Algoma Steel Group Inc. Q2 FY2022 Earnings Call

Good morning, everyone, and welcome to Algoma Steel Group, Inc. Second Quarter Fiscal 2022 Earnings Conference Call. Leading today's call are Michael McQuade, our Chief Executive Officer; and Rajat Marwah, our Chief Financial Officer. As a reminder, this call is being recorded and will be made available for replay later today in the Investors section of Algoma Steel's corporate website at www.algoma.com. I would like to remind you that comments made on today's call may contain forward-looking statements within the meaning of applicable securities laws, which involve assumptions and inherent risks and uncertainties. Actual results may differ materially from statements made today. In addition, our financial statements are prepared in accordance with IFRS, which differs from U.S. GAAP, and our discussion today includes references to certain non-IFRS financial measures. With that in mind, I would ask everyone on today's call to read the legal disclaimers on Slides 2 and 3 of the accompanying earnings presentation and to also refer to the risks and assumptions outlined in Algoma Steel's second quarter fiscal 2022 Management's Discussion and Analysis. Please note that our financial statements are prepared using the U.S. dollar as our functional currency and the Canadian dollar as our presentation currency. Our fiscal year runs from April 1 to March 31, and our financial statements have been prepared for the 3 and 6 months ended September 30, 2021. Please note, all amounts referred to on today's call are in Canadian dollars, unless otherwise noted.

Thank you, Brenda. Good morning. Welcome, and thank you for joining Algoma's earnings call for our second fiscal quarter ended September 30, 2021, our first earnings call since closing our merger with Legato and returning to the public markets. I will start my comments by addressing what truly matters most to us, the safety of our employees. At Algoma, we believe in safety without compromise, and our continued focus has resulted in substantial improvement over the last decade in our lost time injury frequency rate, which I'm proud to say was zero for the second consecutive quarter. I commend our entire team for their collective success on safety performance, a top priority for Algoma. Before we get into a discussion about our exceptional results for the quarter, let me address the two transformative announcements that we made this morning. First, we are happy to report, with the approval of our Board, we have reached a positive final investment decision for our proposed Electric Arc Furnace project. This announcement marks a major milestone for the business evolution of Algoma and demonstrates our commitment to producing greener, more sustainable steel. The project entails dual furnaces that are designed for a combined annual raw steel production throughput of 3.7 million tons, matching our downstream finishing capacity. It's also expected to lower our carbon emissions by approximately 70% when fully operational. Additionally, the project adds new vacuum degassing to increase the product capability of our steel plate grades. The project is expected to increase productivity and make Algoma a more agile and profitable company. But just as importantly, it is expected to result in a three million-ton per year reduction in our CO2 emissions as we drive towards a more sustainable method of steel production. The CO2 reduction would represent 11% of the federal and 100% of the provincial targets for industrial emitters as set for 2030 under the Paris accord. The total project cost is expected to be approximately CAD 700 million, funded with previously announced financing commitments, the proceeds of a recently completed merger, and ongoing cash flows. We expect the two Electric Arc Furnaces to come online in 2024 following a 30-month construction phase, with continued transition away from blast furnace steel production to follow as increased power supply becomes available. The other strategic announcement we made this morning was that our Board has approved a plan to retire all of our outstanding senior secured debt, which totals USD 358 million, leaving us with an even stronger balance sheet to support critical investments like the Electric Arc Furnace to drive growth and create additional long-term value for all of our stakeholders. We expect the process of retiring the debt to be completed by the end of next week. Combined, these two announcements mark the next great milestones in our company's evolution. Now let's turn to the quarter's results. Our strong fiscal second quarter results displayed the impressive cash-generating potential of Algoma. I'll remind you again that all numbers are expressed in Canadian dollars unless otherwise noted. The results were highlighted by record net income of CAD 288 million. Quarterly adjusted EBITDA of CAD 431 million, reflecting an EBITDA margin of 43%, as well as cash generated by operating activities of CAD 380 million. We finished the quarter with a total liquidity of CAD 659 million, including a cash position of CAD 367 million and availability under our credit facility of CAD 292 million. Rajat will expand on the numbers and give our outlook for the third fiscal quarter in a moment. Optimism continues for steelmakers across North America. Strong demand in key end markets continues, and pricing remains at near-record levels. The strong cash flows we are generating, our focus on operational efficiency, and the strategic moves made regarding our capital structure are positioning Algoma as a next-generation steelmaker, focused on sustainability with attributes that we believe will make Algoma successful across the steel market cycles. We have several reasons to be very optimistic about what lies ahead for Algoma, and we'll share more details later on the call. But first, I will pass it over to Rajat to go over the financial highlights of the last quarter.

