of performance. We are narrowing our guidance for fiscal 2019 to the upside, with earnings per share in the range of $1.90 to $2.25 per fully diluted share, and annual sales in the range of $930 million to $970 million. We are experiencing generally improved market conditions, and we feel confident about our organizational changes and realignment activities. Additionally, we are executing on our strategic initiatives to drive improved operational performance.

We are pleased with the actions we have taken to manage our commodity costs and improve labor hiring and retention, as well as the positive impact of tax reform, both on our profitability and on the demand created by investments for many of our customers. We will continue to focus on driving performance for the balance of fiscal 2019 and positioning AZZ for strong fiscal year 2020.

With that, I'll open it up for questions.

Questions and Answers:

Operator

Thank you, Mr. Ferguson. Ladies and gentlemen, we will now begin the question and answer session. To ask a question, you may press * then 1 on your telephone keypad. If you are using a speakerphone, please pick up the handset before pressing the keys. If your question has been addressed, you may withdraw from the queue by pressing * then 2.

The first question will be from John Franzreb of Sidotie & Company. Please go ahead.

John Franzreb -- Sidotie & Company -- Analyst

Good morning, guys. First, on the metal coatings business, can you talk a little bit about how long it takes you to fully absorb price increases and decreases in zinc, and when would that fully be reflected in the P&L?

Tom Ferguson -- Chief Executive Officer

It takes about six to eight months, John, and kind of the peak prices were in that first part of the year, February/March. So, that's why we're pretty confident, particularly with higher volume. So, we'll start seeing that to head lower toward the end of this quarter into the fourth quarter.

John Franzreb -- Sidotie & Company -- Analyst

Got it. And your efforts to regain market share in metals, can you just describe what you're doing there and what kind of timeline to get back some of the lost customers?

Tom Ferguson -- Chief Executive Officer

Yeah, we feel like we've regained quite a few already. Our focus was in probably two or three regions where we felt like competitors had sort of had a free reign for a while, as our operations were purely focused on margin. So, with the change in the sales force really building out that professional sales effort, getting them focused on really talk -- not just talk coverage, but building that value, highly satisfied customer relationship, we're making a lot of progress. And I think you see it in our revenue already. We've still got a little ways to go. I think we'll be at that through the balance of this third quarter. But I would anticipate, as we make the turn into January for the calendar year, that we're gonna be pretty comfortable, that we're regaining most of what we lost, and that we've started taking share in the some of the other regions.

John Franzreb -- Sidotie & Company -- Analyst

Perfect. Okay. And on the energy side of the business, can you talk a little bit about the fall turnaround season? I know the spring was relatively good for you. You had some deferred work that came back to market. It seems like the fall is gonna be equally as good, if not better. Can you just describe what's driving that, if it's better than your expectations, say, a few months ago?

Tom Ferguson -- Chief Executive Officer

Yeah. I think the fall's looking really good. Our challenge now is balancing resources, so we pretty much have, as I like to say, all oars in the water right now. So, our folks in the Welding Solutions business are trying to balance project teams, and project engineers, and quality folks. So, we're full on the typical industry refinery side. Nuclear outages still haven't been that robust, but that's OK. We've pretty much aligned our resources to be able to focus on the higher industrial opportunities. The thing -- and we're seeing that pretty much across the globe. So, in our Europe business, in our Latin America, as well as in our Canadian business. So, we feel real good about this third quarter. And well, on one hand, I kind of wish we had a few more resources, but on the other hand, that would have probably made for a tougher second quarter. So, we feel real good right now.

John Franzreb -- Sidotie & Company -- Analyst

Just -- I thought you implied that your nuclear business second half was looking better relative to the first half. Is that not the case?

Tom Ferguson -- Chief Executive Officer

Well, there's two different pieces to our nuclear business. One is the Welding Solutions piece, which is focused on the maintenance side, and then there's the Nuclear Logistics Inc., which is more around components, and parts, and certification. And so, they tend to run -- while we use an integrated sales organization, they still tend to run a little different. So, we -- what we're feeling better is that nuclear -- that NLI business, they're focused on new opportunities. They're focused on their traditional batteries and things like that. So, that's where we think that utilities have probably cut about as much as they can in terms of their inventories and in terms of the components. So, we feel better about that.

We also feel better about some of the international opportunities we're seeing, whereas traditionally, we're almost totally focused the last year or two on the domestic market. So, that's why we feel better overall on the nuclear side, international and NLI.

John Franzreb -- Sidotie & Company -- Analyst

Perfect. Thanks, Tom. I'll get back in the queue.

Operator

The next question will be from Noelle Dilts of Stifel. Please go ahead.

Noelle Dilts -- Stifel -- Analyst

Hi, thanks. I wanted to dig into the labor side of things a little bit more. Could you give us a better feel for which crafts are sort of in tight supply, and if there's more or less tightness from a geographic standpoint, if there are any areas that are particularly difficult? And if you could comment on if you're seeing any tightness in terms of welders, that would be helpful.

