Kaiser Aluminum Corporation (KALU) Q2 2017 Earnings Report, Transcript and Summary

Good day, ladies and gentlemen and welcome to the Kaiser Aluminum Second Quarter 2017 Earnings Conference Call. At this time, all participants are in a listen-only mode. [Operator Instructions] As a reminder, today’s conference maybe recorded. I would now like to turn the call over to Ms. Melinda Ellsworth, Vice President, Investor Relations and Corporate Communications. Ma’am, you may begin.

Thank you. Good afternoon, everyone and welcome to Kaiser Aluminum’s second quarter 2017 earnings conference call. If you have not seen a copy of our current earnings release, please visit the Investor Relations page on our website at kaiseraluminum.com. We have also posted a PDF version of the slide presentation for this call. Joining me on the call today are Chief Executive Officer and Chairman, Jack Hockema; President and Chief Operating Officer, Keith Harvey; Executive Vice President and Chief Financial Officer, Dan Rinkenberger; and Vice President and Chief Accounting Officer, Neal West. Before we begin, I would like to refer you to the first two 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, 2016. The company undertakes no duty to update any forward-looking statements to conform the statements to actual results or changes in the company’s expectations. In addition, we have included non-GAAP financial information in our discussion. Reconciliations to the most comparable GAAP financial measures are included in the earnings release and in the appendix of the presentation. Any reference in our discussion today to EBITDA means adjusted EBITDA, which excludes non-run rate items for which we have provided reconciliations in the appendix. At the conclusion of the company’s presentation, we will open the call for questions. I would now like to turn the call over to Jack Hockema. Jack?

Thanks, Melinda. Welcome to everyone joining us on the call today. Our second quarter results exceeded our expectation as Trentwood performed significantly better than anticipated despite project-related equipment outages and operational disruption. Beyond Trentwood’s strong performance, our other facilities continued to achieve solid underlying manufacturing efficiency. We also benefited from favorable scrap material prices similar to the first quarter and overhead and other costs. In this quarter we are also more favorable than we had anticipated. In addition to reduce complexity and the execution risk at Trentwood, we have rescheduled approximately $4 million of major maintenance projects unrelated to the modernization project from the second quarter to the second half. As anticipated, industry dynamics remain largely unchanged from the first quarter despite construction-related throughput constraints at Trentwood and destocking in the commercial aerospace supply chain, total shipments increased 3% year-over-year. Reduced year-over-year aerospace shipments were more than offset by year-over-year growth in shipments for general engineering and automotive applications driven by strong industrial demand and new automotive program launches. While shipments improved year-over-year, we experienced a 2% decline in total value-added revenue due to a lower value-added product mix, higher contained metal costs and competitive price pressure. Unusually favorable price spreads for scrap raw material purchases continued from the first quarter and partially offset margin pressure from the lower sales prices. Despite headwinds in the aerospace market and disruption for modernization construction activity at Trentwood, we achieved strong EBITDA and margin comparable to the prior year demonstrating benefits from our past capital investments as well as our focus on continuous improvement in our manufacturing operations. In addition, we returned cash to shareholders through share repurchases and dividends of $14 million in the second quarter and $82 million in the first 6 months of the year. The Trentwood modernization project is proceeding as planned and we expect to complete the heat treat furnace outage and restore normal operations and material flow during the third quarter. I’ll now turn the call over to Dan for additional color regarding the second quarter results and then provide an update on our outlook for the second half and the full year of ‘17. Dan?

