Michael Cummings - Executive Vice President & General Manager-East Coast, Alpha IR Group Michael J. Hartnett - Chairman, President & Chief Executive Officer Daniel A. Bergeron - Chief Financial Officer, Director & Vice President.

Walter Liptak - Seaport Global Kristine Tan Liwag - Bank of America - Merrill Lynch Steve Barger - KeyBanc Capital Markets, Inc..

Good day, ladies and gentlemen, and welcome to the RBC Bearings Fiscal Second Quarter Earnings Conference Call. At this time all, participants are in a listen-only mode. Later there will be a question-and-answer session and instructions will follow at that time. As a reminder this conference is being recorded.

I would now like to turn the call over to Michael Cummings of Alpha IR Group. Sir, please begin..

Good morning, and thank you for joining us for RBC Bearings Fiscal 2016 Second Quarter Earnings Conference Call. With me on the call today are Dr. Michael J. Hartnett, Chairman, President and Chief Executive Officer; and Daniel A. Bergeron, Vice President and Chief Financial Officer.

Before beginning today's call let me remind you that some of the statements made today will be forward-looking and are made under the Private Securities Litigation Reform Act of 1995. Actual results may differ materially from those projected or implied due to a variety of factors.

We refer you to RBC Bearings recent filings with the SEC for a more detailed discussion of the risks that could impact the company's future operating results and financial condition. These factors are also described in greater detail in the press release and on the company's website.

In addition, reconciliation between GAAP and non-GAAP financial information is included as part of the release and is available on the company's website. Now, I will turn the call over to Dr. Hartnett..

Thank you, Mike, and good morning. Net sales for the second quarter of fiscal 2016 were $148.7 million, versus $112.6 million for the same period last year, a 32.1% increase. Our aerospace markets increased 59.6% on a year-over-year basis and our industrial markets were down 2.4%.

The second quarter of fiscal 2016 sales of industrial products represented 33% of our net sales, with aerospace products at 67%. I'd like to take a few minutes and update you on the Sargent acquisition. The assimilation of the Sargent business is going well.

Sargent now accounts for approximately 30% of our total sales and integration is definitely ahead of plan. We are absolutely delighted to find that some businesses in the group were capacity constrained and we are busy working through the kinks in order to flow product to the customers at the rate that matches demand.

Other area where we focused is procurement. First, combining Sargent's raw material purchases with those of RBC is yielding the intended and obvious benefits. Secondly, and even more importantly, Sargent has a great dependency on external businesses to supply manufacturing services for components that in many cases RBC is already tooled to supply.

We are working through these procurements with a make versus buy meter and a plan to convert $5 million per year of these purchases to RBC in-sourcing each year over the next few years. Let's talk a little bit about cost control management.

As you know, RBC formally budgets our businesses every quarter and issues to management a quasi P&L statement daily showing revenue and daily expenses. This allows visibility and close control of expenses on a business-by-business basis, absolutely one of the tools needed to run a variable-cost business.

This is all carefully designed around achieving a gross margin objective, something similar to zero-based budgeting. Sargent was once a smaller division of a larger company and had not developed this level of spending controls as a result.

This process always produces big benefits wherever we implement it and it's producing benefits for us now at the Sargent plant.

The Sargent plants are responding well to RBC production management methods and consequently we expect to see continued margin improvement over successive quarters as we work through the issues sometimes pricing, sometimes methods that underlie the opportunity. It seems the list of improvement items can last a very long time.

In any event, it appears that over time this business can demonstrate margins that are much better than their historical averages. Relative to our aerospace business, sales were up 59.6% on a year-over-year basis for the quarter. Aerospace OEM increased 66.8% and aerospace distribution and aftermarket increased 28%.

On an organic basis, including foreign exchange impact, aerospace distribution and aftermarket increased 2.8% driven by the commercial aircraft aftermarkets. Aerospace OEM sales decreased 6% driven entirely by defense.

Our defense customers contracted as a result of lumpy demand in defense helicopters, which is more timing issue this year than lost volume. We plan to see this recover later in the year as a result of where the orders are placed in our annual plan. Our commercial aerospace OEM was up 1% driven by the main aircraft builders.

This is another area where demand will accelerate. Our industrial business was off 12.7% organically. A component of this drop is constrained plant throughput, as alluded to earlier, accounting for about a third of the decline. Another component is lumpiness in demand for train components.

They were very strong last year, their weakest period, and we expect to see them stronger next year. This accounts for another third. And finally, weak demand from mining and oil markets rounds out the total.

