Carpenter Technology Corp (CRS) 2016 Q1 法說會逐字稿

Good morning and welcome to Carpenter Technology's first-quarter earnings conference call. My name is Greta, and I will be 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.

Thank you, Greta. Good morning, everyone, and welcome to Carpenter's earnings conference call for the first quarter ended September 30, 2015. 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 Tony Thene, President and Chief Executive Officer; and Tim Lain, Vice President, Controller, and Chief Accounting Officer. Also in the room, I am pleased to announce is Damon Audia, Carpenter's new Senior Vice President and CFO.

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, 2015 10-K, and the exhibits attached to that filing.

Please also note that 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 Tony.

Thank you, Mike, and good morning to everyone on the call. A special welcome to Damon. We are very happy to have him on the team.

Let's get started on slide 4 with an update on our safety performance. In fiscal year 2015, we reduced our total case incident rate, or TCIR, from 3.3 to 2.1, a 36% improvement. For the first quarter of fiscal year 2016, it is disappointing that as a total Company we regressed with 31 recordable injuries and a 2.3 rate. We plan to reverse this trend by placing great emphasis on employee engagement and human performance factors. A safe, injury-free workforce is a more productive workforce, and we remain convinced that a zero injury workplace is possible.

Let's turn to slide 5 and a summary of our first-quarter performance. A primary driver of our first-quarter performance was the continued weakness in the energy market, primarily the oil and gas sector. This, combined with normal seasonality, drove our volumes down 15% sequentially. The decline is consistent with the market outlook update we communicated in early September. An encouraging sign, which is overshadowed by the oil and gas decline, is the year-over-year growth in our aerospace and defense end-use market. Again, we experienced year-over-year quarter growth and expect that trend to continue.

We also experienced year-over-year quarter growth in our transportation end-use market. We expect this market to continue to grow for us. Most importantly, our special alloys operation segment, or SAO, continues to make progress on operating cost improvement initiatives, despite the lower volume. And, as expected, our performance engineered products segment, or PEP, was significantly impacted by the weakness in the oil and gas businesses as well as the lower sequential demand for aerospace titanium fastener materials.

Now, let's turn to slide 6 and discuss the end-use markets in more detail. Our aerospace and defense end-use market saw year-over-year growth driven by a modest increase in engine material sales and strong demand growth from materials used in structural applications. We are also seeing continued strength in our defense-related sales with continued spending on supported programs. This is the fourth consecutive quarter of year-over-year growth for aerospace and defense.

As we pointed out on our last call, we did experience a sizable sequential decrease in demand for titanium fasteners, following a robust fourth quarter, as well as the normal seasonality impact. Overall, we remain bullish on the aerospace market based on projected build rate and our position on new engine platforms in airframe. Specifically, Carpenter supports each of the new designs offered by major jet engine manufacturers with high performance materials which are utilized for critical, high temperature applications such as turbine disks and rings, fasteners, and bearings.

Carpenter also supports the next-generation variants of single aisle and wide-body commercial aircraft with high-strength and corrosion-resistant materials, which are manufactured into landing gear, structural, and actuation components. This includes stainless, titanium, and super alloy products. Carpenter is also the leading source of supply for materials used in aerospace electrical, avionics, and other safety-critical system applications. Looking forward, we remain confident in the aerospace market fundamentals and our ability to extend influence as our Athens facility becomes further qualified.

Turning to energy. Our energy end-use market continues to be impacted by low oil and gas prices and reduced global demand which has significantly reduced drilling and completion activity. A key indicator for demand of our materials is the North American quarterly, directional, and horizontal rig count which is down 51% year over year. But, it is important to note that this is a market that is still very strategic to Carpenter. Oil and gas drilling will continue to move into harsher environments where corrosion resistance and strength are critically important. These conditions are where we can further differentiate ourselves as Carpenter offers material solutions that extend the life of the tools and reduce the net cost of operation for our customers.

