TimkenSteel Corp (NYSE:TMST)
Q2 2016 Earnings Conference Call
July 28, 2016, 09:00 ET
Tina Beskid - VP, Corporate Controller, IR
Tim Timken - Chairman, CEO & President
Chris Holding - EVP & CFO
Novid Rassouli - Cowen and Company
Tyler Kenion - KeyBanc Capital Markets
Aldo Mazzaferro - Macquarie Securities
Justin Bergner - Gabelli & Company
Good morning, ladies and gentlemen. My name is Sally and I will be your conference operator today. At this time, I would like to welcome everyone to the TimkenSteel Second Quarter 2016 Earnings Conference Call. [Operator Instructions].
I will now turn the conference over to Tina Beskid, Vice President, Corporate Controller and Investor Relations. Please go ahead.
Thank you and good morning and thank you for joining TimkenSteel's second quarter 2016 earnings call to discuss our financial results. I am joined here today by Tim Timken, our Chairman, CEO and President, as well as Chris Holding, Executive Vice President and Chief Financial Officer. During today's conference call, we may make forward-looking statements as defined by the SEC. These statements relate to our expectations regarding future financial results, plans and business operations, among other matters.
Our actual results may differ materially from those projected or implied due to a variety of factors which we describe in greater detail in today's press release, supporting information provided in connection with today's call and in our reports filed with the SEC, all of which are available on the www.TimkenSteel.com website. Where non-GAAP financial information is referenced, we have included reconciliations between such non-GAAP financial information and its GAAP equivalent in the press release and/or supporting information as appropriate.
Today's call is copyrighted by TimkenSteel Corporation. We prohibit any use, recording or transmission of any portion of the call without our express advanced written consent.
Now I would like to call turn the call over to Tim.
Good morning and thanks for joining us. The second quarter shaped up much like we anticipated. Automotive markets remained strong. Industrial volumes improved. Our employees remained disciplined in cost control. Scrap and commodity markets showed signs of stabilizing and we improved our liquidity position. As a result, we've improved EBITDA, delivering $4 million in the quarter which is at the high end of our guidance. I want to take a moment to put that into perspective.
When you think back a year ago, we faced a massive drop in oil and gas production, a profitable market for us. We also faced a historic drop in scrap prices. And as we were completing a 5-year investment program and new world-class assets, suddenly demand, sales and asset utilization dropped to unprofitable levels. EBITDA was a loss of $19 million in the second quarter of 2015.
The last year has been a real test for this century-old startup. We were faced with market factors that were out of our control, but our response to that challenge is how we got to where we're today. Year-over-year sales are actually lower today; yet we delivered positive EBITDA and strong cash flow in the quarter. We achieved this improved performance by taking action to enhance our financial stability and operate more efficiently. We reduced spending across the company by nearly $100 million. We realized even greater savings than anticipated by implementing a production schedule that has us running very efficiently. And we issued $86 million in convertible senior notes.
At the same time, we were also winning new business because of our people, our innovation, our assets and our products which all deliver real value. As we reduced costs, we preserved the fundamental elements of our business that make us unique in the market. In fact, in some cases, we further invested in the fundamentals, like opening the country's only dedicated SBQ steel technology center just a year ago.
I'll give you a few examples from the second quarter. Our material scientists created a new technology to not only make the world's cleanest air-melt steel possible, but also certify it to exacting standards. This new line of ultra-premium steel is ideal for demanding highly loaded industrial applications like gears and bearings. We won new business on our ability to deliver a direct improvement to our customers' product performance.
Also in the quarter, Marmon/Keystone Canada recognized us for our customer service and the value of our innovation. Our engineers worked together with theirs to develop a material solution that's improving the reliability of rotor bars for progressive cavity pumps. These are just two examples of how this ability to innovate keeps us competitive, even in adverse market conditions. Every action we've taken over the last year has made us a stronger company.
