MATERION Corp Q1 FY2020 Earnings Call

Greetings and welcome to the Materion First Quarter 2020 Earnings Conference Call. At this time, all participants are in listen-only mode. A brief question-and-answer session will follow the formal presentation. As a reminder this conference is being recorded. It is now my pleasure to introduce your host Mr. Steve Shamrock, Vice President, Corporate Controller and Investor Relations. Thank you, sir. You may begin.

Good morning. This is Steve Shamrock, Vice President, Corporate Controller and Investor Relations. With me today is Jugal Vijayvargiya, President and Chief Executive Officer and Joe Kelley, Vice President of Finance and Chief Financial Officer. Our format for today’s conference call is as follows: Jugal Vijayvargiya will provide opening comments on COVID-19 and an update on key strategic initiatives. Following Jugal, Joe Kelley will review detailed financial results for the quarter and then we will open up the call for questions. Before we begin, let me remind investors that any forward-looking statements made in this announcement, including those in the outlook section and during the question-and-answer portion are based on current expectations. The company’s actual future performance may materially differ from that contemplated by the forward-looking statements as a result of a variety of factors. Those factors are listed in the earnings press release we issued this morning. Additionally, comments with regard to operating profit, net income, and earnings per share reflect the adjusted GAAP numbers shown in Attachment Number 5 in this morning’s press release. The adjustments are made in the prior year periods for comparative purposes and remove special items, non-cash charges and certain income tax adjustments. And now, I will turn it over to Jugal for his comments.

Thanks, Steve and welcome everyone. I hope all of you and your loved ones are safe as we progress through these unprecedented times. Today I’ll first share the impacts of COVID-19 on our company and then update you on some key strategic initiatives. Health and safety of our people has been and remains our overriding priority. Over the last three years we have reduced our recordable injuries by 77% with a keen focus on prevention. 16 of our global facilities have had zero injuries in the past year. As COVID-19 started to emerge, we employed the same level of focus to protect our people. We have listened to available resources and have enacted changes globally. Three people have been confirmed positive in our global Materion family and they're doing well at this time. We have the majority of our office employees working from home. All of our factories are operating in support of the essential products and services we provide to critical industries such as healthcare, telecommunications, defense, and energy. In particular, we’re proud to support the fight against this virus by supplying products for healthcare equipment used by medical staff around the world. For example, our Precision Coatings business is supplying optical filters which are used in medical systems to test for COVID-19 as well as for critical CO2 gas detection in capnography and ventilator applications. Our PAC business is supplying copper beryllium strip products which are used for ventilators. We have seen increased demand for these products and are determined to maintain supply to help in the fight against COVID-19. While we see increased demand in these products, we’re experiencing significantly lower demand in automotive, oil and gas, aerospace, and industrial end markets. Semiconductors and defense end market demand continues to hold at this time. In total, we expect second quarter demand to be comparable or slightly better than first quarter demand. Despite the challenges presented by COVID-19, our teams have been focused on moving the company forward. Let me share with you some exciting progress towards our One Materion multi-pillar profitable growth strategy. As you know, investing for organic growth has been our top priority. We have ramped up R&D spending and made significant commercial investments to align with future growth opportunities. In our last earnings call, I highlighted the growth in aluminum-scandium premium targets. Today I’m excited to share another major growth opportunity. This time in our engineered clad strip product line. We have unmatched capability to custom design clad material solutions and solve the most pressing challenges per customer space in thermal management, extreme vibration, and high voltage. Our engineered clad strip is used in electronic applications which serve a variety of end markets including consumer electronics, automotive, energy, and industrial. I’m very pleased to report that we’ve entered into a business arrangement with a new customer to expand our manufacturing capacity for highly engineered clad strip. This material will be used in a next-generation model of an existing product. Therefore, the overall end market demand exists today. We expect to fulfill this market demand and support increased demand as the customer's end product continues to gain acceptance globally. The customer has also provided a $12 million prepayment towards establishing a new leading-edge manufacturing facility for future product supply. We anticipate finalizing the long-term supply agreement for this exciting new opportunity later this year. At the same time that we’re driving profitable growth in our go-forward portfolio, we’re also taking the tough decisions to exit non-strategic businesses. Today I’m announcing our intent to sell the Large Area Coatings business. This action will allow our teams to focus our efforts on growing the remaining Precision Coatings business where we have exciting opportunities with our differentiated optical coatings expertise. We anticipate the sale and closing to occur later this year. In parallel to driving significant organic growth and aligning the portfolio, we’re continuing to improve our cost structure. Today I’m announcing the closure of two facilities and consolidating work in one of our existing facilities. This will be a significant structural cost reduction to the PAC business where we are the only fully vertically integrated beryllium producer in the world. We are closing a service center in Detroit, Michigan and will be closing a manufacturing facility in Fremont, California later this year. We expect this action to improve our cost structure by $4 million to $5 million annually. I would like to thank our global team who has risen to the challenges posed by this global pandemic. With their dedication, we’re supplying key components used for critical medical equipment in the fight against COVID-19. In addition, our teams are more broadly focused and continuing to transform Materion into an advanced materials business. Now I’ll turn the call over to Joe to cover the financials.