For example, our Amega West business, a manufacturer and service provider of complex machine components for drilling and exploration and a part of our PEP segment, has built close relationship with our customers and continues to invest in the development of new material solutions for items such as mud motor applications, rotary shafts, and non-magnetic collars. This focus on new products, as well as superior customer service, is enabling Amega West to gain share, albeit in a depressed market. We believe these close customer connections will yield dividends when the market recovers.

Moving to transportation which continues to be our fastest-growing end-use market as sales are up sequentially and year over year. North American light vehicle and heavy-duty truck production is forecasted to be near record levels at approximately $17.5 million and $500,000 respectively. Further influencing our sales growth in this market are regulations such as reduced emissions in support of CAFE standards and improved fuel efficiency under US federal and EU emission standards which favor our technology and industry-leading products. These dynamics allow us to increase positions on engine fastener, valve, and fuel system applications, leading to a richer mix of products.

As an example, we recently won with a large OEM for exhaust valves that require our alloys to accommodate higher internal combustion temperatures. This is just one area where we are working hard to leverage our strengths and grow our share in the marketplace.

Sales to our medical end-use market were down 6% year over year, but our mix continues to improve. We experienced a competitive market for our transactional business. However, we continued to experience strong demand for our premium titanium, nickel, and cobalt materials used for implants. In fact, we see opportunities to grow sales further for these higher end applications.

Sales into the industrial and consumer end-use market declined year over year. This was driven by two ongoing factors. First, slowing global economies have reduced demand for these products, especially through the distribution market. Second, we have seen a ripple effect from lower crude oil prices as a meaningful amount of our industrial material sales are used for components and processing equipment within energy-related sectors. Having said that, our overall year-over-year sales into this end-use market declined at a lower rate than volume, evidencing a stronger mix of product.

Now, let me turn the call over to Tim to cover the financial review.

Thanks, Tony. Good morning, everyone.

Let's start on slide 8 with the income statement summary. Net sales in the quarter were $456 million, or $385 million excluding surcharge. Sales excluding surcharge were down 17% sequentially on 15% lower volume. The gross profit margin, excluding the impacts of surcharges was 17.8% in the current quarter as compared with 19.1% in the sequential quarter. The reduction in gross margin reflects the impact of the lower sequential volume. It was critical for us to drive operating cost improvement initiatives as the lower volumes would have had a much more significant impact on gross margin had we not taken the actions we took to reduce operating costs. More work needs to be done on driving operating costs lower, but we remain confident that we can build on the momentum we have seen over the last two quarters.

In the quarter, selling, general, and administrative expenses were $43.4 million which is down $1.8 million sequentially and $3.6 million year over year. The results reflect continued focus on cost control throughout the organization. Operating income was $24.8 million in the quarter. Excluding pension EID, the restructuring charges, and special items, operating income was $32.6 million, or 8.5% of net sales excluding surcharge. We will walk through the significant drivers of the sequential change in adjusted operating income in a later slide. Also to note, on a year-over-year basis, operating margins improved by 290 basis points.

Our first-quarter effective tax rate was 44.7%, which includes a $2 million discrete tax charge as a result of our decision to pursue the sale of an equity method investment in India. Excluding this discrete charge, the effective tax rate would have been 32.3%, which is in line with our anticipated normal rate for the fiscal year 2016.

Net income for the quarter was $8.9 million, or $0.18 per share. Adjusted for the $4 million of after-tax restructuring charges and special items, which I will cover in the next slide, earnings per share would have been $0.26 per share. Let's move on to slide 9 to discuss the restructuring charges and special items in a little bit more detail.

The restructuring charges in the current quarter represent some trailing costs associated with the actions we took in connection with the restructuring plan we outlined in our prior-year third quarter. The special items in the quarter include $1.7 million after-tax of consulting costs associated with our business management office and certain strategic planning initiatives.

Also, as I mentioned on the previous slide, in the current quarter we recorded a discrete tax charge of $2 million. For your reference, the operating income impact of the restructuring charges and special items are included in corporate costs and not included in our segment operating income.

