Earnings Call Transcript - ATI Q4 2020

Operator, Operator

Good morning everyone and welcome to the Allegheny Technologies Incorporated Fourth Quarter 2020 Result Conference Call. All participants will be in a listen-only mode. Please note, this event is being recorded. At this time, I would like to turn the conference over to Scott Minder, Vice President, Treasurer and Investor Relations. Sir, please go ahead.

Scott Minder, Vice President, Treasurer and Investor Relations

Thank you. Good morning and welcome to the Allegheny Technologies fourth quarter and full year 2020 earnings call. Today’s discussion is being broadcast on our website at atimetals.com.

Robert Wetherbee, CEO

Thanks Scott. Good morning. No surprise. We're glad 2020 is over. It was a challenging year amplified by significant uncertainty. Yet we made the best of it. Our team persevered and focused on doing the right things quickly and decisively to position ATI to emerge from the crisis stronger, a company focused on aerospace and defense. The fourth quarter results reported this morning exceeded expectations as we safely delivered for our customers continued strong cost controls and improved working capital efficiency. For the year, our free cash flow generation was positive overall. At $168 million pre-pension contributions, free cash flow exceeded our full year guidance by 18%. On today's call my remarks will focus on three major themes, our leadership priorities that drove our actions and results, our transformation to a more profitable aerospace and defense focused company and our outlook for our key markets. So, let's start with our leadership priorities. 2020 began with reasonably strong customer demand and without a hint of a looming global pandemic. ATI posted solid first quarter 2020 financial results. We enjoyed the benefit of stable jet engine demand bolstered by increased customer volumes that were delayed from the second half of 2019. While these results will make for a difficult year-over-year comp in the first quarter of 2021, they did help to offset the significant headwinds we faced in the subsequent three quarters of 2020. When the pandemic took hold late in the first quarter, we responded quickly and decisively. The leadership priorities, shown on slide four, drove our results and continue to guide our actions today. First and foremost, we focused on keeping our people safe. Safety is a core ATI value. We quickly enacted policies and procedures around the world to ensure a virus-free work environment, mitigating the risk of spread. Our efforts continue to be largely successful. We remain vigilant to ensure our people go home safely each and every day.

Don Newman, CFO

Thanks Bob. Over the next few minutes, I'll focus on highlights from two key areas. First, our Q4 financial performance; and second, our expectations for 2021. 2020 was a difficult year for all of us. For ATI, it started with 737 MAX challenges that carried over from 2019. Of course, those challenges grew exponentially with the global pandemic. Its impact on our key end markets, including commercial aerospace, energy and medical was profound. Even with those challenges, we took the strategic and tactical steps necessary to improve our business and position it for a healthy future. Now let's discuss Q4 performance. For the third quarter in a row, our results exceeded expectations. In the Q3 earnings call, we noted seeing signs of stabilization in a number of our key end markets, like commercial aerospace. At that time, we said we expected our Q4 performance to be similar to Q3. In fact, Q4 revenue increased 10% to $658 million versus Q3 levels. We see this as a further indication of stabilization in our key end markets and a sign that the worst of the lingering aerospace downturn is behind us. Our adjusted EBITDA increased 39% to $23 million in Q4 from Q3 levels. Adjusted EPS was a loss of $0.33 per share in Q4. This was better than the optimistic end of our EPS guidance range, which was a loss of between $0.36 and $0.44 per share. Our improved performance was largely due to stronger cost reduction actions and higher than expected sales. Thinking of cost reductions, in early 2020 we announced targets to cut costs by between $110 million and $135 million for the year. We increased those targets multiple times in 2020, as we built momentum. In the last earnings call, we shared a target of $160 million to $170 million of 2020 savings. The final tally, reductions near the high end of our guidance and nearly $170 million in 2020. That means a run rate of $270 million to $280 million of cost reductions that will benefit full year 2021.

