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Materion Corp (NYSE:MTRN)
Q2 2020 Earnings Call
Jul 23, 2020, 9:00 a.m. ET

Contents:

  • Prepared Remarks
  • Questions and Answers
  • Call Participants

Prepared Remarks:

Operator

Greetings and welcome to the Materion Corporation Second Quarter 2020 Earnings Conference Call. [Operator Instructions]

It is now my pleasure to introduce your host Steve Shamrock, Interim Chief Financial Officer. Thank you. You may begin.

Stephen F. Shamrock -- Interim Chief Financial Officer

Good morning. This is Steve Shamrock, Interim Chief Financial Officer. With me today is Jugal Vijayvargiya, President; and Chief Executive Officer.

Our format for today's conference call is as follows. Jugal Vijayvargiya will provide an update on COVID-19 and key strategic initiatives. Following Jugal, I will review detailed financial results for the quarter and then we will open up the call for questions.

Before we begin, let me remind investors that any forward-looking statements made in this announcement, including those in the outlook section and during the question-and-answer portion are based on current expectations. The Company's actual future performance may materially differ from that contemplated by the forward-looking statements as a result of a variety of factors. Those factors are listed in the earnings press release we issued this morning.

Additionally, comments with regard to earnings before interest and taxes, net income and earnings per share reflect the adjusted GAAP numbers shown in attachment number 5 in this morning's press release. The adjustments are made in the prior-year period for comparative purposes and remove special items, non-cash charges and certain income tax adjustments.

And now, I'll turn it over to Jugal for his comments.

Jugal K. Vijayvargiya -- President and Chief Executive Officer

Thanks, Steve, and welcome, everyone. I hope all of you and your loved ones remain healthy and safe, as we continue to manage through these challenging times.

Today, I'll provide a COVID-19 status, followed by an update on our key strategic initiatives. Health and safety of our people continues to remain our overriding priority. Throughout this very difficult time, we've taken input from all available sources and implemented protective measures for our people. To date, 11 of our employees have tested positive for the virus. And I'm happy to report that they're all doing well at this time. Nine people have returned to work, while two are quarantined at their home. A majority of our office employees continue to work from home, while all of our factories continue to operate.

As you would expect, we felt the full impact of COVID-19 in a number of our key end markets in the second quarter, including consumer electronics, energy, industrial, automotive and aerospace. Despite these very challenging market conditions, we delivered sequential value-added sales and earnings growth.

Defense end market sales rebounded in the second quarter and we continue to see strong demand going forward. Sales in the medical market, particularly healthcare equipment used in the fight against COVID-19 contributed to sequential growth. We expect this to continue into the third quarter.

In response to reduced demand, we actively managed our costs, which you can see in our financial results. Sequentially, our sales increased 2%, while earnings increased 14%.

Let me now transition to providing an update on our One Materion multi-pillar profitable growth initiatives. Once again, I have some exciting news to share. You will recall, we held a special call announcing the signing of Optics Balzers acquisition. Our teams have worked diligently to close the acquisition in just six weeks. This week, I'm excited to officially welcome Optics Balzers to the Materion family. The combination of our two companies creates the world's leading thin film optical coatings provider, with a highly complementary geographic, product and end-market portfolio.

With this acquisition, Materion significantly expands its geographic reach extending beyond its core of North America, to include Europe and Asia. Optics Balzers maintains a very strong European presence with two R&D and manufacturing locations in Liechtenstein, in Germany. In addition, Optics Balzers recently launched a state-of-the-art manufacturing facility in Malaysia, which has been a key enabler for growth in Asia.

Complementary technologies across the electromagnetic spectrum use the capabilities of the combined thin film optical coatings portfolio and position Materion to capitalize on key mega trends in the areas of life science, consumer and industrial. We're excited to get started on the value creation opportunities.

Our engineered clad strip project, which I announced in the last call remains on schedule. As a reminder, we entered into a business arrangement with a new customer to expand our manufacturing capacity for a highly engineered clad strip product, which will be used in a next generation model of an existing product. The total investment of the project is expected to be approximately $85 million.