Moving to slide 10, and the adjusted operating income bridge. We have included an adjusted operating income bridge to provide some more clarity on the drivers of the sequential change in adjusted operating income from $48.2 million in Q4 of fiscal year 2015 to $32.6 million in the current quarter. Working our way from left to right on the bridge, the lower sequential volumes are mainly a result of the weakness in energy and industrial consumer markets as well as the normal seasonality, all of which was covered earlier by Tony in his comments on the markets. There was also some unfavorable mix shift from Q4 of fiscal 2015 to Q1 of fiscal 2016. This market dynamic put considerable pressure on our results. We estimate that the combined impacts of volume and mix resulted in about $33 million of lower sequential operating income.

The actions we initiated at the end of fiscal year 2015 to reduce our operating costs were especially important in this environment of lower volumes. The benefits we recognized as a result of our efforts on cost improvement had a meaningful impact on our operating income performance in the quarter. We estimated to have about a $60 million sequential cost benefit in operating income.

As a reminder, we said the restructuring actions we initiated were expected to yield about $30 million of annual fixed overhead cost savings. We remain on track for these savings. In addition, the team is working hard to execute on opportunities to further reduce variable operating costs. Lastly, the other bucket includes a $4 million benefit associated with an insurance recovery during the current quarter that is included in the SAO segment, which is largely offset by the impact of the inventory evaluation adjustment reported in our PEP segment in Q4 of 2015 that did not repeat in the current quarter.

Moving on to slide 11 and the free cash flow summary. In the first quarter, we generated $7 million of positive free cash flow. The free cash flow results for the quarter include the impact of increasing inventories by about $33 million. Historically, we tend to ship more material in the second half of our fiscal year due to some seasonality in customer order patterns. Accordingly, we generally build inventory in Q1 and Q2 and reduce inventory in the second half of the year. We remain committed to our plans for further year-over-year reductions in inventories from where we ended the fiscal year 2015.

In the quarter, we used cash to pay for $30 million of capital expenditures and received an insurance claim reimbursement of $4 million. We remain committed to our capital spending targets of $120 million for the fiscal year, and we will continue to manage capital projects closely to balance the need for maintenance and infrastructure capital against investments to capitalize on growth opportunities. Our total liquidity stands at $524 million, which includes $31 million of cash on hand and $493 million of available borrowings under our credit facility. Let's move on to slide 12.

Slide 12 is an update of the two-year $500 million share repurchase program that was authorized in October of 2014. Through September 30, 2015, we spent about $170 million to buy our shares or about 34% of the total authorized. During the first quarter, we used $46 million of our cash to purchase approximately 1.2 million shares. We remain committed to the share repurchase program and plan to continue to execute the authorization based on the needs of the business, general market conditions, and the market price of our stock at any given time.

With that, let me turn the call back to Tony.

Thanks, Tim. Let's turn to slide 14 to cover the individual reporting segments starting with SAO. Compared to fourth quarter of fiscal year 2015, net sales ex-surcharge are down [16]% on 15% lower volumes driven by normal seasonality and further demand weakness in the energy and industrial and consumer markets. And, as I mentioned earlier in my market comments, transportation remains a bright spot for demand growth. Operating margins were relatively flat sequentially. Normally, I wouldn't be satisfied with flat sequential margins, but I think it is important to highlight that the SAO team was able to achieve this result despite a 15% reduction in volumes. We are making real progress on reducing our operating costs and it is showing up in our results.

As you know, last March we implemented a plan to reduce fixed overhead costs by approximately $30 million annually, and we are on track for these savings. We are also focused on reducing our variable manufacturing costs and in a period of reduced volume, I am encouraged by the result. As we look to the second quarter of fiscal year 2016, we expect similar volumes due to the continued weakness in oil and gas demand. However, we expect to see steady demand in our aerospace and defense markets and further opportunities to grow in transportation. Although we have made meaningful progress with the cost improvement initiatives, we are by no means complete and it remains a top priority for the team.

Now, let's turn to slide 15 and the PEP segment overview. On a year-over-year basis, performance in PEP was significantly impacted by the decline in the oil and gas business due to limited drilling activities. Of the $10.1 million year-over-year operating income decline, 84% is due to the downturn in the oil and gas business. Sequentially, PEP sales and operating income were down driven by three primary factors. The aerospace demand for titanium products was lower due to short-term adjustments in the aerospace fastener supply chain, lower demand for industrial and consumer powder products, and as we mentioned in our fourth-quarter fiscal year 2015 earnings call, we had a favorable operating income impact related to inventory valuation that did not repeat this quarter.