Adjusted gross margin for the second quarter of fiscal 2016 was $56.4 million or 37.9% compared to $53.5 million, or 38.6% for the same period last year. We're expecting to see sales in the third quarter in the neighborhood of $145 million compared to $106.3 million last year.

Keep in mind this is our shortest quarter in production days due to the holiday season, which has a direct impact on the top line sales in the quarter, and there's some caution built into this projection as a result of the constraints that we talked about earlier.

Our fourth quarter has many more production days based upon the way our accounting calendar is structured and so you really have to look at the two quarters as being representative of the last six months of our business. I'll now turn the call over to Dan, who will provide more details on financial performance..

Okay. Thanks, Mike. SG&A for the second quarter of fiscal 2016 was $24.9 million compared to $18.5 million for the same period last year. As a percentage of net sales, SG&A was 16.8% for the second quarter of fiscal 2016 compared to 16.5% for the same period last year.

Excluding the impact of Sargent acquisition of $4.6 million, SG&A year-over-year increased $1.8 million, which is mainly due to $0.2 million in stock compensation expense, personnel-related expenses of $1.1 million, $0.3 million in professional fees and $0.2 million in other expenses.

Other operating expenses for the second quarter of fiscal 2016 was expense of $3.6 million compared to expense of $2.9 million for the same period last year.

For the second quarter fiscal 2016, other operating expenses were comprised mainly of $1.1 million in acquisition-related costs, $0.2 million in integration and restructuring costs, $2.4 million in amortization of intangibles and this was offset by $0.1 million in other income.

Operating income was $23.6 million for the second quarter fiscal 2016 compared to operating income of $18.3 million for the same period in fiscal 2015. On an adjusted basis, operating income would have been $29.2 million for the second quarter of fiscal 2016 compared to $24.7 million for the same period last year.

Adjusted operating income as a percentage of net sales would have been 19.6% for the second quarter of fiscal 2016 compared to an adjusted 21.9% for the same period last year. For the second quarter fiscal 2016 the company reported net income of $14.5 million compared to net income of $13.2 million for the same period last year.

On an adjusted basis, net income would have been $17.8 million for the second quarter of fiscal 2016 compared to net income of $16.5 million for the same period last year, a growth rate of 8%. Diluted earnings per share was $0.62 per share for the second quarter fiscal 2016 compared to $0.57 a share for the same period last year.

On an adjusted basis, diluted earnings per share for the second quarter of fiscal 2016 would have been $0.76 per share compared to an adjusted diluted EPS of $0.70 for the same period last year, a growth rate of 8.6%.

Turning to cash flow, the company generated $18.1 million in cash from operating activities in the second quarter fiscal 2016 compared to $17.8 million for the same period last year. Capital expenditures were $4.5 million in the second quarter fiscal 2016 compared to $8 million for the same period last year.

In the second quarter of fiscal 2016, the company paid down $20 million on a revolving credit facility, $5.6 million under term loans, and repurchased $5.5 million of company stock. The company ended the second quarter fiscal 2016 with $44.1 million of cash on the balance sheet.

I'll now turn the call back over to the operator to begin the Q&A session..

Thank you. Our first question comes from the line of Walter Liptak with Seaport Global. Your line is now open. Please go ahead..

Hi. Thanks. Good morning, guys..

Hi, Walt..

Good morning, Walt..

Mike, I wanted to ask about the commercial OE business. It looks like excluding or just on an apples-to-apples basis it was up 1%, and I wondered if you can give us some color on what some of the moving parts might be in getting the low single-digit growth like that. And you also mentioned that you expect the demand will accelerate.

I wonder what kind of programs you're looking at and what kind of rate of growth would you expect over like the next 12 months?.

Yes, well the industrial OEM, is that the business you're referring to?.

Sorry, no – the commercial OE business. So the aerospace business that you mentioned was up 1%..

Right.

Why is that going to accelerate, is that the question?.

Yes. I guess that and any color around why we're not seeing better growth last quarter..

Okay, sure. Well, first of all, it would have been flat year-to-year on aerospace OEM with the exception of where we're going to ship orders to the defense guys.

We have the orders; it's just a matter of at what quarter are they coming out so they're going to come out in the last two quarters and they didn't come out in the first two quarters, that sort of thing. So, that brings it flat.

What's going on there, Walt, is both Boeing and Airbus are going through major contract negotiations with their sub suppliers in terms of placing new contracts with those suppliers over the next three to five years.

And as a result, there's a lot of moving around in terms of who's going to be the subcontracting supplier to Boeing, who picks up which contract, and who exits which contract. So there's other people absorbing new contracts and there's a certain subset that are losing contracts. Now, those sub-systems have our bearings in them.