You will recall, we had received $12 million of the approximately $70 million the customer would want. Now, I can report to you that the customer has paid us $31 million with additional payments scheduled to be made over the next year. In support of this customer program, we are actively working to establish a new leading-edge manufacturing facility for future product supply. We're making progress on negotiating a long-term supply agreement and still expect to finalize later this year.

Lastly, a quick update on PAC facility consolidation project to improve our cost structure. We completed the closure of the Detroit, Michigan service center in the second quarter and remain on schedule to exit the Fremont, California location by the end of this year.

In closing, we remain committed to take all necessary precautions to protect our people. I'm extremely proud of their dedication to our company during these difficult times. Despite all of the macroeconomic challenges we are facing, we are continuing of course to follow our One Materion multi-pillar profitable growth strategy.

Now, I'll turn the call over to Steve to cover the financials.

Stephen F. Shamrock -- Interim Chief Financial Officer

Thank you, Jugal, and good morning to everyone joining us on the call today. During my comments, I will cover second quarter 2020 financial highlights, review profitability by segment, provide brief comments on the balance sheet, cash flow and modeling assumptions. And finally, cover the earnings outlook for third quarter 2020. Following my remarks, we will open up the line for questions.

In the midst of a global pandemic, I am pleased to report second quarter results, which exceeded the first quarter. Second quarter, value-added sales, which exclude the impact of pass-through metal cost. We're a $161.6 million, up 2% compared to first quarter value-added sales of a $158.7 million and down 17% versus second quarter of 2019.

Compared to the first quarter, defense, telecom and data center and medical end-market sales improved, which offset reduced demand in markets impacted by the COVID-19 pandemic, including automotive, consumer electronics, aerospace and industrial. We also had higher raw material hydroxide sales on a sequential basis of approximately $4 million. On a year-over-year basis, all major end markets except semiconductor were down, due to the impact of the pandemic. With the consumer electronics, industrial, energy and aerospace end markets were most severely impacted.

Gross margin was $48.1 million in the second quarter, compared to $69.6 million in the prior year, second quarter. Excluding special items related to COVID-19, adjusted gross margin was $50.8 million or 31% of value-added sales, an improvement compared to the first quarter adjusted gross margin of 30%, versus the 2019 second quarter, gross margin was down due to lower sales volumes and resulting manufacturing inefficiencies.

Selling, general and administrative expense totaled $32.9 million, a decrease of $7 million versus the prior year of $39.9 million, excluding special items related to the acquisition of Optics Balzers, adjusted SG&A expense totaled $31.5 million. As a percentage of value-added sales, adjusted SG&A expense was 19% in the quarter, down 100 basis points from 20% in the prior year period. We continue to aggressively manage our core SG&A expenses in response to current demand trends.

Research and development expense of $4.5 million increased 11% versus 2019. As we continue to make investments to develop new products and applications to drive long-term profitable growth.

In the second quarter, we recorded restructuring expense of $2.4 million related to the previously announced closure of our Detroit and Fremont facilities primarily for relocation costs and severance. We also reported a $2.2 million foreign exchange gain related to a special item regarding our purchase of Optics Balzers. The purchase price was denominated in Swiss Franc, so we entered into a foreign currency hedge when we sign the agreement to limit our exposure.

We reported second quarter EBIT of $9.6 million compared to the prior year second quarter EBIT of $19.6 million. Excluding special items related to COVID-19, restructuring charges and the acquisition of Optics Balzers, adjusted EBIT was $13.9 million or 9% of value-added sales.

Looking at income taxes, we recorded income tax expense of $1.6 million in the second quarter of 2020, an effective rate of approximately 19.5%, in-line with our previous guidance.

Finally, net income in the second quarter totaled $6.7 million. On an adjusted basis, we reported net income of $10 million or $0.49 per diluted share, compared to $0.43 per share in the first quarter. The increase compared to the first quarter was due primarily to commercial performance improvements driving higher gross margin. Compared to the prior year, decrease was driven by lower value-added sales, partially offset by spending cost controls.

