Carpenter Technology Corp (CRS) 2015 Q2 法說會逐字稿

Good morning, and welcome to Carpenter's Technology's second-quarter earnings conference call. My name is Allison and I'm your coordinator for today.

(Operator Instructions)

I would now like to turn the call over to your host for today, Mr. Mike Hajost, Vice President of Investor Relations and Treasurer. Please proceed, sir.

Thank you, Allison. Good morning, everyone. And welcome to Carpenter's earnings conference call for the second quarter ended December 31, 2014.

This call is also being broadcast over the Internet along with presentation slides. Please note, for those of you listening by phone, you may experience a time delay in slide movement. Speakers on the call today are Greg Pratt, Chairman, President, and Chief Executive Officer; Tony Thene, Senior Vice President and Chief Financial Officer; Andy Ziolkowski, Senior Vice President, Commercial for Specialty Alloys Operations, or SAO, as we call it; Gary Heasley, Senior Vice President, Performance Engineered Products, or PEP, as we call it; and also in the room is Dave Strobel, Senior Vice President of Global Operations.

Statements made by management during this earnings presentation that are forward-looking statements are based on current expectations. Risk factors that could cause actual results to differ materially from these forward-looking statements can be found in Carpenter's most recent SEC filings, including the Company's June 30, 2014 10-K, September 30, 2014 10-Q, and the exhibits attached to those filings.

Please also note, in the following discussion, unless otherwise noted, when management discusses sales or revenue, that reference excludes surcharge. When discussing operating income, that reference excludes pension earnings, interest, and deferrals, or EID. When referring to operating margins, that is based on sales excluding surcharge and operating income excluding pension EID.

I will now turn the call over to Greg.

Thank you, Mike. And good morning, everyone. It is good to be with you today.

As I turn to Slide 4 of our presentation, you will note that this is a new slide showing our safety performance trend. Safety is one of our key principles, and we take our responsibility to protect our employees very seriously. We are very proud of the improvements we have made in the safety area over the last six years and are committed to getting even better.

Turning to Slide 5, I want to provide some highlights on our recently completed second quarter and provide some perspective on how we see the business positioned going forward. We certainly had an operationally smoother quarter than the first fiscal quarter, so explaining the significant sequential improvement in earnings is not necessarily that meaningful. We drove SAO revenues up year-over-year in all end-markets and achieved a portion of the richer sales mix that, we previously described, was building in our backlog as we exited the first quarter.

Having said that, we are not able to show improved margins year-over-year. The sales growth and richer mix were more than offset by higher SAO costs in the current quarter as we worked through the integration of our mill operating system.

We expect to see SAO cost performance improve as we further increase Athens production capabilities and qualifications. I will speak more about our progress on Athens qualifications later on this call.

We are very pleased to see the substantial gains in our PEP segment. PEP increased sales by 18% and turns us into a 47% increase in operating income. They did this through yield improvement and productivity gains.

As we look forward, there is both uncertainty and excitement. With respect to uncertainty, we began to experience cancellations and deferrals for oil and gas materials as drilling and completion activity slows with falling oil prices. I will let Andy and Gary provide a fuller assessment of this risk on the businesses during their segment discussions.

With respect to excitement, our overall view of our end-markets, our order book, our backlog, all point to higher sales volume with a stronger mix. To realize higher profitability on this growth, we remained focused on driving down our operating costs.

We are also excited about transitioning to an era of positive free cash flow generation. With the majority of our annual CapEx plan spent in the first half of the year, and a continued commitment to reduce inventory from current levels, we expect to drive positive free cash flow in the second half of FY15.

Now let me turn to Slide 6 and discuss some highlights in our end use markets. During our first-quarter earnings call, this slide had more red arrows than green. This is a much better picture today, and demonstrates the strength that is returning to our end-use markets.

Overall, sales, excluding surcharge, were up 8% year-over-year on flat volumes, reflecting a stronger mix of products sold. In our strategically important aerospace and defense end-market, we drove both higher year-over-year and sequential sales. We experienced stronger engine and fastener material activity and saw higher demand with improving mix for products sold into the aerospace distribution market, often a leading indicator of overall aerospace growth.