Thank you Jugal and welcome to everyone joining us on the call today. During my comments I will cover first quarter 2020 financial highlights, review profitability by segment, provide brief comments on the balance sheet, cash flow, and modeling assumptions, and finally cover the earnings outlook for the second quarter 2020. Following my remarks, we will open the line for questions. Let me start with a summary of our first quarter financials. We delivered adjusted earnings of $0.43 per share on $158.7 million of value-added sales. We continued our strong cash generation with $9.1 million of cash flow from operations. We ended the quarter with $107.6 million in cash, a record for any first quarter. Going into more financial detail. First quarter 2020 value-added sales, which exclude the impact of pass-through precious metal cost, were $158.7 million down 2% compared to the fourth quarter and down 15% versus the $187.7 million in the first quarter of 2019. The recovery in the semiconductor end market continued into the first quarter as value-added sales in our largest end market increased 10% sequentially and 4% versus the prior year. The second consecutive quarter of year-over-year growth. Aerospace and defense end market sales were heavily impacted due to timing of defense orders and the continued weakness in the aerospace market. In addition, the COVID-19 pandemic impacted demand from several end markets including energy, automotive, industrial, and telecom and data center. Gross profit was $45.6 million in the first quarter compared to $69.3 million in the prior year first quarter. Excluding a non-cash $1.3 million write-down for oil and gas specific inventory in our PAC business and other non-recurring items related to the COVID-19 situation, adjusted gross profit was $47.1 million or 30% of value-added sales. The decrease in gross profit and margin was driven by lower sales volumes and resulting manufacturing inefficiencies. Selling general and administrative expense totaled $30.7 million, a decrease of $9.4 million versus the prior year of $40.1 million. Due to a combination of aggressively managing cost in response to the current business conditions and lower variable compensation expense. As a percentage of value-added sales, SG&A expense was 19% in the quarter down 200 basis points from 21% in the prior year period. Research and development expense of $4.2 million increased 12% versus 2019 as we continue to make investments to drive long-term profitable growth through development of new products and new applications. During the quarter, we recorded restructuring expense of $2.2 million related to the plant closure of our Detroit and Fremont facilities primarily for employee severance and other facility closure obligations. Based on the planned sale of the LAC business as Jugal mentioned, we classified the LAC business as held for sale. As a result, we recorded non-cash impairment charges of $10.8 million to write-off the remaining LAC goodwill balance of $9.1 million and adjust the remaining net assets to fair value. As a change from past practice, we’re moving to utilize earnings before interest and tax (EBIT) to measure profitability, to maintain comparability given the changes in the company's pension plan moving from 2019 to 2020. We reported a $3.6 million loss before interest and taxes in the first quarter of 2020 compared to the prior year first quarter EBIT of $21.1 million. Excluding special items related to non-cash asset impairments, restructuring charges for facility closures, and other non-recurring items, adjusted EBIT was $10.9 million or 7% of value-added sales. Looking at income taxes, we recorded an income tax benefit of $800,000 in the first quarter of 2020. Excluding the tax impact of special items, adjusted tax expense was $1.9 million or an effective tax rate of 18% in line with our previous guidance. Our net loss for the first quarter of 2020 totaled $3.1 million. On an adjusted basis, we reported net income of $8.8 million or $0.43 per diluted share compared to $16.9 million or $0.82 per share in the prior year. The $8.1 million year-over-year decrease in earnings resulted from a $29 million decrease in value-added sales offset by aggressive cost