WEG SA

BOVESPA:WEGE3

Earnings Call Transcript 2018-Q2

[Operator]

Good morning, and welcome to WEG's conference call to discuss the results of the second quarter 2018. We would like to inform you that we are webcasting this conference call accompanied by the slides on our Investor Relations website at ri.weg.net. And upon completion, the audio will be available on our IR website. [Operator Instructions]

Any forward-looking statements contained in this document or any statements that may be made during this conference call regarding future events, business prospects, operating and financial projections and goals and WEG's future growth potential, constitute mere beliefs and expectations of management based on the information currently available.

These statements involve risks and uncertainties and therefore, depend on circumstances that may or may not occur. Investors should understand that general economic conditions, industry conditions and other operating factors may affect WEG's future performance and lead to results that differ materially from those expressed in such forward-looking statements.

We would like to remind you that this conference call is being recorded conducted in Portuguese with simultaneous translation into English.

With us today in Jaraguá do Sul are André Luís Rodrigues, Chief Financial Administrative Officer; Paulo Polezi, Finance and Investor Relations officer; Wilson Watzko, Controller; and André Salgueiro, Investor Relations manager at WEG. Please, Mr. André Rodrigues, you may proceed.

[André Rodrigues, executive]

Good morning, everyone. It's a pleasure to be with you again for the conference call to discuss the results of the second quarter of 2018. I would like to start by highlighting that in this quarter, we observed the continuity of the business dynamics that occurred in the first quarter of the year, highlighting the following points.

The first point is the strong revenue growth, 34% in consolidated terms, 35.6% in the domestic market and 32.6% abroad. In the domestic market, this growth was driven mainly by the economic recovery by the greater share of the solar generation plants businesses and by the recent acquisition of the steam turbine business, TGM, which we started to consolidate as of March 2018. And the foreign market growth is still concentrated on the sales of short-cycle equipment, but we have already identified some opportunities in major industrial projects that require long-cycle equipment. In addition, the consolidation of the new transformers business in the United States has helped drive revenue growth.

The second point, capital margin was within our expectations, showing a slight improvement over the first quarter 2018, but standing below the margin of the second quarter 2017, impacted by the rapid growth of the solar business -- solar generation business during maturation and with the lower operating margins and by the acquisition of the transformers operation in the United States.

Finally, I would like to highlight again the generation of operating cash, which reached BRL 643.5 million in the first half of 2018 and the growth of return on equity in the annual comparison, which is WEG's main performance indicator.

Then going to Slide 4, we have more details of ROIC, which presented growth of 1.6 percentage points in relation to the second quarter 2017, reaching 16.8%. The growth in the after-tax operating income is a result of revenue growth and improved operating performance. This growth more than offset the growth in the capital employed, which is necessary to support business growth, both from recent acquisitions and working capital investments, fixed assets and intangible assets made over the last 12 months.

I would like to remind you that on the last WEG Day, we announced a small adjustment in the ROIC methodology. And in this slide, we present the new calculation formula. For purposes of comparisons, we also made the same adjustment in previous quarters. Our IR team is available should you have any questions about this process.

I now turn the call over to Paulo Polezi to continue the presentation.

[Paulo Polezi, executive]

Good morning, everyone. Turning to Slide 5, we present the evolution of the business areas in the different market. In the areas industrial, electrical and electronic equipment in Brazil, sales are still concentrated on short-cycle products, especially low-voltage motors and serial automation equipment. The solar generation business was the highlight in GTD, gaining relevance in the recent months, now counting on 3 important solar projects added to our portfolio.

In addition, this March, we have been consolidating the operation of TGM in this business area. As for engines for domestic use, there was a small downturn in revenue, reflecting the dynamics of consumption in Brazil, impacted by the truck drivers' standstill this quarter. The performance of the paint business reflected the performance of industrial and consumer goods markets, which intensify the recovery process in recent quarters.

Abroad, we show revenue growth in all areas, with the exception of engines for domestic use where we can observe the specific impact on the operations of China and Argentina. In electronics, growth continues to be driven by short-cycle products, and countries in Europe, Asia and Africa posted significant revenue growth this quarter.

