reliance steel & aluminum 2007_Q4_Conference_Call_Transcript

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FINAL TRANSCRIPT

Conference Call Transcript

RS - Q4 2007 Reliance Steel & Aluminum Co. Earnings Conference Call

Event Date/Time: Feb. 21. 2008 / 10:00AM CT

FINAL TRANSCRIPT

Feb. 21. 2008 / 10:00AM CT, RS - Q4 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. (“Reliance Steel”) – Chairman of the Board and CEO

Gregg Mollins Reliance Steel & Aluminum Co. (“Reliance Steel”) - President, COO

Karla Lewis Reliance Steel & Aluminum Co. (“Reliance Steel”) - EVP, 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 Paul D'Amico TD Newcrest - Analyst

Evan Steen EOS Partners - Analyst

Mark Parr KeyBanc Capital Markets - Analyst

Michelle Applebaum Applebaum Research - Analyst

Timna Tanners UBS - Analyst

Tim Hayes Davenport & Co. - Analyst

Bob Richards Longbow Research - 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 Co. 2007 fourth quarter and fiscal year conference call. At this time, all participants have been placed in a listen-only mode, and we will open the floor to your questions and comments following the presentation. It is now my pleasure to turn the floor over to your host, David Hannah. Sir, the floor is yours.

David Hannah - Reliance Steel - CEO

Great, thank you. Good morning and thanks to all of you for taking the time to listen to our report, and our financial results conference call for the fourth quarter and the fiscal year ended December 31, 2007. Gregg Mollins, our President and Chief Operating Officer, and Karla Lewis, our Executive Vice President and Chief Financial Officer, 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. A transcript of today's conference call, including Regulation G reconciliations will be posted on our Website at www.rsac.com/investorinformation.

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We are very pleased to report our results for the year ended December 31, 2007. Net income amounted to a record $408.0 million, up 15% compared with net income of $354.5 million for 2006. Earnings per diluted share were a record $5.36 for the twelve months ended December 31, 2007, up 11%, compared with earnings of $4.82 per diluted share for 2006. Sales for 2007 were a record $7.26 billion, an increase of 26% compared with 2006 sales of $5.74 billion. For the 2007 fourth quarter, net income was $79.9 million, or $1.06 per diluted share, compared with net income of $74.6 million, or $.98 per diluted share for the 2006 fourth quarter, and net income of $93.6 million, or $1.22 per diluted share for the 2007 third quarter. Sales for the 2007 fourth quarter were $1.71 billion, that is an increase of 9%, compared with 2006 fourth quarter sales of $1.57 billion, and it was down 6% compared to the 2007 third quarter. All share and per share amounts have been adjusted for our two-for-one stock split that was effective July 19,2006. For the 2007 fiscal year, our volume increased 17.3% and average prices increased 8.5% compared to 2006. That was driven mainly by our acquisitions in both 2006 and 2007. For the 2007 fourth quarter, our volume increased 10.4%, and average pricing decreased almost 1%, compared to the 2006 fourth quarter. Our volume was down 5.4%, and average pricing was flat compared to the 2007 third quarter, in-line with expected seasonal slowness for the fourth quarter. For 2007, carbon steel products were 46% of our revenues, aluminum was 19%, stainless steel was 19%, alloy was 9%, toll processing 2%, and the remaining 5% was miscellaneous including titanium, copper, and brass. 2007 proved to be quite a volatile year, with prices for all of our products moving up and down at different times throughout the year. Supply dynamics changed as the year progressed. Demand, overall, in our major markets was pretty steady, but was impacted a bit as our customers changed buying patterns in response to rather significant pricing fluctuations. Remember, also, that the service center industry began 2007 with way too much inventory, and was in a destocking mode for most of the year. Consequently gross profit management was our biggest challenge, and I think we handled it well, finishing the year down only slightly from our 2006 level. We also managed our working capital well which, when combined with our record profits, resulted in record operating cash flow of $639 million, or $8.40 per diluted share. Inventories at December 31, 2007 represented 2.55 months on hand based on average 2007 sales activity. Overall once again we were able to take a challenging business environment and turn it into another record year through a combination of 1) effective and efficient operational management of our existing businesses, 2) taking advantage of internal growth opportunities, and 3) additional accretive acquisitions. In December of 2007, we announced that our subsidiary, Valex Corp., opened a facility in the People's Republic of China that will produce ultra-high purity tubes, fittings, and valves for the semiconductor, LCD, and solar industries. This expansion will enable Valex to improve it's already significant share of the growing Asian market. In January 2008 we sold the assets and business of the Encore Coils division of Encore Group Limited, a subsidiary of Reliance. We acquired the Encore Group of metals service center companies effective February 1, 2007. The Encore Metals and Team Tube divisions of the Encore Group, which we have retained, specialize in the processing and distribution of alloy and carbon bar and tube, as well as stainless steel sheet, plate, and bar products. The Encore Coils division processed and distributed carbon steel flat-rolled products. The Encore Coils business did not fit well for us because we didn't have any similar facilities nearby that could help support this relatively small business. On October 17, 2007, the Board of Directors declared a regular quarterly cash dividend of $.08 per share of common stock. The 2007 fourth quarter dividend was paid on January 4, 2008, to shareholders of record on December 7, 2007. In recognition of the Company's significant growth in revenues, earnings, and cash flow, all of which set records in 2007, the Board of Directors approved a 25% increase in the regular quarterly dividend rate to $.10 per share effective with our 2008 first quarter dividend that will be paid on March 28 to shareholders of record on March 7. The Company has paid regular quarterly dividends for 48 consecutive years and has increased the dividend 15 times since our 1994 IPO. Looking forward, carbon steel prices have risen significantly during the first quarter of 2008, and the prices of the other metals that we sell are relatively steady, resulting in an overall pricing environment that is much more favorable than the last two quarters. Demand however is more difficult to predict, given the current uncertainty in many parts of the economy. The widespread doom and gloom attitude portrayed by the media, confuses us somewhat, because we still see some strength in the main markets we serve, especially in the energy, oil and gas, and aerospace industries. Also non-residential construction activity for us is still good, but it is not at 2006 or 2007 levels.