Robert Wetherbee, CEO

Thanks Don. Although we have some pretty good outcomes and we're proud of it. We accomplished a lot in 2020. Even still, it's great to be starting 2021 with a clear plan. And we're boosted by the first signs of favorable multi-market trends we've seen in over a year. As Don described, we ended the year with a strong performance in a challenging market environment. Our progress in 2020 was a total team effort that delivered results. We worked diligently to control what we could and responded nimbly to what we couldn't. Our entire organization remains relentlessly focused on cash generation. I'm proud of how we're living our values, guiding us every step of the way. Today, in 2021, we still battle a fair amount of uncertainty, but there's already a lot less turbulence than we saw last year. We're gaining velocity, aligned and accelerating in a clear direction as we move ahead. We're well-positioned to emerge in this downturn leaner, more profitable ATI, a fierce competitor not waiting for markets to recover as we gain momentum. Scott, back to you.

Scott Minder, Vice President, Treasurer and Investor Relations

Thanks Bob. That concludes our prepared remarks. Operator, we're ready for the first question.

Operator, Operator

Ladies and gentlemen, at this time, we'll begin the question-and-answer session. And our first question today comes from Richard Safran from Seaport Global. Please go ahead with your question.

Richard Safran, Analyst

Bob, Don, Scott, Good morning. How are you?

Robert Wetherbee, CEO

Good morning, Rich. Welcome back.

Richard Safran, Analyst

Thank you, sir. So, two questions, both related to what a recovery looks like. First, with respect to jet engine products, I wanted to know if you could talk a bit about how jet engine products recover with higher volume. Now, Bob, I think you mentioned forgings in your opening remarks. I think materials lag, but I was curious about how different types of forgings, castings, and alloy manufacturing, what that looks like in a recovery.

Robert Wetherbee, CEO

Okay. Let me address the first part regarding the market recovery, and then I'll let Don discuss the recovery from the API perspective as we undergo transformation. In terms of jet engine materials, our isothermal forgings are a key component in the jet engine sector. During the downturn, our jet engine customers aggressively adjusted their supply chain inventories and demand. Consequently, we don’t see a large amount of inventory in the pipeline. We do have some stranded inventory that we're managing. However, isothermal forgings will align with demand increases relatively quickly. We're beginning to see real demand returning, which I believe will accelerate through mid-year and strengthen in the latter half of the year, along with some market share gains for us entering 2021. The isothermal forgings will lead our efforts, and we also have smaller aerospace forgings that will complement this. We are no longer in the castings sector, so our visibility there is limited, but I expect them to follow a similar pattern. Regarding billet, bar, and ingot, we are observing emerging demand. During the downturn, many companies were focused on managing their cash flow, so not every supply chain partner is prepared for a demand increase, leading to some irregularities. We anticipate some strong emergency demand, and we believe we are well-prepared to respond. You didn’t specifically inquire about airframe products, but by mid-year, we expect the billet, ingot, and bar market to progress positively. We should see these tracking with engines, but the airframe titanium plate market may experience slower growth throughout most of 2021 before beginning to improve, with notable increases expected in 2022. Overall, the most challenging period for us appears to have been in Q4, with Q1 showing signs of stabilization without the order fluctuations we experienced previously. Now, Don, I’ll hand it over to you to discuss the transformation.

Don Newman, CFO

We are discussing several transformative elements in our overall business. Regarding jet engines and our inventory management for recovery readiness, I want to emphasize that we have effectively reduced our inventory levels while maintaining a recovery-ready mindset. This positions us well to respond to market demand as it shifts. Alongside this, we are implementing broader transformation efforts that will benefit the company beyond just the jet engine sector. It's crucial to consider how these changes will shape our business as we recover. We have multiple initiatives in motion that we have introduced throughout 2020. These include significant cost reductions that were achieved in 2020 and will continue to impact us positively in 2021. Additionally, we announced a transformational project in December that will significantly enhance our specialty rolled products business. A pertinent question could be how all these transformations will shape our business at a normalized level. Referring to 2019 as a normalized period, we achieved $440 million in EBITDA with around 11% EBITDA margins. With the cost savings from 2020 and the upcoming changes from the project announced in December, we anticipate an increase of over $200 million in run rate EBITDA on top of what we reported in 2019. This is significant as it effectively boosts our 2019 EBITDA margin from 11% to over 17% when adjusted for these changes, reflecting a 600 basis point margin expansion. As we look at transformation and the evolution of our business for 2021 and beyond, this is the framework guiding our perspective on the benefits of the actions we have taken.

Richard Safran, Analyst

Thanks for that. And just quickly as a follow-up. So specialty energy projects that were referenced in your opening remarks, could you just discuss a bit about how much they're worth and when do you see those decisions being made?