As we look ahead, we continue to face weak, but somewhat stabilized, energy and industrial markets. We're not seeing recovery yet, but we're staying close to customers to win business and to capitalize on any spot opportunities. We expect some seasonality in automotive demand in the third quarter, although overall automotive demand remains strong. You've seen the grit and determination of our employees over the last year in the form of improving performance in weaker markets. The full value of our actions will become even more apparent when key markets begin to recover and we emerge stronger than ever.
Now Chris is going to walk you through the numbers and then we'll both be back at the end to take questions.
Thank you, Tim. Good morning. Shipments of 190,000 tons in the quarter were 2% higher than the first quarter of the year. We continue to see strength in the mobile side of our business. North American light vehicle production was about 3% higher than the first quarter and car sales continued to trend toward record levels, but showed signs of peaking. We project that the third quarter mobile shipments will be about 5% lower sequentially due to expected seasonal production shutdowns.
Industrial shipments increased 4% compared to the first quarter of the year. Global commodity markets began to stabilize in the first half of the year which positively impacted the industrial end markets. Additionally, more balanced inventories in the industrial supply chain favorably impacted our results. We expect these market dynamics to continue into the third quarter.
Shipments to the energy end market however, declined more than 20% sequentially, as U.S. rig count remains depressed and customer inventory levels continue to be inflated. We do not expect any changes to our order book level in the third quarter, but are encouraged by emerging improvement in market supply and demand dynamics in the energy sector. Net sales for the quarter were $223 million with base sales of $200 million and surcharges of $23 million. Base sales per ton were about 3% lower than first quarter due to end market product mix changes and price pressure.
EBIT for the quarter was a loss of $15 million and we generated $4 million of EBITDA which was a $5 million improvement over the first quarter. The higher earnings were primarily due to a $9 million sequential increase in raw material spread which was in line with our expectations. The three city average scrap index increased about 35% over the first quarter from $177 per ton to $239 per ton.
SG&A was $24 million in the quarter, down $6 million or about 20% compared with the same quarter in 2015, primarily from cost reduction actions. Sequentially, SG&A was slightly higher primarily due to expense timing. Melt utilization was 45%, slightly below the 47% utilization realized in the first quarter of 2016. Despite the relatively low utilization rate, we generated positive EBITDA primarily due to our cost reduction actions and more normalized scrap markets. We also expect to operate at a similar melt utilization rate in the third quarter.
In the second quarter, we generated a net loss of $11 million or negative $0.24 per share. The income tax rate was around 37% for the quarter and we expect our tax rate to be around 37% for the year. The effective tax rate was higher than the U.S. federal statutory rate of 35% primarily due to U.S., state and local taxes.
Capital expenditures for the first half of the year were approximately $15 million, with about half of the spend going to growth projects. We estimate second half capital expenditures of $30 million which will be primarily maintenance-related and coincide with our annual maintenance and shutdown activities. We generated $21 million of free cash flow during the quarter, primarily as a result of our continued focus on effectively managing working capital through the cycle.
During the quarter, we issued $86 million of convertible senior notes. The notes pay interest at a rate of 6% per year and mature in five years. We evaluated multiple financing arrangements and chose the option that provided the appropriate amount of liquidity with lower risk. The convertible note financing provides enough liquidity to support both the long and short-term needs of the Company. Accordingly, we terminated the sale leaseback agreement entered into in the first quarter.
We reduced our outstanding revolving credit facility balance by $105 million in the quarter. $83 million of the reduction was from proceeds from the convertible note issuance and $22 million was from free cash flow. At the end of the quarter, we had about $156 million of liquidity between the revolver and cash. Our net debt to capital ratio was a very healthy 13%.
Turning to the outlook for the third quarter, we expect shipments to be down 5%, primarily due to automotive seasonality. Additionally, our normal annual maintenance activities will impact our earnings by about $5 million compared to the second quarter. As a result, we anticipate that the third quarter's EBITDA range to be between breakeven and a $10 million loss.
This ends our prepared statements and we will now take your questions.
[Operator Instructions]. Your first question comes from the line of Novid Rassouli with Cowen and Company. Your line is open.
