Kaiser Aluminum Corp Q2 FY2020 Earnings Call

Thank you all for being here, and welcome to the Kaiser Aluminum Second Quarter 2020 Earnings Conference Call. All participants are currently in listen-only mode. After the presentations, there will be a question-and-answer session. I will now turn the conference over to your host Melinda Ellsworth. Please go ahead.

Thank you. Good afternoon, everyone and welcome to Kaiser Aluminum’s second quarter and first half 2020 earnings conference call. If you have not seen a copy of our earnings release, please visit the Investor Relations page on our website at kaiseraluminum.com. We have also posted a PDF version of the slide presentation for this call. Joining me on the call today are Chief Executive Officer and Chairman, Jack Hockema; President and Chief Operating Officer, Keith Harvey; Senior Vice President and Chief Financial Officer, Neal West; and Vice President and Chief Accounting Officer, Jennifer Huey. Before we begin, I would like to refer you to the first three slides of our presentation and remind you that the statements made by management and the information contained in this presentation that constitute forward-looking statements are based on management’s current expectations. For a summary of specific risk factors that could cause results to differ materially from those expressed in the forward-looking statements, please refer to the company’s earnings release and reports filed with the Securities and Exchange Commission, including the company’s Annual Report on Form 10-K for the year ended December 31, 2019, and Form 10-Q for the quarters ended March 31, 2020, and June 30, 2020. The company undertakes no duty to update any forward-looking statements to conform to the statement to actual results or changes in the company's expectations. In addition, we have included non-GAAP financial information in our discussion. Reconciliations to the most comparable GAAP financial measures are included in the earnings release and in the appendix of the presentation. Any reference in our discussion today to EBITDA means adjusted EBITDA, which excludes non-run rate items for which we have provided reconciliations in the appendix. At the conclusion of the company’s presentation, we will open the call for questions. I'd now like to turn the call over to Jack Hockema. Jack?

Thanks, Melinda. Welcome to everyone joining us on the call today. I want to begin today by acknowledging our recently announced executive succession plan following a multiyear planning process. I will step down as CEO on July 31 and Keith Harvey will assume the role of President and CEO of Kaiser Aluminum while I remain on the Board of Directors as Executive Chairman. Keith and I have worked together for the past 25 years developing and implementing the culture and the strategy that have positioned Kaiser as the highly respected industry leader it is today. Keith has had full responsibility for the operations of the company as President and COO since 2015 and during that time, he's focused on building a strong and deep management team as we work through a planned transition for him to assume the additional duties of CEO. Keith is highly respected within the industry and the company, and the announcement of a strong internal candidate as CEO has been met with enthusiasm by our customers and employees alike. I am confident in Keith's ability to lead the company to continued growth and I congratulate him on his new position. Turning to slide six, as we communicated during the April earnings call and through extensive investor engagement since then, our business model is predicated on maximizing opportunities during the expanding economy as well as being well prepared for unexpected economic adversity. To that end, recognizing the cyclicality of our end markets and the inevitable economic downturns, our ongoing financial strategy focuses on management of liquidity and debt leverage. We manage our liquidity to provide funding for sustaining and strategic investments and dividends through the full business cycle. Following the additional capital raise we completed in late April, we have approximately $1 billion of liquidity, which provides a strong safety net as well as positioning us to capitalize on attractive investment opportunities. As a key element of our financial strategy, we also seek to maintain leverage at or below a ratio of two times net debt to normalized EBITDA. In order to fund attractive strategic initiatives, we would allow greater than two times leverage but only if we have a clear plan to de-lever to two times or less. Turning to slide seven, our capital allocation priorities are unchanged. Our top priority continues to be organic investment. With the change in demand for commercial aerospace, the $375 million Trentwood expansion project has been placed on hold until market conditions justify the expansion. As noted during our first quarter earnings call, we temporarily curtailed capital spending to fund only critical sustaining projects while we assess the implications of COVID-19. With approximately $1 million of liquidity, we are positioned to be proactive in funding attractive organic investments to further enhance efficiency and advance our competitive position. Our second priority is our inorganic investment where our strategy remains unchanged. We are constantly on the lookout to acquire businesses that we understand, that are complementary to our existing portfolio and that can be acquired at a price that creates long-term shareholder value. During times of economic distress, there may be acquisition opportunities and we are positioned with financial flexibility to consider attractive opportunities. Our third priority is the regular quarterly dividend. We consistently test our long-term ability to sustain and increase our dividend and we have evaluated a multitude of scenarios for the COVID-19 economy. In all possible scenarios that we envision, we have confirmed that the current dividend is sustainable. Our fourth and last priority is share repurchases, which we curtailed in March. Share repurchases deploy excess liquidity beyond what is required for organic and inorganic investments as well as dividends. In addition, if projected leverage exceeds two times normalized EBITDA, we would seek to de-lever before repurchasing shares. While the COVID-19 economy is an unwelcome development, we are confident in the long-term prospects for the company and are well positioned to capitalize on opportunities to further strengthen our prospects for long-term profitable growth. We've successfully navigated challenging market conditions in the past, emerging stronger and better positioned to compete, and we believe we will do so again when this market rebounds. I will now turn the call to Keith who will review the current state of the business, second-quarter results, and our outlook. Keith?