Our defense business is showing increased activity, but remains below prior-year levels. Defense products help us improve our margins as many of these products are ultra premium materials sold into very demanding applications.

Our energy end-market, we also saw strong year-over-year as well as sequential growth. This was led by increased sales and rentals for oil and gas drilling products at Amega West as well as oil and gas completions product sold through SAO. We do expect that falling oil prices will have a negative impact on our energy business.

We had strong year-over-year growth in medical-market sales as demand improved for materials used in orthopedic procedures and surgical instruments. We believe the market has reset off lower prior-year levels but remains extremely competitive with new entrance creating pricing pressures.

In transportation, we continue to achieve strong year-over-year sales growth and an improving mix, with materials aimed at higher-value engine components. With lower gas prices, we are also seeing a trend towards bigger vehicles with larger engines which utilize more of our materials.

And lastly, our industrial and consumer business serves as a good example of how our mix management efforts are more and more successful. We were able to grow sales by 9% year-over-year on 8% lower volume. We did this by driving sales to our high-value customer electronics and industrial goods applications. Again, the net result was an 8% increase in sales year-over-year on flat shipments, demonstrating a stronger mix of products.

Let me now turn the call over to Tony, who will walk you through the financial summary.

Thank you, Greg. And good morning to everyone. This is Tony Thene.

Let's start on Slide 8 with the income statement summary. Net sales in the quarter were $548 million, or $446 million excluding surcharge, with aerospace and energy accounting for 58% of the total.

In the quarter, SG&A expense was down $7 million sequentially, driven primarily by lower variable compensation expense, as well as lower amortization expense. As we move through the balance of the fiscal year, we expect the quarterly SG&A expense will return to a more normalized level, similar to what we reported in our first quarter of FY15.

Operating income was $45 million in the quarter and $47.4 million excluding pension EID. Operating margins increased sequentially by 500 basis points to 10.6%, driven by a stronger mix in SAO, offset somewhat by lower volumes and an improved performance in PEP. Operating margins decreased year-over-year by 180 basis points.

Although SAO mix and PEP performance were much improved, SAO operating costs were higher year-over-year. Interest expense was higher year-over-year due to the Athens assets coming online and, therefore, the less capitalized interest. Net income for the quarter was $24.1 million, or $0.45 per share. Excluding the $1.6 million discrete tax item, earnings per share would have been $0.48.

Now let me turn to Slide 9 to discuss the effective tax rate and discrete tax item in more detail. Our second-quarter tax expense includes $1.6 million, or $0.03 per share of additional tax expense associated with the tax extenders legislation that was enacted in December of 2014. This legislation provision includes a retroactive extension of the research and development tax credit to calendar year 2014. This resulted in a positive change to income tax expense and the effective tax rate.

However, the legislation also included a retroactive extension of bonus depreciation for calendar year 2014, which reduced our taxable profits for the FY14 tax return, and accordingly, reduced our domestic manufacturing deduction. This resulted in a negative change to income tax expense and the effective tax rate.

In total, there was a net negative impact on the tax expense of $1.6 million, resulting in an effective tax rate of 36.9% for the quarter. Both the R&D tax credit and the bonus depreciation impacts are primarily a result of the startup of our Athens operation in 2014.

It's important to note that although this legislation negatively impacted our tax expense this quarter, we expect to see a significant benefit in our cash taxes in the second half of our fiscal year as we finalize and file the 2014 tax return. We expect the cash tax benefit to be in the range of $55 million to $60 million. For quarters 3 and 4, we expect the effective tax rate to be in a range of 33% to 34%.

Now let me turn to Slide 10, and the free cash flow summary. Free cash flow was a negative $66 million for the quarter, driven primarily by two items.

The first, a $31 million increase in inventory. As we've told you in the past, historically, we do build inventory in the first half of our fiscal year to prepare for the highest shipment in the second half of the year. That said, we continue to work initiatives aimed at reducing working capital levels, which of course would be heavily focused on reducing inventory levels across the organization in the second half of this fiscal year.

