ATI Inc (ATI) 2018 Q3 法說會逐字稿

Good morning, and welcome to the Allegheny Technologies Incorporated Third Quarter 2018 Results Conference Call. (Operator Instructions) Please note this event is being recorded.

I would now like to turn the conference over to Scott Minder, Vice President, Investor Relations and Corporate Communications. Please go ahead, sir.

Thank you, Rocco. Good morning, and welcome to the Allegheny Technologies Third Quarter 2018 Conference Call. This call is being broadcast on our website at atimetals.com. Participating in the call today are Rich Harshman, Chairman, President and Chief Executive Officer; Bob Wetherbee, CEO-Designate and current Executive Vice President, Flat Rolled Products Group; John Sims, Executive Vice President, High Performance Materials & Components segment; Pat DeCourcy, Senior Vice President, Finance and Chief Financial Officer; and Kevin Kramer, Senior Vice President, Chief Commercial and Marketing Officer. If you have connected to this call via the Internet, you should see slides on your screen. For those of you who dialed in, slides are available on our website. After our prepared remarks, we will open the line for questions. (Operator Instructions) Please note that all forward-looking statements are subject to various assumptions and caveats, as noted in the earnings release and shown on this slide.

Now I'd like to turn the call over to Rich Harshman.

Thank you, Scott. Good morning to everyone on the call and to those listening on the Internet. I would like to provide a brief overview of our third quarter results, and then turn the call over to Bob Wetherbee. As we announced on August 14, Bob will become ATI's next CEO on January 1, 2019. I will remain as ATI's Executive Chairman until my retirement in May 2019.

Bob is an experienced leader within the specialty materials industry with an extensive background in the aerospace and defense and oil and gas markets. Bob is an outstanding choice by our board to ensure continued progress on the strategic journey currently underway at ATI and to lead the company forward into the next decade.

ATI's third quarter performance was solid. Results were in line with our expectations and the guidance provided on our second quarter earnings call. Third quarter results built on a strong first half 2018. Our 2018 year-to-date financial results provide tangible proof that we are delivering on our strategy to generate sustainable profitable growth and to be the world's best specialty materials and components company.

Year-to-date, sales have increased 15% with solid contributions from both segments, while segment operating profits have grown by 67%. The incremental leverage achieved on our top line growth demonstrates the scalability of our advanced manufacturing capabilities and the effectiveness of our prior business restructuring efforts.

Based on the strength of our commercial aerospace business, the ongoing recovery in the oil and gas markets and the operational performance of our world-class assets, we expect ongoing revenue and operating profit growth in the quarters and years to come. I am pleased with what we have achieved thus far and look forward to the future successes that Bob and the ATI team will no doubt deliver.

With that, I would like to turn the call over to Bob to cover the third quarter highlights. I will return at the end of the call to wrap up and take questions. Bob?

Thanks, Rich. First, I want to thank Rich and the members of the ATI board. I'm honored and humbled to be chosen to lead ATI into the future. We're in a great position to continue to meet our profitable growth targets and to serve our customers' increasing need for specialty materials, parts and components. To all of you on the call that I have yet to meet, I look forward to speaking with you on future calls and in-person meetings as I travel to visit our customers, operations and shareholders.

Overall, third quarter 2018 results were in line with our expectations. ATI's top line revenue grew by 17%, marking our fifth consecutive quarter with double-digit year-over-year revenue growth.

Both business segments were strong contributors to this growth, with the High Performance Materials & Components segments benefiting from the ongoing aerospace production ramp and transition to next-generation products and Flat Rolled Products segment improving due to the ongoing recovery in the oil and gas markets as well as growth in other important markets.

Segment operating profit nearly doubled versus the prior year, with margins expanding by 400 basis points. Top line growth benefits from product mix enhancements in both segments and increased asset utilization at key operating facilities helped drive the third quarter's robust year-over-year incremental margin growth.

As a result of this disciplined and profitable growth and despite a modestly elevated tax rate due to strong earnings at our STAL precision rolled strip joint venture, ATI earned $0.37 per share in the third quarter 2018 compared to an adjusted loss of $0.07 per share in the third quarter 2017.

With that as the backdrop, I'll hand the call over to John Sims to provide a more detailed review of our performance in the HPMC segment. Following John's comments, I'll return to review FRP segment results. Pat DeCourcy will comment in more detail on our third quarter financial results, and Rich will return to give our fourth quarter outlook and to provide concluding comments. We'll then open the call to your questions.

John, over to you.

Thanks, Bob. Turning to Slide 4, the HPMC segment's third quarter financial performance was well-aligned to our expectations. Year-over-year segment revenue remains solid increasing by 14%. Similar to the first half of 2018, aerospace market demand growth outpaced growth rates in other end-use markets. Segment operating profit increased by 23% versus the prior year, driven by favorable product mix and stronger asset utilization rates.

We continue to experience robust demand for next-generation jet engine products, particularly our differentiated nickel alloys and complex components. We worked diligently to remain an industry leader in product quality and on-time delivery, ensuring that our customers can produce more engines and airplanes to satisfy expanding market demand for air travel and airfreight. We expect these macro market trends to continue for the next several years, thus supporting long-term demand growth for ATI's specialty materials, parts and components.

Looking at our business sequentially. Third quarter revenue and operating profit declined versus the second quarter. This decrease was anticipated by the segment outlook provided on our second quarter earnings call and discussed on our first quarter earnings call as well. The reasons for this sequential decline are both structural and specific to 2018.

Each year, our HPMC segment faces recurring third quarter headwinds. First, several large customers, particularly aerospace-related forge operators, reside in Europe. Many of these customers take extended summer shutdowns aligned to local business practices.