Thank you, Jack. Our second-quarter results reflect the impact of COVID-19 on each of our end markets in varying degrees as we initially noted during our first-quarter earnings call. Demand for our commercial aerospace applications declined as Boeing and Airbus temporarily halted production and curtailed deliveries, while demand for defense applications remained. While conditions for our service center customers were challenging, as many of their customers temporarily shut down during the quarter, our general engineering business remained strong. Demand for our high-performance KaiserSelect products, along with the solid support from our long-term customers, helped create additional pull for our products in the second quarter. In addition, with lower aerospace shipments, we shifted capacity to meet demand for general engineering plate, partially mitigating the impact of lower demand for other general engineering applications. Demand for our automotive applications significantly eroded during the second quarter as virtually all North American automotive assembly plants temporarily shut down due to the COVID-19 concerns. Although most automotive manufacturers resumed operations in June, restarts were slower and uneven throughout the supply chain as facilities continued to deal with restart issues. As we began experiencing lower demand during the quarter, we leveraged our business model by aggressively flexing cost and operating capacity at our facilities. Although there is often a lag between these flexing actions and the related savings, our highly variable cost structure allows us to react quickly and appropriately flex costs through all cycles. Despite the decline in end market demand, pricing has held as the industry response has generally been to reduce operating levels to match demand. As Jack noted, we manage liquidity to ensure we maintain a recession-tested safety net in order to sustain capital spending and dividends through all business cycles, including periods of unexpected economic adversity. With total liquidity of approximately $1 billion, we will continue to maintain our capital allocation priorities, including our regular quarterly dividend, the most recent that was just announced at $0.67 a share, which will be paid in August. Before I turn the call over to Neal to provide more color around our second-quarter results, I want to acknowledge our employees who have continued to work safely, following the protocols we've established for minimizing the spread of the virus while continuing to perform at a very high level of customer satisfaction in terms of quality and delivery. I thank them for their dedication and commitment in this very challenging environment. I will now turn the call over to Neal to discuss second-quarter results in more detail.