So first, I want to start off on the EBIT. I see you guys generated about $4 million of EBITDA with a melt utilization that's roughly 5% below kind of historical breakeven melt of 50%. So it looked like you received a pretty nice benefit from raw material spread, but it was partially offset from volume price, mix and LIFO. So I just wanted to see if you guys are seeing kind of a true sustainable reduction in breakeven melt utilization or if this is really just kind of movements in the raw material and we're still really at about 50%.
Yes, Novid, I'll start and then have Tim provide a little bit more color. The primary reason for our EBITDA of $4 million with such a relatively low melt utilization has been through cost reduction. If you think about the spread, well, the spread was favorable in the quarter. We were coming off a really difficult, almost call it horrendous, scrap spread year in 2015. So 2015 is kind of the abnormal year.
This is getting back to a more normalized year, but still not what we've seen in the past. So the short answer to your question, there's a bunch of things that go into the breakeven, but the primary reason we're above the breakeven level of EBITDA is through the really significant cost reduction actions that we've taken over the last year.
And then a second question for you guys is we saw an uptick in demand from the distribution channel last quarter. It kind of helped drive the higher than expected shipments. I just want to see if you guys can give us some insight into the buying patterns of your distribution channels customers currently.
Yes, I think based on the conversations that we've had with our distribution partners, I think what we saw in the first quarter was just kind of a level setting after a pronounced slowdown at the end of last year. In other words, they really threw the brakes on, found out they had some holes in the shells, went to restock a little bit. And now things are beginning to level out and waiting for more pronounced market demand signals to really drive further activity.
And what would those pronouncing those be? I guess what are they looking for to get more confident? Is it just really predicated on energy or is there anything else that you think could be the driver there?
Orders is the simple answer, Novid. I think they're seeing just sluggishness in their end markets in the industrial and oil and gas space. And I think in order for them to get confident again, they really need to see their incoming order rate pick up.
Your next question comes from the line of Tyler Kenion with KeyBanc Capital Markets. Your line is open.
I just wanted to start just with a high-level question here. But when you think about what's changed relative to the guidance you set forth in April, what in your mind is better? And what in your mind may be a little bit worse?
If you look, the quarter came out pretty much as we expected by and large, we were within obviously the range of our guidance and on the high end, but by and large, within our expectations.
Okay. So just looking out into the back half of the year, any green shoots that you may or may not be seeing in energy at this point or any sense kind of on what the feel is for your broader industrial business?
Yes, I guess, Tyler, I would say that with the lead times the way they are right now, we got pretty good visibility on the third. You get into the fourth, things are still a little bit opaque. The news in oil is getting better; rig count went up 15 last week for the fourth week in a row. So the industry dynamics are improving right now. But we're still seeing people being very cautious.
And then just speaking of cash flow, how should we be thinking about working capital as we move through the remainder of the year here? I would assume just with higher scrap input costs, you may be likely to see some upward pressure just on dollar value inventories. And it looks like you've done a really nice job in terms of managing the payables here in the first half of the year which may flip back to a use in the second half. So how do we think about working capital I guess through here?
And then just on the CapEx guidance, it would imply a pretty meaningful ramp in the back half of this year. And I know that you do have some maintenance that you will be undergoing here in the third quarter. But is there any way that maybe we should be viewing that target for the full year as being somewhat conservative to perhaps maybe a little bit above what maybe the reality may be?
Okay. Well, I'll start in reverse order. Now I think our CapEx guidance is going to be dead on. We have projects lined up that we need to do from a maintenance, safety, CI perspective. And they're well underway. So I'd say our guidance on CapEx will come in just dead on.
On the working capital side, yes, I think most of the favorable cash flow and working capital would've been realized in the first half. The second half obviously depends upon what the sales will turn out to be. So in the third quarter, we're not expecting working capital to be a very significant driver. And for the fourth quarter, it's a little bit too early to tell.
