Earnings Call Transcript - TX Q2 2022

Sebastian Marti, Global Investor Relations and Compliance Senior Director

Good morning and thank you for joining us today. My name is Sebastian Marti and I'm Ternium's Global Investor Relations and Compliance Senior Director. Ternium released yesterday its financial results for the second quarter and first half 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 yesterday. With that, I'll turn the call over to Mr. Vedoya.

Maximo Vedoya, CEO

Thank you, Sebastian. Good morning, everyone, and thank you very much for your participation today in our conference call. Ternium reported strong results for the second quarter with $1.2 billion adjusted EBITDA and a margin of more than $400 per ton. These results were similar to those obtained in the first quarter of the year, representing a solid start for 2022. Over the past 12 months, Ternium's solid competitive position and the outstanding effort of its people enabled it to take advantage of our very attractive business conditions. In this period, we generated $5.8 billion of adjusted EBITDA, $1.9 billion of free cash flow, and returned to shareholders over $500 million in dividend payments. Looking ahead, we expect increased volatility in the business environment. In the first quarter, Russia’s invasion of Ukraine caused an upsurge in raw material and steel prices. Over the last few months, higher energy costs, inflationary pressures, consequential monetary tightening, and the effect on global supply chains of China's COVID-19 restrictions drove raw material and steel prices to a significant decrease. Looking ahead, I believe the main steel business variables are today closer to more sustainable levels. So we could see stabilization during the next couple of months. Having said this, volatility will persist for some time, as there continues to be a considerable level of uncertainty related to the factors I’ve just mentioned. Let's turn now to a review of our main markets. In Mexico, the industrial market remains relatively healthy, with different dynamics across industries. The auto industry continued to suffer from supply chain disruptions affecting the availability of semiconductors and other inputs for its production process. We have been expecting these disruptions to decrease for several quarters already, but they seem to be harder to solve than what most people expected. Recent China’s lockdowns continue to affect these global supply chains. On the other hand, there is significant unsatisfied end-user demand in this industry. So when these procurement problems are finally resolved, there will be an opportunity for us to increase shipments to OEMs. In addition, we have been making progress with product certification in our new hot rolling mill in Pesquería, something that will enable us to gain market share in this sector. Other manufacturing industries like HVAC and electrical motors are doing well. The white goods industry is slowing down production rates as a result of a regulation of end-product inventory in the value chain. Finally, the commercial market in Mexico, mostly driven by construction activity is currently experiencing weak apparent demand due to a destocking process resulting from the decrease in steel prices over the last few months, as well as the impact on end customers of higher interest rates and inflation. Looking forward, the low level of inventories in the market is going to need a restocking that will probably happen during the second half. Moving now to Argentina. Steel demand in the market remains at similar levels to those of the last few quarters despite a higher level of volatility in the country's macroeconomic environment. Most of the sector in Argentina continues to show good demand like agribusiness, the auto industry, the white goods industry, and the energy sector. However, the uncertainty regarding the country's macro situation has increased since our last conference call. I would now like to share our progress on some sustainability topics. Last quarter, Ternium released its annual sustainability report. In this new edition, we reinforce our reporting framework by adding SASB standards for iron and steel producers and also the recommendations of TCFD. We believe this is a step forward in the sustainability disclosure of our company in line with current discussions on the matter. We have also been working on improving the tools we use for the management of CO2 emissions in our company. Recently, we completed the assessment of Ternium's greenhouse gas emissions under the GHG Protocol accounting standards. This is complementary to the reporting of CO2 emissions and the World Steel methodology, which has been carried out over the last few years. With the application of the GHG Protocol standards, we are extending the assessment boundaries to the whole company. This methodology also provides enhanced emissions management capabilities down to each production line. It is important to note that we have also performed for the first time a third-party verification of Ternium's emission metrics. Another relevant topic for Ternium is safety. A few weeks ago, we had our annual safety day event with the participation of employees and managers from all the countries where we operate. It was an opportunity to share the results of safety programs in place, our best practices around the organization, and future action plans. Safety is a key issue in the company's agenda, and we are encouraged by the results we are achieving so far, as our lost time injury frequency rate during the first half of the year has been the lowest ever. Wrapping up, we expect to keep showing healthy shipments over the following quarters. On the other hand, the normalization of steel business variables will bring a decrease in margins to more sustainable levels. I am positive that Ternium is well positioned to show distinctive profitability once steel business variables stabilize and all recent changes to steel prices and raw material costs go through our books. The strength of Ternium's balance sheet and our enhanced competitive position will allow Ternium to navigate the expected volatility in the market. Furthermore, we anticipate cash generation will remain robust, as we should gradually release a good share of the working capital investment made when input costs and steel prices were significantly higher than they currently are. With that, I stop here and ask Pablo to go ahead with the review of our quarterly performance.

