Earnings Call Transcript - TX Q3 2022

Sebastian Marti, Global Investor Relations and Compliance Senior Director

Good morning. Thank you for joining us today. My name is Sebastian Marti, and I am Ternium's Global Investor Relations and Compliance Senior Director. Ternium released today its financial results for the third quarter and first nine months of 2022. This call is complementary to that presentation. Joining me today are Ternium's Chief Executive Officer, Maximo Vedoya; and the company's Chief Financial Officer, Pablo Brizzio, who will discuss Ternium's business environment and performance. At the conclusion of our prepared remarks, there will be a Q&A session. Before we begin, I would like to remind you that this conference call contains forward-looking information and that actual results may vary from those expressed or implied. Factors that could affect results are contained in our filings with the Securities and Exchange Commission and on Page two in today's webcast presentation. You will also find any reference to non-IFRS financial measures reconciled to the most directly comparable IFRS measures in the press release issued this morning. With that, I'll turn the call over to Mr. Vedoya.

Maximo Vedoya, CEO

Thank you, Sebastian. Good morning, and thank you all for participating in our conference call today. Ternium reported a good set of results for the third quarter with adjusted EBITDA of $679 million on a margin of more than $200 per ton. This is equivalent to an adjusted EBITDA margin of 16% of sales, a level that is within Ternium's historical margin range. On top of this, we had a very strong cash generation in the quarter. Cash from operations was more than $1 billion, aided by a significant working capital release. Last year, we transitioned from an annual payment schedule to a twice a year payment with an advance in November and a final payment in May. I believe this change in our dividend payment schedule was a positive development that underscores our long-term commitment to the return to our shareholders. In this line, Ternium's Board of Directors announced today an interim dividend payment of $0.90 per ADS, equivalent to $177 million that will be paid on November 17. This represents an increase of $0.10 per ADS compared to last year's interim dividend payment. Looking ahead, we are facing a complex global economic situation with uncertainty driven by policy and geopolitics, such as monetary tightening, the war in Ukraine and China's economic slowdown. The rise in interest rates, combined with high inflation, is undermining economic confidence and slowing down investment as well as household spending. Focusing on the U.S., according to the World Steel Association short-term outlook that was just released, steel demand is not expected to enter negative territory despite a softening economy. Construction activity in the private sector will decrease due to a downturn in the housing market. However, offsetting this, the non-residential sector remains strong, and an increase in infrastructure investments due to the infrastructure law and rising investment in the energy sector will support growth in steel demand. Additionally, the automotive sector is expected to maintain a positive momentum on the back of pent-up demand and the gradual easing of supply chain constraints. In Mexico, our expectations are very similar to those in the U.S. as both markets are closely related. The recovery in the construction sector has been slow, and as a result, activity in this sector is expected to remain below pre-pandemic levels in 2023. Furthermore, the manufacturing sector, which has performed better since the pandemic, also faces a weakening output in relative industries like household appliances and small HVAC. On the other hand, similar to the U.S. automotive sector, there will still be growth, thanks to easing supply constraints. It's worth noting that while PBT in the North American region is slowing down, we do not expect internal shipments in Mexico to decline. Several factors should help us sustain, and probably increase, our shipments in the market during 2023. Nearshoring of manufacturing capacity is gaining momentum. There has been a spike in investment announcements for new manufacturing capacity in northern Mexico, much of which has been made by companies that are new to the region. As a result, construction activity related to industrial facilities is also strongly increasing. In the future, many of these new facilities will be steel-consuming customers for us. Another aspect of our activity in Mexico is our progress with the certification of new products as we continue ramping up the new hot strip mill in Pesquería. The capabilities provided by our new R&D center at this facility are significantly speeding up the certification of new products. This has enabled us to broaden our product range, and as a result, we are booking new supply contracts for 2023 that will help us grow our shipments gradually throughout next year. Over the last 10 years, we have invested in our facility to expand and enhance our product offering. This new capacity places us in a unique competitive position in the Mexican market to take advantage of these new opportunities, enabling Ternium to increase its market share against imports and other local producers. Turning now to Argentina. Steel demand remained stable, as it has for more than a year now. The construction sector is healthy and industries like household appliances, automotive and energy are operating at good levels. Although we expect stable shipments in this market for the fourth quarter, we need to continue to provide a warning regarding the unstable macro situation in the country. Let me now share some thoughts on safety. Two weeks ago, one of our employees was fatally injured in our Rio de Janeiro facility in Brazil. We are deeply moved by this development, and our thoughts are with his family and friends. We hadn't had a fatality in Ternium for more than four years. I traveled to Brazil right after I heard the news and worked with our team there to understand what happened. We will continue investigating the causes of this tragic event, and we are set to learn from our findings. Let me now make a brief note about our mining activity in southern Mexico and the effects of September's earthquake on our facility and surrounding communities. On September 19, there was a 7.7 magnitude earthquake in Michoacan, with its epicenter about 120 kilometers from our mining facilities. After this event, we had our tailing dams, both from Ternium and Pena Colorada inspected twice by a third-party expert, and their findings were that the dams are in perfect condition. Unfortunately, the situation was not the same for some of our surrounding communities where infrastructure was significantly affected. As a result, we have created a fund to help rebuild some schools and a medical clinic in these remote communities. To wrap up my prepared remarks, I would like to say that we are optimistic regarding our shipment levels for the following quarters, even in a softening macroeconomic environment, as is expected. We are confident that our efforts to increase Ternium's competitiveness and expand its product range will help us sustain and gradually increase shipments during 2023, mainly by substituting imports in the Mexican market that serves the manufacturing sector. With this, I'll let Pablo go ahead with the analysis of our results for the third quarter. Thank you very much.