Thanks, Jack. Similar to the first quarter, value-added revenue in the second quarter reflected a lower back mix with fewer aerospace shipments and more automotive bumper and general engineering shipments. Additionally compressed margins on spot sales of certain products continued from the first quarter into the second quarter. While total shipments increased 3% year-over-year in both the second quarter and the first half of 2017, value-added revenue declined 2% in the second quarter and 3% in the first half reflecting mix in the compressed margins. Aerospace value-added revenue declined 6% from the prior year second quarter and 7% from the prior year first half due to supply chain destocking of aerospace plate as well as planned project related equipment outages that temporarily constrained our second quarter plate capacity. Additionally, competitive pricing on aerospace spot transactions continued to prevent full pass-through of higher contained metal costs. Automotive value-added revenue increased 3% compared to both the second quarter and the first half of the last year on higher volume, particularly for bumper programs for which shipments nearly doubled. General engineering value-added revenue also continued to show year-over-year improvement, increasing 3% over the second quarter and 5% over the first half of last year. As with some of our aerospace products, continued competitive pricing hindered our ability to pass through higher contained metal costs on some of our higher value-added general engineering products. On Slide 7, EBITDA for the second quarter of 2017 was $54 million compared to $55 million in the second quarter of last year. Compressed sales margins and a lower value-added product mix resulted in a $6 million adverse sales impact in the second quarter while major maintenance expense exceeded the prior year quarter by $2 million. However, as Jack mentioned, favorable price spreads for scrap purchases continued in the quarter, providing a $4 million year-over-year benefit. Additionally, operating and overhead costs were slightly lower than the prior year quarter. With solid operating performance across our manufacturing platform, second quarter EBITDA margin grew 26.7%, which was higher than any prior quarter. During the second quarter, we chose to reduce complexity and execution risk at our Trentwood facility by rescheduling major maintenance that was not critical or required to be completed in conjunction with the hotline and heat treat furnace upgrades. We believe this continued to the Trentwood team’s efficient execution of equipment upgrades and enabled favorable sales and cost performance that we initially did not expect during the quarter. The rescheduled major maintenance projects totaling $4 million are now planned for the second half of the year. EBITDA in the first half of 2017 of $108 million was $2 million lower than the prior year, reflecting a $14 million adverse sales impact largely offset by a $6 million benefit from favorable price spreads for scrap purchases and $6 million of favorable operating and overhead costs. EBITDA margin in the first half of 2017 was 26.6% slightly higher than 26.4% EBITDA margin in the first half of last year. Turning to Slide 8, operating income as reported for the second quarter of 2017 was $11 million. This was net of $33 million of non-cash non-run-rate losses. Adjusted for the non-run rate losses, operating income for the second quarter was $44 million compared to $46 million in the prior year second quarter. The $2 million decline reflected the $1 million reduction in EBITDA that I just covered as well as a $1 million increase in depreciation expense. For the first half of 2017, operating income as reported was $71 million adjusting for $18 million of non-cash non-run-rate losses however. First half 2017 operating income was $89 million, down slightly from $92 million in the prior year period, reflecting a $2 million reduction in EBITDA and a $1 million increase in depreciation expense. Non-run-rate losses for both the second quarter and the first half of 2017 included an $18 million impairment of goodwill associated with our January 2011 acquisition of Alexco. The impairment reflected our updated assessment of market conditions for hard alloy aerospace extruded shapes. Non-run-rate losses for the second quarter also included $12 million of non-cash mark-to-market losses on our commodity hedge positions. Reported net income for the second quarter of 2017 was $5 million or $0.27 per diluted share and for the first half of 2017 was $41 million or $2.34 per diluted share. Adjusting for non-run-rate items, net income was $25 million for the second quarter and $52 million for the first half or adjusted earnings per diluted share of $1.47 for the quarter and $2.99 for the first half. Our effective tax rate was 32% for the second quarter and 34% for the first half of 2017, but our cash taxes continue to be low as we use our net operating loss carryforwards. Capital spending totaled $25 million in the second quarter and $40 million for the first half of 2017. We expect capital spending for the full year will be approximately $80 million, which is more than twice our level of depreciation. A significant portion of our 2017 spending is related to the Trentwood modernization project. Additionally, during the first half of 2017 as Jack mentioned, we returned $82 million of cash to shareholders in the form of share repurchases and dividends. At June 30, cash and short-term investments totaled approximately $233 million and borrowing availability on our revolving credit facility, was approximately $287 million. And now, I will turn the call back over to Jack to discuss our outlook and business market trends. Jack?

