Howmet Aerospace Inc (HWM) — Q1 2020 Earnings Call Transcript

Thank you, Shelby. Good morning, and welcome to the Howmet Aerospace first quarter 2020 results conference call. I’m joined by John Plant, Executive Chairman and Co-Chief Executive Officer; and Ken Giacobbe, Executive Vice President and Chief Financial Officer. After comments by John, we will have a question-and-answer session. I would like to remind you that today’s discussion will contain forward-looking statements relating to future events and expectations. You can find factors that could cause the company’s actual results to differ materially from these projections listed in today’s presentation and earnings press release and in our most recent SEC filings. In addition, we’ve included some non-GAAP financial measures in our discussion. Reconciliations to the most directly comparable GAAP financial measures can be found in today’s press release and in the appendix in today’s presentation. With that, I’d like to turn the call over to John.

Good morning, and thank you for joining the call. Given the prerelease of earnings, we’ll move swiftly through the slides and then get to your questions. Revenue and profit for the first quarter were in line with the prerelease on April 14. Moreover, earnings per share is at the favorable end of the expected range. If you move to Slide 4 please. Then as we discussed on the last call on the 1st of April, we separated Arconic Inc., reported entity into two companies. Howmet Aerospace, which is Remain Co, which is primarily focused on the aerospace sector and contains the four business units within the Engineered Products and Forging segment. Arconic Corporation, SpinCo, which is primarily focused on rolled and extruded aluminum products, contains the three business units within the Global Rolled Products segment. The targeted guidance for onetime operational and CapEx costs related to the separation were $175 million. The final costs for the separation will actually be approximately $130 million, excluding tax leakage and debt breakage. Onetime separation costs were funded by divestiture proceeds of approximately $190 million. The highlight slide for the combined company of Arconic Inc., which includes the EP&F segment, the GRP segment and Corporate. Performance in the quarter was strong despite the impact of COVID-19, which surfaced during the last three weeks of March. Additionally, we were impacted by lower year-over-year 737 MAX production rate reduction. Q1 revenues were $3.2 billion, down 9% versus 2019 and down 6% organically, adjusting for the pass-through of lower aluminum prices, currency changes and the divestiture of businesses. Operating income, excluding special items, was up 19%, with a 350 basis points improvement. Moreover, EP&F improved 300 basis points and GRP improved 310 basis points. We have now had five consecutive quarters of year-over-year margin expansion. Earnings per share, excluding special items, was $0.62, a record and up 44% year-over-year. Adjusted free cash flow, excluding separation costs, improved $19 million year-over-year, and the cash balance at the end of the quarter was $2.64 billion. We’ve taken several actions to delever and improve our debt maturity profile, which I will discuss later in the presentation. Lastly, return on net assets was up 410 basis points to a record 14.8% return after tax. Now let me turn it over to Ken for a more detailed view of the financials.