Tom Ferguson -- Chief Executive Officer

Yeah, it's got all of the above. I think you hit on all the points, Noelle. I'll start with the welders. We've got good access to craft. And so, we've got probably enough craft right now to handle what we see in the third quarter. As we look forward, I'd say we're probably more worried about the supply of welders in outer years. So, we are working on better training programs, working with the unions that we work with, and trying to make sure that we've got the best of the group available to us, and in a variety of ways. So, we've renegotiated some of those union contracts for contractors. And we feel fairly good right now with what's available to us. In the metal coatings side, it's a different story. We've got some regional issues. I'm not gonna call out any specific ones, because we have competitors in almost every area as well.

So, we have increased wages by $1.00 to $2.00 in those areas to, one, allow us to attract a little better quality of individual; and two, to retain the folks, the experienced folks we have. Most of that is unskilled to semi-skilled labor. So, it's -- we had some issues in -- but we've been able to fill our range pretty well. We're doing job fairs. We're getting more creative at how we recruit, how we bring folks in, how quickly we ramp them up, how do we get them oriented, and then how do we evaluate or retain? So, we've had to become more innovative in how we find unskilled and semi-skilled craft, and we're doing that in both the metal coatings, as well as in the electrical side. And we've had success with those job fairs.

So, our human resources folks are getting a lot better at that, and we're getting a lot better at using the tools we need to bring folks in. I think there's gonna continue to be some pressure. But on the other hand, I think we're feeling good about how we're able to drive productivity and efficiencies as we look forward. So, we're not seeing a lot more pressure to increase wages because we're not in some of the really high-cost areas like California or up in the Northeast. So, in the South and through the Midwest, we feel pretty good about the adjustments we've made and about the new techniques we're using to find, recruit, and retain folks.

Noelle Dilts -- Stifel -- Analyst

Okay, thank you. That's very helpful. And then on -- I was hoping you could expand a bit on the tariffs, and steel in particular, and where that's kind of impacting you, both directly and indirectly, and how receptive the market has been in terms of the pricing there as it relates specifically to raw material inputs.

Tom Ferguson -- Chief Executive Officer

Yeah, great question. And it varies. I think in metal coatings, most of the fabricators we're dealing with have access to the steel they need, so we haven't seen much impact there and feel pretty good as we're looking forward, at least as we're talking to the contractors and fabricators. When it comes to the electrical side, where we have seen some impact, we had some tariff impact on our oil field related products, particularly tubing. We're working to mitigate that. It wasn't enormous because tubing's a relatively small business unit for us. And two, they're pretty adept at adapting. So, we feel good about their access to steel going forward for the tubular business.

When it comes to the enclosures, and particularly, there has been some cost increase in terms of steel plate and sheet metal particularly. We've been able to pass most of that through, because it is project basis, and so, we've been able to get that into our bids in anticipation of the higher cost. So, we have not seen a lot of pushback from customers because a lot of our customers are experiencing the same thing. But we have had access to the plate and sheet that we needed, just at a little higher cost, which has not been reflected in our margins, as we've been able to pass it through on a project basis.

So, not just -- as we kind of stated, it's something we're paying close attention to where it could impact us. China, one of the reasons we're moving to a Wulfi in China instead of a JV was in case the tariffs get worse or the trade situation with China gets worse, we want to be able to manufacture more locally and not have any impact on our margins on some of the projects we have in backlog. So, we feel -- once again, we feel good about the steps we've taken the last few months, and been a lot of hard work by our legal and finance and business teams. But we think we've made the right steps, particularly with the front page of the Wall Street Journal today talking about things getting worse with China.

Noelle Dilts -- Stifel -- Analyst

Mm-hmm. Okay, great. And then one last one for me. Could you walk us through, just on the galvanizing side, some of the trends that you're seeing in terms of volume in some of the verticals in which you operate? So, a little bit of a feel for what's going on in the solar, T&D, OEM, etc.?

Tom Ferguson -- Chief Executive Officer

Yeah, Paul's gonna respond to that.

Paul Fehlman -- Chief Financial Officer

Yeah, Noelle, good morning. So, the current trends are that we're seeing upkicks across almost every end market that we're addressing. We had some particular strength in agriculture in the second quarter and in general industrial, as well as the electric utility side, funny enough. Pretty flat on construction. Bridge and highways got a tiny uptick. And we're seeing good pickup in OE as an end market. So, the interpretation on that is that really, the general economy is going well. The uptick in agriculture, I would say, has to do with some of the anticipated possible issues in China as we're building out more storage for grains and poultry units also. It's that time of year where this picks up as we head into the fall.

Noelle Dilts -- Stifel -- Analyst

Okay, perfect. Thank you.