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Our January 2008 was strong. Contrary to overall industry statistics just released, we had record monthly revenues and volumes. They were up 6% and 4% respectively, compared to January 2007. Our gross profit margins on a FIFO basis improved from December, but they still didn't reach the January 2007 level. Because of the improved pricing environment, we expect some continued improvement in our gross profit margins during the 2008 first quarter, but are still somewhat uncertain about the pace of demand. As a result, we currently estimate earnings per diluted share for the 2008 first quarter in a range of $1.25 to $1.35. Once again, we are proud of our performance and our leadership position in our industry, and believe that our proven ability to grow both internally, and by successful accretive acquisitions, on a consistent basis and through varying market conditions, 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.

Gregg Mollins - Reliance Steel - President, COO

Thank you, Dave. Good morning. We are very pleased with our record sales and earnings in 2007. Our managers did an excellent job in what proved to be a very difficult operating environment. We completed five acquisitions that were immediately accretive, with annualized revenues of over $600 million. In addition, our internal growth initiatives continued to move forward, supported by a capital expenditure budget in excess of $120 million in 2007. The MSCI trade association reported service center volumes were down approximately 7% for the year and our same store sales were down less than 2% which suggests an improvement in our market share. Our fourth quarter posed some operational challenges that we met head on. Service centers continued to reduce inventories which caused added pressure on margins. Average daily sales were pretty steady in October, November, and the first half of December, but trailed off quite a bit the last two weeks of the month due to seasonal closures. We reduced our inventories over $100 million during the fourth quarter, and ended the year at 4.4 turns. We are committed to improving our turn in the future. As for 2008, we feel good about our position in the regions and industries that we support. Our inventory is in good shape, and prices on most of our products are going up. As a spot buyer and seller of metal, we pass these price increases through as quickly as possible, and expect to see an improvement in our gross profit margins. In spite of all the rhetoric about a recession and whether we are in one now or will be shortly, we are optimistic about what lies ahead in 2008. Many of the industries we support are doing well. These include aerospace, energy, rail car, ship building, barge, ethanol plants, agricultural equipment, non-residential construction, infrastructure, capital equipment and wind turbines, to name a few. We have very little exposure to the domestic automotive and appliance markets, which have and most likely will continue to struggle. We are not running scared, but quite the contrary, we are moving ahead with confidence in our growth strategy, an important part of which is our largest ever capital expenditure budget of $210 million for 2008. We expect to provide the highest level of service to our customers and get paid for it. From a pricing standpoint, carbon steel prices have gone up dramatically since the first of the year. Raw materials like coke and iron ore have sky-rocketed. With the weakness in the dollar and high freight costs, imports have declined, and our suppliers can export any extra material they choose to produce. Our only concern is that if prices get too high, it may allow imports to increase. Also large projects that are made up of a great deal of steel could be delayed due to the inflated prices. We believe the Big three North American producers will have the discipline and intelligence to manage this effectively. As for aluminum, midwest spot ingot prices have increased $.23 a pound since January 1. Demand in commercial grades of aluminum is flat, at what we feel are reasonable levels. Aerospace demand is still quite strong, so there are no real surprises there. Stainless demand is still relatively strong. Surcharges continue to go up and down, but not to the degree we saw in the first nine months of last year. Turning our inventory in this product is of the utmost importance.

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To summarize, demand in most of the major industries we support is still pretty good. Pricing is strong, and we will continue to focus our attention on outstanding customer service, managing our gross profit margins, and turning our inventory. We look forward to another good year at Reliance. This concludes my report. I will turn the program over to Karla to review the financials. Karla.

