RS

Business Context and Reporting Period

Company: Reliance Steel & Aluminum Co.
Filing Type: Form 10-Q (Quarterly Report)
Period Ended: September 30, 2008
Business Overview: Reliance is a metals service center company processing and distributing carbon steel, stainless steel, aluminum, and other metals. The reporting period was significantly impacted by the acquisition of PNA Group Holding Corporation on August 1, 2008, which added 23 steel service centers and increased the company's exposure to carbon steel products.

Key Financial Metrics

Note: Working Capital calculated as Total Current Assets ($3,085,675) minus Total Current Liabilities ($1,113,116).

Material Changes vs. Prior Period

• Revenue Growth: Net sales increased 42.0% in the third quarter and 18.5% for the nine-month period compared to 2007. This was driven by a 27.1% increase in tons sold (Q3) and a 12.8% increase in average selling price (Q3), largely due to the PNA acquisition and higher carbon steel prices.
• Profitability: Operating income rose 59.7% in Q3 and 25.0% for the nine-month period. Operating margins improved to 10.4% (Q3) and 11.0% (9 months) from 9.3% and 10.5% in the prior year periods, respectively.
• LIFO Impact: A significant LIFO reserve adjustment of $79.0 million (Q3) and $136.5 million (9 months) reduced gross profit. This was primarily due to record high inventory costs for carbon steel and the inclusion of PNA's inventory levels.
• Debt Levels: Total debt increased from $1.09 billion at year-end 2007 to $2.28 billion at September 30, 2008. This increase was primarily to finance the $1.1 billion PNA acquisition.
• Cash Flow: Operating cash flow for the nine months ended September 30, 2008, was $115.4 million, a significant decrease from $384.7 million in the same period in 2007, due to increased working capital needs (inventory and receivables) driven by higher metal prices.

Guidance, Outlook, and Risks

• Guidance: Management did not provide earnings per share guidance for the fourth quarter of 2008 due to significant uncertainty regarding demand and pricing.
• Market Outlook: Management anticipates continued declines in demand and selling prices for carbon steel, aluminum, and stainless steel in the fourth quarter. Prices for carbon steel began declining in September 2008.
• Liquidity Strategy: The company expects to reduce working capital (inventory and receivables) in the fourth quarter, generating cash flow to pay down debt. Free cash flow will be primarily used for debt reduction.
• Capital Expenditures: The company has cut back on fourth-quarter capital spending due to the credit and economic climate and does not expect to reach its $210 million annual budget.
• Risks:
  • Acquisition Integration: Uncertainty regarding realizing anticipated benefits from the PNA acquisition.
  • Liquidity Constraints: Reduced liquidity may force the company to forego future acquisition opportunities.
  • Market Volatility: The global credit crisis has negatively impacted the fair value of defined benefit plan assets.
  • Goodwill Impairment: While no impairment was noted as of September 30, 2008, significant changes in market conditions or stock price could impact future impairment tests.

Investor Verification Checklist

• PNA Integration: Verify the progress of integrating PNA's operations and the timeline for achieving projected gross profit margin improvements.
• LIFO Reserve Accuracy: Monitor the actual year-end LIFO expense against the revised estimate of $210 million for 2008.
• Debt Covenants: Confirm continued compliance with debt covenants, specifically the interest coverage ratio (currently 11.6x vs. 3.0x requirement) and leverage ratios, given the increased debt load.
• Inventory Levels: Track inventory turnover rates and days sales outstanding to ensure working capital reduction targets are met in Q4.
• Commodity Pricing: Monitor spot market prices for carbon steel, aluminum, and stainless steel to assess the impact on Q4 margins and revenue.