Kaiser Aluminum Corp Q3 FY2020 Earnings Call

Welcome to the Third Quarter 2020 Kaiser Aluminum Earnings Conference Call. My name is John, and I will be your operator for today's call. All participants are currently in a listen-only mode. Later, we will have a question-and-answer session. I will now turn the call over to Melinda Ellsworth.

Good afternoon, everyone, and welcome to Kaiser Aluminum's third quarter and first nine months 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 President and Chief Executive 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'd 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 full year ended December 31, 2019, and Form 10-Qs for the quarters ended March 31, 2020, and June 30, 2020. The company undertakes no duty to update any forward-looking statements to conform the statement to actual results or changes in the company's expectations. In addition, we've 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 to our discussion today to EBITDA means adjusted EBITDA, which excludes non-run-rate items for which we've provided reconciliations in the appendix. At the conclusion of the company's presentation, we will open the call for questions. I would now like to turn the call over to Keith Harvey. Keith?

Thanks, Melinda, and good morning, everyone. We delivered solid third quarter results driven by a rebound in automotive demand and continued strength in demand for our defense and general engineering applications. Following the onset of COVID, we have continued to aggressively flex costs to align with changes in market conditions. Although demand for our commercial aerospace applications in the third quarter dropped sharply from the strong first half of the year, we continue to reiterate the outlook for the second half of 2020 given in our second quarter earnings call. Strong execution by our employees enabled us to deliver solid third quarter results in very challenging conditions as we continue to deal with varying market dynamics influenced heavily by the impact of COVID. Total liquidity remained strong at $1 billion. Our capital allocation priorities and our financial guidelines remain unchanged, and we continue to sustain our quarterly dividend. Let me comment briefly on the end markets. As we noted on our second quarter earnings call, we anticipated the full year decline in demand for our commercial aerospace applications would be reflected in our second half results as the large commercial aircraft manufacturers continue to deal with production interruptions and slowing deliveries as a result of significantly reduced domestic and international air travel. During the quarter, we quickly moved to lower costs in our aerospace and high-strength focused facilities and pivot available capacity to other markets where possible. In addition, we continued working with our customers on modifications to existing declarations. As we have previously noted, we have long-term strategic relationships with our customers, many with multi-year agreements in place that allow both parties to mitigate the short-term impact of changing market conditions and meet agreed-upon commitments. The continued strength in demand for our defense applications has partially offset the decline in commercial aerospace, and we have been successful in adjusting capacity and lead times to meet double-digit year-over-year growth in demand for these applications. Turning to automotive. As we expected, our automotive extrusion shipments and resulting value-added revenue bounced back strongly in the third quarter to mirror our strong first quarter results as new program launches resumed. These launches and other recently awarded programs are expected to continue to drive growth through 2021 and beyond. With these expected increases in automotive demand, we have recalled virtually all furloughed employees in our automotive-focused facilities. We are well-positioned to manage the expected longer-term growth for these applications with minimal additional investments. Our general engineering business continues to remain strong despite normal seasonal demand weakness in the second half. Solid service center demand for our KaiserSelect products and continued strength in the semiconductor and automotive end market applications drove third quarter results. As I mentioned earlier, our ability to pivot aerospace plate capacity to meet the demand for general engineering applications enabled us to better meet demand and improve lead times for our customers. Pricing for these applications continued to remain stable during the quarter, as the industry has responded to changing demand with adjustments to operating levels. I am pleased with how our employees aggressively addressed cost and managed spending in the quarter, given the different dynamics in each of our end markets. While our aerospace and high-strength facilities were ramping down to align with lower commercial aerospace demand, the opposite was occurring for those facilities serving automotive and general engineering markets, where we were ramping up to meet improving demand. Despite the challenge in managing our operations with these significant swings in demand, our results reflect our ability to flex our variable cost structure to changing levels in demand in an efficient and effective manner. As business levels improve, we expect increased operating leverage will drive margin improvement as incremental costs will lag volume increases. In addition to strong execution and aggressively managing the impact of the COVID virus in our facilities, our employees are also achieving record safety performance. I'm extremely proud of the work they're doing and the manner in which they're achieving these results. Turning now to our outlook on aero and high-strength on slide number 7. We see a continued slow recovery for large commercial aerospace applications, driven by longer-than-expected recertification of the 737 MAX, slower recovery in domestic and international air travel, and destocking in the supply chain. Destocking also occurred in the business jet supply chain as manufacturers dealt with temporary production delays due to COVID-19 outbreaks in late second quarter and early third quarter. As we reassess the full-year outlook for these applications, we anticipate value-added revenue for commercial aerospace will now be down approximately 30% to 35% year-over-year from our record year 2019 versus the 20% to 25% previously anticipated. Demand for our defense applications remains strong and is expected to continue into 2021. Moving to slide number 8. Strong demand for our automotive extrusions is expected to continue in the fourth quarter, with value-added revenue and shipments similar to our strong third quarter results. Build rates for North American vehicles are currently projected to increase approximately 18% from a 12.9 million vehicle production rate in 2020 to over 15.2 million vehicles in 2021. In addition, we expect continued growth in aluminum extrusion content as consumer preference towards larger vehicles and light trucks drive demand. Moving on to slide number 9. We see continued strength in demand for our general engineering applications despite second-half normal seasonal demand weakness. In addition to strong service center and end market demand, we continue to see the emerging trend for OEMs reestablishing domestic supply chains. Our KaiserSelect rod bar and plate products and our long-term service center partnerships uniquely position us to capitalize on these opportunities as they continue to develop. On slide number 10 and a review of our outlook summary. Looking at the balance of the year, we reiterate our outlook for the second half of 2020, as communicated on our second quarter earnings call. We anticipate total value-added revenue in the second half will be down approximately 10% to 15% from the second quarter rate, driven by lower aerospace and some high-strength sales, offset by continued strength in demand for defense, automotive, and general engineering applications, with EBITDA margin expected to be in the mid-teens. We have reduced costs to align with demand levels across the organization in our operations and in support functions that will provide significant operating leverage as business levels continue to improve. As discussed in our second quarter earnings call, in addition to capital spending for critical sustaining projects, we resumed spending for other organic investment opportunities to further support automotive growth and enhance efficiencies throughout our operations. We continue to expect capital spending for the full year will be in approximately $50 million to $60 million. I'll now turn the call over to Neal to discuss the third quarter in more detail.