The second item I wanted to highlight is the $68 million of capital expenditures in the quarter, including $35 million of Athens capital spending. Year-to-date, through December, we spent $67 million related to our Athens facility. As the bulk of our plan capital spending is now behind us, we remain committed to our plans to generate positive free cash flow in the second half of this fiscal year.

Our guidance on capital expenditures remains at $160 million to $175 million for the year. Our total liquidity stands at $484 million, which includes $29 million of cash on hand. Another important item to add, even though it is not part of our free cash flow calculation, is that, during the quarter, we used $10 million of cash to repurchase approximately 200,000 shares under the share repurchase program that we announced in October of 2014.

In addition, we used $20 million of cash to repurchase approximately 465,000 shares during the month of January. In total, we have used approximately $30 million to repurchase shares to date.

With that, let me turn it over to Andy.

Thank you, Tony. I will now cover the SAO segment depicted on Slide 12.

Compared to a year ago, revenues grew by 5% on 2% lower volume, showing a strengthening in our sales mix, particularly for our transportation and industrial and consumer applications. We experienced growth in all end-use markets. And, as we indicated in last quarter's call, our mix is also richer on a sequential basis, and we expect this trend to continue as we look forward into our third quarter.

Operating margins lagged last year but we're stronger on a sequential basis as we outpaced the higher operating costs caused by startup issues after our annual maintenance shutdown. Compared to last year, operating costs were higher due to higher Athens depreciation and our previously communicated Reading press outage. In addition, overall operating costs were higher as we worked through the early stages of integrating our combined mill operating system.

Looking forward, and as previously stated, based on the health of our backlog, we believe our margins will continue to improve into the third quarter. The full impact of the recent and dramatic decline in crude oil prices is too early to tell.

To date, we have seen an increase in the order cancellation rate and requests for deferrals for oil and gas materials. Due to our current lead times, we will realize some negative impact in this current fiscal year. While the Athens customer qualification process continues to progress, and the early indications are that the technical and operational benefits appear to be consistent with our expectations, we believe that the startup and associated inefficiencies will continue as we work through the integration of our combined mill operating system.

I will now turn the discussion over to Gary Heasley to cover the PEP segment.

Thank you, Andy. And good morning, everyone.

On a year-over-year basis, PEP reported revenue growth of 18% and operating income increased by 47% compared to the second quarter of FY14 on strong performances by all PEP business units. Revenue growth was driven by higher shipments of our powder metal and titanium bar and wire products, and increased sales and rentals of downhole tools. PEP's results for the quarter improved as a result of the volume increases and productivity gains in our titanium, powder, and machining operations, and improved profitability in our distribution business, resulting from cost management on essentially flat sales.

Looking forward to the fiscal third quarter, we expect the steep decline in oil and gas prices to cause a reduction in drilling activity. This will affect our downhole tool business, our distribution business and, to a lesser extent, our powder metal business.

Although we did not see an impact in the second quarter, our backlog for downhole drilling tools has declined, and we anticipate a reduction in demand for rentals that will affect our fiscal third quarter. We are already taking actions to align our cost structure with lower demand in our oil and gas-focused businesses, and will continue to manage our costs aggressively as market conditions change. Overall, we expect PEP's earnings to be down between 25% and 30% in the fiscal third quarter, as a result of the anticipated pullback in drilling activity.

On the positive side, we expect the overall demand for powder metals to remain steady. Also, we expect continued strength in demand for our titanium products in both the aerospace and medical markets, and we have installed an additional titanium wire finishing line to better serve our customers in those markets. Our new line will be fully ramped by the end of our fiscal third quarter.

PEP had a solid quarter due to the impact of productivity gains and yield improvements, but the third quarter will present challenges to our PEP segment. We will continue to proactively adapt our operations as market conditions and customer needs change in order to minimize the impact of the energy market decline on our businesses.

Thank you. And now, I will turn the call back to Greg.

Thank you, Gary.

Turning to Slide 16, I want to provide an update on the Athens qualification process. As you know, this is a very important part of our near-term growth opportunity. I want to use a simple framework to help you better understand where we are today and the next steps in timing to progress us further.

First of all, as we grade ourselves, we do believe our qualification process is on track. We are currently operational at Athens and we are already providing capacity relief to our Reading and Latrobe operations.