Okay. And then just one last one if I may -- it looks like base pricing and mix, although I would assume it was probably more mix, in the second quarter, stepped down pretty substantially. So I guess just if you could provide us just with a sense of maybe either at the end-market level or even just broadly speaking, kind of what your expectation is there for base pricing and mix moving into the third quarter. It looked like oil and gas saw a nice step up quarter-over-quarter, while we saw some deterioration just on the industrial front and also within the mobile business.
Yes, Tyler, this is Chris. I'll start and Tim can provide some color if he sees fit. Remember, our mix gets to be a couple-fold. One is just flat out product mix. If we sell carbon bar in the base sales per ton, the margin on that doesn't look anything like a tube end product with heat-treat, for example. So you have that dynamic. And then you have other market dynamics in terms of not only which application, but which market that item is sold into. So you're right, the third quarter mix was the single-biggest item in the volume-price mix. And we don't see probably a whole heck of a lot of change going into the third quarter.
You also have to remember that 70% of our order book, at any given time, is under contract versus spot. So whatever pricing impact you're seeing is on the spot side of the business which right now, given our mix, is a significantly smaller portion of the portfolio.
And then just as a reminder, you'll be beginning kind of your annual discussions in terms of contract pricing late fourth quarter, is that right?
Late third quarter, we generally start the conversations and try to wrap everything up by the end of the year.
[Operator Instructions]. Your next question comes from the line of Aldo Mazzaferro with Macquarie. Your line is open.
I have a question on your manufacturing strategy. A 45% utilization rate, I think if I remember correctly, you're still melting at two locations, right and then finishing at a third? I'm wondering why you -- or if it's possible, why wouldn't you consider completely shutting one facility and running the other one full?
Yes, as you can imagine, although we've gotten very creative in the way that we're using our manufacturing assets. And quite frankly, they've done it extraordinarily well. You have to remember that across our two shops, we have differences in size range. So our Harrison mill is at 1 to 6 mil; our Faircrest mill is at 6 and above mil. Then we obviously have our tubing operations and our value-add operations.
Right now, we're flexing as much as we possibly can across those assets. Some of that has to do again with physical properties and other has to do with customer certifications, PPAPs in automotive. And we've been working that aggressively throughout really the latter half of last year and through the first part of this year. And have created flexibility and will continue to drive that going forward.
So it's really casting size that would limit that ability to swap back and forth, I guess, the cast--?
Customer qualifications is a big part of it as well especially when you talk about switching melt, they get kind of jumpy and there's process that you got to go through. And then there's usually a price you got to pay, quite frankly and we're working our way through that. With the investment in the new caster, you might remember we replicated the mold size that we have in Harrison out of Faircrest now. And so going forward, that just creates more flexibility for us.
So Chris, in terms of your cash flow and uses of cash, I got two questions. Can you say what your longer term funding requirements may be for the pension? And also, is your availability in your credit line affected by the working capital levels?
Yes, well, I'll start with the pension question first. U.S. pension, where 95% of our pension liability is within the U.S., we don't see any required contributions for the next X number of years. And obviously, as things change, but certainly for the next 5 years, we just don't see any pension requirements. Because at the end of last year, we were right around 100% funded on our plans that we need to fund. So we're in really good shape on -- from a cash basis on pension.
And then yes, our credit facility is impacted because we have an asset-based loan. And it has three parts to it, an M&E part and then a working capital part. And the working capital section has accounts receivable and inventory. So the various inventory levels and receivables do impact what we're able to borrow.
Okay. Can you say what the availability is right now and whether that's -- is that up against the covenant now, that if you reduce the--
No. So what happened when we received the proceeds from the senior convertible note, that all was applied to the revolving credit facility. So our net availability on the revolver is $119 million at the end of the quarter. And then you add $37 million of cash. So we have $156 million of total liquidity at the end of the quarter.
And obviously, that's about $100 million better than we had at the end of the first quarter. And so we've improved our liquidity by not only the cash flow, but by the senior convertible note.
And then just one kind of longer term strategic question, Tim. I sit nearby here a lot of our retailing analysts. And there's a sense that the consumer spending side of the economy is weakening a little bit. And I -- you know industrial is much smaller as a percent of the economy, but at the same time, it's unlikely to recover if consumer is weakening. I'm just wondering what you think about that potential for a really long long-term deep weakness here on the industrial side. And how would you cope with that?