Thanks, Dan. We continue to expect destocking in the commercial aerospace supply chain through the remainder of 2017. Despite the destocking and constraints on capacity from our planned equipment outages at Trentwood, we continued to expect full year 2017 shipments similar to 2016 for our aerospace applications. Although we expect most of the aerospace destocking to be resolved by the end of the year, we now expect isolated instances of inventory overhang to linger into 2018. However, we continue to anticipate strong demand growth for aerospace applications in both 2018 and 2019 driven by commercial, military and other aircraft applications. For automotive extrusion applications while the 2017 North American build rate forecast has decreased slightly since our last call, the build forecast is unchanged for larger vehicles that represent a significant portion of our automotive mix. Shipments for our new bumper programs are ramping up as expected and our outlook for 2017 automotive shipments and value-added revenue are unchanged. We continue to expect double-digit year-over-year growth in shipments and mid single-digits value-added revenue growth as demand growth is concentrated in lower value-added parts. Turning to Slide 10, we experienced destocking for general engineering applications in the second quarter, following restocking in the first quarter. Supply chain inventories appear to be in equilibrium and underlying industrial demand remains strong. Our current lead times at Trentwood are 14 weeks for general engineering plate and 10 weeks for high strength alloys. The longer lead time for general engineering plate is related to working around the planned outage just completed for the light gauge heat treat furnace. Turning to Slide 11 and a summary of our outlook for the full year of 2017, our sales outlook for aerospace, auto and general engineering applications is unchanged. Project-related inefficiencies will continue at Trentwood in the third quarter. We expect to restore normal operations and material flows by the end of the quarter and to begin realizing the quality cost and capacity benefits from this work later in the year. As demand strengthens and we fully implement the improved practices and capacity expansion, these benefits will continue to grow in 2018 and beyond. As mentioned in my earlier remarks, we made a decision during the second quarter to reschedule certain major maintenance projects to the second half of the year. As a consequence, approximately $4 million of planned major maintenance spending has been shifted from the second quarter to the second half of the year. Reflecting the seasonality of our business, we typically experienced reduced sales and EBITDA in the second half compared to the first half. This year, we expect a pattern very similar to 2016 although the scheduled major maintenance expenses will cause additional drag on the second half compared to the prior year. Turning to Slide 12 and a summary of our comments today as expected, second quarter results were negatively impacted by construction-related activities at Trentwood, aerospace supply chain destocking and reduced sales margins. However, we had strong operational performance and scrap raw material prices continued to be unusually favorable. As a result, we improved year-over-year EBITDA margin for both the second quarter and the first six months of the year. In the second half, we expect normal seasonality, unusually high planned major maintenance expense and restoration of normal operations and material flows at Trentwood by the fourth quarter. Longer term, our strong balance sheet and cash flow generation will support continued investments in organic and inorganic growth and return of cash to shareholders. We will now open the call for questions.

[Operator Instructions] Thank you. And our first question comes from the line of Edward Marshall with Sidoti & Company. Your line is now open.

Hey, Jack and Dan. How are you?

Hey, Ed. Good.

So, I guess Jack in Q1 you talked about major maintenance running in about $5 million to $7 million higher than 1Q. Obviously, there has been some change with the rescheduling here. I know the hotline you said was done the furnace is partially done on its way in 3Q. So, kind of maybe you can parse that $4 million kind of how does that work into that 5 to 7 as it relates to the first quarter?

Sure. I don’t remember the $5 million to $7 million. I think we are probably talking to first half of year-over-year, but anyway basically we shifted $4 million of planned major maintenance not related to the modernization project shifted that from the second quarter into the second half of the year. In terms of the modernization project, we had the major equipment outages in the second quarter on the hotline, little more than a week on the hotline and several weeks on a light gauge heat treat furnace. The light gauge heat treat furnace had just started up late last week. So, we are beginning to ramp it up and the big new sheer that we put in place also begin to ramp up early this week. So, we are through the major outages now and we are in the early ramp up phases on the major equipment installations that we made. But in terms of how it affects EBITDA, the only real effect from our outlook that we gave on the last call is we have moved roughly $4 million of unrelated modernization major maintenance projects from the second quarter into the second half.

Got it. And is there any way you can kind of talk second half over second half or first half over second half as to the maintenance costs?

Yes. We didn’t expect it was going to be that way this year, with all the planned maintenance that we had in the first half, but now that we moved it to the second half as we said in our outlook, we are expecting that the second half this year compared to the first half this year is going to be a very similar pattern to what we saw last year with the exception that we have got even $4 million of additional major maintenance loaded into the second half. So, we are going to have even more increased major maintenance spending in the second half this year than we had last year.

Got it. And you are seeing the yields I guess release the initial yields off the furnace and maybe even this year probably too early to tell, but are they meeting kind of expectations at this stage – at this early stage?

Yes, but we are only days into it. So, we haven’t even finished the first inning yet.

And you gave some commentary on the general engineering and the heavy – or the heat treated plate based on lead times today where were they year ago?

Well, I think we were 30 weeks or so, 15, 20 weeks a year ago.

15, 20, so it’s come down significantly, okay. And you had mentioned that the scrap versus primary and the benefit in Q1 just to refresh, there is about $1 million to $2 million benefit right in Q1 I think it was?

Well, I think Dan said that this quarter over prior year was $3 million to $4 million.

$4 million in the quarter compared to last year.