Now, let me review 2020 second quarter performance by business segment. Looking now at our Performance Alloys and Composites business, value-added sales were $89.8 million, an increase of $6.1 million or 7% compared to the first quarter but down versus a $115.3 million in 2019. The sequential increase is due to stronger demand in defense. Compared to the prior year, the decrease in sales can be attributed to lower demand across all major markets, primarily as a result of COVID-19.

EBIT excluding special items was $12.3 million or 14% of value-added sales, compared to EBIT of $8.2 million in the first quarter and $19.1 million in 2019. The sequential improvement in EBIT is due to commercial initiatives to drive higher sales and improved mix. The decrease in EBIT versus 2019 is due to lower sales and reduced manufacturing efficiency, lower production volumes.

Despite the global pandemic, PAC managed to deliver the tenth consecutive quarter of double-digit profit margins and sequentially improved EBIT margins by approximately 400 basis points compared to the first quarter.

Moving to advanced materials, value-added sales in the second quarter of 2020 were $54.7 million, versus $58.3 million in the prior year. Semiconductor end market sales were up 4% versus the prior year, the third consecutive quarter with a year-over-year increase. However, the impact of the pandemic on the energy, industrial and automotive end markets more than offset this increase.

EBIT excluding special items was $5 million in the quarter, compared to $6.1 million in 2019. The decrease in profitability was due primarily to the decrease in sales volumes and unfavorable manufacturing performance. Compared to the first quarter, EBIT margins improved from 8% to 9% due to favorable product mix and aggressive cost management, despite the sequential decline in value-added sales. Looking ahead, we continue to focus on improving manufacturing performance in this business.

Turning finally now to the Precisions Coating segment, second quarter value-added sales were $17.8 million, down compared to $23.1 million in the second quarter of 2019, primarily due to lower sales of the Large Area Coatings product for the blood glucose test strip market. As you may recall, we announced our intention to sell this business on our first quarter earnings call. We continue to expect to complete the sales process later this year.

Excluding the LAC business, second quarter 2020 value-added sales were $15.1 million, down 2% year-over-year, due to lower market demand in industrial and consumer electronics related to COVID-19. EBIT excluding special items was $2.4 million, a 13% of value-added sales, compared to $1.2 million in the first quarter and $3.9 million in the second quarter of 2019. Compared to the first quarter, EBIT excluding special items improved by $1.2 million due to higher optical filter sales and manufacturing performance improvements. The decline in profits versus the prior year was entirely driven by the decrease in sales within the LAC business, partially offset by cost reduction actions.

Moving now to the balance sheet and cash flow. The company ended the second quarter of 2020 with a net cash position of $113.3 million and a $179.1 million available on the Company's credit facility. We continue to have more than adequate liquidity to manage in this challenging environment. Despite everything that has happened this year I want to point out that we have improved our net cash position by over $41 million, compared to the second quarter of 2019. Even with the Optics Balzers acquisition, our pro forma leverage ratio at the end of the second quarter is only 0.4 well below our targeted level of 1.5.

Our capital spending increased in the first six months to $32 million, the increase versus the prior year is related to the customer funded engineered strip growth opportunity Jugal covered. We also increased our dividend in the second quarter for the eighth consecutive year. For financial modeling purposes in 2020, capital spending should run approximately $30 million net of the customer prepayments related to the new engineered strip project, mine development investments should be approximately $14 million. Annual depreciation and amortization should run approximately $40 million and assume an 18% to 20% effective tax rate excluding special items.

And finally, now the earnings outlook for 2020. The impact of the COVID-19 pandemic continues to create unprecedented levels of uncertainty, making it very difficult to predict the extent to which our business, results of operations, financial condition or cash flows will ultimately be impacted. Therefore, we are only providing a near-term outlook.