Thanks, Mike. Good morning, and thank you for joining the call. Before we get into these details, I'm happy to report that we had another very successful quarter. The second quarter of our fiscal year ended September 30, 2021. Total revenue in the quarter was CAD 1.01 billion, up 168% year-over-year. Our steel revenue was CAD 936.5 million, which was up 179% versus the prior year quarter. We shipped 587,000 net tons in the quarter, up 14% from 516,000 net tons in the same quarter of last year, primarily as a result of a return to near run-rate utilization levels compared to the pandemic lows experienced last year. This resulted in average steel revenue per ton of CAD 1,594, up 146% from CAD 649 a year ago. As a reminder, both our contract and spot orders are subject to a pricing lag due to pricing mechanics and mill lead times. We started to see these positive results flow through our earnings last quarter, and that impact continued in this quarter. Steel markets have remained strong, and prices, while off from record levels achieved last summer, remain near those elevated levels. On the cost side, Algoma's cost of goods sold per ton increased quarter-over-quarter as some commodity price increases had an effect on selected raw material inputs. In an effort to offset these increases, Algoma remains focused on our cost-saving initiatives. And to date, we have captured run-rate savings of approximately CAD 45 million on an annualized basis, and we remain on track to reach our CAD 50 million target. When compared to the same quarter of last year, the cost of steel products sold per ton is approximately 37% higher. The year-over-year increase was primarily driven by higher commodity pricing impacting some of our raw material input costs and higher cost of utilities. Please keep in mind that last year, Algoma was eligible and did receive benefits under the Canadian Emergency Wage Subsidy program as the pandemic impacted our business substantially, which allowed us to keep our employees working during this period of low production volume and mitigated higher fixed costs on a per-ton basis. We generated CAD 431 million of adjusted EBITDA during this quarter compared to CAD 281 million of adjusted EBITDA in the prior year quarter. We are continuing to reap the rewards of even higher pricing moving through our results. However, due to the lagging nature of our order book, we expect to realize higher prices in the subsequent months. We generated CAD 380 million of cash from operating activities and ended the quarter with CAD 367 million of cash on the balance sheet, which resulted in liquidity of approximately CAD 659 million, including availability under our credit facility. I'd like to take a moment to follow up on Mike's comments around our announced debt retirement. It truly is a remarkable achievement that when you consider our September end cash position and add the cash received in connection with the closing of the merger transaction, Algoma, today, is in a position where our cash exceeds our outstanding debt. We've begun the process of retiring all of our senior secured outstanding debt at par. We expect that this positive cash flow will only improve going forward considering the strong steel market and our competitive cost position. We feel this places us with a stronger balance sheet as we began constructing the Electric Arc Furnace, which puts us in a tremendous position to create long-term stakeholder value from a position of strength. Now turning to outlook. As you all know, there has been a sustained significant increase in the index price of steel since August of last year. Strong demand, coupled with low customer inventory levels across the supply chain, continue to support flat-rolled steel prices above historical peaks. Demand from key end markets, including automotive, remained strong, and we expect this to continue into next year. We feel that the investments we have made in our plate mill are serving us well as traditionally, as roll plate is priced higher than hot-rolled coil. Today, that relationship is inverted. However, with infrastructure spending, we believe the traditional relationships will return and Algoma will be ready at that point with higher production capacity and broader market reach for our products. With the macroeconomic drivers in the North American market, that includes projected infrastructure spending, Section 232 tariffs, replacement tariffs, rate quotas, and discussions around carbon border adjustments, we believe that pricing will remain elevated for the foreseeable future, resulting in a new paradigm for steel selling prices. All of these factors support our positive guidance. Shipments in the third quarter of 2022 ending December 31 are expected to be in the range of 590,000 to 610,000 net tons. Net sales realization is again expected to be directionally higher as we expect to see our realized prices climb month-by-month in parallel with the significant index price increase we have experienced. We expect adjusted EBITDA performance of at least CAD 450 million. I would like to add that subsequent to the quarter end, we announced that we had established a metals sourcing joint venture with MMM, one of North America's largest privately owned ferrous and nonferrous metal recycling companies. We expect this joint venture to add stability to our scrap supply chain, helping us take some of the volatility out of our cost structure. To take us further through our strategic activities, I will pass on the call to Mike.