It is worth noting that on a sequential basis, the operating results of the oil and gas businesses within PEP remained relatively constant despite a 24% decrease in revenue. This was driven primarily through tight cost control. For the second quarter of fiscal year 2016, we expect sales to be relatively consistent with the first quarter.

More specifically, we expect aerospace demand for titanium products to continue at the reduced first-quarter levels. Again, this is due to short-term adjustments in the aerospace fastener supply chain. We do not expect this to be a long-term trend. In addition, we expect continued softness in industrial and consumer demand for powder products.

Lastly, we currently expect oil and gas demand to remain at the current low levels. As we navigate the oil and gas downturn, our focus continues to be on cost control and strategic positioning. We are pursuing new and innovative ways to provide high quality service to our customers with the goal of gaining market share so that we are well positioned for the future.

Turning to slide 16, let me give you an update on two very exciting growth enablers for Carpenter. Let's start with our Athens facility. During September, we achieved our second aerospace VAP qualification for Athens. We are still on track to achieve broader aerospace VAP approvals during calendar-year 2016.

We are also making progress towards obtaining site qualification for our nickel-based, super alloy materials used in oil and gas completion applications. The standards for these materials have become more stringent and an increasing number of supply chain partners are now involved in the approval process. At this point, we have achieved the required technical targets and have five external approvals complete. This work will continue through the second fiscal quarter, and we expect to have the bulk of these qualifications completed by the end of calendar-year 2015.

Overall, we have achieved 85% of the planned, non-VAP product approvals for various end-use market applications. Within aerospace, this includes fasteners, standard grade rings, and structural stainless steels for airframe applications. Within oil and gas, the facility is also qualified to make non-magnetic drill collars, and within transportation, materials used for engine components.

Like you, we would like the process to move quicker, but we are making the appropriate progress on what is a complex and lengthy qualification cycle. I can assure you that the team remains laser-focused as it is one of our highest priorities.

I am proud of the employees at our Athens facility and their focus on safety, qualifications, and cost control. Remember, although the facility is currently running at low utilization levels as we work to obtain required qualifications, our finances reflect the full operational cost of the facility. Therefore, as the aerospace market grows and when the energy market shows even modest improvement, the operating margin benefit to our bottom line will be significant.

Now let's talk about Carpenter powder products, an exciting growth business for us. Our powder products business consists of four manufacturing locations in the US and Sweden and is one of the world's most diverse producers of spherical gas atomized specialty alloys, from tool steels and stainless steels to nickel and cobalt-based super alloys that will be produced at our recently constructed facility on our Athens campus in Alabama.

Carpenter powder products leads the way as a powder supplier for additive manufacturing, metal injection molding, coatings, and consolidated parts produced by hot isostatic pressing. Support from a strong research and development team has allowed our products to be mainstays, used in cell phones, subsea oil and gas systems, automotive fuel systems, and aircraft engines.

And, just recently, we approved a capital expenditure to build a titanium powder operation adjacent to our powder facility in Athens, Alabama. This titanium powder product offering will increase our reach into aerospace and medical markets and offer growth opportunities in transportation. We will be able to supply a complete sales offering to additive manufacturing OEMs, service providers, and machine suppliers. It is important to note that the capital spending for the project is included in the guidance we have communicated previously.

Let's turn to slide 17 and my closing comments. It is clear that the weak energy end-use market is challenging to Carpenter and the entire industry. However, it is important to note that our products and markets are generally not significantly impacted by the major issues that are being experienced by those that participate in flat rolled commodity stainless steel markets, such as significant global overcapacity, a surge in low-cost imported materials, and low nickel prices. We are defined by our high-value, long-only differentiated products that are used in demanding niche applications.