Pablo Brizzio, CFO

Thanks, Maximo, and good morning to everybody. Thank you again for your participation today. Let's move to the webcast presentation to Page 3. You will see that over the last few quarters, we have transitioned to a more sustainable level of profitability, as we had already expected. Adjusted EBITDA in the third quarter was a solid $679 million with a margin of $229 per ton or 16%. The sequential decrease in adjusted EBITDA in the third quarter was primarily the result of lower fuel prices and higher cost of sales. As we anticipated in last quarter's call, EBITDA margin in the fourth quarter will continue to decline, reaching a level below the company's typical range before reversing this trend in the first quarter of 2023. As a result of the first-in-first-out accounting, our financials in the fourth quarter will have a temporary mismatch between prices and costs, reflecting a price level at one point in time with costs incurred much earlier. In the fourth quarter, steel prices under quarterly contracts in Mexico will reset at lower levels than those in the third quarter, but the cost per ton will not decline correspondingly. Thus, it will continue to reflect the gradual flow through the company's inventories of relatively high-cost raw materials purchased during the first half of the year when the Russia invasion of Ukraine disrupted steel markets. Raw material purchased more recently at lower prices will be reflected in our cost per ton from the first quarter of 2023 onwards. Net income in the third quarter fell to $220 million, equivalent to earnings per ADS of $0.78. This includes a $0.57 per ADS loss related to a write-down of Ternium's investment in Usiminas. We impaired our investment in Usiminas following a performance review at the end of September. The main changes to the company's previous estimation of Usiminas' value-in-use, which led to this impairment, were related to the lower production availability of Usiminas' coal facilities, which need further capital investments, alongside the current global macroeconomic situation. Net income in the third quarter was also affected by a loss of $95 million due to the adjustment of the fair value of certain Argentine securities collected by Ternium as dividends in kind from its subsidiary, Ternium Argentina. Turning now to Page 4 in the presentation. You can see that steel shipments increased in Mexico in the third quarter of this year compared to the second quarter and on a year-over-year basis, reaching 1.7 million tons. Looking forward, shipments in Mexico are expected to increase slightly again in the fourth quarter despite a seasonal year-end slowdown in demand, as a result of an improvement in Ternium's market share in the region and restocking in the commercial steel market. In the southern region, shipments decreased slightly sequentially. In Argentina, demand for steel products remains relatively stable, although the macro situation, as already mentioned by Maximo, continues to be quite uncertain. Shipments in other market regions in the third quarter were slightly below the levels achieved in the second quarter. As you can see in the top right chart, the volume of slabs shipped to third parties remained at relatively low levels in the period, reflecting a high level of integration of Ternium's slab facility in Brazil within the company's industrial systems. Turning now to Page five. You can see that on a consolidated basis, Ternium's steel shipments totaled 3 million tons in the third quarter, very similar to the volume achieved in the previous two quarters. Compared to the third quarter of last year, consolidated steel shipments decreased in the third quarter, reflecting a decrease in the volume of slabs shipped to third parties, partially offset by higher finished steel shipments. Moving to realized steel prices, revenue per ton in the third quarter declined sequentially and on a year-over-year basis, as expected. Realized steel prices in Mexico or revenue per ton in this period reflected the quarterly reset of contract prices at lower levels and a downward trend in market prices. As I mentioned earlier, we anticipate a further decrease in steel prices in Mexico in the fourth quarter