Thank you, John. Good morning, everyone. Let’s move to Slide 6. So for Q1, revenues were $3.2 billion, down 6% organically year-over-year. Market declines were driven by disruptions from COVID-19 and 737 MAX production declines, which impacted both segments. Revenues for EP&F were down 4% organically, driven by reductions in commercial aerospace of 7% and commercial transportation of 21%. We did have favorability in defense aero, which was up 17% driven by the continued demand for the Joint Strike Fighter. Also, our industrial and other markets were up 13% driven by increased demand for industrial gas turbines as natural gas prices are at 25-year lows. GRP revenues were down 7% organically driven by all in markets with the exception of industrial, which was up 14% year-on-year as expected. Please move to Slide 7. On this slide, we’ve provided more visibility to the Howmet Aerospace end markets. The left-hand side of the slide breaks down Q1 revenue by market. So commercial aerospace, is 58% of total revenue. Defense aero is 15%, commercial transportation is also 15%. And industrial, combined with our other end markets are 12%. We expect defense aerospace to continue to grow year-over-year due to strong demand for the Joint Strike Fighter on both new builds and engine spares. Within the industrial and other markets slices of the pie, the highest growth section is IGT, our industrial gas turbines business. The IGT market was at a low level last year, and we expect to see growth in 2020 driven by increased demand for both new builds and spares. Regarding spares, we’ve previously communicated that airfoil spares represent approximately $800 million of annual revenue. Of the $800 million, approximately 50% relates to commercial aerospace engine spares and the other half for defense aero and IGT spares. Going forward, we expect reductions in commercial aero spares, but an increase in defense aero and IGT spares. Hopefully, this slide gives greater transparency into Howmet Aerospace’s end markets. We have created the same slide for GRP, which is listed in Slide 21 in the appendix. Now, let’s move to Slide 8. Operating profit, excluding special items, increased $75 million or 19% year-over-year, resulting in a record margin of 14.5% despite COVID-19 and 737 MAX impacts. Margin expansion was 350 basis points, up year-over-year, combined for total Arconic Inc. If we peel that back, EP&F had margin expansion of 300 basis points and GRP had margin expansion of 310 basis points. Corporate expenses, excluding special items, improved 29% year-over-year to $36 million, which is on track with our 2020 annual target. If we estimate a Q1 split of Arconic Inc.’s corporate expenses into the new Howmet Aerospace and new Arconic Corp., approximately $20 million of those corporate expenses go to Howmet and $16 million to Arconic Corp. Moving to EP&F. Our productivity continues to improve. For the first quarter, EP&F realized $26 million of year-over-year net cost reductions from actions that we took in 2019. The annual target for Howmet Aerospace was $50 million, and therefore, we’re ahead of target for the first quarter. Additionally, we’ve announced another $100 million of incremental run rate net cost reductions and have taken a $16 million after-tax restructuring charge in the first quarter. Turning to price. We had $5 million of price increases in the first quarter, which was in line with our expectations. Moving forward, we expect greater price increases in quarters two through four despite the market conditions. GRP also had good net cost reductions in the quarter. GRP extrusions returned to profitability in Q1 and the Tennessee plant improved profitability by approximately $11 million year-over-year. Lastly, North American scrap utilization approached 60%, a record level. GRP price was approximately flat to the prior year quarter. So let’s move to Slide 9. In Q1, we continued year-over-year segment margin expansion for both segments despite COVID-19 and the 737 impacts. To give you even greater visibility, let’s quickly move to Slide 10. Since Q1 of 2018, EP&F segment operating profit has increased 520 basis points, and GRP’s segment operating profit has increased 540 basis points. If we converted the EP&F segment operating profit to a pro forma Howmet Aerospace adjusted EBITDA, you get a percent of approximately 23.7%, which is in the top quartile of the peer group. Now let’s move to Slide 11, where we have adjusted free cash flow and earnings per share. The charts show the consolidated company of Arconic Inc., and we’ve also tried to give you a view of what the estimate would be for Howmet Aerospace. Adjusted free cash flow for the quarter was negative $246 million. That was in line with our expectations due to our Q1 seasonal capital – seasonal working capital build and an expected incremental $70 million of variable compensation payments tied to 2019 performance. Free cash flow for Q1 was $19 million better than the prior year and is the best performance since our first separation in 2016. Howmet Aerospace’s free cash flow is approximately 40% of the total at negative $100 million. Earnings per share, excluding special items, was a record of $0.62, up 44% from Q1 of 2019. As expected, earnings per share increased primarily due to operational improvements from segment and corporate productivity. Approximately 65% of the earnings per share relate to Howmet Aerospace or $0.40 per share. Special items totaled approximately $60 million after tax, and they were primarily driven by separation costs of $50 million and severance costs of $16 million. Most of the severance costs are tied to the new incremental $100 million cost reduction initiative to realign our cost base as we move into a period of demand uncertainty. With that, let me turn it back over to John.