In addition, projects increased capacity and build new plants, which also demand the long-cycle products, continue their growth trajectory, mainly in the oil and gas industries, infrastructure and pulp and paper production. In GTD area, revenue growth was driven mainly by the consolidation of the new U.S. transformers company. As to paint, revenue growth in the foreign market reflects the search for new customers, mainly in Latin America with products already consolidated in Brazil.

Slide 6 shows the evolution of EBITDA in second quarter 2018, in which the main highlight in the quarterly comparison was revenue growth. EBITDA increased 25.5% in relation to the second quarter 2017, with a reduction of the EBITDA margin to 15.2%. As André commented on, this performance was better than the previous quarter and was within our expectations. And the recovery of the EBITDA margin is happening naturally, with the integration of the new acquisitions and the maturation of the new business in GTD.

On Slide 7, we provide details on the net financial result, which was negative BRL 6.5 million. The decrease in the quarterly comparison is mainly due to the lower interest rates received on our cash position. It's worth mentioning that although they negatively impact our financial results, the interest rate reduction is very positive for the company's business as it reflects a more stable economic environment with a higher consumption trend and consequently, a higher level of industrial investment.

On Slide 8, we have the analysis of the cash flow. Cash generation in operating activities reached BRL 643.5 million in the quarter, an increase of 3% when compared to the same period of the previous year, mainly as a result of better operating performance. Investment activities consumed BRL 407.6 million in the quarter, reflecting the recent acquisition of TGM and the movement of long-term financial investments. Finally, financing activities consumed just BRL 724.2 million in the period, reflecting the settlement of loans, the payment flow of interest on equity and dividends in the quarter.

Finally, on Slide 9, we show the investments of the last quarters. In the second quarter 2018, investments reached BRL 92.6 million, out of which 47% went to Brazil and 53% to production units abroad. It's worth mentioning that the normalization of the market behavior will require that we gradually increase disbursement in modernization of production capacity and purchase of new machinery and equipment.

With that, I wrap up my part and turn the call back to André.

[André Rodrigues, executive]

Thank you, Paulo. Before beginning the question-and-answer part, I wanted to reinforce some points. As anticipated in the last -- latest releases, revenue growth and the continued focus on ROIC will be the key drivers for 2018. Revenue is expected to grow both organically with improved global industrial investments and the new businesses, such as solar generation and acquisitions that increase our competitive advantage, such as the recent acquisitions of WEG transformers in the United States and TGM, for example.

The second point is that in the external market sales, recovery is already a reality. Industrial production is growing in the main global market, and the improvement in short-cycle products continues to be driven by the OEMs. In addition, important industries continue their recovery fast, with the emergence of project opportunities involving long-cycle equipment. I must mention that we are watching closely the increase in exchange rate volatility where a weaker real allows us an additional budget to increase our competitiveness, which we can and will continue to use to grow.

In Brazil, the diversification of our business should continue to contribute positively to revenue growth. After the recovery in 2017 of the area of electronic industrial equipment, in 2018, we have the business of solar generation and acquisition of TGM contributing to the growth of GTD revenue.

We can now start the Q&A session. Operator, please, you may continue.

[Operator]

[Operator Instructions] The first question comes from Mr. Alexandre Falcao, HSBC.

[Alexandre Falcao, analyst]

I have 2 questions. The first one is related to the domestic market. I would like to know if there was any impact due to the truck drivers' strike. It could have been even impacted worse as we saw as the consequence in Brazil. And in terms of GTD, what's the total in terms of solar area and the rest? And what can we expect for the quarters to come?

[André Rodrigues, executive]

This is André speaking. Well, talking about the truck drivers' strike. Of course, there was a specific impact on the week of the strike, but it was not significant considering the nature of our products when the clients usually place the orders in advance. We had some [ stills of ] some lines because there was no raw material. At this time, once again, I would like to say that the diversification model of WEG was very important so that we could have -- avoid impact. For example, for electrical motors, you have the factory of rotary stator, and we then -- we suffered some problems and we focused on some other areas then. If we considered only the impact due to the days that were not -- came to a standstill, it affected some inventory levels, but we are recovering this along the year. I believe that this movement may impact the confidence of some entrepreneurs and some analysts because there was a downturn of the GTD that is projected for the year. WEG is a global company and the foreign market has been having a very good performance. Regardless of the Brazilian situation, if we to consider the impact in terms of margin, I would say that it was 0.3 percentage points on the EBITDA. This was a consequence of this strike, which was not due to the idleness at the plants.