as contract prices continue to reset at lower levels, reflecting the downward trend in steel market prices over the last six months through September. Now on Page six, let's review the main drivers behind the decrease of adjusted EBITDA and net income in the third quarter. The sequential decrease was mainly due to lower realized steel prices in Mexico, as already discussed, and higher steel costs in all sectors. The increase in cost in the third quarter reflected the gradual flow through inventories of high-priced steel slabs and raw materials purchased during the first part of the year. Regarding net income, at the bottom chart, we have the sequential decrease in operating income, and to a lesser extent, the two items I mentioned at the beginning of the call: a $120 million impairment of our investment in Usiminas and a $95 million decrease in the fair value of securities received as a dividend in kind from Ternium Argentina. Let's now review the performance of our cash flow and balance sheet on Page seven. Cash flow from operations in the third quarter was $1 billion, including a working capital release of $548 million. Free cash flow in the third quarter of the year was almost $900 million after CapEx of $136 million, which drove our net cash position to $1.8 billion by the end of September. To finalize the presentation, let's review on Page 8 our cash flow performance on a year-over-year basis. Cash from operations in the first nine months of 2022 was $1.7 billion, slightly above the level achieved in the previous year's same period. Looking forward, we expect Ternium will continue generating significant cash in the fourth quarter based on the estimated CapEx for the year of close to $600 million and further working capital release after significant working capital investment last year, as you can see in the top-right chart. Moving to the chart of dividends at the bottom of the page, we can see the $0.90 per ADS interim dividend that the Board of Directors announced early today. As already mentioned, that is $0.10 per ADS higher than the interim dividend paid last year. We expect Ternium's Board of Directors to announce the yearly dividend corresponding to 2022 in February 2023 when they review the annual accounts. Looking forward, the company will continue striving to sustain, and if possible, improve shareholders' returns. I will stop here so that we can start taking your questions. Thank you very much for your time and attention.

Operator, Operator

Your first question comes from Caio Greiner with BTG Pactual. Your line is open.

Caio Greiner, Analyst

Hello, good morning, everyone. Two questions here. So the first one on your working capital release. In 2021, you had $2.6 billion in working capital investment, that's from your presentation. And so far, you've only reversed a small part of that. My question is, are you expecting to continue posting positive contributions from working capital in the next quarters? Should we expect a full reversion of those $2.6 billion ahead or did something change that might lead you to only claim a part of that or even ahead of that going forward? My second question is on capital allocation. I know that's pretty much the same question we have been asking for a while, but the truth is that free cash flow generation continues to be very robust, maybe even more than expected a while ago, and you continue to pile up cash, I mean, $1.8 billion already in net cash. So my question is, what can you do in the short term? I mean, even with projects you have already announced? The CapEx outflow is supposed to take a few years. You could finance that with free cash flow generation, even if the first part of my question is true with working capital being reversed? If that happens, free cash flow generation is still going to continue to be strong. So despite dividends rising, it won't materially change that. What can you do in the short term regarding that amount of net cash that you have been piling up? Could you announce a buyback or an extraordinary dividend? I know you mentioned in the past that it's not really an option favored by the board, maybe an M&A that you have been analyzing? What can you do regarding that? Thank you very much.