management. Decremental margins were 28% on a 15% decrease in value-added sales. Now let me review 2020 first quarter performance by business segment. Looking now at performance alloys and composites business, value-added sales were $83.7 million compared to $109.6 million in 2019. The decrease in sales can be primarily attributed to lower demand across all markets as a result of COVID-19, continued tariff impacts, and the timing of defense sales. EBIT excluding special items was $8.2 million or 10% of value-added sales compared to EBIT of $18.8 million in 2019. The decrease in profit and margin compared to 2019 is due to lower sales and reduced manufacturing efficiency related to the lower production volumes. Despite the current challenging environment, PAC managed to deliver the eighth consecutive quarter of double-digit profit margins, far above historical profit levels at comparable sales volumes. Moving to Advanced Materials, value-added sales in the first quarter 2020 were $59.2 million, up 3% versus the prior year amount of $57.5 million. Semiconductor end market sales increased 12% sequentially and 8% compared to the first quarter of 2019, as commercial performance initiatives specific to new products combined with increased end market demand drove the growth. EBIT excluding special items was $4.9 million in the quarter compared to $7.1 million in 2019. Manufacturing inefficiencies on new product launches combined with unfavorable product mix led to the profit decrease. The demand for the new products is strong and we’re focused on improving manufacturing efficiency related to these existing new launches. Turning finally now to the Precision Coatings segment. First quarter value-added sales were $17 million down 24% compared to the $22.5 million in the first quarter of 2019, primarily due to lower sales of the Large Area Coatings product for the blood glucose test strip market. Excluding the LAC business, first quarter 2020 value-added sales were $14.3 million down 3% year-over-year led by COVID-19 issues. EBIT excluding special items was $1.2 million compared to $2.1 million in the first quarter of 2019. The decline in profits was entirely driven by the year-over-year decrease in sales within the LAC business, which is now classified as held for sale. Moving to the balance sheet and cash flow. The company ended the first quarter of 2020 with a net cash position of $105.5 million and $345.8 million available on the company’s credit facility. This compares to a net cash position of $39 million at the end of the first quarter of 2019. We spent $14.8 million on capital investments in the quarter. The increase versus 2019 is related to the customer-funded engineered strip growth opportunity which Jugal covered. Additionally, $6.8 million was spent on the repurchase of 158,000 shares of common stock. For financial modeling purposes in 2020, capital spending should run approximately $30 million net of customer prepayments related to the new engineered strip project. Mine development investments should be approximately $10 million. Annual depreciation and amortization should run approximately $40 million. Assume an 18% to 20% effective tax rate excluding special items. And finally now the earnings outlook for 2020. The impact of the COVID pandemic is fluid and continues to evolve, and therefore we cannot predict the extent to which our business, results of operations, financial conditions or cash flows will ultimately be impacted. For these reasons, we’re withdrawing our previously announced full year earnings guidance of $3.15 to $3.30 per share. Related to our near-term outlook, we are cautiously optimistic about second quarter results based on current order entry levels. Certain end markets are expected to be more adversely impacted by the current economic environment such as energy, automotive, aerospace, and industrial. While other end markets are seeing steady or improving demand like semiconductor, medical, and defense. Assuming our factories remain operational in the rapidly changing fight against COVID-19, we expect second quarter results to be comparable or slightly better than the first quarter. This concludes our prepared remarks. We will now open the line for questions.