[Alexandre Falcao, analyst]

What about the GTD?

[André Rodrigues, executive]

Yes, Paulo will talk about the GTD.

[Paulo Polezi, executive]

This is Paulo speaking. The solar area, in its internal -- in its market, about BRL 280 million was in addition to what we had. And part of it, a large part of it, was the solar field. We also have the distribution of a solar energy included in this amount. Most of it comes from the mills, from the plant, but both has to be considered in the total amount. You asked about the future perspectives about the solar field. As we said in the beginning of the call, today, we are delivering 3 projects, 3 solar plants, so the 3 plants are underway. And we also have to [ see there ] the distributed generation of energy in different states in Brazil. And we want to add something around BRL 500 million to BRL 600 million for 2018. And in terms of backlog, the delivery of the projects are happening now, and they are likely to be happening in a linear fashion this year. And the 3 projects that were included in the portfolio will be completed up to the first quarter of 2018.

[Alexandre Falcao, analyst]

Wonderful. Could I ask another question in terms of revenues abroad, in terms of Mexico? What can you disclose to us in terms of verticalized project?

[André Salgueiro, executive]

Falcao, this is André Salgueiro speaking. And for this year, we approved the CapEx for the market abroad, which is focused on Mexico, so we expect to continue the project. And according to our schedule, we are going to start testing the end of the year, and we plan to start production in the beginning of the year. For China, we have completed what we had planned, but China has been performing very well in times of market and production. So we are evaluating whether or not we will have to make a new investment in China. And we're discussing investing an additional $22 million to increase the capacity of production in China.

[Operator]

The next question comes from Daniel Gewehr from Santander.

[Daniel Gewehr, analyst]

I have 2 questions. The first one is related to ROIC, which was very strong this quarter, and I would like to understand what is the percentage we spend. If we look 3 years ahead of us, is that a goal to intend to reach 20%? And if you give us a breakdown, what would be the ROIC in Brazil and ROIC abroad, so that we can have a clear vision on the ROIC? And I would like to ask a follow-up on Falcao's question related to solar field. You mentioned BRL 500 million as an additional revenue. So I would like to understand what's the potential of solar activities as a whole?

[André Rodrigues, executive]

This is André speaking. So let's talk about ROIC then. First, we do not disclose a long-term covenant for ROIC, but our expectation is that it will stand around 15% or 17%. And this is what we have always mentioned and this is our main indicator of performance of our company. In relation to your question related to the breakdown of ROIC in Brazil and abroad, we do not have a goal in relation to this aspect. But it's important to say that at WEG, every business unit, regardless of whether it is production or commercial, it has its individual ROIC target. And the value that's established for each unit will depend on the level of verticalization, as we mentioned in Falcao's question. The point is that the more mature units have a certain level, which is already established, and we have opportunities of improvement in the units that are under development.

[Paulo Polezi, executive]

Daniel, this is Polezi speaking as for GTD and solar, to provide more details on them. For 2019, as for solar mills, we do not have anything contracted. Of course, we are working on this. At this time, what we can talk about is the distributed generation. For example, in 2017, this area added BRL 50 million in our sales. And this is likely to double in 2018, and we expect that this is going to continue to grow rapidly in the years to come in Brazil. What I would also like to point out, still talking about solar energy. The latest project that we are providing or delivering is still related to the energy auction of 2015. So we have the visibility to implement projects of other auctions that were much stronger. And our perspective is that this business is going to continue to be positive in the future and the orders are likely to be captured as well. So this is the visibility that we can share with you in terms of solar energy.

[André Rodrigues, executive]

And to complement, this is André speaking, solar may vary from 6 to 8 months. So there's still the possibility of being part of projects and include them in a portfolio for next year. We still do not have this visibility now, but as Paulo said, there are many opportunities out there in the market.