Karla Lewis - Reliance Steel - EVP, CFO

Thanks, Gregg. The increase in our 2007 annual consolidated sales of 26.3% compared to 2006, resulted from a 17.3% increase in our tons sold and an 8.5% increase in our average selling price per ton sold. (Please note that our tons sold and average selling price per ton sold amounts exclude the sales of Precision Strip because of the “toll processing” nature of its business.) Our 2007 acquisitions along with our 2006 acquisitions of EMJ on April 3, 2006 and Yarde Metals on August 1, 2006, contributed significantly to the increase in our 2007 sales levels. Same-store sales, which exclude the sales of our 2006 and 2007 acquisitions, were $4.1 billion in 2007, up 2.1%, with a 1.8% decrease in our tons sold and a 5.7% increase in our average selling price per ton sold. Demand from most markets was relatively strong in 2007, but down somewhat from 2006 levels. In 2006, we experienced significant strength in the non-residential construction and aerospace industries. Although we experienced various degrees of pricing volatility in all the metal products that we sell, with the most significant volatility in stainless steel products, overall 2007 pricing levels were above 2006 levels. Our 2007 fourth quarter sales were down 5.9% from our 2007 third quarter sales, with a 6.6% decrease in tons sold and a flat average selling price per ton sold. The decrease in tons sold was mainly due to the normal fourth quarter seasonal slowdown experienced in our industry as many of our customers close during the holidays. The decline is in line with prior years. Our 2007 fourth quarter gross profit as a percentage of sales was 25.1%, compared to 24.8% in the 2006 fourth quarter and 24.3% in the 2007 third quarter. On an annual basis, our gross profit percentage in 2007 was 25.3%, compared to 26.3% in 2006. The decline in our gross profit margin in 2007 was mainly due to significant competitive pressures during the year, resulting from excess inventories throughout the industry, especially during the first half of the year. A significant amount of this de-stocking was in stainless steel products. Stainless steel costs were increasing significantly in the first half of 2007 and we can typically increase our gross profit margins in these environments; however, the de-stocking caused us to reduce our selling prices to compete, reducing our gross profit margins. In the 2007 third quarter, stainless steel costs experienced sudden and significant declines. This adversely impacted our margins because we had to reduce our stainless selling prices more rapidly than our inventory costs on hand were reduced. In the fourth quarter of 2007, costs of most products were stable with third quarter levels, allowing us to realize some improvement in our gross profit margins from third quarter levels. Our 2007 fourth quarter LIFO adjustment, which is included in our cost of sales, was income of $1.2 million, or a $.01 contribution per diluted share(1), compared to LIFO expense of $37.9 million, or a $.31 charge per diluted share(1) in the 2006 fourth quarter. For the 2007 year we recorded LIFO expense of $43.8 million, or $.36 per diluted share(1), compared to 2006 LIFO expense of $94.1 million, or $.79 per diluted share(1). Our 2007 LIFO expense resulted mainly from the further increases in the cost of stainless steel products at year end 2007 compared to the beginning of the year. We had estimated $15.0 million of LIFO expense in the 2007 fourth quarter mainly due to anticipated increases in carbon steel costs; however, most of these increases were pushed to the 2008 first quarter. This resulted in a minor amount of LIFO income. Our 2007 warehouse, delivery, selling, general and administrative expenses as a percentage of sales are consistent with our 2006 expense level at 14.3%. In the 2007 fourth quarter, our SG&A expenses were 15.4% of sales due to the lower fourth quarter sales levels. We continue to focus on cost control and take appropriate cost reduction measures when needed. During the 2007 fourth quarter, we reduced our headcount 1.3% due to the lower sales volumes. Our 2007 depreciation and amortization expense increased $17.4 million over 2006 mainly because of our 2007 acquisitions and a full year of depreciation and amortization expense from EMJ and Yarde. Operating profit for 2007 was a record $735.2 million, or 10.1%(2), compared to $633.9 million, or 11.0%(2), in 2006. The operating profit dollars increased due to the increased business levels provided from our 2006 and 2007 acquisitions; however, our operating profit margins deteriorated because of our lower gross profit margins in 2007. Interest expense for 2007 was $78.7 million, compared to $61.7 million in 2006. The increase occurred mainly due to increased borrowings to fund our 2006 and 2007 acquisitions.

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Our 2007 effective income tax rate was 37.7% compared to 37.9% for 2006. Our 2007 fourth quarter rate was 38.3% due to a catch up from our estimate of 37.5% used for the first nine months of the year. The 2007 rate is slightly lower than the 2006 rate due to increased international exposure through our 2007 acquisitions and various tax credits that were available to us in 2007. Net of acquisitions, we reduced our accounts receivable balance by $61.3 million and our inventory levels by $129.6 million in 2007 from our year-end 2006 levels. This was mainly due to somewhat lower demand levels in 2007 as compared to 2006, especially in the fourth quarter, and also due to our continued focus on working capital management. Our accounts receivable days sales outstanding rate was about 40 days, improved from 41 days at year-end 2006. Our inventory turn rate of 4.4 times was equivalent to about 2.7 months on hand, and consistent with our 2006 rate. Our reductions in working capital and continued solid profit levels in 2007 provided net cash flow from operations of $639.0 million, compared to $191.0 million in 2006 when we were building working capital to support increased business levels. In 2007 our strong cash flow funded capital expenditures of approximately $124.1 million, acquisitions of approximately $270.0 million and stock repurchases of $82.2 million. Our outstanding debt at December 31, 2007 was $1.1 billion, consistent with year-end 2006, however, our net debt-to-total capital ratio was 32.4%(3) at year-end 2007 compared to 37.6%(3) at year-end 2006. Outstanding borrowings on our $1.1 billion credit facility were $185.0 million at December 31, 2007. The significant availability on our credit facility and relatively low leverage position provides adequate liquidity for us to fund our growth activities. In 2007, we repurchased approximately 1.7 million shares of our common stock at an average cost of $49.10 per share under our Stock Repurchase Plan. This was the first time that we had repurchased our stock since 2000. As of December 31, 2007, we had repurchased 12.75 million shares of our common stock under the Plan at an average cost of $12.93 per share. In early 2008, we repurchased an additional 2.4 million shares at an average cost per share of $46.97. We currently have 7.9 million shares available for repurchase under the Plan. Book value per share increased to $28.12 at year-end 2007, up from $23.07 per share at year-end 2006. Thank you. We will now open the discussion for questions.