Thanks, Keith, and good morning, everyone. In the third quarter of 2020, value-added revenue was $154 million, which represents a decline of about $60 million or 28% compared to the same quarter last year, mainly due to a 30% reduction in shipments driven by decreased aerospace demand. Specifically, aerospace high-strength value-added revenue was $73 million, down 43% as shipments fell by 59% compared to the previous year's strong demand. While demand for defense applications remains solid, the COVID-19 pandemic significantly impacted commercial aerospace demand, affecting shipments. The third quarter's value-added revenue reflected lower volumes, a favorable product mix, and about $15 million in additional revenue recognition from modifications to multi-year contracts with customers. Automotive value-added revenue was $24 million, up about 2% from the third quarter of 2019 due to a 5% increase in shipments as new program launches ramped up following the automotive supply chain's return to production after the COVID-related shutdown in the second quarter. General engineering value-added revenue of $55 million saw a decline of around 4% with a 5% reduction in shipments, typical of seasonal demand weaknesses in the second half, though pricing remained stable. For the first nine months of 2020, total value-added revenue reached $546 million, down $97 million or 15% due to a 19% drop in shipments. The pandemic's impact on our aerospace high-strength applications accounted for most of the decline compared to the prior year's period. Additionally, the automotive sector's downturn in the second quarter and other planned exits from non-strategic applications further affected year-over-year value-added revenue and shipments. Adjusted EBITDA for the third quarter was $30 million, which is a decrease of $27 million from the previous year, reflecting the total sales impact, including the $15 million previously mentioned and other costs associated with reduced demand. The EBITDA margin for the third quarter was around 20%, down from 26% in the prior year due to lower value-added revenue and operating leverage. For the first nine months of 2020, EBITDA totaled $124 million, which is a decline of $36 million from the previous year, primarily due to the third quarter's results. The EBITDA margin for this period was about 23%, compared to 25% in the previous year. Reported operating income for the third quarter of 2020 was approximately $12 million. After adjusting for $5 million in non-recurring charges, the operating income was $17 million, down from $44 million in the same quarter last year. The non-recurring charges for the third quarter mainly included a $4 million reserve increase for environmental issues related to PCB cleanup at our Trentwood facility. The reported net income for the third quarter of 2020 was $400,000, or $0.02 per diluted share. After making adjustments for non-recurring items, net income was $5 million, compared to $29 million in the same quarter last year. This adjusted net income reflects lower operating income and a $6 million increase in pre-tax interest from our recent bond offering. Adjusted earnings per diluted share in the third quarter fell to $0.33 from $1.82 in the prior year. For the first nine months of 2020, the reported operating income was $63 million. After adjusting for $22 million in non-recurring charges, the operating income became $85 million, compared to $124 million in the previous year. This adjusted decline in operating income was primarily due to the previously mentioned decrease in EBITDA and about $3 million in higher depreciation expenses. The non-recurring charges year-to-date included a $12 million restructuring charge for severance and benefits reported in the second quarter and a total of $6 million in reserves for ongoing environmental cleanup projects. Reported net income for the first nine months of 2020 was around $23 million or $1.44 per diluted share. Adjusted for non-recurring items, net income was $41 million compared to $82 million from the prior year. Adjusted earnings per diluted share for the first nine months were $2.60 versus $5.06 in the previous year. The effective tax rate for the quarter was influenced by discrete issues during that period. Nevertheless, we still project the effective tax rate for the entire year of 2020 to be in the low to mid-30% range, mainly due to an increase in state tax net operating losses, valuations, and adjustments for non-deductible executive compensation. We anticipate a cash refund of $11 million related to AMT monetization for our 2020 net cash tax. Capital expenditures were $5 million in the third quarter and $37 million for the first nine months of 2020. Full-year capital spending is estimated to be between $50 million and $60 million, as Keith mentioned earlier. In the first nine months of 2020, we returned approximately $45 million in cash to shareholders. Additionally, we recently announced a quarterly cash dividend of $0.67 per share, which will be paid on November 13. As of September 30, total liquidity was $1 billion, consisting of $750 million in cash and cash equivalents, along with roughly $253 million in borrowing availability on our undrawn revolving credit facility. Now I’ll turn the call back to Keith for closing comments.