Second, ATI uses this period of lower sales volumes to perform critical annual preventative maintenance on our factories. These proactive multiday repair periods occurred at our facilities in North Carolina, Wisconsin and Oregon to serve to reduce the possibility of unplanned facility outages in 2019 and beyond.

In addition to the annual events, the third quarter 2018 experienced 2 specific events that had a negative impact on our operating margins: First, as discussed on our second quarter earnings call, we continue to experience operating inefficiencies in our forging operations related to the ongoing delivery delays from a customer-directed non-ATI source of nickel powder billet. Second, we experienced approximately 1.5 day shutdown of our North and South Carolina facilities due to Hurricane Florence. I'm happy to say that all of our workers were able to safely return to work, and we worked diligently to make up the lost shifts. Although our production losses were modest, we did experience some logistics-related challenges in the second half of September due to a shortage of available trucking capacity and local infrastructure damage.

Lastly, although our ratio of next-generation jet engine product sales to total jet engine product sales was only modestly lower than the elevated first half 2018 rates, the mix of products within this category was less favorable. While each of these products benefits segment operating profit levels, the contributions are not uniform. Product mix can vary by quarter and can be difficult to predict in advance due to unknown customer inventory levels at the material or component level.

Despite these challenges, the segment achieved operating margins of 13%, which is above 2017's average and supportive of our full year 2018 guidance to improve operating profit levels by 300 basis points year-over-year. This margin growth represents our ninth consecutive quarter of at least 100 basis point expansion in year-over-year operating margins, underscoring our long-term growth opportunities primarily in the aerospace and defense markets.

Turning to Slide 5, the pie chart and accompanying table show HPMC's third quarter 2018 sales by market and a comparison versus prior year. In aggregate, segment revenues grew by 14%, with year-over-year growth in all major markets, including double-digit percentage growth in the segment's largest market, aerospace and defense. Customer demand growth was widespread across our product lines led by increased sales of our specialty mill products.

Third quarter aerospace and defense market sales grew by 15% year-over-year with mixed growth rates in the major submarkets. Commercial jet engine revenue expanded by 16%, led by a significant increase in next-generation product sales versus the prior year. Sales of next-generation product sales were 48% of total jet engine product sales in the third quarter, generally in line with rates in the first half of 2018. This sales growth was led by our specialty nickel mill products and forgings. While we expect the production of these new engine models to steadily increase our next-generation product sales over time, the ratio of these sales to legacy product sales will vary quarter-by-quarter as will the material mix within our next-generation product sales. Year-to-date, we have significantly outpaced our demand expectations for next-generation products.

Third quarter commercial airframe sales grew by 21% versus the prior year, led by strong demand for titanium billet from our OEM customers. Demand levels were elevated in part due to our ability to deliver on emergent demand orders from our largest airframe customer after a successful conversion to their new supply chain system. This growth was partially offset by lower year-over-year sales to our distribution customers.

Sales to the government and defense markets were in line with prior year but mixed by submarket. Military jet engine and rotorcraft product sales increased but were offset by naval nuclear product sales declines.

Looking beyond aerospace and defense markets. All of HPMC's smaller markets saw year-over-year sales increases. Sales to the construction and mining markets grew by over 35%, driven by our customers' demand for their large mining trucks.

Sales to the oil and gas market increased by 25% after a small decline in the second quarter, while electrical energy market sales increased modestly after growing nearly 70% in the second quarter. Medical market sales continue to improve modestly, with biomedical specialty materials sales growth more than offset declines in other product lines.

In summary, the HPMC segment posted strong financial results building on our strong first half 2018 results. Next-generation jet engine product sales increased by more than 40% year-over-year. These sales are highly accretive to our operating margins and should continue to expand in the fourth quarter 2018 and 2019.

I will now turn the call back over to Bob to talk about our performance in the Flat Rolled Products segment.

Thanks, John. Let's turn to Slide 6. The FRP segment generated solid third quarter financial results, improving on our very good second quarter results. The segment continued to experience strong demand for its products across several end markets and geographies.

Segment revenues increased 22% versus the prior year led by a nearly 40% increase in aerospace and defense market sales, mainly for our commercial aerospace products, and a 40% increase in automotive market sales driven by our Precision Rolled Strip products. Segment sales increased 4% versus the second quarter 2018. Results were mixed by market with strong growth in aerospace and defense, partially offset by modest declines in the larger oil and gas market.

Segment operating profit of $30 million or nearly 7% of sales increased both sequentially and year-over-year. Compared to strong second quarter 2018 results, operating profits increased by 13% while reversing a small loss in the third quarter 2017.

These gains were driven by a better product mix as well as by continued asset utilization rate improvements. The year-over-year comparison was favorably impacted by a better matching of raw material costs and surcharges, while the comparison to the second quarter saw minimal raw material impacted results due to relatively stable commodity input prices.

Looking ahead to the fourth quarter, we expect significant raw material headwinds in the segment as both ferrochrome and nickel prices are lower versus the third quarter, resulting in a surcharge timing mismatch. Despite the headwind, we anticipate the FRP segment remaining profitable in Q4.

In summary, the segment's third quarter financial results continue to demonstrate the success of our actions to generate improved levels of operating profit. As evidence of this improvement, the FRP segment's Q3 2018 year-to-date operating profit of $67 million is more than 4x the $15 million earned in the same 2017 period.

While we're not satisfied with these results, I am pleased with the FRP team's progress in 2018. We intend to build on these gains in 2019 to further progress towards our long-term goal of generating consistently profitable results across the business cycle regardless of trade policy.

