Materion Corporation (MTRN) Q3 2017 Earnings Report, Transcript and Summary

Greetings and welcome to the Materion, Third Quarter 2017 Earnings Conference Call. At this time all participants are in a listen-only mode. A question-and-answer session will follow the formal presentation. [Operator Instructions] As a reminder, this conference is being recorded. It would now like to turn the conference over to your host Mr. Steve Shamrock. 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 the quarter and an update on key 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 or contained in today’s press release, 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 five in this morning’s Press Release. The adjustments are made in the current quarter for comparative purposes and removes CEO transition cost and non-recurring cost reduction actions. And now, I’ll turn it over to Jugal for his comments.

Thank you, Steve. I’d like to start with a very warm welcome to everyone on the call. I’m pleased to report strong results for the third quarter where we delivered improved performance in both top and bottom line for the third straight quarter. Today we are reporting earnings of $0.50 per share, up 19% from the previous quarter and up 9% year-over-year. For the first three quarters of this year EPS is at a $1.21 versus $1.03 for the same period last year, that’s a 17% improvement year-over-year. Value added sales for the quarter were $171 million or a 9% increase from the prior year. This is the fifth consecutive quarter of year-over-year sales growth. Record level of new product sales increased demand for existing products and the addition of Heraeus’ target materials acquisition contributor to year-over-year sales increase and above market growth. New product sales were close to $31 million accounting for approximate 18% of value added sales. This is the highest level of new product sales since we started to report this metric. We had another record quarter for ToughMet sales. Through the first three quarters ToughMet sales are up 60% year-over-year. In the consumer electronics market demand for higher strength and corrosion resistant materials is driving increased use of ToughMet products for camera stabilization components in high end Smartphones. Success in current year products is leading to follow-on business for next year’s Smartphone models. In the Aerospace market ToughMet applications are winning over legacy materials in bushing, bearings and structural attachments, given the strength to weight ratio of ToughMet and the wear resisting characteristics. New applications in aerospace are some of our largest new business wins this year. Across Materion we are making meaningful progress, leveraging our strengths and becoming a more consistent performer. As I noted earlier, we have improved both top and bottom line for three consecutive quarters. As part of this, Performance Alloys and Composite segment is continuing to deliver on the recovery plan. Operating profit for this segment came in at $7 million or 8% of value added sales. This is the highest level of profitability since early 2015 and represents a 13% improvement sequentially and 59% improvement year-over-year. We expect the performance improvements to continue and return to business to historical profitability levels by end of 2018. For the Precision Coating segment, we’ve taken steps to reduce overhead costs with headcount reductions and general spending controls. We are in the early phases of the previously announced four-pillar strategy of operational excellence, commercial excellence, innovation and acquisitions. Focus plans are being implemented for each pillar and a number of actions are already underway. For example, a PMO or Project Management Office has been launched to identify, track and achieve meaningful and permanent cost savings across Materion. We appointed a Chief Technology Officer who will lead innovation efforts globally and we’ve consolidated the operating units within the Precision Coating segment to generate greater synergies and cost effectiveness. These types of changes, combined with a disciplined performance based culture are positioning Materion to consistently deliver profitable growth. We are confident in our ability to continue to progress into Q4. As a result, we are narrowing the full year earnings guidance range to $1.55 to $1.60 per share, which is at the high end of the previous guidance range. Thank you. I will turn the call over to Joe.

