WEG SA

BOVESPA:WEGE3

Earnings Call Transcript 2019-Q2

[Operator]

Good morning, and welcome to the conference call of WEG to release the results of the second quarter of 2019. We are transmitting this conference call, along with a slide deck in our Investor Relations website at the address ri.weg.net. After its completion, an audio will be available in our Investor Relations website. [Operator Instructions]

Any forecast in this document or any statements made during this conference call about forward-looking events, business prospects, operational and financial projections and goals and the potential for WEG's future growth are mere beliefs and assumptions of WEG's management, and they are based on information currently available. Forward-looking statements involve risks, uncertainties and therefore, depend on circumstances that may or may not occur. Investors should understand that general economic conditions, industry conditions and other operational factors may affect the future performance of WEG and may lead to result that will be materially different from those expressed in such forward-looking statements.

As a reminder, this conference call is being conducted in Portuguese and you are listening to the simultaneous translation into English.

Today with us in Jaragua do Sul, we have Mr. André Luís Rodrigues, Administrative Financial Superintendent Director; Paulo Polezi, Finance and Investor Relations Director, Wilson Watzko, Controller; and André Salgueiro, Investor Relations Manager of WEG.

Please, Mr. André Rodrigues, you may start.

[André Rodrigues, executive]

Good morning, everyone. Once again, it's a pleasure to be with you here for the conference call of our earnings of the second quarter of 2019.

Starting with the highlights, net operating revenue grew 7.5% as compared to Q2 '18, in spite of the expectation of a smaller share of wind generation business. The details about this performance will be presented by Paulo further on. The second highlight was the 15.4% growth in the EBITDA, which reached BRL 535 million. And it's the first quarter ever that we exceeded the mark of BRL 500 million EBITDA in the history. EBITDA margin grew 1.1 percentage points, reaching 16.3%. This mark is the result of a combination that was favorable, margin gains of some operations in Brazil, followed by the better profitability of our operations overseas in addition to a more favorable mix of the projects that we sold. Lastly, ROIC reached 18.4%, showing another quarter in evolution. Factors such as revenue growth, better operational margins, scale gains and efficiency gains in allocation of capital have supported the growth that we presented over the past quarters.

Then moving to Slide #4, we have more details about the ROIC, which presented a growth of 1.5 percentage points as compared to Q2 '18, reaching 18.4%. The growth of the operating income after tax explained by the growth and better operational margin more than offset the more capital that we invested to support business growth. The consistency of this indicator in the past few quarters is a reflect of the combination of the business development strategy with an attractive return on capital invested together with discipline in the use of capital, demonstrated by working capital management, optimization of our investment program.

Now I give the floor to Paulo Polezi.

[Paulo Polezi, executive]

Good morning, everyone. Now moving to Slide 5, you can see the evolution of the business areas of different markets. I'll start in the area of industrial electro-electronic equipment in Brazil, where short-cycle equipment sales are still growing. The performance of this unit was not better only because in the second quarter, the sale of long-cycle products remained stable as compared to the same period last year, especially in terms of automation panels. GTD also presented a reduction in revenue in Brazil, especially due to the already expected smaller share of wind generation projects. On the other hand, solar generation, still the positive highlight, especially in terms of distributed generation. And the business of transmission and distribution is still positive this quarter, with an improvement in the business dynamics in all product lines.

In terms of motors for domestic use, there has been a significant growth in the revenue in Brazil, which is related to the inventory dynamics of some customers that are important and a higher share -- and a higher market share important segments, such as washers. The good performance in coating business is especially due to the improvement in significant manufacturing industries, such as mining, metal structures and home appliances and important projects in the industries of oil and gas and sanitation.

Outside Brazil, we can see a consistent demand for short-cycle equipment and a growing demand for long-cycle projects with orders and deliveries in terms of high-voltage engines and automation panels. We have projects to increase capacity and to build new factories that also demand long-cycle products and continue with good prospects, especially in industries related to oil, gas, pulp and paper, infrastructure and mining.