Robert Wetherbee, CEO

A lot of the decisions regarding the specialty energy projects have already been made. There is a pollution control initiative involving nickel and alloy materials going to Asia, with many of those decisions set to take place in 2021. We believe the orders are either secured or the commitments are confirmed. We're also observing ongoing strength in the solar sector, and we're beginning to see signs of recovery in land-based gas turbines. Additionally, on the topic of clad pipes, there seems to be a slight slowdown currently. However, there is a solid pipeline of significant projects expected over the next two to three years. While we may not win every project, we will be competitive in all of them, and we anticipate seeing shipments starting in Q2. Does that address your question?

Richard Safran, Analyst

It really does. Thanks for that color, guys. I appreciate it.

Operator, Operator

And our next question comes from Gautam Khanna from Cowen. Please go ahead with your question.

Gautam Khanna, Analyst

Yeah. Hey guys. Good morning.

Robert Wetherbee, CEO

Good morning, Gautam.

Gautam Khanna, Analyst

I wanted to ask a couple of questions, starting with the quarter itself. The high-performance EBIT margin, excluding depreciation and amortization, was a negative 5.4%. I was curious if there was anything unusual; it didn’t seem like the mix was significantly different sequentially. Was it just the number of working days or something similar that caused the decrease sequentially? I have a follow-up as well.

Robert Wetherbee, CEO

Okay. So I'll take the first one, Gautam. I think what you saw in Q4 in addition to a slightly weaker mix, a little more transactional business that wasn't in the aerospace category, so that contributed to a dosing that was going on in Q4. We actually have some proactive inventory management. So, we wrote off some inventory that obviously affected the margins in Q4, but there's not going to be an ongoing concern.

Gautam Khanna, Analyst

Okay. Just to clarify, it seems you believe that the engine destocking has peaked at this point. Therefore, we should expect improvements in Q1 and Q2 compared to what we experienced in Q3 and Q4, and there should be a further increase with A320 rates and similar models in the second half of the year. I want to ensure I understood that correctly. Additionally, regarding airframe titanium, despite the lack of aircraft deliveries for the Boeing 787 since the third quarter, this will not alter your previous expectations for airframe titanium in 2021. Thank you.

Robert Wetherbee, CEO

We are confident about the jet engine side, mainly due to our ongoing relationship with customers. While there will always be schedule adjustments, we are seeing more clarity now. Many of the adjustments originated in late 2019 due to issues with the MAX, but supply chains adapted quickly. The wide-body issues became clear over the last three quarters. Overall, we expect to see improvement throughout the year, accelerating in the first half and looking significantly better in the second half as we prepare for 2022. Regarding titanium plate, we anticipate that 2021 will be the lowest point for us. We are keeping an eye on Boeing's production announcements, and we believe we are gaining market share in the airframe business globally, which should benefit us in the latter half of 2021.

Gautam Khanna, Analyst

Thanks a lot, guys.

Operator, Operator

Our next question comes from Phil Gibbs from KeyBanc Capital Markets. Please go ahead with your question.

Philip Gibbs, Analyst

Hey, good morning.

Robert Wetherbee, CEO

Hey, good morning, Phil.

Philip Gibbs, Analyst

So, my first question is just on the free cash flow bridge. I think you had pointed to being $40 million positive at the midpoint, excluding pension. When I think, Don about cash contributions, I've got about $100 million of interest, $160 million of CapEx and cash taxes. And then you've got some offset from networking capital. So, I'm ranging somewhere between $225 million and $250 million of cash needs for you all this year. Should we kind of take that as a decent range in terms of what you're trying to communicate and then add free cash flow to that to back into an EBITDA view in terms of what you all view as the potential for the year?

Don Newman, CFO

I think your reasoning is valid, Phil. I wouldn't anticipate that level of cash burn. Considering our cash generation, we've managed it well throughout 2020 and ended up in a solid position. I do foresee us burning cash overall in 2021, but not to the extent you're suggesting. One of the major advantages we had in 2020, which will be less impactful in 2021, was the release of working capital. This was mainly due to the decline we experienced in the first half of 2020, leading to significant releases in our accounts receivable. By the end of the year, we started gaining momentum with our inventory releases. Looking ahead to the second half of 2021, we expect to see some business growth, which will require us to deploy more working capital. Nonetheless, we still believe that working capital will be a source of cash for us, which might not be accounted for in your calculations. Additionally, we are disciplined in managing our levers. In 2020, we significantly adjusted our CapEx to align with the new demand, and we plan to do the same in 2021. We will adjust our CapEx and inventory in response to market signals, which could positively impact the cash burn figure you mentioned.