Thank you, Jugal, and good morning to everyone joining us on the call today. During my comments I will cover a review of our third quarter 2017 financial highlights, profitability by segment, make some brief comments on the balance sheet, cash flow and modeling assumptions and finally cover the earnings outlook for the remainder of 2017. Following my remarks, the line will open for questions. We are pleased to report strong third quarter results, which exceeded the earnings guidance provided and represented the third consecutive quarter with year-over-year growth in both top-line value-added sales and operating profit. Third quarter 2017 value-added sales of $171.4 million increased 9% versus the third quarter of 2016. As a reminder, the Heraeus acquisition closed late in the first quarter of 2017 and accounted for $11.4 million of value added sales in the third quarter of 2017. If you recall we also recognized a large spot sale of raw material beryllium hydroxide in the third quarter of 2016. Compared to 2017 where under the new long term supply agreement we only recorded approximately one-third on the annual sales volumes of beryllium hydroxide in the third quarter. Excluding the impact of these two non-comparable factors, value-added sales grow 4% year-over-year in our base business. New product sales in the third quarter of 2017 totaled $30.7 million, an increase of 25% compared to the same period in the prior year. New product sales accounted for 18% of total value added sales in the third quarter of 2017, a new record level. We experienced strong demand in most key end markets, including our two largest end markets of consumer electronics and industrial components. Offset partially by a meaningful sales decline into the medical end market. Looking at gross profit margins, performance improvements in value based pricing and manufacturing operations largely offset the negative impact of lower medical end market sales. Gross profit margin as a percent of value-added sales was 32% in the third quarter of 2017 comparable to the third quarter of the prior year and an approximate 100 basis point increase over the second quarter of 2017. Sales, general and administrative expenses totaled $36.4 million, $2.2 million over the prior year third quarter of $34.2 million, due primarily to increase cost associated with the Heraeus' target business acquisition. SG&A expense as a percent of value added sales decreased to 21% in the third quarter of 2017 as compared to 22% in the prior year period. It is important to note that SG&A expense, excluding the impact of the acquired Heraeus' business is flat with the prior year as realized cost saving from cost reduction initiatives have offset CEO transition cost and variable expense directly related to value added sales growth and improved financial performance. Operating profit totaled $11.6 million in the third quarter of 2017. Adjusted operating profit, excluding special items was $13 million, an increase of almost 7% versus the prior year third quarter adjusted operating profit of $12.2 million. Performance improvements around commercial execution and sales growth combined with realized savings from cost reduction initiatives led to this increase. Net income in the third quarter of 2017 totaled $9.3 million versus $8.1 million of net income recorded in the prior year third quarter. Tax expense in the quarter was $1.7 million, reflective of an approximate 15% effective tax rate, comparable to the prior year and the year-to-date rate. However the effective tax rate on adjusted profits excluding special items is approximately 18%, in-line with guidance provided. Diluted earnings per share were $0.46 in the third quarter of 2017. Adjusted for special items, earnings totaled $0.50 per share in the third quarter of 2017, which compares to $0.46 per share of adjusted earnings in the third quarter of 2016, a 9% improvement in earnings. Now a review of our third quarter 2017 financial performance by business segment. Starting first with Advanced Materials. This segment delivered $60.4 million of value added sales in the third quarter of 2017, a more than 30% increase over $46 million of value added sales in the prior year third quarter. Excluding sales related to the acquisition, value-added sales growth was 7% year-over-year and represents the sixth consecutive with year-over-year organic growth for this segment. New product sales and strong end market demand in the segments largest end market of consumer electronics drove the increase in sales. Operating profit for the third quarter of 2017 totaled $9.8 million compared to $8.3 million in the third quarter of 2016. The 18% increase in adjusted operating profit was due to a combination of increased sales volume and improved performance in manufacturing and commercial execution. This business continues to performance and we are focused on maintaining this momentum as we continue to progress with the integration of the Heraeus’ acquisition which remains on schedule. Turning to our Performance Alloys and Composites business, third quarter 2017 value added sales were $90.6 million, up 4% compared to $87.2 million of value added sales in the third quarter of 2016. The year-over-year increase was net of a $3 million reduction in raw material beryllium hydroxide sales due to the large spot purchase in the third quarter of 2016. Excluding hydroxide sales, the base business value added sales increased 8% versus the prior year third quarter. The above market growth rate in value added sales was driven by success with new product introductions and commercial execution around value based pricing and improved product mix. Adjusted operating profit in the third quarter of 2017 was $7 million compared to $4.4 million in the same period last year and $6.2 million in the second quarter of 2017. The 59% year-over-year increase in profitability and 13% sequential improvement is reflective of successful implementation of the PAC recovery plan introduced last year. We are pleased with the continued progress we are making and returning to profitability of the PAC segment to historical levels. Adjusted operating profit margins as a percent of value added sales was 8% in the current quarter, the highest in over two years. We remain focused on identifying top line and cost reduction opportunities in this business, including yield and productivity improvements to drive further profit growth and margin expansion. Turning finally to our precision coatings business. The third quarter 2017 value added sales were $21.9 million compared to $25.8 million of value added sales in the third quarter of 2016. The year-over-year decrease in value added sales is due to the combination of a 44% decrease in value added sales of a large area coatings material into the blood glucose test strip market, offset by an 8% increase in the sales volume of precision optics. Here we continue to have success introducing new products for imaging and sensing applications. As mentioned on previous calls, a significant customer began a product transition to a next generation product line late in the fourth quarter of 2016, which has negatively impacted value added sales into the medical end market for the last four quarters. The customer’s product transition is complete and we are participating in the next generation product line. Adjusted operating profit was $2 million in the third quarter of 2017 or 9% of value added sales as compared to $3.4 million in the same period of the prior year. The decreased profit was due primarily to lower sales volume in the medical applications. We have taken actions in Asia and North America to reduce our headcount and related cost structures based on these lower sales volumes. We remain focused on identifying opportunities to improve the top line and grow the profits of this business segment. Moving to the balance sheet and cash flow, the company ended the third quarter of 2017 with a net cash position of $18.5 million, compared to a net debt position of $8.1 million at the end of the second quarter. Materion continues to have significant available liquidity to support capital allocation priorities we have mentioned previously, including organic growth opportunities, further inorganic strategic growth opportunities and to consistently return capital to shareholders. Cash flow provided from operating activities totaled $35.5 million in the quarter. We were able to grow operating cash flow year-over-year due to improved operating results and focus on reducing working capital investments. And finally key financial modeling assumptions. Cash flow from operations should run approximately $55 million to $60 million for the full year. Capital spending should run approximately $25 million and mine development investments should be less than $2 million. Annual depreciation should run approximately $43 million and an effective tax rate on adjusted earnings of 18% to 22% should be assumed. In terms of the earnings outlook for the remainder of 2017, we have delivered three consecutive quarters of value added sales and profitability growth on a year-over-year basis. The growth has been driven by strong performance, including record level new product sales, improved commercial execution, manufacturing efficiency and an improved cost structure. On our year-to-date performance and our expectation that these positive factors will continue for the balance of the year, we are narrowing the full year earnings guidance to $1.55 to $1.60 per share. This reflects the high end of the previously issued earnings guidance range of $1.45 to $1.60 per share. The midpoint of our updated guidance represents a forecasted improvement and profitability of approximately 20% compared to the full year 2016 results. Looking specifically at the fourth quarter, the midpoint of the guidance represents an approximate 30% year-over-year growth in adjusted earnings. This concludes our prepared remarks. We will now open the line for questions.