[Operator]

The next question comes from Ricardo Alves, Morgan Stanley.

[Ricardo Alves, analyst]

My question is not going to be related to GTD. I would like to talk about industrial equipment. We are trying to understand a little bit better. It's good performance in Brazil. We saw that there was a very strong evolution in the annual growth when compared to the growth in the first quarter. And if we consider the rupture or the disruption due to the truck drivers' strike and also in terms of pricing, has there been any relevant changes in pricing or maybe a better mix, I don't know, maybe for the long-cycle products being more relevant? I would like to understand the good evolution for this area.

[Paulo Polezi, executive]

Ricardo, this is Paulo Polezi speaking now. To answer your question, I'm going to step back and look at the first quarter this year wherein the performance in this business area, motors and automation more specifically, it was a little bit flat in relation to last year. And in this semester, we can see a growth. Automation was more stable because there is a balance in terms of serial products and engineered products of long cycle. And the first quarter was weaker and this is something that did not happen in the second quarter. Automation continues to perform well in terms of serial products and also for panels and other equipment that we refer to as engineered products. And motors performed quite well with the growth of 14%. So we can see that this is a process in a year when the economy is -- still have changes, is not very solid, but in our client base, we haven't felt any changes. So we can see that we have some stability. In this quarter, automation, the engineered part is the part that made the difference.

[Operator]

The next question comes from Rogério Araújo from UBS.

[Rogério Araújo, analyst]

My first question is related to GTD in Brazil. We know that the portfolio of wind products will be seen the end of the year. Can you give us a breakdown what you have planned for the year in terms of portfolio?

[Paulo Polezi, executive]

Rogério, this is Polezi speaking, okay. For the wind power, we have already announced in other moments, our portfolio is very similar to what we had in 2017, about BRL 700 million. For this quarter, it was a bit stronger in terms of delivery. If you divide this value in equivalent quarters, you can see that the second quarter was over 200 million, and this is due to the high concentration of deliveries and some improvements in some plants. This is the portfolio. There's nothing new. What was new is that we concentrated a little bit more on the second quarter in relation to the previous quarters.

[Rogério Araújo, analyst]

Okay, perfect. My second question is relating -- related to the markets abroad. WEG has been watching closely the market outside or do you have some share in some other regions? Have you been gaining shares abroad? If you could disclose to us in which segments and where are the markets you have entered into.

[André Rodrigues, executive]

WEG's share in the foreign market, we shared this information on WEG Day. We have -- we delivered materials with important details. And this is a process of evolution. Of course, we have strong share everywhere we operate. In the United States, the region outside Brazil where we have the greatest share, we stand as the second position, competing with Beloit. And depending on the country, we stand -- we rank as the third or fourth. And Asia, as to motors, we can see a very fragmented market, and we have been working on this market. We're still in the beginning of this product -- in this process. And in China, we would have a share around 2%. So we are working on recovering this share. And this improvement that we have reported this year will improve to increase the share -- our shares outside Brazil as well.

[Rogério Araújo, analyst]

And the last point in relation to the raw materials, I would like to know where -- when are we going to see the COGS of the raw materials impacted at WEG? And what are the negotiations for the -- to passing through the prices to client? Is there a time when this price is going to be passed through the client? And how are you going to handle this price passing through?

[André Salgueiro, executive]

Rogério, this is André Salgueiro speaking. In relation to the hedge, we always look at 1-year horizon, and we may divide them in scales. The copper price is going to be updated as the agreements are matured. So we do this to have a prediction of the prices, then to make settlements in the price of commodities. But we understand that this is something we cannot control. We can see that copper prices, for example, is linked to the second question, which was relative to price. We made a new recomposition of prices at the beginning of the year, as we always do. Of course, the raw material cost increased since then. But we always expect until we make any decisions, because we have the hedge mechanisms that allows us to have this predictability. And we always want to understand how stable the foreign exchange rate is going to be because we -- otherwise, we run the risk of increasing the prices more than necessary. So this is a decision that we are waiting to be made, and we can see that the prices are adequate, considering the raw materials prices that we have at present.