Thanks, Keith. Value-added revenue of $175 million in the second quarter 2020 declined by $35 million or 17% compared to the prior year quarter, with a 24% lower shipment reflecting lower demand for our aerospace markets due to the impact of COVID-19. Aerospace value-added revenues decreased 15% from the prior year second quarter, a 25% year-over-year decrease in shipment, which predominantly reflects the production suspension of aerospace at Boeing and Airbus, as noted by Keith, while value-added revenue per pound reflects a slight increase due to customer mix. Automotive value-added revenues decreased approximately 58% compared to the second quarter of last year, a 58% reduction in shipments. As noted earlier, our automotive shipments were significantly impacted during the quarter as virtually every North American automotive manufacturer temporarily shut down operations. General engineering value-added revenue was up 1% year-over-year, a 7% reduction in shipments reflecting solid pricing and mix. The decline in shipments is primarily related to disruption caused by COVID-19, while that value-added revenue per pound is up due to customer product mix. For the first six months of 2020, total value-added revenue decreased approximately 9%, and 14% lower shipments reflecting lower demand for our aerospace and automotive applications in the second quarter. Turning to slide 12, EBITDA for the second quarter 2020 of $34 million declined from $48 million in the prior year quarter, primarily reflecting approximately $21 million sales impact due to lower demand, partially offset by $5 million lower maintenance cost, in addition to reductions in overheads and other costs. During the second quarter, we incurred approximately $1 million of cleaning and prevention costs associated with COVID-19, and we anticipate ongoing quarterly costs of approximately $250,000 related to buyer's prevention. EBITDA margins for the second quarter were approximately 20% compared to roughly 23% in the prior year quarter, driven by lower demand and operating leverage. EBITDA for the first half of 2020 of $94 million declined by $10 million compared to the prior year period, primarily reflecting the reduction of EBITDA in the second quarter 2020 due to the reasons previously discussed. EBITDA margin of 24% in the first half of 2020 is comparable to the prior year period, driven by a record 27.4% first-quarter 2020 EBITDA margin and the drag on margins in the first half of 2019 due to the planned and unplanned downtime in Trentwood and lower automotive shipments due to full rank transition. Turning to slide 13, reported operating income for the second quarter 2020 was approximately $5 million. Adjusting for $17 million of non-run rate charges, operating income for the second quarter of 2020 was approximately $21 million compared to $35 million in the prior year quarter, reflecting the items previously mentioned and the $1 million year-over-year increase in depreciation expense. The $17 million in non-run rate charges in the second quarter primarily reflects a $12 million restructuring charge for severance and benefit costs that reflect our cost structure and reduce our operating levels to align with lower demand, along with an additional $2 million of increase for environmental issues associated with ongoing historical PCP clean-up. Reported net loss for the second quarter 2020 was $7 million or $0.41 loss per diluted share. Adjusting for the non-run rate items, adjusted net income for the second quarter was $6 million compared to $23 million in our prior year quarter, reflecting the lower impact of lower operating income and an increase of $5 million of pretax interest related to our recent bond offering. Adjusted earnings per diluted share in the second quarter declined to $0.36 from $1.40 in the prior year period. Reported operating income for the first half of 2020 was $50 million, adjusting for the $70 million in non-run rate charges. First half 2020 operating income was $68 million, down from $80 million in our prior year period. The decline primarily reflects a decrease in EBITDA previously discussed. Reported net income for the first half of 2020 was $23 million or $1.41 per diluted share. Adjusting for the non-run rate items, first half adjusted net income was $36 million compared to $53 million in the prior year period. Adjusted earnings per diluted share for the first half of 2020 was $2.27 compared to $3.24 for the first half of 2019. The effective tax rate for the quarter was impacted by discreet issues during that period including an increase in state tax and a lot of valuation, and an adjustment for non-effective executive compensation. The effective tax rate for the year 2020 is projected to be in the low to mid 30% range due to the same items. We expect our 2020 net cash tax to be a cash refund of approximately $11 million related to AMT monetization. Capital spending totaled $11 million for the second quarter and $32 million for the first half of 2020 as we limited capital spending in the second quarters only to sustain profits. During the first half of 2020, we returned $34 million of cash to shareholders in the form of share repurchases and dividends. As a reminder, we suspended our share repurchase in early March due to the uncertainties related to the pandemic. In April, we further strengthened our liquidity and financial flexibility, issuing $350 million of 6.5% senior unsecured notes that mature in 2025. As of June 30, cash totaled approximately $711 million, reflecting the additional capital raised. Our earning availability and our undrawn revolving credit facility was approximately $282 million, providing us with ample liquidity of $1 billion. And now, I'll turn the call back over to Keith to discuss our outlook.