Thank you. We will now be conducting a question-and-answer session. [Operator Instructions] Our first question comes from Edward Marshall with Sidoti & Company. Please proceed.

Good morning guys. How are you?

Good morning Ed. We’re doing well.

We’re doing well.

So I’m looking at the Advanced Materials, I see the good margin there on the gross margin side and I know that the electronics, consumer electronics sales increased. I’m curious; is there a mix as well as cost savings benefit there in the third quarter?

Yeah, so there is a favorable – as you pointed out, the consumer electronics is a strong margin, so that is favorable. However, the increase of Heraeus’ so that $11.4 million on the margins of the AM business offset that partially. So that’s why you see the incremental margins on a year-over-year basis, where they are.

Got it. So I wanted to switch gears to Precision Coatings for a second though. We were at a run rate in 2Q. It looks like your down 10% sequentially again and the margin came in too. I’m curious, is this the run rate now or is there something – are you participating fully in the blood glucose test strip or did you get less than the 50% split that you expected, if you can help me out there.

Yeah, Ed to your comment, this is the run rate that we’ve been at now for approximately the last three quarters around $2 million of operating profit and around $22 million of value added sales. It is reflective of our participation in the next generation product line. The only thing I would add Ed is that there was a slight disruption late in Q3 with the hurricane in Puerto Rico. Our large customer there had some disruption and so we did see a slight push out right at the end of the quarter in sales. But largely speaking, this is reflective of the run rate. What the good news embedded in here is that our optics business is growing, growing 8% year-over-year in the quarter and we have some nice trends there and are quite optimistic about that continuing with some of their new product portfolio.