So the guys that are losing contracts are working down their inventories and the guys that are absorbing the contracts are starting to ramp up. That transition has been occurring here for the last six months. And obviously we've been a part of this too, because we're negotiating a bunch of contracts with all of these folks at the same time.

So, what we're seeing is a delay in order placement as the new guys come online. Some of these guys don't even realize there's bearings in their componentry, and we have to make sure that they understand not only are there bearings but we're the supplier of those bearings and sort of get everything tied together in ink. So that's the delay mechanism.

And we're seeing that now break loose, and so I think the balance of year for the aerospace OEM is going to strengthen every quarter..

Okay. Well it sounds like going into the December quarter you may continue to see some of the delays from the rolloff of some of your subcontractor customers.

Is that true?.

You know, I didn't parse it out to what component of the aerospace OEM is going to contribute to that $145 million. I know the $145 million is sort of mitigated because of some of the constraint problems that we have in the Sargent plants, so there's some caution in that number to begin with..

Okay, got it. And you made some positive comments on Sargent and they're taking to some of your manufacturing methods and focus on gross margin.

I wonder if you can help us understand where those gross margins are right now? Did you see improvement with Sargent's gross margins in the quarter and maybe what you think you can get those to?.

Well I think when you look at the Sargent businesses they have some very good businesses and they have some business that overall when we purchased the company weren't contributors to the overall EBIT number. So the good businesses, we expect to see those margins expand every quarter.

The businesses that we're marginal we expect to see those margins increase and we are seeing some of those margins increase but it will be a more gradual increase, number one; based upon some of the existing contracts that they have to execute to and number two; just because of the markets that they're in.

Now, some of our sales – I don't know if you can call it a shortfall to the analyst estimates on our aircraft sales was in part the result of price pruning.

And what I mean by that is when you have a marginal business and you're selling a certain mix and you don't have the skills or the tools to sell that mix, you often sell it at less than your manufacturing cost which is not a good thing.

So the way you fix that is you decide which parts you're good and at which parts you are not good at, and the parts that you're not good at, you raise prices.

And if those parts stay in your mix, then they're profitable, and if they don't, you really don't miss them because you're not good at making them anyway and they're not material to your business plan. So, we're executing the price pruning strategy now with some of these marginal businesses and that will continue..

Okay. All right. Great. Thank you..

Thank you. Our next question comes from the line of Kristine Liwag with Bank of America Merrill Lynch. Your line is now open. Please go ahead..

Hi. Good morning, everyone..

Hi, Kristine..

Good morning, Kristine..

Mike, broadly speaking as a result of the shuffling of the Boeing subcontractors, are you seeing a net increase or a net decrease on your shipped sub-contact?.

Good question. We haven't – I'm just running through – we haven't seen any significant losses. We haven't seen any significant losses. We have seen some pickups in some of the new products that we've introduced, so I would say, we're net positive..

Great.

And the price pruning that you just mentioned, is this related to just Sargent? Or is this also legacy RBC Bearing?.

Well we've always done that with RBC. I mean you got to – when you're in the manufacturing world, you really have to decide what you're good at and where you're going to – what mix you're going to support with your technology and your capital programs. You just can't be everything to everybody.

And so, once you decide how you're going to build out your revenue base and what's going to be core to that revenue base and what you need for technology and capital and human asset, I mean, that's your business plan. Anything that's sort of outside that core is extraneous and needs to be priced accordingly..

So, is there a way to quantify how much of an impact that would be on top line? Or is it too early? And maybe a different question to ask that question would be, what's your expected gross in aero for the second half of fiscal year 2016?.

I think those are two different questions. I think on the Sargent side of the fence that will probably have a $5 million per year, maybe a little bit more impact on revenue. But that should lead to a substantial improvement in margin. And our aerospace business for the balance of the year is a number I don't have in front of me right now, Kristine..

Great. And one final question in terms of adjusted gross margins, when you first closed the Sargent deal when we looked at the last 12 months, 2014 pro forma numbers, your adjusted gross margins were more like 36.2%. But then now as we look through the first half of fiscal year 2016, the first quarter was 38.7% and this quarter was 37.9%.

Is there a reason why we shouldn't think that full year 2016 gross margins should be between 38% to 39% level on an adjusted basis?.

Yeah. I think we're in that ballpark. Just to let you know, to look at it from the six-month standpoint through the second quarter because I'm getting Sargent into the loop here, you can say (22:05) RBC or organic gross margins are at 39.2% over last year of 38.7%.

So even though we had a contraction in our business, we were able to still get the cost out and maintain and increase those gross margins. But Sargent, it's a combination too, as Mike talked about.