Thanks, Neal. Summarizing our remarks on slide number 16. We delivered solid third quarter results driven by a strong rebound in automotive demand and continued strength in demand for our defense and general engineering applications despite the impact of the ongoing pandemic, and we have aggressively flexed costs and reallocated capacity to align with the changes in market conditions. We continue to anticipate total value-added revenue for the second half of 2020 will be down approximately 10% to 15% compared to the second quarter run rate with EBITDA margin in the mid-teens. Total liquidity remains strong at $1 billion. Our capital allocation priorities and our financial guidelines remain unchanged. We are well-positioned to continue to navigate challenging market conditions and capitalize on opportunities to further strengthen our prospects for long-term profitable growth. We will provide more color on our 2021 outlook during our fourth-quarter earnings call next February, but we believe that 2020 will be the trough for earnings. Our philosophy has always been to prepare ourselves to navigate through the highly cyclical nature of the end markets we serve. We're confident that we have the levers in place to navigate through this period with our strong customer relations, our broad product offering, solid multi-year agreements, which provide a safety net through challenging market conditions, and a very strong balance sheet that allows us to manage our business and capitalize on additional opportunities, which may come our way. With that, I'll now open the call for questions.

Our first question is from Curt Woodworth from Credit Suisse.

Can you provide more insight into the change in aerospace guidance? Is it primarily due to ongoing destocking? Were there any further reductions in the build rate? I understand the MAX certification was delayed. While it may be premature to consider next year’s customer nominations, do you have any perspective on how the market might shape up in the early part of next year or the pace of inventory destocking, which is likely to take at least another two quarters to resolve?

In analyzing the market, we observed that major airframe manufacturers began to quickly reduce orders after the second quarter ended. From a destocking standpoint, they initiated this process early, which we believe will lead to a shorter destocking period compared to what we've seen before. We're still evaluating the return by measuring against the strong performance of 2019. We think, along with our end customers, that it will take around two to four years to reach that 2019 peak level again. However, we may start to see some gradual recovery sooner, possibly within a year or two. We're closely monitoring this situation and maintaining discussions with all stakeholders. We are waiting for the recertification of the MAX, which we believe is a key hurdle we need to overcome to gain better insights into how quickly recovery will occur. Additionally, we anticipate that as people become more comfortable with returning to travel, demand will increase, leading to a recovery. The speed of this recovery will depend on how these factors unfold. Looking ahead over the next few years, we are encouraged by the solid multi-year contracts we have, which we believe will provide us with a safety net as we navigate through the end of destocking and work toward increased sales with the major airframes.

Okay. That makes sense. And then with respect to general engineering, clearly, some pretty strong success, at least in the common alloy market on the anti-dumping outcome for the 18 countries. Have you seen any shift in buying behavior or with respect to that? We had heard that some service centers had engaged in a little bit of a pre-buy to get ahead of it. And is pricing now starting to recover more? Or how would you kind of characterize the broader industrial market right now?

Yes. I believe that the increased activity in general engineering and the other markets I mentioned is positively impacting pricing conditions. The strong demand, along with the recovery in other markets and the industry's management of capacity, tends to benefit everyone. Typically, if we look back to the 2008-2009 recession, we saw a decline in prices. But hopefully, despite some challenges in key markets, we will see stability in pricing across the board. So, this added activity is benefiting everyone, Curt.

Okay, great. And then just one final one. And maybe it's a little bit difficult to kind of talk about this now. But in terms of like the future for Kaiser, you have the incredible balance sheet. You have a lot of optionality with respect to some of the interesting secular things going on in the market. From an M&A perspective, are you looking to become more active? I mean there are a couple of assets that are pretty decent quality assets available in the market now, I believe, for sale. Do you have any kind of vision for how the portfolio could look maybe not next year but in the next 3 to 4 years?