Got it. Jugal, you spent some time here. I’m curious, what are some of the biggest opportunities that you see for improvement within Materion now that you spent some time at the different division and different segments etcetera?

Yeah Ed, I have had about six months or so here and I can tell you, I continue to be very excited, in fact more excited about the business and the opportunity to sort of un-tap the potential that this company has. When I look at the opportunities that we have for new business growth and converting a lot of the innovation activities into revenue, that excites me quite a bit and I think we’re well positioned to do that. I mean you’re starting to see some of that already. As we indicated already that we’ve had 18% of VA as new business growth. It’s the highest level that we’ve had since we started reporting this metric, almost $31 million in Q3. So I think we’re starting to see some of that and I hope that we’re going to be able to demonstrate a lot more of that as we go forward. I think there are opportunities on operational excellence. So as I indicated in my remarks, we’ve set up a project management office, a PMO that is looking to identify and really drive significant improvements in operational excellence. We’ve got a really good start on that number of initiatives that we’ve put in place and I expect that quarter-by-quarter we would see some improvements come through you know with operational excellence. And then of course you know the opportunity I think that we have you know from the balance sheet perspective. I mean it’s a great opportunity, what we did here in the third quarter of paying down debt and you know positioning our company for appropriate disciplined investment that’s organic or inorganic. I think it’s a great opportunity as well. So there’s a number of things that excite me and I think gives us the confidence to be able to do what we’ve indicated we were going to do for the fourth quarter and then position the company for the long term.

Got it. Its high level at this point, I can appreciate that, but is there any specific business or business line that your particularly laser focused on?

Well, I mean you know all of our business is okay; I mean we’re laser focused on. It’s just I think when we look at what the business are; you know there is different things that I would say we’re laser focused on. So when you look at for example the PAC business, I can tell you we are absolutely laser focused on the recovery plan, not only from the – not only from making sure that the bottom line of that business can improve, but we want to make sure the returns, the overall ROIC of that business is substantially better than where it is today, so on that business… When I look at our AM business and our PC business, clearly we got to continue to hit our cost side, but I think there’s tremendous growth push that we’re making on those businesses. So I think we’ve got – you know we got – each business has its own unique things that we’re focused on, but in general it all amounts to hopefully above market growth and double digit EPS growth that we can continue to drive.

Got it. I’m curious; could you talk about the ROIC targets for PAC and where they are today?

Well yeah, I mean I’m not sure if I can go into the specific targets that I can communicate with you on ROIC, but you know what we typically as you know is number one, we want to make sure we’re returning the cost of capital [alright] on any business, and then if we can do better than that, we certainly want to do better than that right, and so we are I can assure you that that’s a key focus for us and as Joe highlighted in his remarks we’ve made substantial improvement in our working capital and we are going to stay focused on it.

Got it. Okay, thanks very much.

Yeah, thank you Ed.

Our next question comes from Marco Rodriguez with Stonegate Capital Markets. Please proceed.

Good morning guys. Thank you for taking my questions.

Good morning Marco.

Good morning.

Hey, I was wondering if maybe we could just dive down a little bit deeper into the gross margin performance sequentially here. I’m not sure I caught everything on the call, but we did see kind of a sequential decline in value added sales, yet your overall gross margins on VA sales went up sequentially. I think I heard some cost cutting initiatives, some value pricing. Can you just maybe dive down a little bit deeper as far as what drove the increase in gross margins?

Yes, so if you look -- let me just break it down by business. If you look at the PAC business there, you know VA was relatively flat, however margins expanded about 100 basis points and that was driven by continued performance on the value based pricing and improvement of the mix within the PAC business and so those gross margins went from 25 up to 26. The Advanced Materials business, you know value add there was also relatively flat with Q3 however looking sequentially was a favorable mix in terms of the consumer electronics side and so that drove margins from 38% up to 40%. There was also some manufacturing efficiency I would tell you, improvements in Q3 within that business, so that’s driving that. And then finally the deterioration sequentially in the Precision Coatings business, that went from 39% down to 34% and partially driven by the sequential drop-off in medical within that segment which it negatively impacts the mix there and growth in our Asia business which offset a portion of that, but is unfavorable from a mix stand point. So that’s the combination that drove the 31% going into 32% on a sequential basis.