Turning to Slide 7. I would like to update you on 2 of the FRP segment's strategic initiatives. While we continue to operate in an uncertain global trade environment, we remain focused on controlling what we can and on making progress toward our goals. We continue to focus on increasing asset utilization rates in a capital-efficient manner.

Last week, we announced an agreement that initiates a long-term relationship with NLMK USA to provide carbon steel hot-rolling conversion services from our world-class Hot Rolling and Process Facility, or HRPF, in Brackenridge, PA. NLMK was attracted to the HRPF's capabilities and its close proximity to many of their customers. ATI will be paid a guaranteed fee per ton for its services with slab shipments beginning in October and accelerating through a ramp-up in the first quarter of 2019. We'll be working with NLMK on future growth opportunities and will continue to run product trials with other potential carbon steel conversion partners with the goal of further increases in our HRPF utilization.

Now I want to update you on the current status of our A&T Stainless joint venture. As a reminder, we requested a Section 232 tariff exemption -- exclusion, actually, on behalf of the JV for a discrete amount of stainless slabs, 300,000 tons, imported exclusively from Indonesia. These slabs are not readily available nor available in sufficient quantities for any melt source in the United States.

Since our second quarter earnings call, there's been a significant change to the U.S. government's Section 232 tariff exclusion request process. This change to the process allows companies that had previously requested a tariff exclusion and received third-party comments on that request to provide public rebuttals to the comments received. Additionally, third-party commenters were also given a chance to provide follow-up public surrebuttals. As of yesterday, October 22, ATI's rebuttals were posted on the U.S. Commerce Department's website. The period for rebuttals has closed, but surrebuttals, if any, have yet to be posted.

In addition to the rebuttal process, the Commerce Department further defined readily available as readily available in 8 weeks. We review and view these changes to the process as very positive as it allowed us to provide additional facts around our exclusion request and do it in a public forum. The A&T Stainless JV continues to operate in a limited capacity while we await the government's decision, which we expect to receive sometime in the fourth quarter.

From a market perspective, the JV's stainless coil customers continue to be extremely supportive of the production ramp-up at the Midland DRAP facility. However, the lack of a U.S. Commerce Department decision on our tariff exclusion request by mid-December -- oops, excuse me, by mid-November will open the doors for the JV's customers to seek alternative sources of 2019 supply, resulting in increasingly reduced levels of production and loss of high-paying jobs in Western Pennsylvania, an unfortunate outcome from an otherwise well-intentioned government policy.

We continue to aggressively engage with officials in Washington, D.C. to achieve a positive resolution to the tariff exclusion request. We firmly believe that the request for a tariff exclusion is fact-based and fully satisfies the criteria established by the U.S. Department of Commerce and is supportive of U.S. national security policy and is accretive to U.S.-based stainless manufacturing and employment. We are committed to the JV for the long-term.

Now I'll hand the call over to Pat DeCourcy to talk about our third quarter financial performance.

Thanks, Bob. Turning to Slide 8. I would like to take a few minutes to update you on our third quarter financial performance and on our progress toward annual free cash flow generation goal.

I'm happy to report that our cash position continues to improve. At the end of the third quarter, we had nearly $155 million of cash on hand and approximately $300 million of borrowing capacity available under our asset-based lending agreement, or ABL. Both totals improved versus the second quarter of 2018.

Similar to our second quarter, we had no outstanding borrowings on our ABL's revolving line of credit at the end of the third quarter. We expect this trend to continue and assume that we will have no ABL revolver borrowings at 2018 year-end.

Third quarter capital expenditures were $31 million, bringing the total to $101 million year-to-date, a pace slightly elevated versus our full year guidance primarily due to the outflows for 2 significant projects: our fourth isothermal press and heat-treating expansion located at our isothermal forging center of excellence in Cudahy, Wisconsin, and the second capacity expansion at the STAL joint venture facilities in China. Looking beyond 2018, we continue to work collaboratively with our commercial aerospace customers to fully understand the need for and timing of additional capital expenditures over the next several years to ensure that we can profitably support desired potential industry production rate increases.

After growth in the first half of 2018, managed working capital decreased by nearly $30 million in the third quarter, primarily due to reductions in our inventories and accounts receivable balances. Despite significant year-over-year business growth in both segments, managed working capital as a percentage of sales stood at 36.4% at the end of the third quarter, reflecting year-over-year decrease of approximately 250 basis points.

Currently, we are outpacing our 2018 goal to reduce managed working capital as a percent of sales by 200 basis points versus the prior year. We will continue to work diligently in the fourth quarter to drive further efficiencies on the way to our long-term goal of 30% of sales.

Pivoting to our long-term liabilities. We continue to make progress on reducing ATI's exposure to legacy pension and post-retirement health care obligations and expect to continue our efforts in the fourth quarter of 2018 and beyond. As we mentioned on our second quarter call, the company's U.S.-defined benefit pension plan and post-retirement health care plans are now fully closed to new entrants. We will keep you updated on our ongoing progress over time but expect key metrics in this area to further improve in the balance of 2018.

Lastly, I would like to update you on our free cash flow generation expectations for the full year 2018. We expect to modestly exceed the upper end of our 2018 capital expenditure range set at $125 million. We can now say with confidence that we will be above our recently increased free cash flow guidance of $150 million, including the $10 million for the recent Addaero acquisition. As a reminder, this figure excludes $40 million for the 2018 ATI Pension Plan contributions. We expect continued managed working capital improvements to more than fully offset any increases in capital spending in the fourth quarter.

Now in summary, we are focused on cash generation and how to best deploy our capital to further reduce the balance sheet risk and financial leverage while positioning ourselves over time to return to an investment-grade credit rating. These efforts will coincide with our actions to ensure that we are well positioned for future profitable growth.

I will now hand the call back over to Rich.

