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Edited Transcript of AZZ earnings conference call or presentation 9-Oct-18 3:00pm GMT

Q2 2019 AZZ Inc Earnings Call

Fort Worth Oct 10, 2018 (Thomson StreetEvents) -- Edited Transcript of AZZ Inc earnings conference call or presentation Tuesday, October 9, 2018 at 3:00:00pm GMT

TEXT version of Transcript

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Corporate Participants

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* Joe Dorame

* Paul Wesley Fehlman

AZZ Inc. - Senior VP of Finance & CFO

* Thomas E. Ferguson

AZZ Inc. - President CEO & Director

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Conference Call Participants

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* John Edward Franzreb

Sidoti & Company, LLC - Research Analyst

* Jonathan Paul Braatz

Kansas City Capital Associates - Partner and Research Analyst

* Noelle Christine Dilts

Stifel, Nicolaus & Company, Incorporated, Research Division - VP & Analyst

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Presentation

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Operator [1]

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Good morning, ladies and gentlemen. Welcome to the AZZ Inc. Second Quarter Fiscal Year 2019 Financial Results Conference Call. (Operator Instructions) Please note, this event is being recorded.

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

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Joe Dorame, [2]

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Thank you, Denise. Good morning, and thank you for joining us today to review the financial results of AZZ Inc. ended August 31, 2018. As Denise indicated, my name is Joe Dorame, Managing Partner of Lytham Partners. On the call, representing the company are: Mr. Tom Ferguson, Chief Executive Officer; and Mr. Paul Fehlman, Chief Financial Officer.

After the conclusion of today's prepared remarks, we will open the call for question-and-answer session.

Please note, there is a slide presentation for today's call, which can be found on AZZ's Investor Relations page under Financial Information at www.azz.com.

Before we begin with the prepared remarks, I would like to remind everyone, certain statements made by the management team of AZZ during this conference call constitute forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Except for the statements of historical fact, this conference call may contain forward-looking statements that involve risks and uncertainties, some of which are detailed from time to time in documents filed by AZZ with the United States Securities and Exchange Commission, including the Annual Report on Form 10-K for the fiscal year ended February 28, 2018. Those risks and uncertainties include, but are not limited to, changes in customer demand and response to product and services offered by the company, [including demand by the power -- the industrial market and the metal coatings market;] prices and raw material costs, including zinc and natural gas, which are used in the hot-dip galvanizing process; changes in the political stability and economic conditions of the various markets that AZZ serves, foreign and domestic; customer-requested delays of shipment; acquisition opportunities; currency exchange rates; adequate financing; and availability of experienced management and employees to implement the company's growth strategies. The company can give no assurance that such forward-looking statements will prove to be correct. These statements are based on information as of the date hereof, and AZZ assumes no obligation to update any forward-looking statements, whether as a result of new information, future events or otherwise.

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

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Thomas E. Ferguson, AZZ Inc. - President CEO & Director [3]

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Thank you, Joe. Welcome to our fiscal year 2019 second quarter earnings call, and thank you for joining us this morning. As we had noted on the last call, we were hoping to maintain positive traction as we continue to the 2019 fiscal year. We believe we accomplished that with solid double-digit growth for both top and bottom lines versus Q2 fiscal 2018.

While we still have several challenges, both within the business as well as outside, we have enough momentum to raise our guidance for the full year, to strengthen our core businesses and ensure our current businesses are focused on their core activities.

Metal Coatings had a good second quarter with record sales while it continues to gain traction on several operational, procurement improvement and growth initiatives. Operating margins of 19% were negatively impacted by the high-cost zinc flowing through our kettles, the disruption of consolidating 2 plants, some impact from higher direct labor wages and our efforts to regain market share in certain markets. We believe margins will show improvement at the balance of this year. And while 25% operating margin is still our target for galvanizing, overall Metal Coatings will be somewhat less than that as powder coating is likely to make up a growing portion of the revenues.

We continue to invest in digitizing our galvanizing plants so that we can improve our industry-leading customer service and drive improved productivity with real-time data. We call this initiative digital galvanizing system, or DGS for short, and we now have DGS in all 40 of our galvanizing plants.

We remain confident that continuous galvanized rebar and power coating will continue to grow and also improve their margins in the coming quarters.

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

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

The Electrical platform continues to see improvement in opportunities for electrical enclosures, switch gear and our oil field related products. We have a large backlog for high-voltage bus but have not been able to replace the large nuclear projects for medium-voltage bus.