Thanks, Ken, and let’s move on to Slide 12. The health and safety of our employees is our top priority, and we’ve added the following precautions to prevent the spread of COVID-19. We’ve restricted air travel, and in fact all travel, and are encouraging employees to work from home where appropriate. We have implemented social distancing standards throughout the manufacturing and office workspaces. And we are ensuring that updated protocols are followed. Lastly, we’re continuing to deep clean and sanitize workspaces, which have potential exposure. We continue to be a reliable partner to our customers who are critical to national defense, commercial aviation, and the global economy. Let’s move to Slide 13. I’ll now turn to the outlook for which I’ll confine my comments to Howmet Aerospace. As discussed on the April 14 preliminary earnings call, we have an incomplete picture of the future demand pattern since many of our customers’ production has been significantly impacted. Information flow is currently limited, albeit improving. Hence, we’re reducing costs, reducing capital expenditure, temporarily suspending the common stock dividend, and improving our debt maturity profile to preserve cash given the lack of clarity. We find ourselves unable to provide reliable guidance at this time. Turning now to COVID-19. We felt the impacts from certain customer shutdowns and suspensions and disruptions within certain shifts within our plants during the last three weeks of the quarter. Today, we have only three smaller plants, which are currently closed and they’re in Europe. To mitigate the impact of COVID-19, we have commenced plans to reduce costs by a further $100 million on a run rate basis. This plan is incremental to the $50 million of carrier actions we are making from 2019 and the actions we took. Cost reductions are primarily driven by incremental overhead and some manufacturing reductions. Moreover, we will reduce our annual capital expenditures by approximately $100 million from the initial target provided at our February 25 Investor Day. The full year capital expenditure estimate of $200 million is driven by lower volumes and us cutting those costs. Lastly, we have temporarily suspended common stock dividend to preserve cash and provide additional flexibility. Despite the low volumes in 2020, we expect to be free cash flow positive for the year based upon these actions and this free cash flow is after pension after interest and, in fact, all items of cash flow. To give greater visibility to free cash flow, let’s move to Slide 14 and its key components. We are providing Q1 results and annual estimates on an annual basis consistent with previous guidance, corporate overhead, depreciation and amortization and cash taxes are unchanged. Pension and OPEB payments have been updated to $210 million based upon final separation calculations. Interest payments have been updated for the new debt issuance and CapEx has been reduced by the $100 million previously mentioned. Common stock dividends have been temporarily suspended. Working capital will be a net source of cash for the year as AR inventory and accounts payable are reduced. Let’s move to Slide 15 and talk about debt maturities. We’ve taken three actions in April. The first action on April 6, that we redeemed all of our 2020 bonds for $1 billion. Additionally, we redeemed $300 million of the 2021 bonds. Secondly, on April 24, we completed a bond issuance for $1.2 billion, which is due in 2025. Thirdly, we initiated two tender offers, one for $760 million for the portion of the remaining 2021 bonds, and the second tender offer for approximately $200 million for a portion of the 2022 bonds. These actions will result in the following three benefits. Firstly, we paid off all of the 2021 bonds. Secondly, we will take pressure off the balance sheet by reducing near-term maturities and turning them out a further five years. Thirdly, we’ll be able to add approximately $119 million of cash to the balance sheet, which will add to our very healthy cash balance that we have currently. A pro forma cash balance as of April 24 would be approximately $1 billion. The pro forma cash balance would be after the Q1 seasonal working capital build. Moreover, we had reduced the operational cash requirements from $400 million to operate our business to $300 million based upon the updated seasonal working capital needs pertaining to Howmet. Finally, let’s move to Slide 16. We have prepared a pro forma capital structure slides as of April 24. Pro forma cash would be approximately $1.30 billion and net debt would be approximately 2.4 times. Additionally, we have an undrawn revolver of some $1.5 billion. And with that let’s move to Q&A.

Hey guys, this is Dan on Gautam. Good morning.

Good morning, Dan.

Hey. So, we were curious, how does the combination of COVID and the lower aero OE production rates impact your ability to get the pricing benefits that have been laid out previously in 2020 and 2021?

Well, I think in terms of the total dollar amount, we should expect something rather lower, given the expectation of lower revenues, but the principle of an increase continues to be valid as it was then. And of course, what we think is, any LTA renewals really need to look at the three to five year period and not a specific one or three year timeframe and the necessary capacities need to be put in place for when the full run rates are achieved. So for example, in the case of Airbus, we expect that in a couple of years they’ll quickly be back at a 60 build rate per month or more. And the 737 MAX will also be progressing well as the planes on the ground are cleared from what we’ve read from Boeing.

Got it. Okay. Thanks. And then just real quick, have you begun to see destocking pressures at all from the aero OE production cuts? And do you guys have like a good idea of inventory already in the channel or is that something that lacks visibility for you?

It’s still tough to have total visibility, given the fact that we’ve only recently had a return to work for those airplane makers. And they are, as you know, have been reassessing their own production plans and now that resetting their own inventories. My basic thought is that when we exited 2019, in fact, our arrears were at a higher level than we’d entered the year. And so, given the arrears were so high, it would indicate that it wasn’t an even sort of vast amount of inventory in the pipeline. But I guess it will be part specific and aircraft specific. So it’s hard to give a very precise answer. But as a basic theme, if your arrears were even higher despite the massive increase in production that we did achieve and the part of the results we achieved last year, we certainly didn’t have a big burn down of inventory and arrears in the first quarter. So I don’t know it’s going to be a massive impact. At the same time, we don’t have visibility into exactly what our customers are carrying.

Good morning, John. If I could ask a technical question about the lifecycle of your engine and your participation. When in an aircraft’s lifecycle will you see your greatest aftermarket events? I’m assuming this is tied to shop visits. And what do events represent as a percentage of the original dollar content? So, if you have x on the original airplane and you get the shop visit one, what does that represent in terms of x as a percentage?