Philip Gibbs, Analyst

Don, I wasn't referring to a burn. I was discussing slide nine, and from what I understood, you reported positive free cash flow of $20 million to $60 million, unless I'm interpreting that incorrectly.

Don Newman, CFO

We had a positive situation regarding our cash flow for 2021. Based on what we know today, I expect that we will likely be a cash user, but it will be a modest usage. We anticipate ending 2021 with a very healthy level of liquidity. We will adjust to end market signals based on demand, which could require us to either increase our working capital through inventory or take measures to reduce capital expenditures.

Philip Gibbs, Analyst

Okay. As a follow-up, I understand there were absorption issues for you in the second half. Bob, you mentioned that you wrote down some inventory. Can you provide some insight into how much the under absorption and these inventory write-downs affected your P&L in the second half of the year? Could it have been around $20 million per quarter? Also, when do you expect the impact of these issues to diminish? Thank you.

Robert Wetherbee, CEO

I think our rough estimates are reasonably accurate. We made some adjustments to the carrying value of our inventories and considered the effects of under absorption. For 2020, you might expect a total impact in the range of $10 million to $20 million per quarter from these two factors. Looking ahead to 2021, it largely depends on production levels and demand signals in the first half. If the first half mirrors the second half of 2020, we could see similar under absorption effects. From an inventory carrying value perspective, I hope we've already accounted for any necessary net realizable value reserves, so significant effects there should be limited. However, under absorption may still be a factor, particularly in the first half. The scenario changes in the second half, which will depend on our growth rate, making it challenging to provide specific guidance on that.

Philip Gibbs, Analyst

Thank you all. Appreciate it.

Operator, Operator

Our next question comes from Josh Sullivan from The Benchmark Company. Please go ahead with your question.

Josh Sullivan, Analyst

Hey, good morning and congratulations on the quarter here. Actually just following up on those cash burn comments for 2021, is there a scenario in 2022 where demand is going to potentially be picking up a little stronger, where we would continue to see a working capital build in a cash burn. But do you think you'll be set up exiting 2021 where 2022 shouldn't see a burn even in a very strong demand environment?

Don Newman, CFO

The short answer is that if there is strong demand, I would anticipate adding working capital in 2022. This really hinges on the speed of the recovery. It also reflects our ongoing focus on improving working capital efficiency, which we accomplished remarkably in Q4. I noted in my prepared remarks that we decreased our working capital percentage from 50% at the end of Q3 to 40% in Q4. Our internal target is to return to 30% or lower. The speed at which we can achieve this goal will counterbalance what we need to add to our working capital due to an increase in demand. If we are fortunate, we can effectively mitigate the need for more investment in working capital by becoming more efficient. Generally, I suggest viewing 2022 as a year for investing in additional working capital to support the growth we expect to see, which is certainly a positive development. We welcome the opportunity to invest for growth.

Josh Sullivan, Analyst

Good. No, thanks for that. And then just switching over to the strength in the STAL venture in China, can you just provide us some color on the strength in those markets sequentially? And what we had Apple deliver its largest number of iPhones by pre-summit Smith's ever, is that strength for STAL more broad based than consumer electronics, or is that really the focus market for you guys?

Robert Wetherbee, CEO

Great question. I want to start by congratulating the team managing our precision rolled strip business in China for achieving record performance in the fourth quarter. This success stems from investments we made about a year and a half to two years ago, which positioned them well to seize the opportunity. Regarding our broader market, consumer electronics remains central, but we're beginning to see initial opportunities in solar, which we've been anticipating for a year or two now, and we expect growth there. Our precision rolled strip business also serves medical applications, including hypodermic needles, among others. In the automotive sector, we continue to play a significant role in Asia, particularly with stainless steel products that are incredibly thin, comparable to the thickness of a human hair. This opens up various applications, including more advanced automotive needs. Thus, we see potential beyond just consumer electronics. Aside from the impact of the lunar New Year in the first quarter, we anticipate that the upward trend will continue, supported by the strength of the underlying markets.