Tariffs had only a minor impact on this segment in the second quarter. We're in the process of converting our Chinese joint venture to a wholly-owned new operation to give us better control and more flexibility in responding to any new tariffs or trade actions. Overall, we are seeing improved demand in most of our Energy segment businesses as we enter the third quarter.

As we look forward, we see solid demand in most of our Metal Coatings plants as fabricators are busy in most regions and infrastructure spend continues to grow. While we have increased prices, we have not been able to offset the majority of the impact from higher zinc and labor costs. We are focused on improving productivity and efficiency while also continuing to improve price realization to offset these increased costs.

We did consolidate 2 Louisiana plant facilities to provide outstanding customer service to the marketplace. On the other hand, we are also more aggressively defending some markets where competitors have attempted to take market share by focusing more on customer satisfaction while competing at the market price level.

As the year progresses, we are beginning to see increased demand for Galvabar and have begun looking for a site to build our second facility to support future growth, probably in the East Coast area. We may look at a fully integrated hot-dip and Galvabar plant, which would be unique. Powder coating demand is growing for both of our plants, helped by our improved selling efforts.

Our Energy segment's full year outlook is solid, and Q3 is seasonally a strong quarter for turnaround of outage activity. We are currently experiencing very strong turnaround activity this fall.

In summary, these positive developments have given us confidence in a strong second half of the year.

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

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Paul Wesley Fehlman, AZZ Inc. - Senior VP of Finance & CFO [4]

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Thank you, Tom. For the second quarter of fiscal year 2019, we reported net sales of $222.8 million, a $26.5 million increase, which was 13.5% higher than the second quarter of fiscal 2018. (inaudible) was $17.1 million, which included a $1.3 million charge to consolidate 2 galvanizing plants on the Gulf Coast. This drove a slight decrease to operating income of $300,000 or 1.6%.

Fully diluted EPS grew 13.2% to $0.43 compared to $0.38 last year, and our backlog finished at $336 million, up 12% versus the second quarter last year.

Our book to revenue ratio finished the second quarter at 1.14% compared to 0.97% in the second quarter last year. We expect to ship 54% of the backlog outside of the U.S. compared to 42% in the same quarter last year.

Gross margins for the quarter were 21.1%, a 120 basis points lower than the 22.3% margin for the second quarter of last year, as we experienced the continued headwinds of realized zinc prices, increasing labor costs and the charges we took to consolidate the 2 galvanized plants.

SG&A finished at 13.4% of total sales compared to 13.5% for the second quarter last year. And as a result, we generated second quarter operating margins of 7.7% compared to 8.9% in the second quarter of fiscal 2018.

On a comparative basis, our quarterly interest expense rose 17% year-over-year or $580,000. Our effective tax rate improved to 19.6% compared to the second quarter rate last year of 28.7%, driven by the Tax Cuts and Jobs Act of 2017.

Cash flows from operations improved by $14.7 million or 527% in the first half of fiscal '19 compared to the performance in the first half a year ago on higher net income.

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

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

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

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Thomas E. Ferguson, AZZ Inc. - President CEO & Director [5]

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Thank you, Paul. We remain cautiously optimistic about fiscal year 2019 and are gaining confidence in our outlook after 2 solid quarters of performance. We are narrowing our guidance for fiscal 2019 to the upside, with earnings per share in the range of $1.90 to $2.25 per fully diluted share and annual sales in the range of $930 million to $970 million. We're experiencing generally improved market conditions, and we feel confident about our organizational changes and realignment activities. Additionally, we are executing on our strategic initiatives to drive improved operational performance.

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

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

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Questions and Answers

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Operator [1]

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(Operator Instructions) The first question will be from John Franzreb of Sidoti & Company.

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John Edward Franzreb, Sidoti & Company, LLC - Research Analyst [2]

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First, on the Metal Coatings business. Can you talk a little bit about how long it takes you to fully absorb price increases and decreases in zinc? And when would that fully be reflected in the P&L?

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Thomas E. Ferguson, AZZ Inc. - President CEO & Director [3]

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It takes about 6 to 8 months, John. And kind of the peak prices were in that first part of the year, February, March. So that's why we're pretty confident, particularly with higher volumes, we'll start seeing that to head lower towards the end of this quarter into the fourth quarter.