Okay, thank you, Bob, John and Pat. Turning to Slide 9. Our third quarter results demonstrated the ongoing success of our strategy to generate sustainable profitability and free cash flow. We achieved significant earnings per share growth versus the prior year and have solid year-over-year revenue and operating profit growth in both segments, building on our strong first half of 2018 performance and results.

In the High Performance Materials & Components segment, third quarter sales increased in all markets versus the prior year led by double-digit percentage growth in both our commercial jet engine and commercial airframe product sales. We are well positioned to continue our growth in the upcoming quarters and years.

In the Flat Rolled Products segment, underlying market demand remained solid, and raw material pricing was relatively stable in the quarter. The business continues to benefit from improving product mix toward high-value products and increased asset utilization. As Bob mentioned earlier, we recently signed our first significant HRPF-enabled carbon steel conversion agreement, and we will build on this success moving forward.

Looking ahead to the fourth quarter, we expect an increase in High Performance Materials & Components sales versus the third quarter due to more normal business seasonal patterns with year-over-year revenue growth rates generally in line with the third quarter's growth rate.

Fourth quarter high performance operating profit margin levels are expected to be better than the third quarter, resulting in us achieving our full year 2018 goal of a 300 basis point year-over-year margin expansion. This guidance assumes a partial improvement in the nickel powder billet supply issues within the fourth quarter.

Modestly lower Flat Rolled Products segment fourth quarter revenue reflecting historically lower customer order patterns due to year-end inventory management actions are also expected in the fourth quarter. A significantly negative raw material impact on the FRP segment's operating profit is expected due to lower product surcharges, primarily related to nickel and ferrochrome, as Bob discussed.

Despite this impact, we expect the U.S. operations and the overall segment to generate profitability in the fourth quarter of 2018. We also expect a moderate LIFO expense headwind in the fourth quarter as we expect to exceed the balance remaining on our NRV reserve in the quarter.

In summary, we anticipate continued strong underlying market conditions to power our fourth quarter results in both business segments, and we will manage through raw material and seasonal impacts to continue our trend of strong year-over-year improvements in our financial results, including free cash flow generation. We look forward to providing an update on our long-term strategy and financial targets at our upcoming Investor Day in New York City on November 8. The event will be webcast for those of you that aren't able to attend.

Finally, after 82 consecutive quarterly earnings results and quarterly conference calls, this is my last one. I have enjoyed the interactions with our shareholders and analysts. Your comments and questions help make all of us better.

I'm very proud and humbled to have had the opportunity to work for ATI my entire 41-year career, and I am extremely honored and privileged to have had the opportunity to lead ATI for nearly 8 years. It has been a long, fun ride. We have made significant progress on our vision to create an aligned and integrated specialty materials company focused on creating sustainable value over the long term for our customers and shareholders while creating opportunities for our employees and communities in which we operate. While much has been accomplished, much more work remains. But that will always be the case.

I'm extremely confident that Bob Wetherbee will lead ATI to great success. Bob is a strong, experienced, values-based leader focused on creating sustainable profitability through the efficient deployment of capital. He has a strong leadership team that supports him and his vision, and I will continue to support Bob and the ATI team as they execute our strategies.

Rocco, may we have the first question, please?

Absolutely. Today's first question comes from Gautam Khanna with Cowen and Company.

Congratulations, Rich and Bob.

Thanks, Gautam.

So I just wanted to get calibrated on mix. Because in the first half of the year, it looked like high performance had particularly strong mix. What should we be expecting as we move into 2019? I just want to -- you gave us color on Q4. But is there anything about the first half of this year that may have been unusually rich relative to what a normal mix might look like in high performance?

Yes. I think that maybe in the first quarter, there was a stronger shipment of forging to a particular jet engine OEM that recovered some late deliveries that had been a result largely of some continuation of late powder billet deliveries. So we had a significant catch-up in the first quarter. The second quarter, I think, is really evidence of the lumpiness, one of my favorite words, that does occur in the business. I mean, when you're shifting from the legacy jet engine programs into the next-generation programs that are continuing to increase in rate production, and you have a strong demand from the legacy program in the aftermarket, this is -- '18 and to a lesser extent, I think, '19 is still a transition year between legacy programs and next-generation programs. I don't think that you'll see maybe the same kind of volatility in '19. In terms of the mix, I think you'll see a continued growth in the next generation mix as we move from '18 to '19. I think this business has historically been a business that is certainly stronger in the first half, I'm talking about commercial aerospace mainly jet engine, stronger -- and to a lesser extent even on the commercial airframe side, stronger in the first half of the year than in the second half of the year, primarily due to the third quarter being impacted by seasonality and historically, the fourth quarter being impacted by some inventory management issues. What has exacerbated that, I think, in the last couple of years is the supply chain rate ramp, some of the problems within the supply chain of reaching that rate ramp, which I think as we move into '19 will smooth out. They're not going to be -- and then you're still going to have some of those challenges, I think, in the supply chain in '19 as the rate ramp continues on in the next-generation platforms. But I think you'll have more predictability, if you will, in '19 than in '18. And then as you get into '20, I would hope that the supply chain is ramping up accordingly to support the backlog, the strong backlogs that exist at both Boeing and Airbus and then, obviously, that exist at all the jet engine companies, so I -- jet engine OEMs. So I think if you're reading -- if you're trying to read something in the short-term gyrations on a quarter-to-quarter basis as to whether or not the long-term trend is intact, I think you're reading far too much into this -- into that scenario. John, do you want to add anything?