At Athens, today we are supporting aerospace applications that require what we call base-industry specifications. We have approved production for some large diameter aerospace nickel products and we are experiencing excellent quality performance. We are producing stainless directional drilling products for the oil and gas market. We're also providing some corrosion-resistant materials for the chemical processing segment.

If I look forward over the next 6 to 12 months, we'll continue to achieve qualifications and believe we'll be able to fully support the oil and gas nickel superalloy demand. We will also continue to achieve more stringent qualifications for the aerospace segment.

If you look out over the next 12 to 36 months, that's where we think we'll be complete with the most stringent aerospace engine parts approval from the primes and other supply chain partners. This will complete the full integration of our key SAO operations and we will achieve our maximum manufacturing capability and flexibility. The end result will result in improved yields and lower costs.

Before we take your -- sorry, the expansion of the Athens production capabilities and added qualifications will provide the overall system with even more flexibility to respond to increased collective demand from all of our end-markets. But before we take your questions, I would like to provide some brief final comments and you will see that on Slide 17.

As we stated earlier, we believe we will see sequential higher volumes and stronger sales mix in our third fiscal quarter. In fact, our average selling price in our backlog, as we exited the second quarter, was 9% higher than at the end of the first quarter. Our ability to translate more of that growth to the bottom line will be dependent on our ability to reduce our costs, on which we are laser-focused.

We are also carefully monitoring and managing the impact of lower oil prices on our business. We have seen some initial impact from this development but the longer term, full impact is currently unknown.

It is important to note, however, that we serve a diverse group of attractive high-growth end-markets. Oil and gas represents about 14% of our total sales. It is rare that all of our end-markets consistently move in the same direction.

And finally, with our Athens product nearly complete, we will experience a large reduction in CapEx spend. Coupled with our targeted inventory reduction, we are now transitioning to positive-free cash flow in the second half of FY15. And as we discussed on our last call, we have prioritized cash deployment towards our recently initiated share repurchase program.

And with that, let me turn back to the operator so that we can open the line for your questions. Operator?

Thank you very much.

(Operator Instructions)

Julie Yates, Credit Suisse.

Good morning. Thanks for taking my question.

A question on jet engine sales. So one of your competitors and customers referenced the continuation of destocking and it seems like you saw a nice year-on-year and sequential increase. Are you seeing a similar dynamic or are shipments starting to align more with production rates?

Julie, this is Andy; I will take that one. So as we said last call, we are not seeing the same destocking phenomenon that you referenced. We think we are pretty much more in line with the engine rates.

I would tell you that there still seems to be some lag in the supply chain, as you work through, specifically, to the build rates that you see published by the OEMs. But we are not seeing the dramatic shifts that you're mentioning.

Okay, and then just a question back to balancing an attractive share price with the timing of free cash flow. $10 million in the quarter seems a little light and I understand that you have been active in January. But given the two-year time horizon on the $500 million, should we expect the cadence of the buyback to be rather back-end weighted over that time period given the timing of cash inflows?

Hi Julie, this is Tony. I wouldn't necessarily say that, that it's going to be back-end weighted. Remember, the program was really put in place late in the quarter, so we really just had about 30 to 40 days in the quarter, and then, obviously, as I said, we were active in January.

So if you -- if a run rate is $60 million, we did $30 million in less than a full quarter. So you can take that for what it is worth. But I wouldn't say that we have any predetermined plan on how much we are going to repurchase in any quarter.

Okay. Great. Thank you very much.

Gautam Khanna, Cowen.

Can you talk about how your views of Athens ramping is now different, if at all, given the slowdown of the oil and gas end markets?

Well, let me start by -- this is Dave Strobel. Good morning, everybody.

Let me start by talking a little bit about Athens and how it fits into what we had described as far as the overall integrated mill operating system. As I think most of you know, both Reading and Latrobe operations are where we do our arc and VIM melt. So we have been working two products between our facilities, the melt shops, to help us grow our capabilities and capacity at Latrobe, and some of the alloys needed to serve our markets and customers going forward as we experience market growth.