I think the best example I can give you is for the CFM engine, which has recently been replaced, as you know, by the engine ranges. Our view is that the peak demand for aftermarket is yet to come. So that’s assumed that peak demand, per our estimate, is around 2025. That would be approximately seven years after the engine replaced. While we have spares demand during the life of any engine, its peak is normally after the installed base is at its highest, hence I’d say approximately a seven-year lag. So that gives you a general direction for it. However, it’s also influenced by the duty cycle of those airfoils on the engine. And I think you’re probably aware that to achieve the fuel efficiencies required for newer engines in the thrust for lower emissions and a lower carbon footprint, those engines are running at higher pressures and temperatures. We do our very best to work with the engine manufacturer to achieve a similar lifecycle of the blades. But certainly, the impact of those pressure and temperatures is higher. So early on in an engine life, we probably have a slightly reduced duty cycle. But then it evens out over time. So that gives you the best answer I can provide, but I wasn’t able to answer your final point about what exactly what percentage that would be; I’d have to go and get that.

Well, we can do that offline, but I was trying to think about it on an individual aircraft basis rather than the fleet as we look at what happens here. But maybe I could try one other thing related. When I go back to your Investor Day slides, which I wouldn’t imagine you have close by, but there’s a slide, Slide 29, that talks about your legacy engine platforms and your next-generation platforms. And you’re on all the new stuff. You’re on most of the old stuff. When we think about those two populations of airplanes and your $400 million in airfoil aftermarket, if I got that number right, how does that $400 million divide between the two groups?

That’s going to be mainly CFM at this point in time, but there will be the offset on the – as an example, I mean I just gave you one engine range. Obviously, there will be the larger engines as well. Therefore, you have to build the, let’s say, the 777 fleet into those numbers or the A330s in there. So there are a lot of factors to consider. But basically, if you just took the narrow-body engines, the vast majority of the aftermarket would pertain to the current engine, albeit we will see those spares demand grow over time for the current engines as well for the LEAP-1A and 1B.

Of course. But what you’re saying is there’s a lot of NG and a lot of CO in that group?

Yes, absolutely.

Okay. Thank you very much.

And the reason why we partitioned today, the spares, to give you a little bit more detail rather than everybody assumed that the $800 million will pertain to the commercial aerospace business. We also want to draw your attention to, obviously, supply spares to defense and industrial as well.

Right, of course. But obviously, I’m focusing on the piece that’s likely to move the most, just during this period of time.

Yes.

Yes. Thank you very much.

Thank you.

Thanks very much and good morning.

Good morning, Seth.

I’m just curious with regard to the different product areas that you guys talked about on Investor Day, the engines, fastening systems, etc. I know we don’t have guidance for the year at this point. But when we think about the relative impact of what’s happening across aerospace and transportation, and we think about how those might stack up in terms of the relative impact on sales and profits in those product segments, is there any color you can offer just on the relative impact there? And do you plan to report out on this basis going forward?

Okay. I think the planned report out is that we’ve been thinking it’s more likely that we give segment information than anything else, albeit we’ve always given growth rates by end markets. I understand why the absolute percentages for end markets are also highly relevant. So, we’ll assess that and see whether we put that out there. The way I think about it at the moment is, let’s say, approximately 58%, just under 50% of our business pertains to commercial aerospace. A very coarse level of analysis would suggest that, for example, if you take the changes currently anticipated by Airbus, narrow-body, the A320, we’re looking at approximately a 35% reduction and wide-bodies at about a 40%. With Boeing wide-body probably about the same, but it’s a bit more cloudy because of the specific build quantities around the 737. It’s really difficult to give a generalized picture for the 737 at the moment. In fact, it’s not recertified. So I’d take a broad sweep through it and say, down 35%, give or take, as a guesstimate at this point in time. Although we do need a little bit more time to be able to give a more accurate and clearer picture. On commercial transportation, I’m going to be rather more pessimistic and say about 15% of our end markets could result in a reduction of close to 50% in that business ultimately. This is given the current dramatic change in the order intake for Class A trucks, as an example, both in Europe and in the U.S. On defense, that 15% you see double digits; it may end up being as big as 17%, but that’s based on 15% growth. I would estimate that industrial would be around 10%, which would be up, based on those sales. So as we try to reforecast each quarter, I use this perspective for guidance. While we will be grappling with it, as we try to reforecast the year going forward, the unknowns require careful navigation. However, we do anticipate being cash flow positive given our operational improvements.

Thanks very much.

Good morning.

Good morning, Josh.

Just a question on free cash. You’re going to be positive here for the year in 2020 with working capital as a source of cash. But if we look at 2021 and what the OEMs have communicated on production rates, just as they stand now, would you be cash flow positive in 2021 or would working capital go the other way?