Regulation G Reconciliations

(1) LIFO expense/(income) is included in cost of sales. The per diluted share effect is calculated as follows (in thousands, except for share and

per share data):

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

2007 2006 Three months ended December 31: LIFO expense/(income) $ (1,244) $ 37,856 Tax rate 38.3% 37.7% Net LIFO expense/(income) $ (768) $ 23,584 Weighted average shares outstanding – diluted

75,490,202

76,053,725 Per share effect $(.01) $.31 Twelve months ended December 31: LIFO expense/(income) $ 43,756 $ 94,106 Tax rate 37.7% 37.9% Net LIFO expense/(income) $ 27,260 $ 58,440 Weighted average shares outstanding – diluted

76,064,616

73,599,681 Per share effect $.36 $.79

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(3) Net debt-to-total capital is calculated as total debt (net of cash) divided by shareholders’ equity plus total debt (net of cash). 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. Thank you. And we will now open the discussion for questions. Q U E S T I O N A N D A N S W E R

Operator

(OPERATOR INSTRUCTIONS) Paul D'Amico, TD Newcrest.

Paul D'Amico - TD Newcrest - Analyst

Good morning, guys.


Good morning.


A question probably for David. In the beginning you gave some good color on the different end markets, and I appreciate the menu list there. And I don't know if you have got the numbers available now, but given the acquisitions in '07, you post the split by product category for '06 and '07, I was trying to track, I just want to see if I am close. Given the acquisitions that have taken place, looking just at the carbon split, specialty I assume is still about 40% total sales exposure, or is that dramatically different now?


What was that, specialty, you said?


2007 2006 Twelve months ended December 31: Net sales $ 7,255,679 $ 5,742,608 Cost of sales 5,418,161 4,231,386 Gross margin 1,837,518 1,511,222 Warehouse, delivery, selling, general and administrative

expenses 1,034,473

821,692

Depreciation expense 67,866 55,591 Income from operations $ 735,179 $ 633,939

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Yes, first I would like to know about the specialty, in terms of consolidated sales exposure, and the second, on the carbon split just trying to get some parallel with the end market exposure, flat roll versus plate versus pipe, to get a split there in terms of the differences for the '07 acquisitions?


Okay. In terms of flat-rolled, it is not really that big of a deal for us. In total, our flat-rolled is about 8% of our revenue dollars. The biggest piece would be in coated, so that would be like galvanized sheet and coil. That is just shy of 4% of our revenue.


So less than 10?


Yes, and since the Jorgensen acquisition, going on two years, there hasn't been a big shift in our percentages by product. So of the 46%, carbon flat-rolled is about 8% of that. The largest piece for us is still carbon steel plate, and that is about 11%. And then bar is about 10% and tubing is about 9.5%. Those are the next two biggest pieces. And then structural steels are a little over 7%.


So very consistent still.


Yes, sure is.


Okay.


In 2006, for carbon, in total we were at 49% of sales, which was 46% as Dave mentioned in '07. And that 3% differential really went to stainless steel products.


I appreciate that. And just lastly to follow up on that, in terms of the menu list of the end market exposures, just roughly is there any one that sort of stands out, or two that stand out versus the others through '07, or are you anticipating through '08?


In terms of just pure size, our largest exposure is still to the non-residential construction market, and we still believe that that represents about a third of our business. And as we have said before, we don't know exactly because many of our sales are to fabricators and job shops, and we really don't know what they are doing with the metal that we sell them. But based upon the type of metal we sell, and those customers where we do know what they are doing, it looks like our non-residential exposure is somewhere in that 30% range.

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The other important markets to us still haven't changed. Aerospace is still around 10%, it will bounce a little higher than that, sometimes a little lower than that, maybe it could go down 2%, or up 2%. But that is still a very strong market for us, despite the fact that it has backed off of 2006 levels. We all have to remember that 2006 was quite an extraordinary year for all of our products. Pricing was moving in the right direction on all products. The right direction, by the way, for us is up. We like it when prices go up. And also demand was very strong across all of the market segments that we sell into in 2006. So being off of 2006 levels in 2007 is not a bad thing in our eyes, because that is coming off of a very, very strong year.


I appreciate it, just a follow up in terms of non-res. You were speaking about in the market commentary, non-res is still decent but not as strong as '07?


Yes.


You talking about volumes and/or pricing, and if so, can you quantify the difference that you are seeing?


Pricing is up, and we expect that it is going to stay up. And probably go up, as Gregg mentioned in his comments. But in terms of the strength of the market, volume is still reasonably good. It is just not as good as it was in 2006. 2007 wasn't as strong, and we are uncertain about 2008 in terms of volume. But we anticipate that it is going to be down a little bit more this year from 2007 levels.


All right. Thank you, guys.


Sure, thanks.

Operator

Our next question is coming from Evan Steen from EOS Partners, your line is live.

Evan Steen - EOS Partners - Analyst

Hi, guys, nice quarter. The first is, could you just rehash, sometimes you give same-store sales for the quarter, and I had trouble keeping up for the same-store sales on a tons and average selling price basis for Q4 alone?


Okay.

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We don't give the absolute numbers for the quarter, we only give the changes compared to other quarters. So what quarter did you want the comparison to?


For Q4 just the revenue, tons and average selling price on a same-store basis.


From Q3?


No, no, year-over-year.


Oh, year-over-year, sorry.


Hold on, we are shuffling papers here.


Well, you mentioned CapEx was going to be a record level. I think earlier you had indicated for the year it would be $165 million, so you came in $40 million short. So if I took $160 million and added $40 million, that gets me to about $200 million. I am curious if that is what was going on, and also what areas you are focusing on, in terms of where the capital is being spent?