At this time, order entry levels remain approximately the same as the second quarter. We continue to expect demand headwinds in several key end markets, including consumer electronics, industrial, automotive, energy and aerospace, while demand for defense and medical should remain strong. We will continue to aggressively manage our cost structure in the current environment. Assuming current conditions continue, we expect third quarter adjusted earnings to be comparable or slightly better than the second quarter.

This concludes our prepared remarks. We will now open the line for questions.

Questions and Answers:

Operator

Thank you. [Operator Instructions]. Thank you. Our first question comes from the line of Phil Gibbs with KeyBanc. Please proceed with your question.

Philip Gibbs -- KeyBanc Capital Markets -- Analyst

Hey, good morning.

Stephen F. Shamrock -- Interim Chief Financial Officer

Good morning, Phil.

Jugal K. Vijayvargiya -- President and Chief Executive Officer

Morning, Phil.

Philip Gibbs -- KeyBanc Capital Markets -- Analyst

The question that I had was around Optics and the acquisition and obviously close to your -- very recently in your guidance commentary for the third quarter, you anticipating this deal to be accretive. Is there any purchase price accounting that we need to be aware of, any help on that would be good and then are you still of the opinion that this is a $20 million EBITDA business in the next two to three years.

Jugal K. Vijayvargiya -- President and Chief Executive Officer

Yeah. Phil. First of all I can tell you that as I indicated, our team has done just a wonderful job getting this thing done in such a short period of time, six weeks, even though we're in the middle of a pandemic. So I -- the teams got to be congratulated and we're extremely pleased to have Optics Balzers and the people on board. Very excited about what I think the future holds, as we've indicated in our call that we had and the few comments that I made already earlier here. With regard to how we move forward here. I wish that they're going to be -- they're going to be in our Q3 for about a couple of months. So we'll have that in there. I don't expect really any meaningful impact here in Q3, as we just kind of bring them on board. But I think we're committed. As we have indicated, I think in our earlier call that we would expect this business to be accretive in our first year of ownership. That's our plan. We're continuing down that plan. As we've also indicated, this is really a growth play for us and we really want to have our two teams work together and drive the maximum possible growth that they can. And so we are going to be quite focused on that, but in general, I expect this business to be, as I said, not really a meaningful impact here in Q3, because it's just a couple of months, but then really starting to hit the ground running here in Q4

Stephen F. Shamrock -- Interim Chief Financial Officer

And what I would add to, Phil, to your comments on purchase accounting, obviously, I mean, we've only owned the Company for less than a week, so that's something that we're really focused on here in Q3, and obviously can give you a better update on the next call relative to the impacts of purchase accounting, so.

Philip Gibbs -- KeyBanc Capital Markets -- Analyst

You're -- I appreciate the existing clad investment is intact. I think your timeline there was late '21, early '22 but you do have existing assets that are prime to perhaps ship greater material into this opportunity later this year, in early '21.

Jugal K. Vijayvargiya -- President and Chief Executive Officer

Right.

Philip Gibbs -- KeyBanc Capital Markets -- Analyst

Maybe give us an update on what you're seeing there, should we anticipate any contribution later this year or early next year? And could it be meaningful?

Jugal K. Vijayvargiya -- President and Chief Executive Officer

Yeah, so I can tell you what we refer to as one of the short-term project to be able to fulfill some near-term demand for our customer. We are taking existing capacity. We are having to update that capacity as we mentioned last time, so we're spending some money to get that capacity to be able to produce this product. We expect that we'll be doing that here, later later this year. And if there was an issue and really what that would mean is more pandemic related or anything then it would be early next year, but we really hope that we're going to be able to later this year have some sales and then really it just comes down to the sooner we can get started, the sooner we can have an impact. There will be a ramp, as you can imagine. So, if we can get started today, then we might be able to have a reasonable impact here in Q4, but if its later, much later in the year, then it may not be able to have a meaningful impact in Q4. And that's one of the reasons why we've really just provided more of a near-term overall company guidance. So, the project is on track and just to answer and maybe anticipating up the potential question for the longer term project. It's on track, as I indicated already that we received $31 million from the customer versus the $12 million that we reported last time, so very-very good progress. And despite again, everything that's going on around us, the team is just making really really good progress to be able to hit that at the end of next year, perhaps early '22.