Maximo Vedoya, CEO

Thank you very much. I would let Pablo answer the first question and then I'll address the second one. Pablo?

Pablo Brizzio, CFO

You are correct. We have generated significant working capital due to the notable increase in prices of different raw materials, and we have started to reduce it as mentioned. As you indicated, we haven't fully reversed the amount yet, but we expect to continue this during the fourth quarter and into 2023. Your assumption is correct; we will continue reducing working capital. However, this will depend on the prices of the various products and raw materials that we purchase. A significant portion of the buildup of working capital we experienced will indeed be recovered.

Maximo Vedoya, CEO

Thank you, Pablo. Regarding capital allocation, it’s true that we have a very strong financial position. However, given the expected uncertainties in the world, we feel somewhat comfortable maintaining this strong position. Nevertheless, we have very important investments to make, particularly in Mexico, with all the investments we have already announced. We have committed to expand our steel shop capabilities to be USMCA compliant by 2027, which requires substantial investment. Additionally, we are providing a high yield on dividends, as noted with the interim dividend we announced. As for buybacks, they are not currently on the table, as we have discussed before. We analyze, and various opportunities for M&A are always under consideration, but there’s nothing to inform today. So we will look for opportunities, but given the uncertainties we expect in the world, it’s wise to maintain our current position and ensure we are comfortable while providing significant dividends, which reflect a high yield.

Caio Greiner, Analyst

Okay. Thank you very much.

Maximo Vedoya, CEO

You are welcome, Caio.

Operator, Operator

Your next question comes from Jon Brandt with HSBC. Your line is open.

Jon Brandt, Analyst

Hi. Good morning, gentlemen. Thanks for taking my questions. Maximo, I first wanted to ask you about steel prices in 2023 and what your view is there. There are concerns about the global economy and how much slowdown we'll see, higher interest rates, higher inflation, zero COVID in China, and things like that. What are your expectations for steel prices, particularly in the U.S. and Mexico as we head into 2023? Do you think we'll potentially see some more downside to current spot prices? My second question relates to the cost pressures you are experiencing. I understand they are temporary, but could you provide a bit more detail? Is it mostly the slabs you are buying and iron ore prices or iron ore costs that have impacted the margins this quarter? If there's a way to quantify it, could you indicate where your margins would have been without these timing issues?

Maximo Vedoya, CEO

Thank you very much. I'll ask Pablo to start with the second question because I think it's shorter, and then I will summarize the first one because it's very broad, the prices issue.

Pablo Brizzio, CFO

You're right in noting the mismatch between the price of our product and the timing of reflecting its cost in our financial statements. This is the impact we see in reduced margins. When prices trend downward, we see a corresponding reduction in margins. When prices are rising, we will observe higher margins than expected. To be clear, we are currently reflecting costs of slabs, iron ore, and coal that we experienced in the second quarter of this year or even the first quarter, where slab prices reached $1,000 per ton and coal prices hit $600 per ton. Today, those prices are significantly lower. As a result, we are confident that, although the next quarter may show a high cost level, we expect to return to a more normalized level early next year. Thus, from our perspective, the numbers we present for 2022 indicate solid performance.

Maximo Vedoya, CEO

I'll try to be brief. Steel prices in 2023 will likely continue decreasing in North America, reaching levels below our expectations. Nonetheless, I believe normalized prices will trend higher, likely in the $800, $900, or even $1,000 range, establishing a new price base. However, in the short term, the global situation is affecting North American steel prices, and the magnitude of this impact is still under analysis. Some regions are likely to face tougher conditions, particularly Europe. The economic slowdown in China contributes to this situation as well. While I am optimistic that if a recession occurs in North America, it won't be as severe as in other regions, we anticipate steel prices to be a reflection of the economic conditions in the upcoming months. Nevertheless, I see positive variances, as companies are investing heavily in nearshoring and reshoring. For instance, our small construction division is fully booked for the next seven months and has secured quotes for the next two and a half years. This indicates that there is an opportunity for growth in both volume and more stable prices moving forward.

Jon Brandt, Analyst

It's not an easy question. I do appreciate the insights. Thank you.