The largest portion of our capital expenditure budget this year is going into plants. We are buying out some leases that we are currently in, from companies that we have purchased in the past, and it makes sense for us to buy out those purchases now. There is also some catch-up at the Earle M. Jorgensen Company. Their capital expenditure budgets, in the past, were maybe not funded as much as they should have been, so there was some catch-up there. Jorgensen represented about 25% of the approximately $200 million that we plan on spending this year.


And as you know, the strength of the markets that Jorgensen serves is primarily in the oil and gas and energy side, which is the one market I think that is stronger now, than it was before.


And we actually expect it to be even better in '08 than in '07.

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That is the reason they are getting the larger share of the capital expenditure budget -- to really take advantage of some opportunities we see there to expand their business, in view of the market conditions.


We are actually planning on building three facilities for Jorgensen They may not be completely finished in '08, but certainly well on their way.


We have some other operations in some structural steel products, where we are expanding facilities. We have outgrown existing locations and there are opportunities to do more, and do it more efficiently, so we are expanding plants. We are also building some new plants, some of which we actually acquired the land last year, and we will go ahead and start construction on buildings, as soon as we get the permits this year.


We have a major project up in Portland, Oregon, for American Steel. We are building them a new plant, and then we are also going into Las Vegas.


And that would be for PDM.


That is correct.


Got you. Lastly, you guys are always active on the acquisition front, and over I think the last year you said the opportunities were as great as ever. Just curious your thoughts on that, and also, you made your first, I think, international acquisition last year -- how do you feel about further increasing your international exposure?


There are still many opportunities on the acquisition side, and we are well-positioned to take advantage of that. As Karla mentioned with the relatively low debt levels that we have, and the ready availability on our existing lines -- the opportunities are out there. We are going to be very selective, as we have been in the past. I think all of the acquisitions that we have done are bigger and better companies today than they were when we acquired them. And the reason for that is the management teams that are in place at those companies, and some of the resources that we can bring to them, that they maybe didn't have access to when they were smaller, independent companies. So we do intend to continue acquisitions. I would be very surprised if we don't continue with acquisitions in '08. I mean, it is something that we have done regularly for many, many years, even before we became a public company in 1994. So it is part of what we do and part of our challenge is to make sure that all of you understand, that we are able to grow the Company in a market like 2007, when most, if not all, of our other industry competitors are not having record years.

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We can take those difficult conditions and turn them into a record year, because of the operations of our existing businesses, but also because we have been very successful in layering on acquisitions, and that is something that we are going to continue to do. So that is an important part of our strategy, and there is still a lot of that to come. With respect to the international piece, we did acquire a company last October called Metalweb in the U.K. They have four locations. We see that as a very good growth opportunity. The management team there is very knowledgeable about business, not just in the U.K. but throughout Europe. They had been involved in a company that was kind of a predecessor company to Metalweb, that had operations in western Europe, as well as Australia, and some other places. So that was a strategic move for us in an effort to really gain knowledge, and a platform to build some additional business in Europe and in the U.K. They are primarily involved in aluminum products. That actually wasn't our first international acquisition. I guess the first acquisition was Everest Metals, which was a very small transaction in China. But again we did that to support our existing electronics industry customers here in the U.S. It is growing,but it is still small But it is important to us over there, more from a customer support standpoint than anything else. Then we do have some greenfield operations. Our first one was in South Korea where we built a plant for Valex Corp. in 1999, and we have expanded it since then. That was a very important move for us as the semiconductor business moved away from North America, and from western Europe, into Asia. So that has been very successful for Valex and for Reliance. And then we built a facility in Belgium for AMI Metals, which is our largest aerospace-related company. That was put in place in 2003 to support Airbus, and all of the subcontractors, and people involved in the European-based aerospace industry. So we will continue to grow internationally, although our strategy there will continue to be more of a rifle shot, as opposed to a shotgun approach. Typically we have been pulled there by customers that we have relationships with in the U.S., and that will most likely continue to be the case as we go forward.


And lastly just circling back on that same-store revenue, tons and average selling price for Q4?


Yes, the fourth quarter '07 revenues were about $1.7 billion, and that included a 10.4% increase in tons sold over the fourth quarter of '06, and about a 1% decrease in average selling price per ton.


Okay. Thank you very much.

Operator

The next question is coming from [Phillip Gibbs], KeyBanc Capital Markets. Your line is live.

Mark Parr - KeyBanc Capital Markets - Analyst

Hi, it is Mark Parr. Good morning. A couple of questions. Let's see. What is your LIFO assumption in the first quarter guidance?


At this point for the year, we are estimating about $60 million of LIFO expense, related to the carbon steel increases, and we’re not really sure on stainless and aluminum. But the $60 million for the year, would give us a $15 million expense for the first quarter.

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Okay. And Karla, I think I heard you say that there were some headcount reductions in Q4?


Correct.


And I am wondering if you could talk a little bit about the potential margin impact Q1 versus Q4, both on cost of sales and SG&A?


To the extent volumes come back in the first quarter of '08, we would expect to potentially bring back some people, and we typically look at SG&A as a percent of sales. We are not expecting any significant changes from where we were last year on that. On margin, we did say we expect to improve a little bit from last year's rate of 25.3% for the year. We didn't say what we expect it to go to. We just expect it to improve, and would expect that to progress throughout the year. It wouldn't all come in the first quarter.