In the area of power generation, transmission and distribution, the greatest contribution came from transformers, which presented a growth in all our operations overseas, with the highlights to the synergies already observed in operations of transformers in the United States and Mexico, and a good book of orders in the factories of generators in India and the U.S.

In engines for domestic use, the revenue is still presenting the impact already observed in the past few quarters, with a smaller placement of orders in the local market in China, and a weak performance of the operation in Argentina, which suffers because of problems in the local economy.

Now in coatings, the drop in revenue in the foreign market also reflect the difficulties in the economic scenario in Argentina, one of the main markets for this business unit outside Brazil.

Slide 6 shows the evolution of EBITDA. In Q2 '19, EBITDA grew 15.4% as compared to Q2 '18. The EBITDA margin closed the quarter at 16.3%, with an evolution of 1.1 percentage points as compared to Q2 '18 as a consequence of margin gains in some operations in Brazil, followed by better profitability of our overseas operations in addition to a more favorable mix as a result of a better revenue from wind generation with the characteristic of lower operational margins.

Finally, on Slide 7, you can see the growth over the past few quarters. In Q2 '19, investments have reached BRL 118 million. 31% were allocated in Brazil and 69% allocated in our overseas manufacturing units with a growth as compared to Q2 '18, especially because of the advance in investments in the first foundry of WEG outside Brazil, which is in the final phases of construction in Mexico.

And I now end and give the floor back to André.

[André Rodrigues, executive]

Thank you very much, Paulo. So wrapping up the presentation and before moving to the Q&A session, I would like to emphasize our recent accomplishments and prospects towards the rest of the year. As we have recently published, there is some important development overseas, such as the refinery in Oman and Arkema in Europe, demonstrating the company's growing recognition of solutions in projects and partnership with major global companies through exclusive contracts or inclusion of us as an approved global provider, which makes us unique and provides special opportunities to WEG. With the aim of advancing towards software and IoT solutions, we announced our new department of digital businesses, which will be responsible for developing products and digital services that will support all business unit and development application of new technologies.

In May, we also announced our technological cooperation agreement with Embraer to develop new technologies and solutions to enable electric propulsion in aircraft. Although this is a long-term partnership without any prospects or short-term results, it demonstrates our technological capacity and the recognition of important customers of our products.

Lastly, we keep our expectation to grow in 2019, however, at a lower level because of the acknowledged reduction of our wind projects.

As to EBITDA margin, we expect to present in the year an evolution as compared to 2018, considering the better performance of mature businesses in Brazil and better profitability of our overseas operations. The growth in revenue and EBITDA margin, together with efficiency in capital allocation, will continue to support ROIC at favorable levels.

Now we may start our Q&A session. Operator, please, you may proceed.

[Operator]

[Operator Instructions] Our first question comes from Lucas Marquiori from BTG Pactual.

[Lucas Marquiori, analyst]

I have 2 things to say. André, you mentioned briefly in the presentation the exclusivity contract with Oman, I think there are some limitations in terms of what you can disclose. Can you give us a little bit more information, volume, when this will be shown in the results and which lines, manufacturing, GTD, just a little bit more detail about the specific contracts? This is the first question.

And the second, could you -- you talked about the recovering your margin of operations, especially in fact, transformers. What level of margin operation? Is there any room for improvement? Or is the run rate already appropriate for you? These are my questions.

[André Rodrigues, executive]

Hi, Lucas. Thank you for your question. So I'll talk about the supply to Oman, which is a joint venture project between Oman Oil and Kuwait Petroleum. And the total investment is about 8 billion in investment. Of course, this is not the exact contract WEG signed, the contract with the engineering company, Técnicas Reunidas from Spain. It was an agreement, and WEG becomes the exclusive supplier of engines and low and high-voltage inverters.