Pablo Brizzio, CFO

Thanks, Maximo, and thanks everybody for participating in our call. As we will see in today's webcast presentation, Ternium continues showing very strong results in the second quarter of the year, similar to those of the first quarter. Let's start by looking at page 3 in the presentation, with adjusted EBITDA and net earnings. Ternium's EBITDA in the second quarter was at $1.2 billion on margins of 28%, or $414 per ton. We expect lower margins going forward, but they start to reflect the significant decrease in steel benchmark prices over the last few months. Although market prices for raw materials have also been decreasing lately, we expect the cost per ton to increase in the third quarter as the company will consume raw materials purchased in previous months at higher costs. Net income in the period reached $936 million, or $4.07 per ADS, solid by historical standards, reflecting the strong operating performance. Let's turn now to page 4 to review steel shipments. In Mexico, volumes were 1.7 million tons in the second quarter of the year, increasing sequentially and slightly below the level achieved in the prior year’s second quarter. In the Ternium region, shipments in the second quarter were 600,000 tons, slightly higher sequentially and down on a year-over-year basis. In the other market region, shipments were 376,000 tons in the second quarter, lower sequentially. On a year-over-year basis, the increase in the volume of slabs shipped to third parties was mostly offset by higher finished steel shipments in Ternium's market in the region. Ternium has been gradually increasing the integration of this slab facility in Brazil, which supplies finishing facilities mainly in Mexico and Argentina. In the next page, number 5, you can see that combining these developments, we arrive at consolidated steel shipments of 3 million tons in the second quarter, stable sequentially and a little down versus the prior year’s second quarter. Looking forward into the third quarter, we anticipate shipments to remain relatively stable. Moving on to steel prices, revenue per ton in the second quarter increased slightly sequentially and is growing substantially on a year-over-year basis. As I mentioned earlier, we anticipate a decrease in steel prices in the third quarter as steel prices have decreased significantly, and this will be gradually reflected by the large set of contract prices in Mexico. Let's now review on Page 6, the main drivers behind the changes in adjusted EBITDA and net income. There was a slight sequential increase in adjusted EBITDA in the second quarter, reflecting higher realized steel prices in Mexico and Argentina, partially offset by higher costs. Labor costs increased in the second quarter, mainly in connection with Ternium Mexico employee profit sharing. This, together with increased energy costs, was partially offset by lower purchase slab costs. Let me remind you that we use FIFO accounting to value our inventories, so it takes up to five months to reflect in our financial statements changes in slab and raw material prices. Looking forward, Ternium expects adjusted EBITDA to decrease sequentially in the third quarter, reflecting lower margins and relatively stable shipments. In the section at the bottom, we see a sequential increase in the second quarter, mainly driven by better financial results. This improvement primarily reflected a higher value of financial instruments, while income tax increased sequentially as a result of slightly better results and a higher effective tax rate. Let's turn now to Page 7. There was no cash from operations generated in the second quarter, mainly as a result of a working capital increase of $681 million and income tax cash payments of over $600 million. Tax payments in the period include an increase in advanced payments for fiscal year 2022 in Mexico and the payment of the outstanding tax balance for fiscal year 2021 in Argentina, both as a result of strong earnings recorded in 2021. The increase in working capital includes a significant impact on inventory values due to higher steel and raw material costs, as well as slightly higher volumes. Free cash flow in the second quarter of 2022 was a negative $166 million after CapEx of $161 million. This, together with the $353 million in dividends paid in May resulted in a reduction of Ternium's cash position to $1 billion by the end of June. Now on the final Slide, number 8, let's review our cash flow performance on a yearly basis. Cash from operations in the first half of the year was $687 million, after deducting income tax payments of $1.5 billion and working capital increases of $350 million. Looking forward to the second half of the year, our expectation is that Ternium will show healthy cash generation based on the CapEx estimate for the year of approximately $600 million, a decrease in income tax payments compared to the first half, and a reduction in working capital as well as the price deflation of steel and raw materials flowing through Ternium Brazil. Okay, with this, we finish our prepared remarks. Thank you very much again for your time and attention. And now we are ready for your questions. Please, operator, proceed with the Q&A session.