The way I believe that we should operate is similar to what I went through in the 2008 and 2009 financial crisis. We should be cash flow positive when capital is coming in and cash flow positive when capital is going out. My expectation at this point is that we expect to be cash flow positive in 2020. I wouldn’t be saying it if I didn’t really believe it.

Got it, thank you.

Good morning. Apologies if I missed this. Was late joining in the call. But John, have you offered any color, any range of what you would think would be the right level for decremental margins as we go down here over the next couple of quarters?

We haven’t given decremental margins. When I talked to you previously during the virtual debt raise, I mentioned that approximately 80% of our cost structure is variable. Now it doesn’t all flex instantaneously, but material costs generally flex according to usage. More extreme adjustments would be related to staff costs, particularly in Europe, where adjustments would need to be made after consultation with the European Works Councils. We try to guide what’s truly fixed versus variable and acknowledge that variables can vary over time. Overall, we believe that very little should be considered permanent; it's all about the passage of time.

Okay. And a quick follow-up, your comment on working capital being a net source this year. What – did that happen in Q4? Or did it happen before that? I mean, I think you typically use working capital through at least the first half of the year.

Typically, we’ve been a working capital user. One of the things we tried hard on last year was to have our cash flow generate earlier, rather than only in the fourth quarter. So we were clearly driving to have our first quarter being a cash outflow. It’s a bit too early to say if we will achieve that given our current uncertainty. What I expect is for working capital to flex; however, inventory management remains a key challenge. As we progress through the year, I expect to see both Q2 and throughout the year, but to a lesser extent; we will be grappling with our inventory strategy. As a basic view, inventory days will improve by year-end compared to Q2, but not reach the previous levels of efficiency. Given the demand contraction we’re potentially facing, it remains a balancing act for us.

Great. Thanks for all the details.

Thank you.

Hey, thanks a lot for the time. Sorry, I was off for a second, John, if you addressed this, but I just wondered if you could speak to just given your military exposure and some of the capital that’s been flowing in even on the commercial side in terms of payments from your customers and that impact on the working capital situation, if you’re seeing any changes there? It seems like money is increasingly flowing. If it wasn’t, just any color there would be helpful. Thanks.

Okay. No, we’ve seen no change in our receipts from customers at all. So everybody’s paid and has been paying to terms. We always have a tiny level of delinquency, but we’re currently up at a very high level of collection percentage, and we’ve checked receipts very carefully with no change.

Okay, okay. Great. And then with respect to the areas of the business where you’ve got a substantial portion of the sales volume that may go through distribution, and I’m thinking about fasteners here. How do you get comfortable that you’ve got the risk appropriately sized there given the ongoing uncertainty around rates and what not? How are you thinking about those portions of the business relative to the aggregate whole? Thanks.

We’ve looked at both the OE bill and projected rates, and that which goes through distribution where our sales are not very high overall, neither in the context of fasteners nor in the context of total Howmet. Thus, while we are cautious, we believe we’ve got a handle on that segment. If we were surprised on the downside, I don’t think it’s going to be significant to us overall.

Okay. Thanks, John.

Thank you.

Yes. It’s just a follow-up on the defense side of the business. Can you talk about the F-35 exposure? How much of that is OEM versus aftermarket at this point as that program matures? And then are defense customers talking about taking advantage of any of the available commercial capacity to maybe build inventories, either as buffer stock or spares inventory?

So, F-35 was – I’m supposed to be giving you the best answer possible before I provide more granular commentary. It’s essentially all OE at this point in time, very little spares. That’s not to say the spares aren’t required because they are. They are critical to the military duty cycle, which is far less than the average commercial engine. But even with its reduced duty cycle compared to a commercial one, given it’s still relatively new in the market, the spares parts of the business has been, I’ll say, fairly limited. When I think about F-35, we were – the critical turbine blades in it were all critical, yes, and the ones which are the most exacting to manufacture. We were under pressure all through 2019 to produce more blades, and I recognize that, while we were not the limiting factor on the engine, we were close to it and sought to increase that capacity with additional dies and improved yields. We believe that the combination of that plus the additional capacity that we brought online has been helpful to that situation, and we’ve seen signs of improvement. At the moment, we can sell everything we can make given the unfulfilled basic demand we currently have. We’re trying to build to a higher rate for 2020, which is higher than the rate in 2019 and preparing for additional rate increases in 2021 and 2022. The alleviation of capacity from the commercial side has been helpful, although that’s not the only issue in meeting the rate increases relative to tooling. The way I look at it is we've found ways to improve rates.

Got it. Thank you.

Thank you very much. And I think that was the last question. So if we could close the call, please.