No, Rich. I agree. I think, Gautam, as we take a look at this, the -- like us, most of the people that are involved in this aerospace supply chain are involved in both the legacy programs and next-generation programs. So as the ramp on the new programs continues and that rate increases, you're going to see some quarter-over-quarter, as Rich calls it, lumpiness as we move through. So what we do is we take a look at it more on an annual basis. We kind of smooth it that way because we're going to see some things where quarter 2 is probably going to be higher, the highest quarter of the year for us, with quarter 3 being the lower and quarter 1 and 4 going to be somewhere in between. So that's how we look at it.

And then just a quick follow-up on your comments around powdered billet. Has that supply constraint abated? Or is this more on the come in terms of what's implied in Q4 for your HPM segment guidance?

Yes, Gautam, that's been an ongoing challenge that we have -- that has -- we have abated to some degree to date. I think the problem we saw in Q3 was some challenges were exacerbated that occurred inside lead times for us to be able to react. We're working very closely with our customer to try to anticipate further requirements on our part to continue to abate those risks, and we're actively working that.

John, you might want to comment on the qualification programs and the status of them with our powder billet qualification.

Yes, that's a great point, Rich. The -- so Gautam, those -- the program that I just described to you is one in which we are qualified and contractually a supplier to. We are in the midst of qualification programs for every other material that we consume from a forging basis. So that within the next couple of years, we should be fully qualified and capable of stepping in should we need to, to provide a measure of safety in the event there is further volatility in directed sourced billet supply.

And our next question today comes from Richard Safran of Buckingham Research Group.

Rich, congrats to you. Bob, I think I have a first question for you. So I saw the announcement of the conversion agreement that you spoke of in your -- in the opening remarks. So a couple of things on that. Where does that take capacity on the HRPF now? And could you tell us also the status of the 4 remaining agreements? Am I correct about that, that you have 4 agreements that you're working on that are in various stages of negotiation?

Good morning, Rich. We are very pleased to have announced the NLMK agreement. It really is the start of a long-term relationship for us at the HRPF. It should move the utilization of the HRPF up 10, 12, to 15 points depending on how the ramp-up proceeds during the course of 2019. We do see it as a long-term relationship. We've invested the last 6 to 9 months within NLMK, first, qualifying the product, then getting a effective slab source, specific logistics in place, followed by NLMK beginning to sell the product. We actually produced product last week that's being sold to end customers already. So the NLMK relationship is off to a great start and should accelerate through the first half, hitting its run rate in Q2 of next year. In terms of what's next in the pipeline, we still are working with other producers. I would say 2 are closer to the finish line than others. We do see the ability to add another 15% to 20% to the utilization of the HRPF. And the combination of our core business plus the JV, the A&T Stainless JV, plus NLMK, plus a second conversion partner should put us in that 75% to 80% utilization, which has been our long-term target for the HRPF and clearly gives us the benefits we're looking for from an asset utilization base. So there are 2 that are very active, 2 that would be still in the wings. And it's really a qualification and customer acceptance issue that's putting them into that prioritization.

The second question I had was on -- I think this may be for you, Pat. You had a lot to say about cash generation. So I thought I'd ask how you might be thinking about the capital deployment. I fully recognize that the immediate priority is improving the balance sheet, et cetera. But you are starting to generate cash here, and I wanted to know if there's any thought being given to dividends, buybacks, capital deployment in general. So I just want to know if you could comment maybe here on what you're thinking about it and the timing if possible.

So the near-term focus, Rich, is still on improving the balance sheet. So we'll focus on pension funding, obviously. The CapEx requirements that we have to fund our strategic growth is a high priority, and then debt reduction in the near term. So we still have a $100 million debt issue that's out there that we can reduce at any time. We do have a focus on debt reduction as well. So it's really about balance sheet improvement in the near term. And I'd say the near term, the next couple of years. On a longer-term basis, as we continue to increase our cash flows, and we believe we will significantly improve our free cash flow over the next couple of years, we can turn then to measures to improve return to shareholders beyond that balance sheet improvement question. Those will obviously be subject to discussion with Bob and the rest of the board here at ATI. But I think there would be a consideration of dividend potentially and then potentially a buyback, but that would be based on whether or not we think the stock is undervalued at the time. So those would be more longer-term considerations. The near term is all about balance sheet improvement.

And our next question today comes from Timna Tanners of Bank of America Merrill Lynch.

I wanted to just try to get a little better sense of the guidance and understand what's being suggested. So starting with the high performance segment, maybe I misunderstood, but there was a comment in the script about run rate perhaps being a little bit ahead of demand in terms of sales. So wanted to just get your thoughts on the run rate so far. And if that kind of pace is sustainable going forward? Do you think that there's been inventory build? Or do you think that the run rate for demand in general in that space and in the jet engine side is something that can be sustained going forward?

Yes. I don't think we made a comment about our deliveries being ahead of the rate ramp. I mean, if we did, that certainly wasn't the intention. I think that my comment that I made in response to the question about the first quarter was that the sales were elevated in forgings because of a recovery from late deliveries. But I think that what we're seeing is actually our customers asking us for more. They're not asking us for less or to hold off. They're asking us for more. And we're being very -- where there's emergent demand and we have the capacity to deliver more, we are doing that, not only on the airframe side but also on the engine side, both in terms of materials, mill products as well as in forgings. So I think that the challenge going forward for the supply chain is going to continue to be to keep up with the demand. I think somebody might ask a question, which is a logical question, that because of some of the challenges that exist at the jet engine OEMs in delivering engines to meet the airframe rate ramp, are you getting any kind of a pushback of -- because we're behind in some of these engine programs, don't ship material to us. The answer to that is an absolute no. And I think that makes sense because if they put a hold on that, they'll never catch up. Because everybody who's in the supply chain, from our perspective at least, is running very hard and very fast. Capacity, if it does exist, is really being created largely out of learning curve, in productivity improvements in the near term. In the longer term, I do think that there's going to have to be some capacity added to support the rate ramp as you -- and the expectations of not only the engine and airframe production rates as we get into 2021, 2022, 2023 time frame, but also the elevation at that point in time of spares and aftermarkets on the next-generation platform, as those engines on the rotating components need replacement on the spare side. So I think that there's going to be continued focus, at least on our part, I can't speak for anybody else, but in talking with the customers, on how are we thinking about capacity additions in the future to meet the expectation of the demand. And to the extent that there's a good, solid business case there for us to make that investment, we would -- we, Bob, would bring that forth to the board, and we go from there. But I don't think that there's -- we're not sitting here worrying about, jeez, do we have too much capacity?