They're averaging around 35.8%, but some of that is mix and then some of it is contributed – I'd say half of it is contributed to the cost savings and improved manufacturing methods in the plants..

Great. Well, thank you very much..

Thank you. Our next question comes from the line of Steve Barger with KeyBanc Capital Markets. Your line is now open. Please go ahead..

Hey, good morning, guys..

Good morning, Steve..

Good morning, Steve..

For the price pruning exercise you mentioned, are any of those non-contributing product lines tied up in long contracts or you able to re-price your exit in pretty short order?.

It's both, Steve. I mean some of them have long contracts. Some of them have price openers. Even though the contract is long, there's price points that open up in various years where some of the corrections can be made and some of the mix corrections can be made. But I think by and large it's 80/20 with 80% of it under our control..

Got it. And I remember the transition for you in the legacy business to making versus buying had a very positive effect on your own results a few years back.

Can you talk about how big the external dollar spend is at Sargent that you can eliminate and give a little more detail on cadence?.

Yeah. Well, the external spend historically has been 50% of their sales. It's a huge number..

That is a huge number..

It's a number that you know that was one of the magnets that attracted us to the business. And then when we saw what the componentry was and how we were tooled, that was very exciting too.

Now, so I think what we've done is we've set up an objective here to work with between the Sargent purchasing and the materials management people and the RBC purchasing and materials management people, a $5 million per year rate of assimilating the Sargent external purchases into the RBC plants.

So I'm assuming that the Sargent subcontractors make money selling those products to Sargent. And so there's got to be a lot of latent profitability tied up there. And I would say that the first $5 million is the lowest hanging fruit and each year it gets a little bit more difficult based upon mix and based upon how we're tooled.

We're not seeing any reason why the first two or three years can't be very successful with this program..

Yeah. It sounds like.

Now, is the $5 million number based on capacity issues relative to taking that volume internal? Do you have to add personnel costs? Or can you basically just integrate that into production with no step-up costs beyond the material?.

Yeah. I think we just integrate it into production. I mean, there might be some personnel as here and there but it's not going to be a significant number..

Got it. And....

I mean, it's a major cost absorption equation for us..

So I know you guys are good planners.

The $5 million number was that based on capacity or just kind of it seemed like it was a reasonable run rate? What was the thought process?.

Well, the thought process there was to set an objective that could be easily achieved in the first year so that these guys got some experience working with the RBC plants, knew which plants were good at what processes and so there's a sort of a learning curve here between Sargent procurement and what they know about RBC.

So the first year's $5 million was a – seemed like a reasonable goal that could be readily met..

Understood. More broadly, from other companies so far this quarter on the industrial side, we've heard about trends for some products continuing to decelerate into October from September.

Are you seeing that in some of your lines or can you talk about where things are relatively better or worse for this quarter and maybe into the back half of your fiscal year?.

Yeah. Well I think if we start out with the business in Switzerland, that business is down and it's the down but steady and it's the impact the currency valuation had when they remove the peg between the Swiss franc and the euro last January.

That dampened the demand for our product from our customers who are the Swiss machine tool producers, but that demand seems to be at a lower level and very steady. So we're not expecting anything unusual there and it's with the autos running at 17.8 million, 17.9 million, 18 million cars a year sold in the United States.

And that's a lot of machine tool component consumption. So I think in part that's driven by auto demand, so we're feeling okay there. The mining, we're looking at our mining numbers and it seems to us that about 80% of our mining business right now is going to the OEM who is supporting his aftermarket.

So, I think as long as the mines are working and the copper and the iron is being mined and the trucks and shovels are being used, we're expecting the demand to be low there but stable. And in oil and gas, I think, oil and gas is pretty low already. I think the guys that can survive at these levels seem to be surviving.

We really expect oil and gas to come back extremely strong and we're trying to position ourselves in that market to be able to support it properly when that happens..

So, just overall, would you expect your industrial business to be up, and I guess this is tough to know because inclusive of Sargent, but organically, would you be up or down on industrial in two half 2016 versus last year?.

I don't have that comparison with me. I don't think we're going to be any stronger than we were in the first half..

On a dollar basis..

On a dollar basis..

Got it. All right. Thanks for the time, gentlemen..

Yup..

Thank you. I'm showing no additional questions. I would now like to turn the call over to Mike Hartnett for closing remarks..

Okay. Well, in closing, I want to thank everyone for their continued support for RBC Bearings and participating in today's discussions and for making RBC Bearings part of your investment strategy. Thank you very much..

Ladies and gentlemen, this does conclude today's program. You may all disconnect. Everybody have a wonderful day..