Thank you, Neal. Turning to slide 15, moving on to each of our business segments, as we noted on our first quarter earnings call, we anticipate full-year 2020 value-added revenue for our large commercial aerospace and defense applications will be down approximately 15% to 20% from our record full year 2019 results. Combined, these two businesses represent approximately 50% of our total value-added revenue. As we previously noted, value-added revenue for our large commercial aerospace business is expected to be down 20% to 25% from the prior year, with sales volume heavily weighted to the first half of 2020. Demand in the commercial aerospace market has been significantly impacted by COVID-19 as air travel has slowed dramatically and by continued delays in recertification of Boeing 737 Max. As we look beyond 2020, we expect that passenger traffic will recover and subsequent growth in aircraft builds will continue. However, as both Boeing and Airbus have noted, it could be two to four years before demand returns to the record levels similar to 2019. We will begin discussions with Boeing and Airbus in the third quarter as to their expected needs in 2021 and while we are optimistic that improvements in shipments will occur next year, it is too early to provide specific outlook at this time. Our defense business remained solid and on track to continue to improve during 2020. We are well positioned on all aircraft models including, but not limited to the F35 Joint Strike Fighter, legacy programs such as the F-18, the F-16 and F-15 fighter jets, as well as various rotary aircraft programs such as the V-22 Osprey and the Chinook CH-47 helicopter. Turning to slide 16, as I briefly mentioned in my earlier remarks, virtually all our automotive customers resumed operations in June and expect to continue to operate through the typical summer hiatus to meet demand requirements. In response, our automotive focus facilities have also ramped up production to meet this resurgence in demand. In addition, we recently secured several contracts with key customers for a number of new automotive programs. We anticipate these and other new programs previously awarded will begin to ramp up in the second half of 2020 and will continue to drive growth in 2021 and beyond. As we look to the second half of 2020, we anticipate demand for our automotive applications will rebound from the weak second quarter 2020 with value-added revenue returning to a pace similar to the first quarter of 2020 as customers return to more normal operations and new program launches resume. Turning to slide 17, value-added revenue for our general engineering applications in the second half is expected to reflect normal seasonal demand weakness. Challenged by the impact of COVID-19, many North American OEMs are developing strategies to secure and shorten supply lines by accelerating the reshoring of their manufacturing part suppliers and requesting domestic supply for their raw material needs. KaiserSelect, rod bar and plate products and our expansive network of longtime service center partners uniquely position us to capitalize on these opportunities as they develop. Turning to slide 18, we continue our planned exit of non-core applications and expect shipments to decline to an annual rate of $4 million in 2020, as we allocate capacity to more strategic extrusion applications. Turning to slide 19, in summary of our outlook for the second half of 2020, as we look at the second half, we expect total value-added revenue will be down approximately 10% to 15% from the second quarter, and EBITDA margin to be in the mid-teens. Aerospace and high-strength value-added revenue is expected to be down in the second half of 2020 versus the first half. We expect a strong rebound for automotive in the second half with value-added revenue on par with the pace set in the first quarter of 2020. In General Engineering, we expect normal seasonal demand weakness compared to the first half of the year. Our second half 2020 outlook for value-added revenue and EBITDA margin anticipates a weaker third quarter than the fourth quarter due to the timing of aerospace sales and approximately $4 million of higher major maintenance costs related to the timing of planned projects. As previously noted, in April, we began limiting capital spending to critical sustaining projects only. However, with greater visibility into our end markets and significant liquidity, we will begin to be more proactive in our capital spending. We have decided to resume spending on a number of good return organic investment opportunities to further support our automotive growth and enhance efficiencies throughout our operations. We anticipate that capital spending for the full year 2021 will now be approximately $50 million to $60 million. As we've stated in numerous discussions around inorganic growth opportunities, we will continue to adhere to the same disciplined approach as in the past. Employing the same filters we apply in evaluating prior potential acquisitions: one, we feel it must be a business that we understand, is compatible with our existing businesses; it must have a winning strategy and be capable of achieving a defensible competitive position; we will not overpay; we will only pay a transaction price consistent with creating long-term shareholder value; and we must meet our liquidity safety net and leverage guidelines. Turning to slide 20 and a summary of my comments today, our second-quarter results reflected the environment and conditions with which we had to operate as COVID-19 impacted demand in each of our end markets. We promptly executed on our strategy and aggressively flexed costs and operating levels to align with changes in business conditions. Despite the decline in demand, pricing held well as the industry has generally responded to lower demand by reducing operating levels. We expect second-half value-added revenue to be down approximately 10% to 15% from the second quarter, with resulting EBITDA margin in the mid-teens. We intend to begin relaxing our earlier hold on capital spending and will become more proactive with planned investments to support new programs in automotive and other efficiency projects while continuing to fund critical, sustaining capital projects at our facilities. We have a proven, solid business model. As Jack noted, our model is predicated upon being well prepared for unexpected economic adversity and our experienced management's ability to flex operations and execute well in all market conditions. As the balance of 2020 becomes clear, we are all well positioned with approximately $1 billion of liquidity providing a strong safety net and the financial flexibility to position for the recovery in our key markets, taking advantage of opportunities as they present themselves to further advance our competitive position. I will now open the call for questions.