No, I'm sorry. That was not what I intended. And you answered that question great. And I'm sure we'll hear more about it at the Investor Day. So specific to the guidance on Flat Rolled Products, I was confused with the comment that, of course, you're going to expect to still be profitable but sequentially be weaker. I understand the sequential weakness, but why would you have to point out you're going to still be profitable if you have the tolling arrangements? Wouldn't those always be profitable? I mean, are you guiding to enough of a squeeze on your cost increases not being passed through to offset even the tolling arrangements? Or are you just talking about reduced profitability on that end? And then the tolling arrangements, one would expect, would continue to be an incremental contribution, no?

Yes, this is Bob. In terms of the tolling agreement, it will really kick in, in the first quarter of 2019. So the comment that I made around Q4 profitability in the face of the nickel and ferrochrome headwinds is actually great news and the progress that we've made refocusing the business. There are people who have questioned how sensitive FRP's earnings are to stainless. We've actually reduced our exposure significantly to commodity stainless over the last 12 to 18 months as part of our restructuring. But when nickel prices and ferrochrome prices fall, we get a lot of questions about the impact. And I think it's important to recognize that we've made the transition to sustainable profitability. Now we still have to grow to our target of $100 million of IBT for 2019. And we believe we're positioned well and the cost structure's in place to do that, with the help of the conversion agreements, which will be predominately a cash benefit to us as well as the utilization benefit across all of our products. But the conversion issue or opportunity will actually come to us in 2019. So we just wanted to reiterate that despite the headwinds, our business in FRP has been repositioned to be profitable for the long term.

Yes. I mean, Bob, great answer. And actually, we were being proactive in making that because in the past, we would've had that question. And in the past, the answer would be no. I mean, because of those headwinds and the size of those headwinds, we're -- we may not be profitable in the Flat Rolled Products U.S. operations. So that's a -- Bob hit the nail on the head. That's a significant improvement and the result of all the work he and his team have been doing over the last 2 years.

And our next question today comes from Josh Sullivan of Seaport Global.

And I echo the earlier congrats. Just to follow-up on the carbon conversion question there. So are you looking at the conversion agreement as additive to the $100 million EBIT guidance for FRP next year? Or was that already kind of factored in when you talked about you expected at least one of these agreements by the end of the year?

Yes. It was factored into our $100 million target for 2019. We were confident we could see the progress being made through the qualification step, building the efficient logistics supply chain. And obviously, the customer, in this case, NLMK, has been very excited. Actually sales teams have been in, and they're off and running. So it has been added. It was already included in the $100 million.

Okay. And then just one on the new isothermal forge you guys are working on. Where is that development? And can you talk at all about how backlog has maybe filled up through the year or just where we are on that?

Yes. Josh, this is John. We expect that new isothermal forge to come online on schedule, and it's currently on schedule, on budget. That forge should be operational in 2020. And at this point in time, that capacity is being utilized as planned based on the contracts we have and opportunities we've gained.

So the new capacity, when it comes online, is basically pretty much spoken for already.

Our next question comes from Phil Gibbs of KeyBanc Capital Markets.

Rich, I had a question on flat rolled into the fourth quarter. Can we at all size up in order of magnitude this impact from the mismatch in Q4? And then what's the LIFO headwind that we're talking about? And is that LIFO headwind in that segment as well?

Yes, Bob will take on the non-LIFO question. Pat will take on the LIFO question.

So when you look at the change in nickel and ferrochrome, I think nickel's down about $0.75 a pound; ferrochrome, about $0.10 or so Q3 to Q4. We would estimate, based on the inventory effect and the lag from the surcharge, to be in the $10 million to $12 million range from Q3 to Q4. Pat, you want to handle the LIFO piece?

Sure. So as we currently project raw material prices, and we still have a couple of months to go here, but it looks like we would exceed the NRV reserve balance by about $4 million in the fourth quarter. And that's a current projection, so it still could move around a little bit.

Okay, that's helpful. And in High Performance Metals, third quarter versus the second quarter, maybe we could isolate the mix changes a little bit better if we could understand what perhaps were the maintenance items of your own in terms of the step-up. And how much was the powder billet issue in the third quarter versus the second? Maybe that could help us in terms of the mix change.

So you're looking for us to quantify those? At this point in time, we're not prepared to do that, Phil. We would not disclose those.