Got you and then maybe you could talk a little bit about the consumer electronics market. Just kind of where, what sort of applications are you seeing the demand from your end customers?

Yeah, so first of all on the consumer electronics market I think we’ve got a number of activities that we are involved in and particularly I’ll highlight the Smartphone or the market. We have a number of initiatives that we’ve launched in there and those are yielding some good results, both on our advanced chemical side, as well as our metal side. So that’s a really strong example of where I think we are making good in-roads into the consumer electronics sector.

Yeah and just to give you some colored commentary on the products, we are talking about precious metals for RF Filters and you are talking PM used and non-PM used in connector material and then as Jugal mentioned, the camera stabilization unit and so the hand held devices was contributing to the strong quarter. And I’ll point out; there is some seasonality when you look. Q3 is generally in the consumer electronics space the strongest quarter.

Got you, helpful. And then in terms of the ToughMet product line, you guys talked a little bit about that in your prepared remarks. It kind of sounds like that’s pushing into new applications, new end markets versus just I believe where it started in the oil and gas. Has that been kind of client driven of have you been doing it from a marketing perspective to kind of push that product into different areas.

Yeah, I would say it’s both, but we’ve actually taken strong initiative to push that business into other markets. So whether that’s the aerospace market, the automotive market, consumer electronics market, our team understands the level of investment that we’ve made over the many years and then the return you know that that investment should get. So we are very active in identifying opportunities for the ToughMet business into new markets.

Got you. Thanks a lot guys. I’ll jump back in queue.

Thank you.

Thanks Marco.

Once again [Operator Instructions]. Our next question comes from Phil Gibbs with KeyBanc Capital Markets. Please proceed.

Hey, good morning.

Good morning Phil.

On the bridge into the fourth quarter, I know you talked about normal seasonality in the electronics market, but as we look at the PAC businesses, how are you thinking about that? Is that more so in-line with the fact that you think the connectors market will be down? I mean are we just talking about normal seasonality here in terms of the guidance.

Yeah Phil, let me comment on that and then Joe can certainly add to it as well. First of all, I think on Q4 we are expecting in planning for a very strong fourth quarter when you look at comparison to a year ago, over 30% improvement from a year ago Q4. There is some seasonality like you said, in particular I would say seasonality around our AM business and consumer electronics, and then there is as Joe also indicated earlier regarding the hurricane in Puerto Rico and some potential impact into our medical business. With regard to PAC, I mean we expect PAC to be I would say comparable to Q3 and we expect the performance that we’ve driven in Q3 to continue into Q4 and then that’s what gives us the confidence you know of delivering a strong year-over-year performance for Q4 and then the overall guidance uptick that we’ve made on the high end of the guidance Phil.

And the only thing I would add from a seasonality standpoint is consumer electronics is soft in Q4 which effects primarily our AM business, but the PAC business also has a large exposure there in their strip product line, both copper beryllium and ToughMet, offsetting some of that decline in the PAC business sequentially due to normal seasonality in consumer electronics will be the strength of the BE, high purity BE business which you are familiar with in Q4 as generally or historically the last couple of years it’s been a strong quarter seasonally for them.

Okay, and a question just on the defense markets in general in terms of what you are seeing there and what your expectations are for the next, call it 12 to 18 months in terms of visibility.

Yeah, so you know the defense market as we’ve indicated I think in the last couple of calls as well has been a bit soft and it’s due to the many changes that are going on in the administration and in fact I would say some appointments that still have not been made. We are starting to see a little bit of a pickup in the defense side with some of the appointments that are now getting made, but I think in general our expectation is that the market will continue to be a good market as these appointments are down and as some budget issues are resolved. So we expect the defense market to be a good market in the next 12 to 18 months.

Thanks very much.

Thank you, Phil.

Okay, thanks very much Phil.

Thank you. There are no further questions at this time. I would like to turn the floor back over to Steve for closing remarks.

Thank you. This is Steve Shamrock and this concludes our third quarter 2017 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 on the call this morning and your interest in Materion. I will be available to answer any follow-up questions. My direct dial number is 216-383-4010. Thank you very much.

Thank you.

Thank you.

This concludes today's teleconference. Thank you for your participation.