As to the amount, we signed the first tranche, and there might be another 2 tranches for the development. We do not disclose the amount of the contract, but I think that the most important point here is that this contract will make it possible to show WEG as a global player. This is a project that provides great visibility outside Brazil. So the brand WEG is very well -- has a good reputation outside Brazil and internationally. And this places us at a different level of quality as a supplier with our supply agreement. And it opens other opportunities for WEG and other supplies of the type.

And I may also say, we have made the -- there are some contracts from the past in terms of trying to develop WEG commercially outside Brazil. And after this contract, we have opened some doors much more easily than we did in the past. So part of the contract will be developed this year and part of it next year, so about 50-50 each year. And the reflexes of that you're going to see in industrial electro-electronic products.

Are we going to see the results of that in the next quarter? We're more in the second -- more towards the end of the year, you will be able to see the impact of this.

About WEG USA -- I'm sorry, about WEG USA. Well, the margin improvement is in WEG USA, but we also are developing margins in other units that we acquired in the past. And yes, WEG USA has been having positive margins since the first half of the year, and we expected this to take place right in the second half last year, but we were surprised by an unexpected inflation in the U.S. market. And so this became a reality this year. It's still in the process, margins are still getting better, and we have the opportunity to continue to develop the margins in that unit and in other units outside Brazil, and so we still have room for growth.

[Operator]

Our next question comes from Rogério Araújo from UBS.

[Rogério Araújo, analyst]

I have 2 questions. One is a follow-up of WEG being recognized as provider of project solutions recognized as a global supplier. So I would like to hear if what has happened is that WEG has been approved to take part in these projects? Did you ever try to do that before? And why didn't you win in the past? And I think that another issue here is whether you see any situations of companies that produce their own low-voltage electrical engine might choose to buy WEG instead of manufacturing themselves. So looking slightly more into the future. And do you think this is a possible or feasible scenario when they will start to become a low-voltage electric engines for less efficient players in this segment? This is my first question.

[Unknown Executive]

Thank you for your question. So WEG has only won this contract now. Well, and why didn't we have it in the past? Well, this is a process. We need to develop our brand to have access to bigger and bigger markets. This is what WEG did. We have had the chance of publishing. So in oil and gas, WEG is renowned outside Brazil. And as more and more companies got to know WEG and have access -- having access to our products, quality, capacity to innovate our products. And now this has placed us on a different level. I think that once again, in the supply such as this places WEG at a different level as compared to the past. There are more doors that are open to us.

We mentioned Oman, but there's -- Arkema is a chemical industry, French, with global presence. We also closed an energy efficiency contract with them. The replacement of engines. This is an exclusive contract with Arkema for the whole of Europe. And we can work with them and the rest of the world, too. And so this is another opportunity for WEG to develop in international markets.

And your -- the second question regarded the supply of electrical engine. Do you think that in the future, some companies will start buying WEG instead of manufacturing with their own engines? No, I don't think that is likely, Rogério. And globally speaking, in terms of global players, they're all very well established, and we have a share with more than 2,000 manufacturers of engines in China. And so we see more market consolidation. In terms of the supply of electrical engines for these companies to retail, I don't see it as likely because these companies will need to do margin on top of margin in retail, and it's not going to be competitive, so I don't see the trend. And I see the possibility of consolidation.

And talking a little bit more about Oman contracts. Just another example, all OEMs, it's not just WEG that is selling directly to the refinery above vendor. So the pump has an engine, there will only be able to sell to the refinery if they have a WEG engine. So I don't see any companies buying the engines to resell, but develop a strategy and growing through the OEMs that WEG has been doing for a long time.

[Rogério Araújo, analyst]

And this market is very big of projects that you did not participate before more in terms of low- and medium-voltage electrical engines. Do we know how big that market is? Are there any major projects?

[Unknown Executive]

Well, Rogério, we can calculate an estimate of the value of the global market later on, but this happens with exclusivity contracts. We have that in many countries in the world. We may develop this in the United States. And you can confirm afterwards, we have more than 25 customers for global supply. So there are customers that buy from WEG in Brazil, China, U.S., Europe, and they are exclusive contracts with global customers. If we get the evolution of the past 3 years, this number has been going up. So there is also a possibility of development in other geographies, too.