Yes, Phil. I think the best way to think about the fourth quarter is we see the -- we are confident of hitting the guidance of a 300 basis point improvement and segment profitability year-over-year. Mathematically, that would put the year of 2018 at a segment operating profit of about 15%. And you can pretty much do the math of what you have to do in the fourth quarter to achieve that. You have to be right at or maybe a little bit above 15%. And the reason for that recovery is the lack of, hopefully, no more hurricanes, not only for our benefit but for the benefit of all the people in the U.S. that have been impacted by that and elsewhere as well. But also because of the expectation of stronger revenue in the fourth quarter because you don't have the third quarter effect of the European shutdowns. And we will have some maintenance done in the fourth quarter as we typically do. But it most likely won't be to the extent that it was in the third quarter. And I don't think that the third quarter, from a materials standpoint, I mean, there was unintended consequences of a 1.5 day outage. But that wasn't a big driver in the quarter. The big driver in the quarter was mainly lower revenue, slightly lower than the third quarter -- second quarter, a softer mix, primarily because of the billet -- the nickel billet delays coming out of the directed source from us, which we expect to be somewhat alleviated in the fourth quarter, not completely eliminated but somewhat alleviated. So the fourth quarter will have a -- is expected to have a recovery in revenue to be, hopefully, one of the higher quarters of the year at the kind of operating profit that we demonstrated to be on average of the first 3 quarters.

And our next question today comes from David Strauss of Barclays.

I think this is for Pat. The CapEx for this year running above the prior top end of the range, what is that attributable to?

Just some accelerated spending, as we said earlier, on a couple of our key projects. We're trying to get those done in an expedited matter so we can hit our requirements on the contract ramps. Just merely more of a pull forward, if you will.

Okay. And then on pension, can you talk about progress to potentially offload some of your liabilities as well as how we should think about pension expense next year, given what's going on with rates and maybe where your return is year-to-date?

I won't comment on the return year-to-date, but I will give you some guidance on some of our actions plan. We do intend to have additional actions within the pension profile planned in the fourth quarter, and we'll talk about them more on the first quarter call. But we do intend to have additional actions executed within Q4 to work the liability side. Pension returns are in line with market returns and our benchmarks overall to give you that type of guidance where we are. We'll see where we end up the year. I think that's it at this point.

Pat will give guidance as we always do in January. And in terms of -- at least preliminary guidance in terms of where we ended up with the year on asset levels and what the expectation is for pension and other retiree expense for 2019.

Our next question comes from Jeremy Kliewer of Deutsche Bank.

A couple of clarification questions on the HRPF utilization rates and stuff. Is there really any JV volumes going through there right now? I mean, there really hasn't been any stainless slabs imported to the U.S. for a couple of months now.

This is Bob. The joint venture, A&T Stainless, is still operating. It's still operating at 35% to 40% of our target. Remember our target is to be at about 300,000 tons. We are importing slab, and we are paying the tariff. In Q3, the operation was actually neutral when you include the utilization benefits of the HRPF. So we are still running.

All right. And then follow-up to that. You said the kind of the mating season or contractual season is coming up here mid-November. So are you guys willing to offer any contracts without the exemption? Or would you prefer to kind of shut down those volumes in 2019?

Yes. I think when you talk about the exclusion, whether we get the exclusion or not, I would say we are very confident in the facts of our case that it does -- our exclusion does meet the criteria established by the U.S. Department of Commerce. So we are focusing on those things that we can control. We can't control what goes on in Washington with trade policy. But we have reconfigured the JV business to be breakeven during this period of time. The team that's part of the JV has done an outstanding job of looking at every dollar and every opportunity. And we have reconfigured the business to be neutral during this period of the tariffs. Historically, the tariffs of this type don't last that long. 15 to 18 months has been typical for a 232 tariff. Now I think we all recognize we're in uncharted waters in terms of how the tariffs will play out. But we're committed to the joint venture for the long term. Our customers have been tremendously supportive. And when the tariffs are behind us, we'll be ready to ramp up. And the team understands that and is focused on operating at a lower level where we are today. Will it be the 30% to 35% level? Could be 25%, could be 45% depending on where the market is at the time. But we continue to operate and have confidence in the JV for the long term.

Yes. And Bob, in addition, I mean, remember, this is a 50-50 joint venture, right. So the decision-making process is a collaborative process between us and our partner. I think both parties went into it with a commitment that this was going to be a long-term venture that we believed in the quality of the product. We believe, not only in the slab coming in from Indonesia, but also the quality of the product that we are producing through the HRPF and the JV's DRAP finishing line. That belief has been supported by the reactions of the customer in the market place, which views it as very high-quality material and this being delivered on time, which is kind of the ideal combination. And so we approach it from the standpoint that we're not -- the JV was never designed to be unprofitable or lose money. That's not the intention of the JV. The tariff is not helping in that matter. If there are ways that the parties can agree to work together to ensure that, at a minimum, the JV is breakeven and we can continue to supply the market with the high-quality products that the customer wants. Even if the tariffs remain in place that would be ATI's intention of doing that. And hopefully, that would be the intention and the support of our partner as well. But we are in a little bit of a holding pattern until the government makes its decision. If the U.S. government doesn't make its decision soon, the partners will continue to have dialogue to see what can be done to continue to sustain operating the JV at a lower-than-planned and ideal rate.

And our next question today comes from Chris Olin of Longbow.

Most of my questions are asked. I just had 2 basic ones. I guess, the first was, how should we think about the vanadium cost impact for the HPM segment or maybe even some of the other master alloys, titanium scrap for that matter? It looks like there could be a potential shortage in 2019 given what the steel industry's doing in China and I guess, now we have that added tariff risk. And then maybe, on top of that, is there any concern on zirconium feedstock?

Chris, this is John. I don't have any concerns on either of those in 2019. And what price volatility we have in the marketplace, we have mechanisms within the contracts we have to pass those through.

Okay. And then any update on the GE9X engine contract? Have you been awarded that? Or any kind of break out yet?

Hasn't been awarded yet. In discussion. Expect that to be completed by -- before midyear next year.

And our next question today comes from Matthew Korn of Goldman Sachs.

And again, congratulations. A couple of quick questions for me. First, what's the progress on the profit levels for ATI cast product. Did you breakeven this quarter? Do we still expect that to go to small profitability into '19?