While we have been continuing that development work at Latrobe, on the melt side, we have also been moving product to Athens and working through the qualifications through the course of developments there. And with those qualifications, there is always additional processing and testing. That's what the process requires from us.

And so we are working through some of those details in Latrobe as well as working through the entire process from inception at Athens. Let me also say this, this is -- you know, with this movement, qualification process, it is not an unusual issue we are working through as far as startup of a new plant. But we have not been calling out the startup-related costs in special items because it is part of what we do, and frankly (technical difficulties) dependencies of the facilities, it's really difficult to justify or itemize anyway.

We do expect that to improve over time and to gain qualifications to dial in on our best paths to make the products with the greatest efficiency across the capabilities of the entire system. So with that said, as far as as we're moving products between the various facilities, it is something that we will have the ability to continue to adjust and really dial in as far as what makes the most sense to make where. And so even with the slowdown, we are picking up business with (technical difficulties) and some other aspects of business that will help keep Athens going.

This is Andy. I would amplify Dave's comments and say, you know, we started to progress on a pretty good run rate and drilling and exhibition materials were part of that. We saw a fair amount of that in (technical difficulties) production activity and like any other capacity, when things get tough there we'll look at capacity. But there will undoubtedly be some sort of impact as we shift and replace (technical difficulties).

Okay, and to follow up on that, presumably with oil and gas weaker, I would imagine it may exacerbate the supply/demand imbalance in nickel alloys, and I just wondered if you could comment on this backlog trend you have seen with richer pricing, or richer mix? Do you anticipate that will continue as we move out over the next four quarters, or do you expect it at any point to take a step back, given the dynamic of a big end market getting softer may exacerbate an oversupply condition?

This is Andy again, I will take that one. As I mentioned, as we look out over our backlog, our backlog remains consistent and the margins continue to grow. So we expect that that trend, as far as we can see now, will continue.

Having said that, we are seeing some downward pricing pressure, specifically from the oil and gas OEMs. But that has not been the case in the other markets and we will look to supplant that activity through those other markets.

Okay, and then if you could just give us some color, Andy, on when you anticipate SAO margins getting back close to that 20% level ex-surcharge that you had just -- not so long ago? Do you anticipate that this fiscal year, or if you could just walk us through some of the puts and takes and perhaps the timing?

We will probably tag team this between Dave and I, but certainly from the view, if you just kind of bifurcate that equation and look at the contribution of the products that we sell, we are seeing the contribution of the products we sell increase, and our expectation is that they will continue to get better as we move forward, again, given the early uncertainty from oil and gas.

What we are working through, and the challenges we see is the putting together the mill operating system, and that will have a lot to do with, and be coupled to, the qualifications that we see at Athens. As we continue to work through that process, things will align into their more normal supply chains, at which time we can optimize the efficiencies and the structures behind that. It will be pretty closely aligned with some of the guidance that Greg gave as we work through the asset qualifications.

Okay, so are we looking out 18 months before we're there? I'm just trying to get a sense for timing so I don't overestimate my estimates, you know?

I think -- this is Greg. I believe that you will see steady progress as we improve our mill operating system. It seems to us that the market side, that is the commercial side, is pretty much in place.

I think much of what you're seeing now is noise associated with the startup, the normal startup of a facility. It is somewhat complicated by the fact that we have to go through our qualification process, which is not 100% within our control, as we work with our partners. So it will be gradual and it will, I believe, improve with each sequential quarter.

We are laser-focused on controlling our costs. And by doing that, we think that that will be a major contributor to our operating margin percentage.

Okay, thank you.

Steve Levenson, Stifel.

Is the comment that you made about shipping some large-diameter nickel product an indication that the open rotary forge is, at least to some extent, qualified now?

The -- this is Dave. The radio press down at Athens, we have been very successful in developing some of the initial products down there, so the Waspaloy, [841] 718 products, we're working our way through those and have been very happy with some of the results. Again, it just takes some time and we've got qualification programs with each of the primes that we need to work our way through.

Okay, thank you. And second, on the additional titanium wire capacity, do you see the increase in demand and your initial use of it related more to the A-350 or is it other programs? And at what point do you think it will be at full capacity utilization?