[Rogério Araújo, analyst]

The second question is very quick. What is the effect of IFRS on your EBITDA margin? And also -- and did you calculate how much that affects ROIC if it does?

[Paulo Polezi, executive]

Rogério, this is Paulo Polezi. IFRS 16 for this quarter according to our calculations, EBITDA margin would be impacted between 0.4 and 0.5 percentage points. So additionally to the impact of depreciation, and this is explained in Note 13 of our financial statement, and we need to think about our mercantile lease in their -- outside Brazil at lower rates, and that's why the impact is not so significant.

As to impacting ROIC, there is an impact of results from that. And just as I said, it's not so representative in the EBITDA, neither in ROIC.

[Operator]

Our next question comes from Joao Noronha from Santander.

[Joao Noronha, analyst]

In terms of solar power, could you give us more information about the current size of the business? And in distributed energy, what is the revenue and how you've been growing?

[André Salgueiro, executive]

Good morning, Joao. This is André Salgueiro. In terms of solar power, in Q1 this year, we mentioned that we were not going to give too much detail in terms of portfolio and backlog as we've been doing last year because this is a new segment and more representative, but it's as we've been mentioning to you since late last year, this is very positive, very focused on distributed solar generation, and our portfolio has been growing consistently since last year. And we're keeping that range. So the placement of orders and billing is evolving, which means that we expect this business to grow over the next few quarters. The point of attention is because of solar farms, that last year, we delivered 3 farms. This year, we have 4. There's 2 have already been delivered, one. And if you compare the wins, the solar farms, if you compare 2019 to 2018, the billing or the revenue performance is smaller this year, which will obviously be offset by distributed generation. But the overall prospect is very positive because of our G&D.

If you look year-on-year, what we'll lose in terms of farms would be offset by the growth in distributed. Yes, G&D, so we are going to recover the farm. Well, it depends on how G&D evolves in the second half of the year, but we are expecting the consolidated solar power will be slightly better than 2018 if we take the whole year.

[Operator]

Our next question comes from Marcelo Motta from JPMorgan.

[Marcelo Motta, analyst]

I have 2 questions. The first one, could you comment the company's market share in international markets? Have you -- you've won market share in Asia, but I would like to understand better about the U.S. and EU markets. So we're thinking GTD, there are many drivers. So less wind and well, the solar generation, but more distributed energy, how is that compared? Distributed energy would be better or worse? So I would like to understand more the direction of your margins.

[Paulo Polezi, executive]

Hi, Marcelo. Good morning. Paulo Polezi. Your first question about market share. Well, actually, we have a continuous process of market evolution and market share gain. And so in some of our businesses, we can have more exact information in terms of industrial electro-electronic equipment and other equipment, GTD. It's difficult to get the information. It's more commercial. So it's a continuing process. We don't have details. And we update that every 2 years. And I can give you an example, 4 years ago in the United States, we were 3 in market presence. Two years later, WEG became second in U.S., with a presence close to 15% of the market. So it's an evolution that is gradual, and it takes place all over the world. So we are very careful. And we're trying to update every 2 years to give you more precise numbers. So it would be too hasty to give you numbers about the markets, but the perception that we have of the businesses is in advance in all segments over 2-digit growth, and our 2-digit growth is an example of that.

Just as to GTD margin, we need to separate businesses from GTD. In terms of wind and solar farms that we work more is integrated, it's a significant part of this business, belongs to third-parties, and we complement with some pieces of the equipment that are manufactured by WEG, and we sell the full solution. So we hope margins for these businesses to be structurally lower than in other businesses. So this is a first part.