Okay. All right. And I was wondering, Dave, you had talked a little bit about the fact that you are going to continue to see acquisition activity in '08. I was wondering how would you compare the current pipeline, compared to, say, where we were six months ago, the quality of the assets you are seeing, valuations. Could you give us an update on that?


Sure. In terms of the pipeline, I don't think it has changed much at all from what it was six months ago. Maybe compared to a year ago or 18 months ago, it might be a little less active, but still pretty active compared to whatever normal would be. But I don't think in the last six to nine months there has really been too much change. In terms of the quality of the assets, again, I don't see any big change. We did see last year, primarily in the first half, a lot of stainless-related businesses for sale.


Gee, I wonder why?


That has calmed down. I won't sit here and tell you that that is still going on. Certainly not at the same pace that it was in the first half of last year. We also saw a lot of line-pipe type, oil related businesses, smaller businesses for sale in the early part of last year. And even mid-year in those products.


Probably two out of the three opportunities that we looked at, had something to do with oil-related and stainless.

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Or energy. One of those two things. And so the type of company has shifted. I wouldn't say the quality has shifted. In terms of valuations, our own look or feel for valuations has not changed, and it hasn't changed in quite some time. We are still valuing businesses based upon normalized pre-tax income as we see it, and I don't think sellers expectations have changed that much. I think earlier in the year last year, they may have had a little more lofty expectations, but not anything that prevented deals from getting done.


If I could just ask one follow-up question. This issue just seems to be becoming more relevant for '08, because of the situation with credit availability. And I have been hearing other companies actually Olympic Steel, right before you guys, was talking about how lack of credit at some of the smaller companies, is really creating market share opportunities. I was wondering do you think that that impacted you guys at all in '07, or would you think that that could impact you more significantly this year?


If it's going on, and I don't know that it is, very honestly, Mark, I don't think, if the credit availability, you are talking about at our competitors’ levels?


Oh yes, not for you guys. I guess the example that we were talking about this morning was Kerry Steel, I believe is in liquidation.


We had heard that, yes. I don't know why or what is going on there. Aren't they in Michigan, in Detroit?


Yes.


So if you are related to the auto industry, or the appliance industry, or the building, the residential type products at this point in time, then you are going to be singing a different song, than we are singing here at Reliance. We don't have exposure to those areas. So I don't know if it is a lack of credit, or just bad business conditions that is putting those guys out. Maybe it is both. But I don't think we have seen anything that is telling us our market share is going to grow because our local competitors across the country can't get money to run their business. We don't see that. If it happens, I guess it would be good for us.


In general, because the industry had been pretty favorable for everyone the last couple of years, most companies had credit levels at fairly low levels. So we haven't seen it yet, but as Dave said, if conditions worsen we could start to see that, but there is nothing significant affecting our competitors that we are aware of.


The issue may be more on the carbon side, because prices are up so aggressively, and continuing to move up.

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I wouldn't use Kerry Steel though, Mark, as a model, because their profitability in that automotive market which Dave was alluding to, I am sure had a major impact on the liquidation, not just the fact that steel prices were going up.


One of the things we do keep a watch on with the credit market like it is, and also, Mark, with prices rising like they are, is what is going on at our customer level. Because, for the customer to buy the same ton of steel in April, it is going to cost them considerably more than it did last December. So we do watch that. We don't see any indications of problems there either. And just as a guide, the same type of condition occurred back in 2004. And it was even steeper and more of an increase. And we didn't have any problems with customers during that period. So we don't anticipate it this time, but we are keeping our eye on things.


And in the '04 period, we were coming out of low profitability levels for people in the industry, so if they made it through that period, hopefully they will be okay during this period.


Exactly. Right.


They are buying what they need for the job itself, and I am sure, if anything, they have just spread out their purchases, and are buying more often, so they can be careful of their cash flow position.


I really appreciate all of color. Thanks very much and congratulations on the great results.


Thanks again, Mark.

Operator

The next question is coming from Michelle Applebaum from Applebaum Research. Your line is live.

Michelle Applebaum - Applebaum Research - Analyst

Hi. Just before I ask my question, I was going to mention when we were talking about Kerry, I think one of the things that makes Kerry kind of unique, was that they always seemed to be inclined to position trade. So I think they made big bets on directions, not as many today, there are fewer and fewer guys who are willing to do that given the volatility. My impression is, there aren't a lot of Kerry's waiting to topple over, or am I wrong about that?

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You are right.


We don't see that either, Michelle.


Okay. Just, my sense is that they were almost an old-fashioned type of company where they were trading and positioning. So it seems like fewer companies do that today.


You are right.


Okay. My question is the same question I ask every quarter which is, how does the backlog of acquisitions look right now?


It looks good. There is still a lot of activity. There is new stuff that pops up every day. Well not every day, but every week at least we find or we hear from someone that we were not aware of, and that continues. And we are not interested in everything that pops up. Sometimes it is kind of on the fringes of the service center business, and we are trying to stick to our niche, stick to the things that we know, that if there is an issue in the future operationally, that we know how to go in and fix those things. The service center industry we think we know, and there is plenty of opportunity in that area. So we are not out to broaden out into some other opportunity that might just be related to service centers. When I say the service center industry, I mean the service center/processor industry.


You typically go through and tell me how many, and what the revenue would be if you did everything on your list.


Yes, I have thrown that list away, Michelle. I have not updated that list in the last two quarters. So I can't give that to you, because honestly I just haven't done it.