We expect second-quarter volumes to be in line with first-quarter volumes. However, we expect to see increased volumes in the second half of fiscal year 2016. Specifically, aerospace and defense exceeding fiscal year 2015 levels and additional growth opportunities in the transportation market. Although the weak oil and gas market will create challenges, it also creates opportunities for us to continually reevaluate our cost structure. The cost actions to date are good early steps to improve the business and better position us going forward as a more flexible and profitable Company.

We will maintain our efforts to improve working capital efficiency and maintain capital spending discipline. We will continue to execute against our share repurchase program. We have added key new management talent to the Carpenter team. They have critical skill sets and experiences that will support and supplement the current management team. And, most importantly, we have a workforce that is engaged and eager to move this Company forward.

Thank you for your attention, and I will turn it back to the operator to open the line for your questions.

(Operator Instructions)

Gautam Khanna, Cowen and Company.

Good morning Tony.

Good morning, Gautam, how are you?

Doing great thanks. Just wondering if you could update us on your buyback plans as your CapEx -- I'm sorry, your inventory targets for the year? Do you expect to have a net drawdown of inventory this year? And, what should we make of the pace of the buyback slowing in the second and third months of the quarter? How should we think about that going forward?

Yes, so I will take the first one. Your inventory question. Yes, it is still our plan to work hard to get the $50 million of inventory out. As we said, the first quarter is usually higher as we get ready for the higher shipments that we expect in the second half. So, we still remain committed to that.

In terms of the buyback, it is not going to be linear. We are on pace, I think, to execute that program. Obviously, there are times that we can and can't be in the market. We take that very seriously. So, I wouldn't read anything into that as far as our intent to move forward.

Okay. And, can you just talk a little bit about what the utilization level is at Athens right now and where you expect it to be given the demand increase you're expecting in the second half, exiting this fiscal year?

Right. It's a tough question, Gautam, as you and I have talked about several times. We are at a low level of utilization in Athens right now. You could say we are at 15% to 20%. We'll have to see how the oil and gas market behaves in the second half of our fiscal year and how the qualification process moves, but I don't anticipate that moving significantly upward over the rest of our fiscal year.

Okay. That's despite the aerospace qualifications being reached.

Yes, well, we've got -- remember -- I think as you look at the big ones that the thing that is going to move Athens, Gautam, is the aerospace market continuing to move upward. That's what is going to do it. We want to make sure that our qualifications are timed that we can take advantage of that increase. And, right now, we believe we're making good progress.

Okay. I will turn it over. Thank you, Tony.

Thanks, Gautam.

Steve Levenson, Stifel Nicolaus & Company.

Thanks. Good morning, everybody.

Good morning, Steve.

Do you guys do some work -- is there a particular oil price that you think has to be reached before demand starts to recover in that market?

Well, I will leave that to the experts, Steve. I know that there is a lot of material out there on that and a lot of different opinions.

Okay, thanks. Second on aero programs, I know one of your customers has had a few issues in some of the testing of their engines. Has that slowed down their volume of material, or are things moving forward as you expected?

We have not seen any impact on our aerospace sales or how we expect them to be going forward.

Okay. And, last question. You talked about the different powders, and you mentioned some applications. I don't think you mentioned isothermal forging. Is that something you can supply for, too? Or, would you have to make some additional investments to further process powders?

No, we would be able to do that.

Okay. Thank you very much.

Thank you.

Chris Olin, Rosenblatt Securities.

Good morning.

Good morning Chris.

I wanted to just dig a little bit further into your commentary on aerospace. Looking at your second-half expectations, is that driven by new builds? Or, are you seeing anything changing regarding the MRO or the replacement market out there?

No, we are not seeing any specific changes. Usually, our first quarter is our lowest quarter in terms of aerospace due to the seasonality. We have experienced, I think four quarters in a row now of year-over-year growth, and there is nothing out on the horizon that would tell us that that would change for us over the next three quarters.

Okay. There has been some discussion with some of your competitors and some other companies about perhaps the aerospace channel over-purchased over the last couple of quarters, and I know you hit on that with the titanium fastener side. I was just curious if you are seeing any added inventory in the other materials that you supply?

No, we are not.