Operator

And once again, if you would like to ask a question, please press * and 1. The next question will be from John Braatz of Kansas City Capital. Please go ahead.

John Braatz -- Kansas City Capital -- Analyst

Morning, Tom, Paul.

Tom Ferguson -- Chief Executive Officer

Morning, John.

Paul Fehlman -- Chief Financial Officer

Morning, John.

John Braatz -- Kansas City Capital -- Analyst

Just a follow-up on the galvanizing side of the business. Was there some incremental acquisition revenue this quarter in the galvanizing segment?

Tom Ferguson -- Chief Executive Officer

Yes. Yeah, there was. We bought Rogers Brothers, which has more spending than most of our other facilities. And so, that's been a nice addition. Still relatively small. Paul could probably give you a little more color on it.

Paul Fehlman -- Chief Financial Officer

Yeah. I won't give you the numbers, but we did pick that up at Rogers Brothers, which was purchased in February, at the end of fiscal 2018. And then actually, we got EPC on the outer cutting side at the end of June fiscal 2018, so you get an extra month -- you get a little extra month bonus there for you, John, in the second quarter. Yeah, there was a pickup from -- in organic.

John Braatz -- Kansas City Capital -- Analyst

Okay. Tom, from a bigger picture standpoint, we're hearing reports about things maybe slowing down in China for whatever reason. I guess my question is, how important is the Chinese market for you as you look forward 12, 18 months? And maybe, are you seeing any weakening, either directly or indirectly, relative -- can you give us a relative sense how important the Chinese market might be for you?

Tom Ferguson -- Chief Executive Officer

Yeah. We've got a very large Chinese backlog in our high voltage bus business up in Massachusetts. And but, those are long-term contracts, very well-negotiated contracts between us and the customers. Those projects are necessary for China's infrastructure, so we so those moving forward. Obviously, we've got contractual terms we believe are fair between us and our customers there. So, our backlog is in hand for the next year to two years. Four high voltage bus. So, we're not too worried there, and there're still other opportunities. So, we look for that to be OK. Like I said, mostly by changing from a JV to our own operation was to give us more control and flexibility if things should get worse, where we would be able to manufacture more domestically in China without impacting our margins.

On the other side, we have been making some entres into the market with our Welding Solutions business, moving some resources in country. We don't see that being affected as well. Part of it is, we just want to make sure we've got equipment on the ground when those turnarounds come up for Coker rebuilds. Coker drum rebuilds. And as well as for the nuclear side. So, we feel pretty well positioned there. It's something we've been working on for the better part of three years, and getting that in place so that we're not at the mercy of things getting hung up in customs. But it's not -- for Welding Solutions, it's just not a huge part of the outlook for them.

John Braatz -- Kansas City Capital -- Analyst

Yeah. Is the backlog in the bus business in China, is it gonna be cancelled, delayed? Or can the terms change at all, or the contract dates change at all?

Tom Ferguson -- Chief Executive Officer

They could. There's clauses in there for cancellation, for changing the order. Obviously, there could be impacts. We don't feel that's likely, just given the strategic nature of those projects. And we still do have good partners. In effect, we've taken our JV partner and converted them to still a source. And so, we still feel very well connected in terms of how we're doing business there. And the way we took these contracts was due to the strategic nature of these projects for the Chinese infrastructure. So, while yeah, there's always a chance there could be some changes, we feel fairly well protected. But more importantly, we feel like these are strategic projects that need to go forward. And by the way, the most recent award is the second largest hydroelectric dam in the world. And as you know, the Chinese like to put those records up.

John Braatz -- Kansas City Capital -- Analyst

Yeah. Okay.

Tom Ferguson -- Chief Executive Officer

So, once again, it's comfortable.

John Braatz -- Kansas City Capital -- Analyst

Okay. All right. Thank you very much. Tom.

Tom Ferguson -- Chief Executive Officer

All right. Thank you.

Operator

And ladies and gentlemen, this will conclude our question and answer session. I would like to hand the conference back to Tom Ferguson for his closing remarks.

Tom Ferguson -- Chief Executive Officer

Thank you. Well, thank you for participating in today's call, and we look forward to talking to you again at the conclusion of our third quarter. And we hope that nobody's in the way of Hurricane Michael. And once again, thank you.

Operator

Thank you, sir. Ladies and gentlemen, the conference has concluded. Thank you for attending today's presentation. You may now disconnect your lines.

Duration: 32 minutes

Call participants:

Joe Dorame -- Managing Partner, Lytham Partners, LLC

Tom Ferguson -- Chief Executive Officer

Paul Fehlman -- Chief Financial Officer

John Franzreb -- Sidotie & Company -- Analyst

Noelle Dilts -- Stifel -- Analyst

John Braatz -- Kansas City Capital -- Analyst

More AZZ analysis

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