Yes. But order of magnitude it’s the same thing, when I put my thumb in the air and compare it to what we think are typical benefits from scrap we are running roughly $3 million a quarter in the first half better than what we were running – than what we typically would run.

Just to be clear that this is strategic choice correct or is there…

Well, no, it’s really two factors. First of all, lot of credit goes to our operations, because they have put a lot of focus on improving our buying as well as improving our scrap utilization. So, we have gotten a permanent improvement in our raw material costs because of actions implemented in our operations. That said, we are working with a favorable market environment. As I said on the first quarter – the call for the first quarter, it was unusually favorable in the first quarter. We didn’t expect it to continue. It was similar in the second quarter. We don’t expect it to continue, but we are hopeful that it continues into the year. And frankly in the first half, it’s been a big benefit a tailwind that’s helped us offset as Dan mentioned offset a lot of the price erosion that we have seen on our heat treat plate products.

Great. This is helpful. Guys, thank you. I appreciate it.

Thank you. And our next question comes from the line of Jorge Beristain with Deutsche Bank. Your line is now open.

Hey, guys. Hey, Jack. Just following up on the same topic, you had guided toward sequentially weaker 2Q margins, adjusted margins, because you thought that 1Q was not repeatable, it’s been repeated again and now you are again guiding to lower adjusted EBITDA margins going forward. But can you just clarify what exactly drove the difference in those adjusted EBITDA margins being about 600 to 700 basis points higher quarter-over-quarter than you had expected?

Sure. Yes, yes. So if you just take the major maintenance, you got $4 million of major maintenance, which is 200 basis points. So there is a third of it. And if you take the scrap profits running $3 million to $4 million better than what our outlook was you have got another close to 200 basis points. Trentwood performed much better than we expected. We thought they would have a lot more inefficiency related to the significant activity going on at the plant and they did a marvelous job in the second quarter not only managing the projects, they were really big project bringing those online, but also managing operations working around all the disruption. And beyond that, we had really strong performance in all of our other plants. So we had just exceptionally strong operating performance throughout all of our facilities. And beyond that, we got a small additional boost from lower-than-expected overhead and some other miscellaneous costs that are lumpy quarter-to-quarter.

Right. So I am trying to dissect the lumpy stuff from the non-recurring stuff, but it sounds like of the stuff that you just walked through, you are kind of – part of it is that deferred maintenance that’s just going to be a 200 basis point headwind in the coming quarter?

Yes.

But a lot of the other stuff I am not clear if that’s going to be unwound?

Okay. Well, first of all, the major maintenance may not all be in the third quarter. I said we moved it to the second half. So, some will be in the third quarter, some in the fourth quarter. The scrap discounts it is difficult to predict. We didn’t think it would be there in the second quarter after the first quarter. We are not anticipating it in the third quarter, but it’s too soon to know. The scrap markets are very volatile and can change on a minutes’ notice. So, we really don’t know if those 175 to 200 or 150 to 200 basis points will be there. In terms of operating efficiency, the summer is always tough in our plants, we have more vacations, a lot of senior people out and we have high heat in – in the especially in our extrusion operations and we always have less volume and the combination always has some drag on efficiency. But we expect the Trentwood’s that while there still fighting through the ramp up they are not going to have near the inefficiency we think that we experienced in the second quarter. So, all-in-all we think our efficiency should be relatively similar in the third quarter to what we saw in the first half and who knows how some of those other costs fall they just match around quarter-to-quarter.

Got it. Thanks very much.

Thank you. And the next question comes from the line of Novid Rassouli with Cowen & Company. Your line is now open.

Hey, guys. Thanks for taking my questions. So back to sticking with the trend of maintenance here, so does the slower maintenance schedule imply that you are going more slowly, because market conditions are likely to stay softer for longer or what was the impetus behind that?

Actually, it was a decision made at the plant. Keith and I are up there early in the quarter and they were showing us all the great work they were doing prepping for the construction and all that. But after we left, they took a look at their whole situation and determined that some of what they were planning to do in the second quarter was an urgent and to reduce the amount of distraction that they were going to have with everything they had on their plate in the second quarter they just made is the decision to move some of that to the third and fourth quarter, which we believe was a prudent decision, but that was a local decision just I am looking at their situation.

Okay. And, of the $2 million spend in the second quarter versus the $4 million left for the rest of the year, is there a portion of the maintenance whether the $2 million of the $4 million that has a greater impact on our production volume inefficiencies, for instance, because you have to shut anything down with respect to the $2 million this quarter that you will need to shutdown for the $4 million or if you could just help us understand that?