Our first question comes from Josh Sullivan of the Benchmark Company. Your line is open.

Just on the transition of the aerospace capacity over to the general engineering side, how much more room is there to go? Can the general engineering market there, absorb additional aerospace transition just as we look at the back half of the year with aerospace volumes potentially being weaker.

Well, we actually are seeing some pretty good demand there, Josh, in a couple of markets in particular. As the automotive business comes back, of course opportunities for tooling plate and other applications provide us an opportunity as well as semiconductor, which has held up very well and shows continuing strength in the second half of the year. You may recall in '19 we actually were able to shift capacity from GE to more aerospace. That flexibility at Trentwood has really served us well in these two particular markets in the fact that we're able to shift back capacity fairly quickly and meet demand if one market wanes versus another. So we think that those opportunities will continue in the second half and, of course, the outlook in 2021, we'll get to that later, but we think we're positioned to take care of any of those, and I mentioned in my comments earlier, we are seeing some reassuring beginning to happen in the North American opportunities. As those happen and with the products and the service center relationships we have, we're really well positioned to take advantage of those.

In what verticals are those reassuring efforts? Is it semiconductor, or are there any other ones to call out?

Well, semiconductor is part of that, but we're seeing that in the automotive supply line, and really through the service center customers, and that's really where a big indicator came to us really in the middle of the second quarter. A lot of supply lines had been disrupted just because of what was brought on by COVID-19, as well as some of the issues that have taken place with tariffs and other things. We believe that's continuing to drive a resurgence of that reshoring. So as automotive progresses and others, we believe more and more that is going to focus on domestic supply.

And then just on, you’ve obviously done a good job on production costs here, but what inning do you think they're in? How much more do you think you can go on that cost quest?

Well, if you look at the second quarter, it was interesting for us. First, we flexed aggressively on the automotive side and as we know, the automotive assembly plants shut down early in the quarter and so we flexed a large percentage of our operations early on, and then, as we know, a couple of months later, all those came back on. So we flexed again to respond to that demand. So we not only brought back a majority of the workforce that participate in those markets, we actually have with some of these new opportunities I mentioned, we're bringing back more employees than we had prior to the outages due to COVID-19. So we’re probably unless we have a second wave, we may be in the third quarter there in automotive. If you move over and reflect on the aerospace side, we had some fairly decent demand in the second quarter, and so while we did flex some of our operations there, we still had a fairly good demand that we had to meet. With our outlook in the second half, we have room to flex operations there and will do so as demand warrants.

And then just to follow up on the automotive side, can you comment on what it looked like in June? Is there any way to frame it in terms of lead times or just how aggressive was the automotive supply chain in picking up the demand?

Well, it was fairly quick. Not only did we have to bring back the employees to begin that, so we had extensive retraining to get used to that, but we also had retraining to how to work safely in a COVID-19 environment. So that started fairly quickly and as I mentioned, a lot of the end-users there were fits and starts to their returning. So June was a chaotic month, but now we're sorted in a group through July. We have a better outlook of what the second half looks like, and so we've ramped up accordingly. June was a transition month for us, but it's happy to be back. We see good strong demand there, and hopefully we'll see that continue as we go forward. The other promising news on that side is that there is a resumption of planned launches that had been temporarily put on hiatus. With those happening in the second half and continuing into 2021, we really see good growth there for us.