Yes. Matt, this is John Sims. I think our guidance for this year was near breakeven, and we achieved that in quarter 3. We expect improvement in quarter 4. And profitability in 2019 is in line of sight, which is also per our guidance.

Excellent. So everything's coming through as expected there.

Yes, Matt. If I could just add to that. I think John's being appropriately humble. He and his team have really done a great job. We're not where we want to be yet. We're not where we need to be to support the customers fully. But the effort that they have done and have been undertaking really for the last couple of years has been short -- nothing short of heroic. And John spends a lot of his time there, and we've augmented that business with a lot of very bright people from across ATI. And people who worked in that business 5 years ago wouldn't recognize it today. It's actually a disciplined manufacturing process or as disciplined as you can have, making an investment casting of some of these parts, which are very complex and tough to make. But we're committed to giving the customer what they want, what they need on a timely basis and rewarding the shareholders with that business being profitable.

Excellent. Let me then follow up this way. On STAL, you brought the expansion past July and since then the market's gotten more concerned on the pace of slowdown in Chinese industrial production, auto sales, other indicators. With the JV largely serving auto and electronics markets, how has that -- the pace of sales there been versus early year projections? Are there any areas of concern or any other cracks that you're seeing there?

Yes, Matt. I'm going to have Kevin Kramer respond to that.

We're pretty confident through the first 3 quarters in what we look into '19 with regard to STAL. The key end markets are consumer electronics. And while the vast majority of that product is manufactured in China, it truly is a global market. Second largest market is automotive, which is more indigenous to China. Our STAL 3 investment continues to be given new opportunities with its capabilities. We continue to be very, very bullish. It's a 22-year profitable joint venture in China, which I think in and of itself, is unique. And the investments we've made, I think, position us very well going forward.

And our next question today comes from Matthew Fields of Bank of America.

I want to echo my congratulations as well. Sort of just bigger picture. I know you guys have sort of said multiple times that your sort of ultimate goal is to get back to investment-grade credit rating. Would you say that, Bob, as he comes in -- and I can ask you, Bob, do you share that same vision of getting back to an investment-grade rating?

The simple answer is I do. And as I come into the role, clearly the priorities are to execute the commercial aerospace ramp in support of the customer commitments that have been made to us and us to them. John certainly has talked about that. He talked this morning about the $100 million FRP IBT target for 2019. Those generate -- both of those generate the cash that gets us to #3, which is an investment-grade balance sheet. The fourth priority for me is continuing to build a world-class talent pool or talent organization to execute and continue into the future. So the strategy that ATI developed with Rich at the helm, I was part of, John Sims was part of, Kevin Kramer, Pat DeCourcy, Beth Powers and Elliot Davis, the executive leadership team of the company. And we and I are still committed to that path.

And maybe just one more. With all the priorities 1 and 2 that you talked about and the comments, obviously very positive, that you made early in the call about, not struggles, but challenges to meet increasing customer demand, should we anticipate kind of a ramp-up in CapEx next year and potentially into 2020 as well?

I'll speak to that, and then Pat can add any color he wants to add. For 2019, our target is to have CapEx at or below our depreciation, and we have -- this time of the year, we've actually started our 2019 planning, and we're in sync with that commitment. Pat, do you want to add anything?

Yes, the only thing I'd add to that, Bob, is we're continuously involved with our customers, looking at the ramp and looking at the requirements. And we're adjusting our CapEx related to that so that we can meet their targets and their build rate ramp. So -- but we will stay within our depreciation and amortization total.

Our next question is a follow-up from Gautam Khanna of Cowen and Company.

I was wondering about this -- the airframe product sales being up considerably in Q3. And just how does -- how is what you've done so far kind of compared to the annual minimums with Boeing? And does this become a potential headwind next year, just given some of the other Boeing titanium suppliers may have had some friction related to the ERP transition? I just wonder if they catch up at some point on a relative basis. Any view on that?

Yes. Gautam, this is John. I would say that what we've seen this year is really indicative of what we've seen for the past several years. We have our contract minimums. We've achieved those. And inevitably, every year, we see emergent demand that's out there that really it's whoever can respond within the lead time required to get that business. And we've been successful doing that for many years, and I don't see that changing. So I would say there's always a percentage of our overall sales in any given year is emergent and I don't believe that's going to change. And we're not anticipating that to be dramatically different in overall volume than we've seen in the last several years. It's just know it -- it's something we can count on that we can perform, so we focus on that.

Our next question is a follow-up from Phil Gibbs of KeyBanc Capital Markets.

I know that the tariff impacts seemingly are reasonably obvious for the joint venture with Tsingshan. But are there any other notable tariff impacts, one way or the other, for the rest of the business that you're seeing right now?

Again, this is Bob. In terms of the tariffs in other areas, I would say they are balanced. What we're seeing is people who are in the automotive industry, who may have had a global supply configuration by product have moved to more regional supply. And that gives us change to deal with, but not overall increases or decreases in demand. So more of a supply chain reconfiguration. I think people are cautious. I don't think they're buying ahead. They're buying for their need. Those are probably the 2 comments that I could make related to the tariffs. John, do you want to add anything on the tariff front?

No, we're good from the high performance standpoint.

This concludes our question-and-answer session. I'd like to turn the conference back over to Rich Harshman for any closing remarks.

Okay, thank you, everybody, for joining us on the call today. And as always, thank you for your continuing interest in ATI.

Thank you, Rich, and thank you to all the participants and listeners for joining us today.

That concludes our third quarter 2018 conference call.

And thank you, everyone. Today's conference has now concluded, and we thank you all for attending today's presentation. You may now disconnect your lines, and have a wonderful day.