We don't have great visibility through our customers to the ends platforms that our titanium wire goes into, but I can tell you that we have struggled now for, well, a long time, to produce enough material to support our customers' needs. So we believe this will ramp up very quickly. We should be fully ramped by the end of the quarter.

And we will be glad to have this capacity so we can better serve our customers. I don't think we're at this point -- well, we're not at this point anticipating any trouble filling the line for now.

Got it. Thank you very much.

Steve, if I could add on that, this is Greg again, if I could just add a quick comment, we anticipate increasing our capacity even further with another line in order to meet our customers' requirements. So we will continue to build as the -- in order to meet the demand. Next question, please.

Paul Gibbs.

Hey, it's Phil Gibbs at KeyBanc; good morning. I had a question just on the cadence as we move into 3Q from 2Q on the earnings side. Obviously some puts and takes; I think Gary talked about a 30% decline in profitability in the PEP segment.

I thought that was quarter on quarter. And then I think you're talking about stronger margins and stronger volumes in SAO. So just trying to think about how to balance that relative to where we were in the second quarter, and if there is, you know, anything else we should be thinking about.

Phil, this is Tony. I think what we try to do at those two segments is split them apart for you so you can really work your models on each one of those individually. So the guidance, the 30% down on PEP, you should apply that to PEP only, so that's just the PEP result.

The primary impact of that is the oil and gas. Obviously they are looking at countermeasures to offset that, but that should be specifically associated with PEP. On the SAO side, when Andy speaks, he is obviously speaking specifically on SAO and that we do, going forward, see continued improvement on the mix and margin piece.

And is that largely due to the pickup in Aero, on the engine business, on the fastener side?

Phil, this is Andy, I wouldn't say only fastener. It is pretty much the balance -- a balanced improvement across the more premium applications that Greg kind of went down on that market slide, will be consistent as it follows its way through the backlog. But certainly Aero engine and Aero fastener plays a role in that.

Okay, and then just a strategic question, how do the inventory reductions that you are expecting in, maybe, the back half of this year and into next year, how does that play into margins and overhead absorption? I mean, how do you balance that with trying to grow your margin piece of the equation? Thanks.

This is Tony. Obviously, that will have an impact on fixed cost absorption, but that is one of the things that we will manage as we go through.

Is it going to be a negative? Yes. And we will do our best to manage that to be as small as possible. But I think the important thing is that what drives us is reducing the inventory and driving that cash to the bottom line.

Thanks, Tony.

Sal Tharani, Goldman Sachs.

Good morning. A couple of questions. On the Energy side, if I look at your 14%, 15% revenue exposure, would it be more impactful in PEP than SAO going forward?

Sal, I will take that. This is Andy.

If you look at the whole segment in Energy, you got to take about 2% off that for power gen. So getting down to the 14%-ish, that is almost roughly split. SAO has about 60% and PEP has about 40% as it relates to oil and gas.

And Gary, you mentioned [fashion] pricing in titanium products in Aerospace and Medical. Can you give us a little more color which one specifically, or is it in both places, and what is the reason for that?

Well, there are multiple reason, Sal. We've got competitive dynamics that are changing, new entrants into the marketplace, and of course, we are meeting them head-on, and then we've also got, in the Aerospace side and the Medical side, OEMs that are pushing for cost reductions, so we are dealing with that as well.

Now, we are offsetting that with productivity gains and getting more throughput in our existing platform as well as adding some volume. So I think if we manage this properly, we will mitigate much of that impact on our business over the course of the next year or so.

So this guidance of 25% to 30% decline is strictly coming from the Energy side while the titanium is already, sort of, looks like flattish margin for you?

It is coming -- it is actually more than just oil and gas. Oil and gas is the vast majority of the impact.

And that is where we anticipate this rather dramatic change coming. So there are other factors in there, but it is really predominantly oil and gas.

Great. Thank you very much.

That concludes the question and answer portion on today's call. Let me now turn it over to Mr. Mike Hajost for closing remarks. Please go ahead, sir.

Thank you again for participating on today's call. We look forward to speaking with you again next quarter. Thank you and goodbye.

Thank you, ladies and gentlemen. That concludes your conference call for today. You may now disconnect. Good day.