Last question. When you talk about the certifications or the approval process with Athens, how long does that typically take to -- after the approvals are given -- to translate into better volumes?

Yes. Well, right now if you look at the oil and gas, it is going to take the market coming back, right? To have any significant volumes down at Athens.

If we saw some approvals on aerospace in calendar 2016, would we assume that that drives volumes in the calendar 2017 year? Or, how do I think about the aerospace contribution?

Yes.

Got you. Thank you.

Thank you.

Andrew Lane, Morningstar.

Good morning. Could you talk a little bit about what the product mix of your backlog looks like right now, particularly for aerospace shipments? Are the orders in your backlog by and large associated with higher-margin product lines relative to what you shipped in fiscal 2015?

I would say if you take a look at our backlog, it is pretty consistent. It is down a bit, only because the lead times have come in a little bit. But, if you look at the mix, I would say it is pretty similar.

Okay. Thanks. And then, finally, given that you guided to $120 million of CapEx this year, I wanted to ask as to when you expect to incur CapEx for the new titanium powder project at Athens? And, if it starts this fiscal year, where does that leave your estimate for sustaining CapEx on an ongoing basis?

We will spend a little bit of money in this fiscal year on titanium powder facility. Not all of it. But, that will be spent within the $120 million.

Right, so on a sustaining basis, or maintenance CapEx basis, do you have a general estimate for where you stand?

We don't give that specific guidance. I will say that over the last couple of years, we are around 80% to 85% of depreciation.

Okay. Thank you very much.

Yes.

Josh Sullivan, Sterne CRT.

Good morning.

Good morning Josh.

Can you just clarify where you were caught off guard in September versus the guidance in July? Obviously, the markets were in a tough position. What were the assumptions that led to that revision? And then, more importantly, the current guidance, are you exposed to any of those similar type of dynamics?

Well, I am not sure exactly what you mean when you say caught off guard. What we try to do is monitor the market on a daily, weekly, monthly basis. We think it is appropriate for us to give updates if we think that's material which is what we did.

The market has moved significantly over the last six months. I think everybody would agree with that. When we saw that, we made note of it.

Okay. That's fair enough. And then, just given the decline in nickel pricing, is there any possibility of an inventory adjustment at some point? Or, are the contracts mostly passed through, and that's not an [issue]?

No, we don't anticipate any adjustment there.

Okay. Thank you.

Thank you.

(Operator Instructions)

Phil Gibbs, KeyBanc Capital Market.

Good morning Tony.

Good morning, Phil.

I had a question on the cost reductions on your bridge here? $16.4 million, you're citing lower quarter on quarter. Any idea or sense how much of that is variable versus fixed cost reductions?

Yes, I will let Tim take that question, Phil.

Hi, Phil, this is Tim. We captured all of that in that one bucket of costs as you can see and as you noted. We said we were -- on the last call on the fourth quarter call that, if you take that $30 million and you look at it on a quarterly run rate, I think we said we had a pretty significant portion in Q4 and then we are kind of hitting our target here in Q1. So, there is some incremental but not a lot on the fixed cost side from Q4 to Q1. And then, whatever is left is, call it variable.

Okay. That is helpful. And, on the side of -- I think it was an insurance settlement. Was that in your $41 million of profitability for SAO in Q1? Or, did that flow through separately?

Yes. As I mentioned, Phil, the $4 million was part of our operating income in Q1. That was an insurance recovery. We had some extra costs last year related to that particular issue. So, it is just part of the flow in operating income.

Okay. And, just lastly, from a housekeeping perspective, I think we were looking for about $8 million in interest expense in the quarter came in at $6.6 million. Is that the rate we should be thinking about moving forward?

That's going to move around a bit based on some interest rate swaps and some other things but I would say that could be fairly consistent on run rate.

Okay. Thanks, Tim. Thanks, Tony.

Thank you.

And, that concludes the question-and-answer portion of today's call. Let me now turn it over to Mr. Mike Hajost for any closing remarks.

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

Ladies and gentlemen, that concludes today's conference. Thank you for your participation. You may now disconnect. Have a great day.