Thanks, Rajat. As you are aware, on October 20, we celebrated a milestone day in this company's rich 120-year history with our return to public markets. Together with the number of employees and other stakeholders, we opened the Toronto Stock Exchange the following day in what was a short one-minute ceremony. A one-minute ceremony that was only made possible by countless hours and hard work and dedication from our team. And while the ceremony was brief, this moment served as validation for the value we have created in this business. For the past three years, we have taken a dedicated strategic approach to improving Algoma. Whether it is our approach to operational and capital improvements, improvements made to the balance sheet, or our focus on organizational excellence and ESG, we have developed the building blocks to position Algoma as a successful next-generation steelmaker. Powered by our employees, it's the collective effort of our team that has facilitated our return to public markets. In connection with the successful merger, Algoma received proceeds of over USD 300 million. Former private Algoma shareholders received public shares of the new company with contingent rates to additional shares pending target calendar year earnout adjusted EBITDA numbers. These will be fully earned if the company generates 2021 calendar year earn-out adjusted EBITDA of greater than USD 900 million. Our current EBITDA guidance projects that we will surpass the earn-out threshold and achieve a calendar year adjusted EBITDA of approximately USD 1.1 billion. This would truly represent a win-win for the company and its shareholders. While the opening of the Toronto Stock Exchange provided a moment to reflect on all the work we have done to get to this point, we are by no means resting on our laurels. With cash injected from the merger, record earnings performance and a commitment of CAD 420 million from the federal government, we are moving on to our next strategic focus. Our team has already mobilized to begin work on the Electric Arc Furnace transformation, and we believe this to be a generational investment that will forever change how steel is manufactured in Sault Ste. Marie, and that Algoma is well capitalized and positioned to execute. Our team is focused both operationally and financially on this critical investment to make our business greener, more competitive, and more resilient. We expect this transformation will create a compelling value proposition for all of our stakeholders. Exciting times to say the least for the steel sector and for Algoma Steel in particular. Thank you very much for your continued interest in Algoma Steel. We very much look forward to what the future holds. At this point, we would be happy to take your questions.

Okay. Before I ask my questions, I just want to congratulate the Algoma team as well on being back in the public equity market. Great to see how Algoma came back, strong balance sheet and solid strategic outlook here. Congrats again.

Thanks so much, David, and I really appreciate you dialing in this morning and look forward to your questions.

Great. Regarding capital allocation, we generated free cash flow of CAD 350 million last quarter and are expecting an even higher figure this quarter. With the de-SPAC proceeds, Algoma is projected to end 2021 with over CAD 700 million in cash and no debt once the bonds are redeemed. Looking ahead to 2022, we anticipate another strong free cash flow yield. I found it noteworthy that the recent press release about the Electric Arc Furnace confirmed plans to partially finance it through previously announced government funding agreements. Given the strength of our balance sheet and upcoming cash generation, do you still intend to utilize the full government funding package, or will you opt for just the forgivable portion? Additionally, are there any restrictions on shareholder returns if you access either the SIF forgivable loan or the CIB loan?

So David, sitting on the front end, we share your optimism with respect to the steel markets, and we'll let that play out. And with certainly, the Electric Arc Furnace final investment decision behind us as well as the debt retirement, we will turn our minds to are turning our minds to the alternatives that are available to us. And it's really focused on maximizing shareholder value. So the degree to which the debt is required, the other strategic options that we have with respect to rewarding the shareholders, regular dividends, special dividends, share repurchases, obviously, are subject to the lockups that exist. Warrant settlement, strategic investments, all of those things are on the table, if you like. So at this point in time, we're not declaring or are we able to declare the plans going forward with respect to specifically the financing that's available from the government. I would note that it is very attractive debt and it may make sense to proceed, and we'll see how the market unfolds and whether that continues. And obviously, this is all done with oversight from the Board, with the stakeholder and shareholder value in mind. With respect to the restrictions, there are some, and it's basically the availability and a reduction of what's available to us from the government as we do that. And again, that will factor into the decisions.

Okay. That's helpful. Just switching gears, just to the contract versus spot mix here. I think it's about 10% of the volumes that are actually tied to annual contracts. I believe that reset at the end of the calendar year. Just assuming you're mostly done with those negotiations now, what's a reasonable average year-over-year price increase for 2022 for that 10% of your business?