Thank you. Our next question comes from the line of Curt Woodworth of Credit Suisse. Your line is open.

First question is on aerospace. The fact that you still saw decent demand in 2Q is somewhat surprising, just given the OEMs showing production as well as continued delays in 737 Max. So I guess one of the questions I have is what was the driver of still somewhat decent demand into 2Q? You had a competitor that reported yesterday, and I think their volumes were off close to 40%. And then specifically for the Max, I think we on the buy-side have a hard time really understanding exactly how meaningful that platform is to Kaiser. We know it's a very material consumer of aluminum plate. So the degree to which that eventually recovers, can you provide any insight in terms of thinking about how that could potentially benefit you going forward?

Certainly, the demand in the second quarter has been the subject of numerous discussions with airframers throughout the year, especially after we experienced a record quarter in the first quarter. There was ongoing demand, but the impact of COVID-19 along with delays in the recertification of the Max has contributed to a slowdown. The strong relationships we maintain with our end-users enable us to engage in almost daily discussions to understand their immediate and long-term needs. While our conversations have largely revolved around shortages and potential extensions regarding shipments in 2020, we are also addressing concerns about the need for capacity when demand rebounds. We are collaborating closely as partners, focusing on both immediate and long-term strategies, which explains the slowing demand in the latter half of the year. Additionally, airframers are actively managing inventory within the supply chain. They have reduced production and are working with us to adjust capacities in order to manage inventory effectively. Overall, the industry is navigating these challenging conditions quite well. Regarding your second point about the Max, it plays a significant role for Boeing, as currently about 70% of their backlog consists of Max orders. Despite some cancellations discussed, the backlog remains strong, and the industry continues to support this aircraft well. Even with lower production rates and the existing backlogs at both Airbus and Boeing, we still have over 12,000 aircraft that represent approximately seven to eight years of production capacity. Thus, we believe the conditions are favorable for solid sequential growth in this business once we move past the concerns related to COVID-19.

Okay. That's super helpful. And then a similar question to what Josh was asking in terms of displacing back in the more GE from the aerospace. There is a pretty major commonality ongoing with, I think, 17 countries. I know that you have a lot of commonality in product, but clearly the outcome of that would be meaningful to all types of products. So can you quantify at all from a volume basis how much you could fit into GE? Would you also be willing to try to even go into the more commodity spectrum just to achieve a certain target utilization rate at Trentwood or is that not really feasible? Thank you?

Sure, Curt. That's not really a market that we would look at for the Trentwood facility. We're the largest domestic supplier of heat-treated plate in North America, and as our capacity becomes available, perhaps due to lower aerospace shipments, we've seen our distributor customers be very pleased to come back and take more volume from us, and actually that reassuring and that concern of supply chain disruptions has really been a catalyst, I believe, in keeping things very positive for us on the GE side.

Thank you. At this time, I'd like to turn the call back over to Keith Harvey for closing remarks. Sir?

Thank you. Before I end the call, I want to formally acknowledge and thank Jack for his leadership and commitment to Kaiser Aluminum, our employees, and our stakeholders over the past two decades. Your impact on the company and each of us has been profound, Jack, and has prepared us well to move Kaiser into our next chapter. In 2021, as Kaiser Aluminum, we will celebrate our 75th anniversary, and as you’ve said, with the strength of the company we built, we're just getting started. On a more personal note, your mentorship to me over the last 25 years has meant more to me than I can effectively express here. I'm honored and humbled to assume the role of Kaiser Aluminum's next CEO, and I look forward to continuing to work with you in your new role as Executive Chair as we continue to execute our strategy and ensure Kaiser Aluminum remains best in class. In closing, on behalf of Kaiser Aluminum, our employees and our stakeholders, I would just like to say thank you, Jack. You made a real difference to all of us. With that, thank you for joining us on the call today. We look forward to updating you on our third-quarter 2020 conference call in October. Thank you.

Ladies and gentlemen, this concludes today's conference call. Thank you for participating. You may now disconnect.