Operator, Operator

Your next question comes from Carlos De Alba with Morgan Stanley. Your line is open.

Carlos De Alba, Analyst

Yeah. Thank you. Good morning. Let's revisit the CapEx and cash flow generation. Can we discuss the potential timing of announcing the new electrical furnace in North America? Will this negatively impact the dividend per ADS in the coming years?

Maximo Vedoya, CEO

Thank you, Carlos. As for your second question, the answer is no; it will not negatively impact our dividends. This is a substantial investment, but Ternium is more than capable of managing it. Regarding the timing, we have been discussing and working diligently on this in the engineering process. We need to have the facility operational by 2027, the deadline for the new USMCA rule of origins. This gives us time to consider how best to structure our investment to enhance our competitiveness in both production costs and CapEx. While we don’t have an exact timing yet, it should be forthcoming.

Carlos De Alba, Analyst

All right. Thank you. My second question is related to the risk of potential imports into the Mexican market mostly from North America, but other places as well. The situation in Europe on the demand side is complicated and they are shutting down capacity, but prices are low, demand is weak, and prices in Asia are also quite low. So how do you see the risk of imports into the Mexican market?

Maximo Vedoya, CEO

The risk is always present. In flat products, where we have room to grow, we see a consistent decline in imports to Mexico over the past 12 months. The information from September indicates this trend will continue. We are eager to capture market share, particularly as we ramp up our hot strip mill. We are securing more contracts, and while there is a risk of spot exports from Europe or Asia, I don't think there is a sustained risk over time. North America is very competitive in steel currently, which diminishes the risk of high-volume imports from those regions. Moreover, both Mexico and the U.S. have measures like Section 232 to help prevent dumping of steel, which provides some level of support. I believe our facilities and cost structure will allow us to compete effectively.

Carlos De Alba, Analyst

Thank you very much.

Maximo Vedoya, CEO

You're welcome.

Operator, Operator

Your next question comes from Thiago Lofiego with Bradesco. Your line is open.

Thiago Lofiego, Analyst

Thank you. Good morning, gentlemen. Maximo, I have a question on the demand side in Mexico. You mentioned that construction activity is low. Can you provide more details by property type, like residential, commercial, and infrastructure?

Maximo Vedoya, CEO

Yes, Thiago, absolutely. The residential construction market is the one that is declining in Mexico. This decline has been occurring for much longer than in the U.S. because residential housing in the U.S. is starting to decline more recently. In Mexico, it has already been falling for quite some time. This has adversely affected industries that supply the residential market, like home appliances. Conversely, non-residential construction is very strong. Our metal building facility, which is small and doesn't significantly impact the overall numbers, has never been busier. We have over two years of quotations for non-residential construction, which is unprecedented. A survey from GLL indicates that the total industrial infrastructure constructed in the first semester of 2022 matched last year's total, with extremely low occupancy rates—around 3%. This translates into continuing strong investments in industrial parks, which is one of the good news. On the other hand, the automotive sector is not performing as highly as expected, primarily due to supply chain issues. However, demand for automobiles remains robust, leading to expectations that automakers will increase production as supply chain constraints ease. Manufacturers of equipment and other industries are also seeing high demand. So, while there are challenges, the overall situation is balanced.

Thiago Lofiego, Analyst

You did answer the question, Maximo. Just a quick follow-up. You mentioned the automotive sector. Is this more of an expectation that things will normalize and auto production will ramp up, or are you already seeing improvements?

Maximo Vedoya, CEO

From what I understand, most automakers have the capacity to produce more, but they are being held back by shortages of semiconductors and other components that limit production velocity. While we have heard that these constraints are easing, the progress is slower than anticipated. Therefore, I can't provide a specific percentage increase, but I anticipate they will produce more vehicles in the future.

Thiago Lofiego, Analyst

And finally, with everything considered in terms of steel demand in Mexico, your best guess is for flattish volumes for next year? Is that correct?

Maximo Vedoya, CEO

Yes, it is an increase. The short-term outlook indicates an increase of 2% to 3% in demand in Mexico, which seems accurate based on our assessments.

Operator, Operator

Your next question comes from Alfonso Salazar with Scotiabank.