[Operator]

Next question comes from Victor Mizusaki from Bradesco BBI.

[Victor Mizusaki, analyst]

I have 2 questions. The first question, in the results release, you said the impact of the transformers and TGM, the new businesses, in relation to the revenue. Could you provide more details of which was the impact in the margin when you made a consolidation of those companies? And the second question, talking about the GTD, on WEG Day, you mentioned in relation to transmission that you have lots of projects that could be implemented or they are under the phase of contracting. Do you have any update in relation to those negotiations? And thinking about solar mill, can we have any idea of values? When we talk about market, what are the projects that need to be contracted in the next years?

[André Rodrigues, executive]

This is André Rodrigues speaking. Let's talk both TGM, WTU. TGM comes from a level of revenue and margin, according to our expectations, margin close to what we have been using in our consolidated terms. We can see that the opportunities for expansions are great, using all the structure that WEG has outside Brazil, not only in Latin America, but across in the world. We have some initiatives in South Africa to bring this business, taking our structure there. And as we said on WEG Day, the United States is a market where we want to operate more strongly. So all fares well. And WTU is at the speed that we expected. The margin is lower when compared to our transformers plants. We are working on improving those margins, and this is going to continue along the year so that we can present better margins than those recorded this year. We expect that the margins for this year is better than last year's and in 2019, the margins will be even better.

[Victor Mizusaki, analyst]

And considering this expansion of margins and operations. And as you mentioned in the beginning, in relation to the increase of inventory because of the strike, after this is normalized and the margins are expanded, can we expect that the ROIC should continue this expansion trend?

[André Rodrigues, executive]

Victor, let's imagine the following: In the situation of normal temperature and pressure, this would be correct to say. You have the same distribution of sales abroad, they've been improving. The unit's ROIC will improve. But at WEG, things are a little bit more complex, considering all the segments. For example, solar had no relevance last year, but now it's more important to GTD now. So we have to understand what's going to be the product mix, what are the markets we are going to continue to grow and everything else. That's why we say that ROIC is -- operate at the range of 15% to 16%. Victor, the second part of your question, if we understood well, is related to the distribution options. So let me talk about the history and what we have said about this topic. WEG has a pre-agreement of BRL 250 million that has already been signed. But with [ GDP ], this is public information. Our business unit is working on different negotiations. We expect a similar value in other agreements, which are less relevant related to the sales of equipment. And what's important to understand is that this is a slow negotiation process. They are also working on the sales of equipment for the winners -- winning bidders and also to suppliers of all the lots. More recently, in June, there was another auction, BRL 6 billion in new projects. As a standard, WEG had some agreements and our clients won a lot. But we still have some other agreements, pending agreements, and WEG is trying to negotiate with other clients. So this is a process which is underway. It's slow and gradual, and we will provide updates as we have more clarity on them. And I think there's another part of the question. I think the last part is related to the solar energy and the potential now of the project in the market. In terms of value, it's difficult to provide information because it would depend a lot on the location, the characteristics of the project. But what we can share with you is that if we consider the auction of December 2017, we had 670 meg of energy for solar and 800 for solar later on. So the process that we're delivering at present would be something around 30 to 60 megawatts. So you can understand the market potential now of the latest auctions, considering what we have in portfolio nowadays.

[Operator]

Next question comes from Murilo Freiberger, Bank of America Merrill Lynch.

[Murilo Freiberger, analyst]

I would like to understand the recovery of long-cycle products, which have ROIC and margins greater when the market is better. So how do you see this? Is there anything related to long-cycle products that is starting to be included in your backlog? So what's the turnaround of CG Power, which is very important to the margin and profitability of the company? So I would like to know what is the long-cycle product profile and the turnaround as well. Those are the 2 questions I would like to ask.