Yes. Well, I don’t know what your $2 million is unless you are looking something quarter-over-quarter.

Quarter-over-quarter.

Yes, but disregard that, that’s a major maintenance is lumpy quarter-to-quarter and half to half. That when we look at the first 6 months of the year, our major maintenance spending was actually slightly higher this first half than it was prior year, but relatively the same as the prior year. And now we are looking at second half other than the $4 million that’s relatively comparable to the second half last year, which almost always is much higher than the first half, plus we move this other $4 million into the second half. So year-over-year we are going to be $4 million or $5 million higher for the total year than we were last year and most of that is lumped into the second half of the year if that clarifies it.

Okay. And then lastly just on general engineering shipments, you had said restocking in Q1, destocking in 2Q. So, is there a kind of reasonable level of shipments to expect going forward closer to 2Q, if you could just help us with that moving forward? And that’s it for me.

We will have the normal seasonality. So you have got the high first quarter, the lower second quarter and typically those are the two strongest quarters a year. And we will see lower shipments in the third quarter and then probably significantly lower in the fourth quarter is the typical pattern.

Okay, thanks for taking my questions.

Thank you. And our next question comes from the line of Josh Sullivan with Seaport Global. Your line is now open.

Hi, good afternoon.

Hi, Josh.

Just with the completion of the Trentwood efficiency investments here around the corner, there have been any changes to your long-term targets for EBITDA I believe in the upper 20s?

No, we are not going to go beyond that, Josh, good try. Now, we are still looking at well over 900 in terms of value-added revenue potential and high 20s of EBITDA margin. And our outlook for the result of the investment we have said we get 5% to 10% increase in capacity just listening to the guys at the plant, they are really, really optimistic about what they are going to get out of these improvements that they have made. But the other thing we are going to get is a step change, important step change in cost and quality on our light-gauge plate and that’s going to position us much better in the marketplace plus give us significant cost efficiencies. Over and above, the efficiencies will get through the whole operation from the upgrades on the hotline. So, we are really optimistic and the plant is exceptionally optimistic about what this all is going to mean once we get the few quarters down the road.

Okay, I had to try. And then just on aerospace destocking, can you give us a sense of where inventory is right now. Our level is consistent with current OEM build rates or if they adjusted for any additional rate reductions such as the A380 or any other any other aircraft at this point?

Well, I mean this year, the destocking is relatively constant through the whole year and that’s typically how it goes. And it’s a full year phenomenon. I think the A380 and some of the other adjustments are responsible for the comment that we made where we have revised our outlook that we are going to see modest destocking continuing into 2018, but we expect much less severe destocking in ‘18 compared to ‘17 and then with increased real demand as total builds are ramping up, we are still very bullish about increased demand in 2018 and 2019.

Okay. And then just one last one, I mean on that lingering comment, I mean is that Q1 or the first half, how far do you think that lingers?

It will affect the full year.

Okay.

Of 2018.

Okay, thank you.

Thank you. And our next question comes from the line of Piyush Sood with Morgan Stanley. Your line is now open.

Hi, Jack and Dan. Congratulations on the strong quarter. First, follow-up on the inventory overhang in 2018. Anything you can say to help us quantify the impact of that drag, let’s say, like it’s a 10th of what the kind of drag you are seeing this year or anything that helps us kind of run some numbers to our model. And second, is it more on the long products side, flat products side, any color you can provide?

In terms of impact, we did not reiterate our outlook for ‘18 and ‘19 where we had set up 10% both years. We will be updating that perhaps on the next call certainly by the February call. I expect it will be less than 10% year-over-year growth. We look at demand growth for ‘18 versus ’17, but still strong growth. How it relates to flat-rolled versus some of the long products, it’s more contained in the flat-rolled but there is some minimal destocking throughout some the rest of the products as well.

Okay, that’s helpful. Thank you. And question on Section 232 since we hear so much about it these days, wondering how much of your aluminum is sourced from outside of North America?

The predominant portion is outside of North America. Yes, the purchases are outside in North America more than inside, yes.

Okay. Thank you for taking the questions.

Thank you. And I am showing no further questions at this time. I would now like to turn the call back to Jack Hockema for closing remarks.

Okay. Thanks, everyone for joining us on the call. We look forward to updating you again on our third quarter call in October. Thank you.

Ladies and gentlemen, thank you for participating in today’s conference. This does conclude the program and you may all disconnect. Everyone, have a great day.