Operator, Operator

Thank you. Your first question comes from the line of Timna Tanners with Wolfe Research.

Timna Tanners, Analyst

Yes. Hey, good morning, everyone. Wanted to ask on volumes a few questions, if I could. First one was just looking at the volumes down year-over-year in Mexico, still begs a question of where the Pesqueria volumes are showing up or if it's just offsetting existing tonnage? And should we expect that to continue to ramp up as you get qualified in any time frame there? The other question is just on the EBITDA guidance of a more sustainable level. I was hoping to see if you could help quantify that a little bit better. If we look at the five years prior to COVID, the average has been about $150 a ton. But of course, the last couple of years have been close to $400 a ton. So any thoughts on the gap between those two levels would be helpful? Thank you.

Maximo Vedoya, CEO

Okay. Thank you, Timna. Volumes from Pesqueria are running at between 80% and 85% of capacity, which is very high, and to be honest, running very well. However, as I mentioned in the last conference call, the problem lies with the commercial market in Mexico, where we have seen a decrease in apparent demand because of the challenges we've discussed. The issue with the volumes is that the other hot strip mill, the one in Churubusco, is running significantly lower than its capacity. The certification process for all these new steel products takes time, and all automotive certifications take at least one year. We are starting to see new products flow through our customers, but this is a process that will take at least another year ramping up each quarter. Regarding EBITDA guidance and more sustainable levels, if you remember, Timna, we've stated that our objective of EBITDA ratios before this last almost two years was between 15% and 20%. That was a normal number and is higher compared to most of our peers. I think this is the outlook we are looking at for the third quarter. Pablo, if you want to add more clarification to this.

Pablo Brizzio, CFO

Hi, okay Maximo. You have already answered, but I'll add some color. So yes, really, what Maximo was saying is that we are expecting, of course, given the uncertainty that we are facing in prices, to return during this period to levels we had before the pandemic. It’s important to note that going forward in 2023 or based on your expectations, we are looking at a more normalized level of prices and raw materials. After all the investment that we made, the ramp-up of the new Pesqueria facility means that we should be targeting margins close to the upper side of our previous range, which is even a little higher. So clearly there will be a reduction in margins in the next couple of quarters, but then we should be returning to normal levels and even targeting a bit higher.

Timna Tanners, Analyst

So the guidance of the higher end of the range would be a function of the investments that Ternium has made in downstream, vertical integration in Mexico, and some of the other company-specific actions. Is that what you're saying?

Pablo Brizzio, CFO

Yes, exactly. You're right. Of course, taking into consideration the prices of the final product, you never know where it will be, but this is clearly what we are looking for and what we are targeting.

Timna Tanners, Analyst

Great. Thanks. I’ll hand it over. Thanks, again.

Maximo Vedoya, CEO

Thank you, Timna.

Operator, Operator

Your next question comes from the line of Andreas Bokkenheuser with UBS.

Andreas Bokkenheuser, Analyst

Thank you very much. Just two quick questions from me. Just looking at the Mexican steel market at the moment, I mean we've obviously seen some new capacity coming online in the US and some of that volume was reported destined for Mexico. Are you starting to see increased import volumes or increased price pressure from some of the volumes that are coming in from the US into Mexico? That's the first question. And maybe the second question, if you could just give us your updated thoughts on potentially expanding within the EAF meal capacity. That would be great. Thank you very much.

Maximo Vedoya, CEO

Thank you, Andreas. Yes, regarding the increase in imports, we are not seeing it. To be honest, if you look at the imports in the Mexican market, especially in flat products, there was a significant increase last year during the period from March to November, when prices were going up, and our hot strip mill was not yet functioning. But as prices started to decrease, those volumes started coming down. The lead time for imported materials is very long, so we have a lag effect. Today, we are seeing that imports are declining from that peak and are a bit lower than 2020 levels. We are not seeing that problem in Mexico; our market share is increasing, and that's the data we have. Regarding the EAF meal capacity expansion, this is a complicated project, but we are still working on the engineering for compliance with USMCA for the automotive industry by 2027. We are progressing in that area.

Andreas Bokkenheuser, Analyst

Got it. That's very clear. Thank you very much.

Operator, Operator

Your next question is from the line of Alfonso Salazar with Scotiabank.