[André Rodrigues, executive]

So here we go. As for long-cycle products sector, we have seen some signs of recovery in the market. And what can we say about it? What we have seen in the Asia Pacific or India, which are markets which are performing well, our unit of long cycle has been receiving orders. And what we see in terms of sectors is what we have been announcing, especially oil and gas which is also picking up and also mining among other areas, which are also having very positive trends. And so the orders are being received, so we can see some recovery. And whenever we have more concentrated presence, we can see that the recovery is very positive. And this is what we can say in terms of what we have measured in the sectors. In terms of WTU turnaround, I can say that it continues. And we consider this process the last 2 years in terms of this improvement, and this is moving on. We have seen that, as I said before, in the second half of the year, we can present a better result than what we have posted since its acquisition. We have made some synergy works, changes in organization, centralization of the sales areas, used to be divided into areas. Now it is unified in a single location, and this is moving according to our action plan.

[Operator]

Next question comes from Felipe Vinagre, Crédit Suisse.

[Felipe Vinagre, analyst]

I have 2 quick questions. One is about the abroad market. You said that exclude the effect of acquisition, but I would like to know if this is going to be maintained in the quarters to come. And the second question is related to GTD Brazil and as far as the solar area. I understood that you are likely to add BRL 500 million up to 2019. However, in the release, I understood that there was a higher concentration in the first quarter on the first half the year. I would like to know if I'm making any confusion considering both pieces of information.

[André Rodrigues, executive]

The international market will have -- will continue with this growth trend, maybe not as the same basis of the first quarter when the concentration was more on the solar area. And as of August, we have a comparison basis, which is not going to be as favorable when we consider the WTU that happened in August. So the basis is going to change, but we have the expectation that this is going to continue to be positive. And what we like to say, as you said, the growth in strong currency and the impact of the acquisition, but we cannot disregard the foreign exchange variations, which can have a very strong influence in the domestic market. As I said in the end of my presentation, we have this increase of volatility in the currency, and the weaker real allows us to be more competitive. And this will allow us to continue to use -- to grow in this process. And the second question is going to be answered by André.

[André Salgueiro, executive]

This is Salgueiro speaking. In relation to the solar, in fact, the 2 projects that were already included in our portfolio since the end of last year, they are more concentrated on this first half of the year. One of them was delivered in July, and we intended to deliver the other project in August. So the revenues are normally concentrated on the first half of the year. On the third quarter, there will be a reduction from the solar farms. And the third project that entered recently in the portfolio will be more relevant in the future. What is new is the project that has not been defined in terms of how much revenue will be included this year and how much will be left for next year. But we're going to continue providing updates in relation to our schedule.

[Felipe Vinagre, analyst]

Last question in relation to income tax. Is there any update in terms of what's going to happen next year? If you could disclose some information, it would be nice.

[André Rodrigues, executive]

We have no expectations in terms of changes in -- as related to the effective rate because the benefits that we provided with today will continue. And these are basically the equity on -- the interest on equity and another law, and we do not expect any changes for next year.

[Operator]

[Operator Instructions] There is a question which is going to be asked in English, David. And he asks us if we can some comments on the demand movements on short-cycle products in Brazil and in the main countries abroad.

[André Rodrigues, executive]

David, short-cycle products, for you to understand clearly, have been recovering quite well in 2017. After a very serious crisis, a very deep crisis in Brazil, we have always have a balance of short cycle and long-cycle products, and the long-cycle products nearly disappeared and the short-cycle products recovered. As of 2016, it was -- the recovery was very strong in 2017, we grew more than 20% in Brazil. And in 2018, this recovery process continues in a less intense rate than in 2017. But in a very wide and varied way, there is no concentration on some specific segments. It's very open segments that used to be very strong before the crisis, especially oil and gas and generations [indiscernible] pulp and paper industries. They do not have such an important role, but the industry as a whole, has been playing this role that the older players used to have. More mature economies at the more advanced pace than we see here in terms -- comparing what's happening abroad. And my clients that demand a short cycle, they have this started to place orders and -- for long-cycle products, and this is the main difference in terms of local markets and the markets abroad. Okay, David? Thank you.

[Operator]

Ladies and gentlemen, we now close the question-and-answer session. I would like to turn the floor over to Mr. André Rodrigues for his final considerations. André, you can proceed.

[André Rodrigues, executive]

Once again, thank you very much for attending the conference, and I hope to see you next time.

[Operator]

WEG's conference call is now closed. I appreciate everyone's participation. Have a good day.