There probably haven't been any significant changes.


Yes, there is no significant company that has come on or gone off of that list.

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If you had to make a guess in terms of the dialogue with guys out there -- still $15 to $20 billion of potential revenues that are in the various phases throughout the industry, not necessarily Reliance targets, but that would fit your criterion?


Well, I think that is probably a little aggressive because to get to $20 billion, you would probably have to throw in some pretty good size companies that are owned by some private equity people, and I think we have said before we weren't interested in those, and that is still the case. So, is it something that is out there that is possible for someone, even us to do, yes, if you take the list of the Top 100 service centers that comes out every May I guess it is. And again, I will remind you that a lot of the deals that we see aren't even included on that list, so that is why many times we are surprised because a $100 million or $200 million in revenue company will pop up, and they are not on any list anywhere, and so we do get surprised occasionally. But if you add up all the revenues except ours on that list, I guess you would you say it is all possible.


Okay. And you have said that you wouldn't buy certain companies owned by PE guys, or any company?


No, certainly there is some stuff out there that we would be interested in. And there are certain things that we wouldn't be interested in, at least today. Things may change in the future. Things get fixed, and we have not and we don't intend to get involved in buying big companies that need fixing. And we think our time is better spent on other things that would be much more accretive than taking that kind of a risk. But we are perfectly willing to pay more for something that is functioning well, rather than pay less and be consumed with trying to fix something.


I kind of get that. We are in the most extreme supply-driven pricing cycle that I have ever seen. And there was one once before in '86/'87, it was similar, the dollar collapsed, and the Reagan administration started enforcing quotas that we had, and so imports dropped off, partly for economic and partly for non-economic reasons. And the public service centers back then, and there weren't many, and you weren't and most of your peers weren't, but there was margin squeeze, because the mills were tightening, were able to tighten more than the service centers were able to tighten. But I think, I am trying to figure out what risks there are that that is going to happen again? It kind of back then was pretty specific to bigger automotive customers, so I am just wondering what is the risk that we have acceleration, it would appear from reading the multiple middle price increases, for instance in the last three weeks, I think we have had two 10 to 15 in Europe, just both for second quarter, that we have room for 30% higher prices in the U.S. going into the, by the time we finish the second quarter. And if that happens, what is the risk that you are not able to pass that through?


Michelle, this is Gregg. Because we are a spot buyer and spot seller, there really is very little risk with that. We are going to pass those increases through as quickly as possible. The only time that I have ever seen in my personal career that was similar to where we are today is in 2004. And in 2004 we had the highest margins, I think, our Company has ever had. So our customers, as you know, are smaller customers. They buy $1,300 per order, significant increases for them would be $1,450 instead of $1,300. It is not the end of the world for us. The only thing that we are frightened of, as I mentioned earlier, is that if we get too high, will imports come in? It seems that for every increase that is announced here in the United States, there are increases that are announced elsewhere in the world that are even higher. So the spread is still pretty good, which is great. But if there are government projects, bridge work or infrastructure type things that could be delayed, they probably will be delayed.

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And they were in 2004 when prices shot up. There were many big projects that weren't critical, so they were delayed. That is the risk that Gregg is referring to.


Many people question us when we go to Wall Street -- your customer base is small fabricators, machine shops, this and that, aren't you better off doing business with the OEMs? We don't feel that way. We don't feel that way at all. It is just the opposite as far as we are concerned, because those fabricators and smaller job shops, if they lose business with Caterpillar, let's say, they have to make it up someplace, and they are very, very good at being able to do that. And when they replace that business with other business they still buy their metal from Reliance.


Because I am the conservative CFO, and Gregg mentioned the 2004 environment being similar to this, we are not telling you that we are projecting those types of high margins for 2008.


God bless you, Karla.


And in our mind, the price increases in 2004 were also more supply driven as opposed to demand driven. To Gregg's point, similar to today, we didn't see any real significant demand improvements, until the latter part of '05 in carbon products. So the huge increases in '04, we think, were supply driven as well.


And in that '86/'87 timeframe that you were mentioning Michelle, the producers were much more fragmented. Now we have three producers that basically control about 70% of the market, and every product that is made of steel. So the discipline that is here today, as you well know, is quite different than what it was in the 80s.


But I think in that environment the producers kind of squeezed the service centers pretty badly, if you go back and look at the margins, and today, that risk would be even greater. But again that was specific to people more involved with the automotive business, right?


Yes.


They were buying on contracts and selling on contracts. And some of it was hedge issues, and you actually did have that in '04 with some of the parts suppliers, where they had no purchase commitments? They were short on the purchase side, and longer term price commitments, and it had actually been a very positive arbitrage up until '04 when it worked against them. I understand it is very different this time, and I understand that

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your markets in particular have less purchase power, you have just stayed away from the big buyer, which brings up another question, with your largest competitor gone private sort of, and kind of readdressing some issues, are you seeing any impact at all from the change in management at Ryerson, positive or negative?


That is a good question, and I ask our people in the field that quite often. And very honestly at this point in time, we have not seen any material change. We expect that that will happen at some point in time, but I still think that there is a push on reducing their inventories, which you would expect with a PE Company that acquired them, but we haven't seen. I would expect that at some point in time and hopefully in the not too distant future, that there would be more pricing discipline within that particular company. But at this stage of the game, we have not seen it.