Well, that's kind of a tough question to answer.
That's a tough question.
You got a lot of people talking about new normals and all these kind of things. And quite frankly, this is a cycle; it's a bad cycle obviously. But I don't believe that we've seen the new normal. I do think markets recover certainly in oil and gas. The world needs energy. I think agriculture is just a typical ag cycle that we're seeing and it will recover.
The industrial world, how it resets after this thing, I think is a good question, but again, I'm confident in the business model that we've developed and our ability to create value for customers, no matter what they're making. And so I'm not overly concerned about the longer term. We're keeping a close eye on the consumer markets that affect us today, so automotive. But again, if you look at automotive, the market dynamics are relatively balanced. People are fretting about lease rates, but they're not out of control. Dealer inventories aren't bad. They haven't gotten carried away with incentives yet.
So long term, I'm an optimist on it. I think at the end of the day, we will see a recovery. And when we do, we're going to kill it. The investments that we've made in this business over the last 5 years position us extraordinarily well and so we're ready for it when it comes.
So how much steel are you putting through your new caster these days as a percent of the total amount?
Our utilization rate is -- also Tina is digging at her book here. I think we're running probably around -- let's see here. We've cast about 1400 heats through it since we turned it on. We're running probably in the 40% capacity range right now which is a challenge obviously, because we'd want to be running that thing a lot fuller. But quite frankly, the quality we're seeing off of it, the yield we're seeing off of it, the productivity, it is going to be an industry-changer. I'm still thoroughly convinced of that as the markets recover.
[Operator Instructions]. Your next question comes from the line of Justin Bergner with Gabelli. Your line is open.
I joined the call a bit late, so I apologize if this question is a bit redundant. But as you look towards your sequentially flattish forecast, are there signs that certain markets are starting to pick up sequentially outside of seasonal factors? And if not, what would hopefully trigger it in the next couple of months?
I guess we would say that the markets outside of automotive, the industrial and the oil and gas and industrial distribution markets, are relatively flat. And that is just based on a lack of end-market demand signals that continue to be sluggish. And so what we're going to have to see, the obvious stuff. We'll have to see continued improvement in oil. Rig count, as I said earlier is up 4 weeks in a row. They added 15 rigs last week; that's good news.
We're seeing kind of spot orders, people filling shelves of critical product in distribution. And in the industrial world, it's kind of a real mixed bag, as it always is. Rail continues to get worse, but there are other markets that are holding in there. And so what do we have to see? We've got to see more orders coming through from the end user to really begin to feel confident about the latter half of the year.
And then on the auto side, I guess demand should be sort of flattish excluding seasonal factors in the third quarter. Are there any signs of any slowdown in auto?
We haven't seen any change in the fundamentals. I said earlier people are getting a little bit jumpy about duration of lease rates and those kind of things. But quite frankly, dealer inventories look reasonable. The incentives aren't out of control. Our order book, apart from the seasonality that we typically see in the third, is looking okay.
We haven't got a lot of pushback from our customers. So I think things right now are holding in there. Do they get better from here? Probably not, but even if they begin to peak out at these kind of levels, this is a pretty robust automotive market right now.
There are no further questions at this time. I will now turn the call back over to Mr. Tim Timken.
Well, thank you for your questions and thank you for your interest in TimkenSteel. We're remaining disciplined to operate as efficiently as possible in these challenging markets. Equally important, our ability to gain share and new business, even in this business environment, is evidence that the cycle of innovation at the heart of our business model continues to position the Company well for the long term.
As I told you last quarter, we're not taking our foot off the gas. Our employees remain diligent in taking the right actions to perform in a difficult environment. And I want to thank them again for their effort. If you have any follow-up questions, don't hesitate to contact Tina. Thanks again and have a great day.
Thank you, ladies and gentlemen, for your time and participation. This concludes today's conference call. You may now disconnect.
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