So to be clear, there is approximately two-thirds of our business, 65%, that is covered under contract, some on a fixed price over the course of the year, some on a one-month lag and some on a three-month lag. But if you were to look at the year-over-year increase, where spot is in late in calendar Q3 and into Q4 as they're being renewed relative to last year, that would be a good proxy for the negotiating starting point.

Okay. So just to clarify, how much of that two-thirds is actually tied to full year annual contracts that reset at the end of this year?

I think you have the number right, it's 10% that is a fixed price for the full year, with the balance being indexed either quarterly or monthly.

Okay. And your point was that if we just look at year-over-year price changes in the spot market, that actually is a reasonable proxy for the magnitude of the increase for that 10% of the business?

Yes, I believe so.

Okay. Great. And then just quickly on the cost side. Coal producers in the U.S. have been flagging some pretty meaningful cost increases, up USD 100 a ton. Is that a reasonable expectation for your 2022 coal costs? And if you can remind us what is your annual coal consumption?

Sure. David, this is Rajat. On an annual basis, our coal consumption is typically about half of our steel shipments. So the requirement is around 1.2 million to 1.3 million tons for the year. We are currently in discussions to finalize our contracts for next year, and I believe we are in a similar range as what you mentioned. Although the index has increased by 300%, North American settlements are usually at a discount to that index, as it primarily reflects material going offshore. Therefore, it seems like a reasonable estimate.

Okay, that's helpful. And then just one last question for me for now. What is the fully diluted share count once the earnout rights are finished? Also, I have the same question regarding the warrants.

Sure. It’s all detailed in our recent F1 filing, but at a high level, there are currently 112 million shares outstanding. This number does not include 37.5 million earnout shares, which are expected to be available early next year, or the 24 million warrants. Additionally, it excludes 3 million management shares that have not yet been issued. In total, there are 112 million shares outstanding now, approximately 3.3 million management shares, 37.5 million earnout shares that will come early next year, and 24 million warrants.

I know you've talked a little bit already, but just in terms of the operating costs, what was sort of driving those higher costs in terms of which commodities? And how would that compare to what we might see in a more normalized environment for an operating cost run rate going forward?

Most of the increase we are experiencing is primarily in the metallics sector, including scrap and iron ore, as well as variable cost items like refractory reagents. All commodities have risen, reflecting the significant increase in steel prices. Additionally, we have seen an uptick in natural gas and power costs, influenced by the situation in Europe. We anticipate a similar trend in the fourth quarter. However, we expect scrap prices to stabilize in line with steel pricing, and natural gas and power costs should also decrease due to the ample supply of natural gas in North America. Regarding iron ore, part of its pricing is tied to steel revenue while another part is linked to the iron ore index, which may also adjust in the future. Overall, while current costs are high due to current commodity prices, we expect them to decrease as conditions normalize.

Got it. And then another one I just had on your volumes. You guys guided for a little bit higher volumes in Q4. I know sometimes Q4 can be a little bit seasonally weaker. So just curious kind of what impacted Q3 shipments, and what the run rate looks like going into start of '22?

So for the third calendar quarter, are you referring to fiscal or calendar Q3 regarding the shipments?

Yes, sorry, calendar Q3, yes.

Okay. So our maintenance is typically concentrated in the nine months really from April through the end of December. And the issue is really not performing a significant amount of maintenance, and I'm talking planned maintenance in the winter months of January, February, and March. So this year, we've completed a regular maintenance on our DSPC, relined our #4 steelmaking vessel, and did hood repairs. So it really is an impact of while we have two million, two and a half million on an annual basis, we do tend to have our strongest quarter in that January through March, and again, supported by the contracted volumes that we have with our customer base.

Got it. And then the last one I had, just curious on lead times for your spot sales. What are those looking like right now in terms of weeks?

Again, we're looking to just clean up and finish the end of December. So we're out to six weeks at this point in time on hot roll, well beyond that on cold roll. But I think hot roll is the most indicative and looking to close out December now and move into January. Well, listen to our first earnings call as a public company. I certainly appreciate the attendance this morning, the interest, and the questions. Certainly exciting times for Algoma Steel, and we look forward to future earnings calls and sharing our success and progress against the objectives that we set. So thanks very much. Have a safe day.

Ladies and gentlemen, this does conclude today's teleconference. Thank you for your participation. You may disconnect your lines at this time and have a wonderful day.