We have the capability to respond if an opportunity arises that aligns with our criteria and capital allocation strategy. Our primary focus has always been on organic growth, but we are open to inorganic growth as long as it meets specific guidelines we’ve established. We will always prioritize being a preferred buyer. This approach will persist in the current environment. If we identify an opportunity that adds value to our business, is well-positioned, and aligns with our culture while delivering long-term shareholder value within our leverage and liability limits, we are ready to proceed. However, we will maintain discipline in this process, and as long as we can meet our established criteria, we're well-positioned to act if suitable opportunities arise.

Our next question is from Josh Sullivan from The Benchmark Company.

Can you just talk a little bit about the conversations you had with aerospace customers, those modifications you mentioned in the prepared remarks? Can you just help us understand some of the parameters around those conversations? Is pricing part of that conversation and maybe what the timelines you're talking about with some of those modifications?

Sure. Without going into the specifics of our agreements, many of our contracts include cost recovery provisions that protect our margins and account for volume and product mix among other factors. When it becomes clear that these provisions cannot be fulfilled, it results in a contractual obligation. During the quarter, we determined that several of these provisions would not be met, which triggered the recorded obligation that Neal discussed in detail. From Kaiser Aluminum's perspective, this is our approach. We have always acknowledged the cyclical nature of the aerospace market, even if it hasn't been apparent lately, and we plan for downturns accordingly. Our long-term agreements reflect this philosophy, and although it triggered for 2020, these agreements remain in place for multiple years with many of our customers.

I mean is there any reason to think that it could be triggered in 2021 at this point or do you think that '20 was the low point and...

It's a great question, Josh. Not necessarily in a position to answer that at this time. But what gives us comfort in being able to understand what our future looks like is understanding that with these agreements there is a safety net at certain conditions. And so we're able to pull on those. If the market were to get worse, we're able to pull on those heavier and hopefully the markets will return quicker than what has been anticipated or communicated to date.

Got it. And then just switching over to general engineering, can you give us any granular detail on the reshoring impact? What products gives you confidence that reshoring is really driving some of that strength?

We are definitely observing some significant disruption in the supply chain, especially for those whose supply chains extend across oceans. As companies reassess the availability of our products, they are finding that many markets have become quite active, particularly in key sectors such as semiconductors and automotive, among others, like munitions and space programs. We are capable of delivering high-quality products with excellent lead times. Currently, our lead times are about half of what some imports can offer, which is appealing for long-term supply arrangements. We are observing a shift in this direction, and we have the capacity to meet that demand and strengthen our supply chain. The overall situation is reinforcing our position regarding capacity and supply chain security, and I believe this trend will continue strongly into 2021. We have achieved some notable successes in this area so far and are in discussions with others about long-term agreements.

And then just one on the automotive strength into 2021. I mean, do you think you're going to be more focused on a couple of these large new product launches that are coming through or do you think it's a little more broad-based?

It's pretty broad for us, Josh. We have multiple launches taking place this year and several planned for this year and next year. I mentioned in the last call that we have received a couple of significant new contracts that are currently being implemented in the third quarter. So we're seeing substantial activity at this moment. We've anticipated this for a long time and have invested millions of dollars in preparation for these markets to develop. We experienced a strong recovery in the second quarter following COVID-related impacts, and the first and third quarters have performed very well, as expected. We anticipate that this momentum will only increase next year. Overall, the outlook for automotive is very positive from our perspective, with many opportunities for new programs across the range of products we offer.

And we have a question again from Curt Woodworth from Credit Suisse.

Yes, hi. I wanted to follow up on Josh's question. Regarding the extrusions market and the trend towards lightweighting with aluminum, I generally think that with the new platform, you have about three to four years of visibility due to the redesign and its timing. Do you still feel confident that this trend will have momentum going into 2022 and 2023? Is the bidding activity for those products still strong, or do you think we are approaching a point of maturation?

No, I think it's very good. When we quote on programs, we're generally looking two to three years ahead, and in some cases three to four years on certain platforms. The businesses we're quoting on are within that timeframe, and we have not observed any decline in the increasing demand for lightweight aluminum extrusions. Therefore, we are confident that this trend has potential and we remain well-positioned to capitalize on it.

And we have no further questions at this time. I will turn it back over to Keith Harvey for closing remarks.

Alright. Well, thank you very much for joining us on the call today. We look forward to updating you during our fourth quarter 2020 conference call in February. Have a good day.

Thank you, ladies and gentlemen. That concludes today's call. Thank you for participating, and you may now disconnect.