Alfonso Salazar, Analyst

Hello, and thank you for taking my questions. I have two questions. First, can you comment on how you plan to respond to lower valuations and the fluctuations in share price that are closely tied to steel prices? Is there anything you can share about recognizing the share price? Secondly, I'd like to discuss the auto industry and some current trends. For instance, there seems to be a trend where OEMs are moving away from affordable cash models, which are largely disappearing, and are instead focusing on SUVs and premium vehicles. With electric vehicles coming at much higher prices, it’s uncertain how auto sales will return to previous levels. Given this context, I want to understand the strategy of OEMs in increasing the use of high-strength steel compared to aluminum parts. Aluminum is becoming more appealing to OEMs for vehicle production. What is the strategy in this regard, and how do you see this market evolving for Ternium?

Maximo Vedoya, CEO

Okay. Hi, Alfonso. Let me take the first question. As you know, we have been discussing this for a long period of time. What we are seeing today, and which we can reflect on for the future is that, probably taking out a few US companies, the rest of the steel sector is having low multiples reflecting the value of the company. This is likely a consequence of the adjustment we made on sales, where we see, as forecasted, an adjustment on margins bringing them closer to the levels we had prior to the pandemic after a couple of years of exceptionally high margins. We are still reflecting multiples that are lower than historical numbers. The share price of Ternium is performing relatively well compared to others, and we have been taking certain actions to enhance and support the value of our company. We have discussed before the two-part dividend payments and increasing our payout ratio. We will continue to work in order to simplify our corporate structure, though we have not been successful yet. Our company is diverse, which can be a plus and a minus factor. However, we will continue to aim to improve our share value. Regarding the second part on the auto industry, there are several points to consider. OEMs are producing fewer affordable cars primarily due to restrictions they face. They are focusing on higher-margin products like SUVs because they have limited capacity. Overall, automotive production was around 103 million units globally, whereas last year it dropped to about 78 million units due to these restrictions. This year, we expect around 82 million units, but this reduction is not driven by demand but rather by supply chain issues. For us, the demand remains stable. As for aluminum, I don't see any significant changes. Demand for steel in the automotive industry will remain stable for the next couple of years until the next generation of batteries comes in. I believe that most electric vehicles will still be produced with steel, mainly because of costs. The cost equation here is clear. So, I'm not concerned about the use of aluminum becoming a significant problem for us.

Alfonso Salazar, Analyst

I totally agree with you. I'm just concerned that it's going to be Asian brands and Chinese brands that will take over a good part of that segment. But we'll see how things evolve. Thank you, Maximo.

Maximo Vedoya, CEO

It could be, Alfonso, but those manufacturers need to use steel to comply with USMCA standards, so we’re confident they will seek our products as their customers.

Operator, Operator

Your next question is from the line of Caio Greiner with BTG Pactual.

Caio Greiner, Analyst

Hello. Good morning, everyone. Thank you. Just two quick questions from my end. First, regarding the situation in Argentina. I mean, we've seen some companies with operations in Argentina reporting seemingly unsustainably high results largely due to the large gap between the official and unofficial exchange rates. I wanted to check with you about what kind of impact we could expect from this going forward for Ternium from an accounting perspective, if there's anything we should be aware of for the third quarter or anything from the second quarter as well? The second point we seek to understand is what kind of impact you've been sensing on steel demand in the country? Have you seen any slowdown from your customers or anything we should be on alert for? And, as a follow-up to a previous question on Pesqueria, I remember that in the last conference call, Maximo mentioned that you expected incremental shipments from Pesqueria, especially for Mexico to be around 1 million tons this year. I wanted to check if that's still the case or if you've adjusted that outlook for 2022, or if you have any projections for 2023. Thank you.

Maximo Vedoya, CEO

Okay. Thank you very much, Caio. I'll start with the second part of the Argentinian question, and I'll let Pablo discuss the accounting part. Regarding the market impact, we haven’t yet seen any major changes in demand from Ternium Argentina; steel demand remains stable at very good levels. The new Minister of Economy is expected to speak about the new economic plan today, which could introduce some uncertainty. We believe the macroeconomic situation in Argentina might lead to changes in demand, but for now, we are seeing solid orders, and our customers are selling well.

Pablo Brizzio, CFO

Okay, Caio, I hope you're doing well. Let me first try to answer your question in a broad way regarding Ternium. We use the official exchange rate for our transactions in sales and purchases. Therefore, we have not experienced the same situation impacting others in Argentina. However, if there's a potential devaluation, it could help profitability initially due to the value of non-dollar-denominated costs. But the macroeconomic situation remains uncertain. We need to wait and see how the situation unfolds following the Minister’s announcements today.