And Michelle, just to be clear, you mentioned hedging, and we don't do that. We are not smart enough to hedge and try to figure out what is going to go on in the future. So just to make sure that everybody knows, and I know you know, that we don't hedge. We don't try to outsmart the market. No. We are not traders.


If you are not smart enough to trade, then why do we ask you what your forecast of steel price is?


I have no idea why you ask us that.


I was just wondering. It made me scratch my head. I will let someone else take a turn. Thank you.

Operator

The next question is coming from Timna Tanners, UBS, your line is live.

Timna Tanners - UBS - Analyst

I really appreciate the great color. Two questions, one is, I wanted to make sure I understand on the guidance for just the comments on demand? Does that really affect your outlook for volume more than margin, or a little bit of both?


A little bit of both.


So you are confident in your ability to pass through higher cost, but is there something that, is it because of volumes going down, that you might be losing some economies of scale, or maybe I am just confused?


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I think if you are comparing to the fourth quarter, Timna, we are certainly looking for, on an operational basis-- and we run the company on an operational basis-- we are looking for a meaningful increase in our gross profit. But it doesn't translate dollar for dollar because we are anticipating a LIFO impact on the first quarter as Karla mentioned, of $60 million pretax, which is somewhere around $0.13 per share. So we are looking for improved volumes compared to the fourth quarter. We are not comparing to the first quarter of last year. So do expect volumes to be up. But to answer your question, it is both. It is improvement in volume, it is improvement in revenue dollars. It is improvement in gross profit. It is improvement, operating expenses being somewhat consistent with what they have been, they have been pretty consistent as a percent of sales. Fourth quarter it was higher because of the seasonal impact on revenues.


And the other thing too, Timna, looking back at 2007 we talked about competitive pressures and some of the pricing volatility, we saw some margins different than we would have anticipated, based on the factors going on during the time.


Which was primarily inventory reductions across the board.


Right. Which we think for the most part has happened, but some companies are still working on that. So we are just a little more cautious, I guess, about the amount of gross profit improvement that we might see because of those things.


Okay. That really helps. Thanks a lot. Just to understand the philosophy, or the way you approach your buybacks, you mentioned 2007 was the first time you bought back since 2000, and then in 2008 so far you have already bought back more than all of 2007. When you look at buybacks do you say, where is our stock price, do you say, what are the alternative investment opportunities? Do you say how does our balance sheet look? Can you talk us through a little bit how you approach the position to buy back shares?


We actually look at all those things Timna, as you might expect. And we look at what our cost of money is. We look at if we were to make an acquisition valuing a company the way that we would typically value a company, what type of accretion do we get from that acquisition, and how does that compare with the accretion we might get in our EPS, by taking the same amount of money and buying our stock back at different prices. And an interesting note is that, if we assume on larger transactions I think we have told everyone that we target maybe a 12% pretax return on investment for a large transaction, off of a normalized pretax income number. We can buy our stock at $50 a share and have double the accretion that we would get, compared to buying a company and getting a 12% pretax return. If we can get double the accretion then that is meaningful. That is something. Now we also know that buying your stock back is not a forever kind of a thing. You are not growing the company. It is like cutting expenses. You can't do it forever. So we would prefer to continue to find acquisitions, and grow our business internally and through those acquisitions. But when there is an opportunity out there to repurchase some of our stock, we will do that on an opportunistic basis. We will look at our balance sheet leverage. We will look at the deals that are out there, that we are already working on or that we think might just pop up in some reasonable time because if we had to make a choice between buying our stock back and acquisition, we would choose an acquisition. But given our leverage position currently, that is not a choice that we have to make, because we can do both.


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We were able to repurchase the stock because our cash flows were so strong, that it didn't have any increase in our leverage position, and we still had plenty of availability to continue with our growth activities. So we will definitely look at that. We are very selective, and look at a lot of the factors whenever we evaluate this.


Okay. Thanks a lot.

Operator

The next question is coming from Timothy Hayes from Davenport and Company.

Tim Hayes - Davenport & Co. - Analyst

Good morning.


Good morning.


I just have one question. Karla, can you repeat what the sequential change for same-store sales for tonnage and average selling price, please?


Yes, compared to the third quarter we had a 6.6% decrease in tons sold, and average selling prices were flat.


Very good. Thank you.

Operator

The next question is coming from Bob Richards from Longbow Research.

Bob Richards - Longbow Research - Analyst

Good afternoon and thank you for taking my call.


Sure, Bob.


Hey, I appreciate your comments or color on the end markets for aluminum being strong, and with the understanding that an increased base price is better for the aluminum sector, or your aluminum space than not, what is your outlook on base aluminum prices for '08?

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Our outlook is that we really don't think that -- I think Midwest spots is at $1.33 a pound, or it was yesterday -- we don't think that is going to be sustainable going forward. Our thought process is for ingot to be somewhere in the neighborhood of $1.10 and $1.20 a pound.


And supply is driving the issue now with the outages in Africa?


Yes.


It is probably more specific later in the supply side. You get the speculators and the traders in there, and they can build a case of, we don't know that the reaction to this power issue is--


Real.


Is real. Yes.


Okay. Thanks very much, and great quarter.


Thanks, Bob.


Thank you.

Operator

There are no further questions in queue.


Okay. Great. Thank you all for taking your time to listen to us, and we look forward to another challenging and exciting year, and we will talk to you in April. Thanks again. Good bye.

Operator

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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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Economy & Finance

reliance steel & aluminum 2007_Q4_Conference_Call_Transcript