Our first question comes from the line of Edward Marshall with Sidoti and Company. Please proceed with your question.

Can you talk about the new customer? You gave a lot of detail, I’m curious could you give what market this new customer is in?

Ed, let me start on that. So first of all, I hope you and your family are safe in this very difficult situation that we’re all facing. This is an exciting opportunity for us. As you know over the last couple of years, we’ve been talking about investing more in R&D, really our top priority being organic growth and I think this is a result of great work done by our team over the last year or so. This is a perfect match where we have some great capability and we’ve been able to leverage that capability into a market that we’ve not played too much in the past. So we can’t specifically talk to you about what market this is, but what I can tell you is that it is a market that I think is exciting. It will hopefully be a long-term activity for us. It’s not intended to be a cyclical or seasonal type of activity. But it is something we’re very excited about and one that I think will be an important part of our company going forward and it’s a great example I think of the work that our team is doing with the R&D collaboration that we’ve been trying to drive within the company.

Do you serve that market already?

Well, we serve the broader market that this happens to fall in already. So yes, we serve the broader market. But you know each market has various sub-segments and I would say, a sub-segment that this happens to fall in is something that is new for us and so it’s quite exciting.

Got it. So moving onto the test strip business, if I remember correctly that's about a $30 million revenue line annually and was that included in the 1Q results and will it be in 2Q until you divest that business or have you divested it? I’m just curious if sales have been discontinued.

Yes, go ahead Joe. Why don’t you take that?

Yes, so you’re correct Ed. This was historically approximately a $30 million business. We recall some of the changes that took place last year in the back half of 2019, and so it is included in our Q1 results and will be in our Q2 results. But the business today is relatively immaterial in the sense that the value-added sales were less than $3 million in Q1 and the profit did not have a material impact on Materion’s Q1 profits. So from a divestiture standpoint going forward, it won’t be a change to our current baseline.

Got it. The cost savings that you put in place; do you have the timing of that $4 million to $5 million when it rolls through?

Yes, let me first just talk about the cost savings in general. As you know, we’ve been driving operational improvement that’s going to impact one of our pillars of our strategic profitable growth objectives that we’ve had for the company. And we’ve been driving our operational improvements across the company. But in particular in our PAC business just because of I think where that business was a few years back and then you’ve seen the growth that business has delivered and profitability. This is just a continuation of the operational improvements that we’re driving in the company. So I think that we’ve been talking about it actually for the last several months and we really were able to pull that off. As I indicated, the first part of the closure is now basically finishing up. It started at the service center. The second part will actually be later this year which is the Fremont, California site, and so we would expect that both of those will be completely done by the end of the year. Therefore, I think the full run rate of the savings should be in effect after that.

Got it, next year. Okay. And you didn’t mention the beryllium hydroxide sales. Was there beryllium hydroxide sales or was that pushed further like it was in Q4?

No, there were beryllium hydroxide sales.

We continue to maintain a relationship with our customer and therefore we did have sales in Q1. I think our progress with them this year, we would expect it to be the same as we’ve communicated to you before.

All right. Final one from me. The guidance you provided, I just - so unclear. You talked about relatively flattish quarter-to-quarter potentially slightly up. Were you referring to revenue, rather value-added revenue and EPS or were you referring to just one specific item? I'm just curious.

Obviously, EPS is related to the value-added sales. I mean directly related to value-added sales and so I would say in general, I think our business, we believe will be comparable or slightly better than Q1 and so I think it probably encompasses both elements.

This is Steve Shamrock and this concludes our first quarter 2020 earnings call. A recorded playback of this call will be available on the company’s website materion.com. We would like to thank all of you for participating in the call this morning and your interest in Materion. I will be available to answer any follow-up questions. My direct number is 216-383-4010. Thank you very much.

Thank you. This concludes today’s conference. You may disconnect your lines. Thank you for participating and have a nice day.