Maximo Vedoya, CEO

As for the amendments to the Pesqueria incremental shipments for this year, we will not achieve the initial objective that we set out in our last conference call. There were higher-than-expected imports at the beginning of the year and a downturn in the commercial market due to a decline in infrastructure construction and GDP. Consequently, we will not achieve those incremental volumes this year; however, production is in line with our original estimates. The ramp-up in certification is expected to occur in 2023, providing incremental volumes from industrial customers, though it may take time for construction activity to improve.

Caio Greiner, Analyst

Thank you very much, gentlemen.

Maximo Vedoya, CEO

You're welcome, Caio.

Operator, Operator

Your next question comes from Thiago Lofiego with Bradesco BBI.

Thiago Lofiego, Analyst

Thank you. Maximo, just a quick follow-up on Pesqueria and on Mexico volumes. If we face a more adverse scenario in 2023 and considering that you will have all the certifications you mentioned, are you going to prioritize Pesqueria volumes over other sites, given its lower costs and better margins? Does that approach make sense? The second question specifically pertains to the construction sector, which you showed caution on. You also mentioned that you see inventory levels relatively low and you expect some restocking to support volumes in the second half. So could you discuss that further? How do you see construction activity evolving in the next six to twelve months in Mexico? What are the key drivers here?

Maximo Vedoya, CEO

Thank you, Thiago. Yes, we are prioritizing Pesqueria today. It is our first mill at full capacity; the second is at Guerrero. The Churubusco facility is the one lagging significantly behind. Regarding key drivers in the construction sector, there are three main areas: infrastructure, private sector initiatives, particularly residential and commercial construction, and industrial site building. Infrastructure performance remains inadequate, while private sector construction is declining. However, we see some positive developments in industrial construction due to strong demand for near-shoring initiatives. This area has a lengthy backlog and should utilize our products extensively, which is a positive aspect. In terms of inventories, we see distributed inventories are low due to the recent price drops. There will likely be restocking, perhaps in Q4, but broader construction demand needs to improve significantly for a real impact.

Thiago Lofiego, Analyst

Yes. Very, very clear, Maximo. Thank you.

Operator, Operator

Your next question is from the line of Caio Ribeiro with Bank of America.

Caio Ribeiro, Analyst

Yes. Hi. Good morning, everyone. Thanks for the opportunity. So I have two questions here. The first, going back to your upstream slab capacity expansion plans in Mexico. I was just wondering, if you could also look to expand your iron ore production as well, and also feed into that additional upstream capacity. And also, in terms of pricing for US HRC in the US after that correction with prices near $800 to $900 per short ton, do you feel that we're near a bottom right now? And after that correction, have you started noticing your bids for your volume starting to pick up? Thank you, gentlemen.

Maximo Vedoya, CEO

Thank you, Caio. Good questions. We are not seeing an immediate expansion of iron ore production; our focus is on analyzing potential projects. However, we are unlikely to establish a new facility for iron ore production to support upstream capacity soon. Overall, we believe we are nearing a bottom for hot-rolled prices in the US, based on our recent sales activity. We've had more inquiries over the past few weeks, and people are looking to buy future contracts, often at higher prices than today. Overall demand from industrial customers remains robust despite recession concerns. Near-shoring is driving demand in the US and on our side of the border, so we are optimistic that prices may stabilize or rebound soon.

Caio Ribeiro, Analyst

Perfect. Thank you very much, Maximo.

Operator, Operator

Your next question is from the line of James Spies with Morgan Stanley.

James Spies, Analyst

Yes. Hello. Thank you for taking my questions. I just wanted to ask about working capital. You had really large usage of working capital this quarter. Could you provide any color on how you see that evolving throughout the rest of the year, considering prices remain relatively stable for raw materials?

Maximo Vedoya, CEO

Thank you, Jim. The increase in working capital is essentially driven by prices. There was some increase in slab volume as well as a significant shift in PCI carbon inventories, as we secondary sourced from Australia due to the previous Russian supply change. The increase in working capital largely represents higher inventory values. We believe that in the upcoming quarters, we will see a decrease in working capital levels.

Operator, Operator

That concludes today's Q&A session for today. I will now hand the call back over to the CEO for any closing remarks.

Maximo Vedoya, CEO

Thank you all very much for participating in the call. As always, contact us if you have any feedback or additional questions. I hope to talk to everyone in the next conference call. Goodbye. Thank you.

Operator, Operator

This concludes today's call. Thank you for joining. You may now disconnect.