The second is the distributed generation, with a slightly more constant margin, slightly better margin, which is more focused on retail without any major variations. And there's all the rest that goes into GTD in terms of generation, both wind and solar plus T&D. We have -- and the long-cycle product dynamics. So when the market demands products, we price better, improve margins when the market -- when demands go down. We in-source projects where margins are better or not. So we have these dynamics. What we see now is a combination of a recovery of the long-cycle products, especially for T&D and a proportional reduction of wind billing with a smaller margin. So if you have the 2 factors, you see that GTD is improving its margins. And it's likely to continue this trend over the next quarters.

[André Salgueiro, executive]

Just complementing what Paulo about the expansion in the foreign markets. So we have demonstrated consistently that we've been capturing markets, not on a one given geography, but in many different geographies. They have been growing consistently in the United States. And when we analyze, and not just one segment, but when analyze the growth rate in the foreign market, so industrial electro-electronic equipment, GTD, this is very consistent in the United States, in Europe and China. In the case of China, this is leading us to increase capacity of WEG's newest blend for the manufacturing of electrical engines, which went live in early 2016. So yes, WEG has been seeking and finding opportunities to grow in these markets and to increase its market share.

[Operator]

Our next question comes from Gabriel Rezende from Bradesco BBI.

[Gabriel Rezende, analyst]

I have 2 questions related to the foreign market. The first one relates to Mexico. When is it going to start operating? And how can you contribute to gaining competitiveness in North America? The second one regards market share. How can the new contracts with Arkema and Oman, how can it drive market share in foreign markets?

[Unknown Executive]

Hi, Gabriel, Mexico foundry will start operating shortly and producing. It's still in the test phase and then officially, so it's just a matter of weeks, it's going to start operating. And we follow -- and this year, we might not see any major changes because they are preoperational, but more consistently next year when we see a higher production volume. So it's a significant investment. We're almost sure that the most modern foundry in the whole of Mexico is our plant is really state-of-the-art technology. And right from the beginning, we need to have capacity because it's difficult to reduce the bottleneck afterwards. So next year and over the next few years, you will see the improvement these contracts once again.

It's difficult to tell now how much -- what this will mean in terms of new markets to WEG. For the international market, WEG, with this type of agreement, it changes its level of qualification as a supplier of equipment that require high technology and reliability and quality. We are mentioning these 2 examples, which are recent examples. But as I have just said, we have 28 or more than that global contracts with major players and major international players. But the way -- there are many examples. And recently, we supplied a high-voltage engine with [ 45 tons ] to the north of China, and part of it was developed Brazilian engineering, part of it in India, and the final assembly in China to assure better optimization of competitiveness of this product. WEG is more and more positioning itself as a relevant brand for these products in all the markets where we operate around the globe.

And one thing leads to the other. As I said, in the case of Oman, we are already getting many calls. There are many people -- I mean, and companies are coming to WEG. And in the past, we had tried to make contact with them, but they didn't know us so well. We didn't have much of a track record. Now as we have a better track record, they are coming back to us. Of course, this is all the result of a strategy focusing on industries over the past few years. They have created teams that are dedicated to covering certain industries all over the world. Oil and gas, for example. And all of this is a result of a long-term strategy that we are being very faithful to its execution.

[Operator]

Our next question comes from Gabriela Cortez from Banco do Brasil.

[Gabriela Elerati Cortez, analyst]

Congratulations on your performance. We've been talking a lot about market prospects and everything. Could you tell us what you expect in terms of cost of raw materials and other input in the second half of 2019? And also can you confirm this year's CapEx in the data that you presented in the first quarter? And as to debt, there has been a considerable drop in the gross debt. So was it due to any settlement or was it the result of FX variation? Could you tell us more about that?

[Paulo Polezi, executive]

Gabriela, good morning. This is Paulo Polezi answering your question. You asked 3 questions in 1. So you talked about the cost prospects. So in our case, the first thing that you need to remember in terms of our cost structure are metal commodities. Number one, copper and then steel and aluminum, in those order. And we've been observing an improvement in costs in the strong currency. And this has helped us effectively, contributed to the margin. And we are working with a scenario of maintenance of this condition in terms of costs remaining stable. Of course, we need to look at the FX aspect of that. So compared to last year, in the second quarter, we saw an FX slightly more stable. So we need to place the 2 items in our calculations, commodity prices and FX variation. So the second half of the year is likely to be more favorable for our businesses with regards to these commodities that are part of our costs.