Alfonso Salazar, Analyst

I have a question regarding global steel trade. What are your expectations not only for 2023 but in the long term? I'm concerned about the problem of overcapacity and the fact that more capacity is being built in North America. With the challenges in China, there might be excess capacity as well. How do you see things evolving over the next four to five years given lower demand in China and increased demand in the U.S.? Given the significant price differences globally, do you expect more protectionism to arise later in the decade? Additionally, to what extent does USMCA protection justify the investments you are making in Mexico?

Maximo Vedoya, CEO

Alfonso, that’s a great question, and I will do my best to respond. I believe that global steel trade is trending toward a reduction in the future, and this is evident. There is a current movement toward greater regionalization. It's apparent that the Atlantic Alliance is progressing in one direction while China is going in another. Indeed, overcapacity in China is a pressing concern that needs to be addressed. We support measures that promote the reduction of this overcapacity. The good news is nearshoring is happening, which will drive steel consumption back to this region. North America will benefit first, and other areas like Brazil will also see similar trends. I do not have concerns regarding overcapacity in the U.S. Yes, there are new plants coming online, which will compete with us. However, there is an excess capacity exceeding 25 million tons in the U.S., and many older facilities will likely shut down in the next five years due to competitiveness issues. I am confident that Ternium is well-positioned to take advantage of these trends over the next several years.

Alfonso Salazar, Analyst

That's very helpful. Thank you.

Operator, Operator

Your next question comes from Timna Tanners with Wolf Research. Your line is open.

Timna Tanners, Analyst

Good morning, Maximo, Pablo. A couple of questions. One is, I know you just mentioned flat volumes in Mexico. But regarding Ternium's volumes, I wanted to get a little more information about both the mix and your ability to ramp up further. Obviously, you have spare capacity we’ve discussed in the past. But with the qualification process you're going through, how should we think about improvements in the mix and taking more share from imports as AMSA ramps up and in light of the competitive nature of the broader market?

Maximo Vedoya, CEO

That’s a good question. The Mexican market presents both opportunities and challenges. While the World Steel Association’s short-term outlook suggests modest growth, we are confident that we will capture a larger volume of flat product sales. The hot strip mill in Pesquería is performing very well. In October, it produced 317,000 tons, setting a record. Our existing mill runs at reduced capacity, but we have that as an option to increase as we introduce new inputs. Imports in Mexico of flat products total around 450,000 tons a month, so there's a significant market share open for us. Notably, many of these industrial customers need to undergo a certification process, which can be time-consuming. We are winning new contracts that will translate into increased shipment volume for 2023. I will also say that the competitive landscape is evolving, as the two key producers are on different trajectories.

Timna Tanners, Analyst

Regarding EBITDA per ton and margins going forward, Q3 was impacted by higher costs while prices fell. Should we expect that even as costs fall, prices will lag due to your quarterly pricing contracts? Is this a solid baseline margin, or can we expect improvement in the future?

Pablo Brizzio, CFO

Timna, your observations are spot-on. The margins we reported in Q3 at 16% are not sustainable as we expect further reductions in the fourth quarter due to similar price dynamics. While we anticipate a return to normalized margins of 15% to 20% starting early next year, this will depend on several market factors. Our goal is to maintain this level through the latter part of the year.

Timna Tanners, Analyst

Last question from me: Can you provide clarity on your anticipated CapEx for 2023? Previously, you mentioned a $1 billion investment in finishing lines. How much can we expect that to increase year-over-year?

Maximo Vedoya, CEO

Yes, we still anticipate $1 billion in CapEx for 2023. It’s likely that 2024 will see a slightly higher investment as we continue to expand.

Timna Tanners, Analyst

Thanks again.

Maximo Vedoya, CEO

Thank you, Timna. You're welcome.

Operator, Operator

There are no further questions. I'd like to turn the call back to CEO, Maximo Vedoya, for closing remarks.

Maximo Vedoya, CEO

Thank you very much all for your participation today. As always, please contact us for any suggestions or additional questions. Have a very good day.

Operator, Operator

This concludes today's conference call. You may now disconnect.