Josh Sullivan, Analyst

Thank you.

Operator, Operator

Our next question comes from Timna Tanners from Bank of America. Please go ahead with your question.

Timna Tanners, Analyst

Yeah. Hey, good morning.

Robert Wetherbee, CEO

Good morning, Timna.

Timna Tanners, Analyst

Good morning. I just wanted to ask two things. One is if we could kind of continue the discussion about cash usage, but talk a little bit instead of working capital, maybe about CapEx needs going forward. Because I caught onto your comments about putting out some projects and just wondering what that looks like when you catch up and how you're thinking about that. And then I have a high level question.

Don Newman, CFO

Sure. In 2020, we intended to invest between $200 million and $210 million in capital expenditures. However, when the pandemic struck, we slowed down our investments significantly, ultimately reducing them to the mid-130s. For 2021, our guidance is set between $150 million and $170 million, which represents a modest year-over-year increase. This increase is based on our expectation of some recovery in the end markets that will drive demand for specific investments aligned with certain customers. We're not taking a "build it and they will come" approach for our capital expenditures. If 2021 unfolds as we anticipate, we will remain within the $150 million to $170 million range. Looking beyond 2021, the investment level we previously considered for 2019, between $200 million and $210 million, could resurface in 2022 as we prepare for the delayed growth that the pandemic paused. I wouldn’t expect that to be a consistent level for capital expenditures, but it's a way to consider our investments for 2021 and 2022.

Timna Tanners, Analyst

That's exactly what I was looking for. Thanks for that. I know I'm asking you to speculate a bit, but with the Biden administration's interest in moving away from fossil fuels and toward alternative energy, can you remind us of the ATI suite of products and opportunities? Where might you face challenges since you used to supply those other areas, but what are the potential opportunities? I know you've historically been significant in nuclear and perhaps other green energy initiatives.

Robert Wetherbee, CEO

Good question. We're still heavily involved in the nuclear sector, which presents an upside opportunity from our operations in Oregon. We're beginning to see potential in solar energy, which, while primarily in the specialty area, focuses on products that require light gauge and tight tolerances—similar to the challenges seen in consumer electronics. Additionally, there's a growing importance on emission control systems, particularly in flue gas desulfurization, as emissions are a global issue rather than just a U.S. concern. We're also witnessing a resurgence of land-based gas turbines as there continues to be a transition from coal and oil to alternatives. Our product lineup in the energy sector is projected to become a major portion of our business, likely comprising 60% to 70% of our activities, whereas historically, oil and gas have been significant contributors along with chemical processing and hydrocarbon processing. We expect to reduce our focus in those areas as they typically involve more standard stainless steel pipes and infrastructure. Our emphasis will be on addressing corrosion and high-temperature challenges, which are critical material science issues in the specialty energy sector. We're well-positioned in various regions, though it remains to be seen which areas will advance first. Additionally, there are prospects in electric vehicles, battery storage, and hydrogen fuel, all of which require specialized materials. Nickel and titanium, especially nickel, will likely play a larger role in these applications. Does that provide the clarity you were looking for?

Timna Tanners, Analyst

Yeah. It does. I just don't know how much of what you'd be losing that used to be hydrocarbon focused is versus what you'd be gaining with regard to the green energy. Is there a mix that's higher value add, or is it an offset or just rough numbers? What you think about incremental?

Robert Wetherbee, CEO

Our choice to exit the standard stainless sheet market was driven by its lower profit margins. We are shifting our focus to higher-margin nickel and alloy products that are more complex to manufacture with varying dimensions and specifications. We believe this change improves our product mix and aligns well with our material science capabilities. Overall, we see this as a beneficial move that justifies our decision to exit stainless, leading to a positive shift in our margins.

Paretosh Misra, Analyst

Thanks and good morning guys. I was hoping if you could just elaborate a little bit about your isothermal forging business a little bit. So, first of all, just to confirm that is that 13%, 14% of your total sales? And then how much of that is direct sales to OEM versus selling powder or feedstock to those customers so that they can forge it at their own facility.