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John Edward Franzreb, Sidoti & Company, LLC - Research Analyst [4]

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

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Thomas E. Ferguson, AZZ Inc. - President CEO & Director [5]

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We feel like we've regained quite a few already. Our focus was in probably 2 or 3 regions where we felt like competitors sort of had a free rein for a while as our operations were purely focused on margin. So [we'll have to change in this] effort, getting them focused on really not just cost coverage but building that value -- highly satisfied customer relationship. We're making a lot of progress in this. I think you see it in our revenue already. We still have got a little ways to go. I think we'll be at that through the balance of this third quarter. But I would anticipate, as we make the turn into January for the calendar year, that we're going to be pretty comfortable that we've regained most of what we lost and that we've started taking share in some of the other regions.

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John Edward Franzreb, Sidoti & Company, LLC - Research Analyst [6]

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

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Thomas E. Ferguson, AZZ Inc. - President CEO & Director [7]

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

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John Edward Franzreb, Sidoti & Company, LLC - Research Analyst [8]

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

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Thomas E. Ferguson, AZZ Inc. - President CEO & Director [9]

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Well, there's 2 different pieces as to our nuclear business. One is the Welding Solutions piece, which is focused on the maintenance side. And then, there's the Nuclear Logistics Inc., which is more around components and parts and certification. So they tend to run -- while we use an integrated sales organization, they still tend to run a little different. So what we're feeling better about is that nuclear -- that NLI business, they're focused on new opportunities. They're focused on their traditional batteries that utilities have probably cut about as much as they can in terms of their inventories and in terms of the components. So we feel better about that. We also feel better about some of the international opportunities we're seeing, whereas traditionally, we're almost totally focused the last year [too] on the domestic markets. So that's why we feel better overall on the nuclear side, international and NLI.

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Operator [10]

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The next question will be from Noelle Dilts of Stifel.

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Noelle Christine Dilts, Stifel, Nicolaus & Company, Incorporated, Research Division - VP & Analyst [11]

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

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Thomas E. Ferguson, AZZ Inc. - President CEO & Director [12]

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Yes. It's kind of all of the above. I think you hit on all the points, Noelle. I'll start with the welders. We've got good access to craft, and so we've got probably enough craft right now to handle what we see in the third quarter. As we look forward, I'd say we're probably more worried about our welders in outer years, so we are working on training -- better training programs, working with the unions that we work with and try to make sure that we've got the best of the group available to us in a variety of ways. So we've renegotiated some of those union contracts for contractors. And we feel fairly good right now with what's available to us. In the Metal Coatings side, it's a different story. We've got some regional issues. I'm not going to call out any specific ones. We have competitors in almost every area as well. So we have increased wages by $1 to $2 in those areas, to one, allow us to attract a little better quality of individual; and two, to retain the folks -- the experienced folks we have. Most of that is unskilled to semiskilled labor. So we had some issues, but we've been able to fill our ranks pretty well. We're doing job fairs. We're getting more creative at how we recruit, how we bring folks and, how quickly we ramp them up, how do we get them oriented, and then how do we evaluate or retain. So we've had to become more innovative in unskilled and semiskilled craft, and we're doing that in both the Metal Coatings as well as in the electrical side, and we've had success with those job fairs. So our human resources folks are getting a lot better at that, and we're getting a lot better at using the tools we need to bring folks in. I think there's going to continue to be some pressure, but on the other hand, I think we're feeling good about how we're able to drive productivity and efficiencies as we look forward. So we're not seeing a lot more pressure to increase wages because we're not in some of the really high-cost areas like California or up in the Northeast. So in the South and through the Midwest, we feel pretty good about the adjustments we've made and about the new techniques we're using to find, recruit and retain folks.

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Noelle Christine Dilts, Stifel, Nicolaus & Company, Incorporated, Research Division - VP & Analyst [13]

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

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Thomas E. Ferguson, AZZ Inc. - President CEO & Director [14]