The second part of your question regards CapEx. So we have an annual CapEx program this year. We have already provided a lot of information about it. And the budget that has been approved is BRL 530 million, most of it 70% overseas, 30% in Brazil. The CapEx has been originally planned to complete our plant in Mexico. And in order of relevance, we have the expansion of the engine plant, manufacturing plant in China. As you said, we are also investing facility to build frequency inverters in China.

And lastly, the new generator, the final power. We don't know yet the details. So there are lots of investments spread in Brazil and all over the world to improve our processes. This is the overall picture. So in Mexico, too, there was an FX variation that played the role; number two, China; and number three, investments in Brazil that explain this quarter's CapEx.

Your third question, reduction of the debt. So debt. So Brazil has been working, and this is not new. It's been a year. So a reduction that is in cash and debt, especially because of the foreign exchange rate, reduced many debt that had a higher cost, usually above the CDI. The result is that we reduced debt, reduced cash and at the same time, there was a reduction in financial expenses. We still have something to do, but most of this work has already been done to reduce our indebtedness.

[Gabriela Elerati Cortez, analyst]

So you think we can consider this level more stable in terms of what you are reporting for June 2019?

[Paulo Polezi, executive]

Probably yes. There might be a variation up or down if we find any interesting or competitive opportunities in the market. We are always looking at that. We have an amortization that is consistent. The company is generating cash at the same time. And this is the most important thing. And we are looking -- or if -- and we are looking at the market, and if any interesting opportunities come up, we might be involved in them.

[Operator]

Our next question comes from Mr. Augusto Ensiki from HSBC.

[Augusto Ensiki, analyst]

Could you tell us more about your software structure? How is it going to fit into the new businesses that you operate? Are you going to change accounting methods?

[Unknown Executive]

Hi, Augusto. Thank you for your question. Talking about the new structure that we call WEG digital businesses, I think that along its history, WEG has been investing in electrical machinery and automation products and systems for companies in the power industry. WEG is not just a supplier of equipment of engine and inverters, but it works in automation with all the basis in industrial activity. So we have frequently -- recently published our own motor scan, but we have lots -- we've been doing a lot there. We have some solutions that comply with the Internet of Things and also internal systems with internal software of our production. So what used to happen is that this was slightly dispersed in our business unit. And the solution that we found is that we have reached a certain size that we have a new department grouping all our initiatives under a single initiative and to develop digital businesses outside and inside the company.

And this is recent. The whole strategy is recent, and it's being refined now. We do not yet have a revenue estimate, but naturally, we are going to start first in Brazil, and then we are going to expand it internationally. And I think, at first, it's going to be slightly more diluted in industrial electro-electronic equipment. But once there is something that we find relevant, we are going to make a disclosure and we might change the way we publish this.

I think the main -- the key message here is that the company is structuring itself to do that. At first, we were slightly more low profile in terms of publishing our capacity to be in that market in terms of internal development. Of course, towards the end of the year, we're going to have a WEG Day here in Jaragua, one of the pilot manufacturing plants of this intelligent brand. And we are going to include it in the visit to show what we have developed. And now we want this to be translated into products to be offered to our customers to complement our extensive product line.

[Operator]

[Operator Instructions] We are now ending our Q&A session. I would like to give the floor to Mr. André Rodrigues for his closing remarks. Please, Mr. Rodrigues, you may go on.

[André Rodrigues, executive]

So thank you all very much once again for attending our conference call, and I hope to meet you again in a few months when we publish the results of the third quarter. Have a good day, and thank you very much.

[Operator]

WEG's conference call has now ended. We thank you all for your participation, and we wish you all a very good day.

[Statements in English on this transcript were spoken by an interpreter present on the live call.]