Robert Wetherbee, CEO

Okay. There are many questions in there, Paretosh, and I will address them. Firstly, isothermal forging is a key aspect of our forged products business, primarily located in Cuday, Wisconsin. I'm not sure if we've disclosed the exact percentage of our business that is isothermal. Regarding your second question about selling ingot, billet, and bar to other forgers, that varies based on the grade and alloy. Our long-term goal is to ensure our forging operation is entirely supplied by our own feedstock. Some customers do supply their own feedstock for forging. Currently, I would estimate that we consume about 40% of our feedstock, while around 60% is sold to other forgers; however, it's subject to variability. In terms of our forging business within the HPMC segment, it represents about 30% of the HPMC business, which includes the value derived from the raw materials we process. This is a 2020 figure, and it has been impacted by the current market conditions. Moving forward, our team has effectively positioned the business for market share growth, with a focus on jet engine applications, while our non-jet engine business remains, albeit less significant. Did that address your questions?

Paretosh Misra, Analyst

Yes, I appreciate all the details provided. As a quick follow-up on your free cash flow guidance, can you clarify if that guidance takes into account any dividends paid to non-controlling interests? I’m particularly referring to your joint venture in China, as it appears you paid $7 million in 2020 and a larger amount of $15 million in 2019. Is that guidance calculated after those payments?

Don Newman, CFO

That would be excluding the dividends paid to the minority owner, which are actually in the finance section. So, they're not part of the free cash flow definition or calculation. The numbers you've mentioned are in the right area, and I expect them to be in the seven plus million dollar range.

Matthew Fields, Analyst

Hey, everybody. I just wanted to sort of touch on liquidity and sort of uses of cash. And I just find it interesting that you ended the year basically with exactly the same amount, $956 million of liquidity that you ended 2019, just a weird quirk there.

Robert Wetherbee, CEO

It is hard work. It's hard work to get to that number.

Matthew Fields, Analyst

You mentioned previously that as you entered the pandemic, your priority was to enhance liquidity while assessing the extent and duration of the impact. I'm curious, if you anticipate an increase in demand in the second half of 2021, when do you think you'll be able to utilize some of this potential excess liquidity for purposes like debt reduction or other initiatives?

Don Newman, CFO

Sure. This is Don. Let me take a run at that. The outcome for 2020 was outstanding. Given the circumstances and the decline in revenue, maintaining flat liquidity in that environment was an impressive result. You have choices to make regarding when to begin taking action, which will depend on our perspective of the end markets and the anticipated recovery trajectory, nine months before that demand truly manifests. We won’t invest the capital any sooner than necessary, and therefore, it's difficult for me to provide a definitive answer beyond that.

Matthew Fields, Analyst

Demand comes back, it seems like you're trying to signal that there'll be a use of working capital, CapEx could kind of ramp back up to that $200 million number. It seems like 2022 will be sort of a more demanding cash year. Can you talk about kind of when we get further down the road this year in 2021, as you see 2022 coming more into focus, what the choice might be between organic investment and debt reduction and kind of where you ultimately want to end up on that debt reduction lever and sort of how we get there?

Don Newman, CFO

Sure. It's tempting to focus on one aspect of cash flow and try to analyze it in isolation. As we look ahead to 2022, we expect several factors to influence our cash flow. The most important is profitability. While it's easy to worry about the need for increased capital investment, the truth is that we will be generating more cash from our sales activities, which is positive for us. We will maintain the same leverage to manage our capital and liquidity in 2022 as we do now, utilizing our working capital effectively. We have been successful in improving our efficiency with working capital, and we plan to continue this trend as we work towards our long-term goals. Similarly, our capital expenditure decisions will be based on the available opportunities at that time. So, I wouldn't overanalyze the situation for 2022 at this stage. However, during an upswing with strong growth in our core business, we tend to generate cash effectively. If we need to allocate more resources to working capital, such as inventory and receivables, it’s a good environment for that. We're confident in managing this in a high growth situation. I hope that addresses your question.

Matthew Fields, Analyst

Yeah. Those are all fair points. Thanks a lot and good luck in 2021.

Robert Wetherbee, CEO

All right. Thanks, Matt.

Don Newman, CFO

Okay.

Robert Wetherbee, CEO

Okay. Well, thank you to all the participants and listeners for joining us today. That concludes our third quarter 2020 conference call.

Operator, Operator

The conference is now concluded. Thank you for attending today's presentation. You may now disconnect.