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Yes, great question. I think in Metal Coatings, most of the fabricators we're dealing with have access to the steel they need, so we haven't seen much impact there and feel pretty good as we're looking forward, at least as we're talking to the contractors and fabricators. When it comes to the electrical side, where we have seen some impact, we had some tariff impact on our oilfield-related products, particularly tubing. We're working to mitigate that. It wasn't enormous because tubing is a relatively small business unit for us; and two, they're pretty adaptive at adapting. So we feel good about their access to steel going forward for the tubular business. When it comes to the enclosures and particularly, there has been some cost increase in terms of steel plate and sheet metal, particularly. We've been able to pass most of that through because it is project based, and so we've been able to get that into our bids in anticipation of the higher cost. So we have not seen a lot of pushback from customers because a lot of our customers are experiencing the same thing. But we have had access to the plate and sheet that we needed just at a little higher cost, which has not been reflected in our margins as we've been able to pass it through on a project basis. So something we're paying close attention to where it could impact us, China, one of the reasons we're moving to a WOFE in China instead of a JV is in case the tariffs get worse or the trade situation with China gets worse, we want to be able to manufacture more locally and not have an impact on our margins on some of the projects we have in backlog. So we feel -- once again, we feel good about the steps we've taken in the last few months and have done a lot of hard work, in fact, by our legal and finance and business teams. But we think we've made the right steps, particularly with the front page of the Wall Street Journal today talking about things getting worse in China.

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Noelle Christine Dilts, Stifel, Nicolaus & Company, Incorporated, Research Division - VP & Analyst [15]

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

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Thomas E. Ferguson, AZZ Inc. - President CEO & Director [16]

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Yes. Paul is going to respond to that.

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Paul Wesley Fehlman, AZZ Inc. - Senior VP of Finance & CFO [17]

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So the current trends are that we're seeing upticks across almost every end market that we're addressing. We had some particular strength in agriculture in the second quarter and, in general, industrial as well as the electric utility side -- funny enough. The uptick in -- we're seeing good pickup in OE as an end market. So the interpretation on that is that really the general economy is doing well. The uptick in agriculture, I would say, has to do with some of the anticipated possible issues in China as we're building up more storage for grains and some agricultural units. Also, it's that time of year where this picks up as we head into the fall.

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Operator [18]

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(Operator Instructions) The next question will be from Jon Braatz of Kansas City Capital.

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Jonathan Paul Braatz, Kansas City Capital Associates - Partner and Research Analyst [19]

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

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Thomas E. Ferguson, AZZ Inc. - President CEO & Director [20]

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Yes, there was. We bought -- most of our other facilities, and so that's been a nice addition. It's still relatively small. Paul can probably give you a little bit more color on it.

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Paul Wesley Fehlman, AZZ Inc. - Senior VP of Finance & CFO [21]

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Yes. I won't give you numbers, but we did pick that up at Rogers Brothers, which was purchased in February at the end of fiscal 2018. And then, actually, we've got an [EPC] on the powder coating side at the end of June fiscal '18, so you get an extra month -- you get a little extra month almost there for you, John, in the second quarter if you look there. Yes, there was a pickup [with the anniv].

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Jonathan Paul Braatz, Kansas City Capital Associates - Partner and Research Analyst [22]

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

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Thomas E. Ferguson, AZZ Inc. - President CEO & Director [23]

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Yes. We've got a very large Chinese backlog in our high-voltage bus business up in Massachusetts, but those are long-term contracts, very well negotiated contracts between us and the customers. Those projects are necessary for China's infrastructure, so we see those moving forward. Obviously, we've got contractual terms that we believe are fair between us and our customers there in the next year to 2 years for high-voltage bus, so we're not too worried there and there are still other opportunities. So we look for that to be okay. Like I said, mostly by changing it from a JV to our own operation was to give us more control and flexibility if things should get worse, where we'd be able to manufacture more domestically in China without impacting our margins. On the other side, we have been making some [entrées] into the market with our Welding Solutions business, moving some resources in-country. We don't see that being affected as well. Part of it is we just want to make sure we've got equipment on the ground when those turnarounds come up for coker rebuilds, coker drum rebuilds, and as well as for the nuclear side. So we feel pretty well positioned there. It's something we've been working on for the better part of 3 years, and get that in place so that we're not at the mercy -- but it's not -- for Welding Solutions, it's not a huge part of the outlook for them.

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Jonathan Paul Braatz, Kansas City Capital Associates - Partner and Research Analyst [24]

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Is the backlog in the bus business in China, is it [late] or can the terms change at all or the contract dates change at all?

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Thomas E. Ferguson, AZZ Inc. - President CEO & Director [25]

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

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Operator [26]

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And ladies and gentlemen, this will conclude our question-and-answer session. (inaudible) for his closing remarks.

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Thomas E. Ferguson, AZZ Inc. - President CEO & Director [27]

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

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Operator [28]

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