Philip Gibbs -- KeyBanc Capital Markets -- Analyst

And the last question. Just housekeeping. Steve, you mentioned, I believe that the mine spending this year was going to be $14 million. What is your gross capex before that and that number?

Stephen F. Shamrock -- Interim Chief Financial Officer

Yeah. So, Phil, we split that out even in terms of providing guidance. So, what we said on the -- I'll say our normal capex, we're still forecasting about a $30 million run rate, if you exclude the the project that Jugal referenced earlier for engineered clad strip. So, if you segregate that, we were at $10 million before on mine development, now we're forecasting $14 million. And that's really just based on the fact that we finalized our pit opening approach strategy and actually that's to minimize overall cost, but actually it's accelerated some of the timing into this year versus next year or so. And as you know that, that mine development expenditures can fluctuate a lot from year-to-year unlike our -- I would say, our more steady state normal capex, so.

Philip Gibbs -- KeyBanc Capital Markets -- Analyst

So it's your -- so it's $30 million of capex, $14 million of development plus the project, less the prepayments.

Stephen F. Shamrock -- Interim Chief Financial Officer

Correct.

Philip Gibbs -- KeyBanc Capital Markets -- Analyst

Okay, thanks.

Operator

[Operator Instructions]. Our next question comes from the line of Marco Rodriguez with Stonegate Capital. Please proceed with your question.

Marco Rodriguez -- Stonegate Securities -- Analyst

Good morning, guys. Thank you for taking my questions.

Stephen F. Shamrock -- Interim Chief Financial Officer

Good morning, Marco

Marco Rodriguez -- Stonegate Securities -- Analyst

Yeah, I was going to follow up on the prior question, in regards to the client for the expansion, it was a pretty nice benefit to your cash flow from operations, which we're receiving the prepayments and then obviously your capex of roughly $32 million year-to-date. Just kind of wondering, if you can kind of walk through the impact you're going to see on your cash flow statement from the prepayments and then how that kind of dovetails into the additional capex you need for that arrangement.

Stephen F. Shamrock -- Interim Chief Financial Officer

Yeah. So, Marco, what I would say is, what you're going to continue to see, even going forward is in our operating section of the cash flow, we'll continue to get additional prepayments from the customer, so that number will continue to grow. And then, as you've seen already, capex -- our capex line in the cash flow statement, it's up significantly versus just last year due to this project, so you're basically going to see a gross-up of both lines there, as we kind of progress throughout the year. So, hopefully that's helpful from that perspective, so.

Marco Rodriguez -- Stonegate Securities -- Analyst

And I apologize if I missed this, but did you segment the $32 million that you spent year-to-date between what is Materion normal or run rate versus the prepayment.

Stephen F. Shamrock -- Interim Chief Financial Officer

No, we're not breaking that out separately, but obviously that's a significant driver of the increase year-over-year, so.

Marco Rodriguez -- Stonegate Securities -- Analyst

Got it, OK. And then kind of sticking along with the PAC segment, just kind of wondering looking at the end-market breakouts that you provided in your press release, automotive, while obviously down year-over-year, it doesn't seem to be as significant as some of the other areas, and just kind of given the fact that most of the automotive manufacturers, at least in the U.S. and then obviously at times in Europe were shut down completely, just kind of wondering, I would have expected a much larger decline year-over-year. Can you maybe talk a little bit about that segment and what you're kind of seeing there?

Stephen F. Shamrock -- Interim Chief Financial Officer

Yeah, I think what you're looking at perhaps, you're doing the year-over-year comparisons there, so part of that I think it's just the baseline comparisons, Marco, that you're seeing. And part of it is, which OE is that we deal with and which customer, so it's really just also depending on that, I mean, as we've talked before, I mean our automotive business is mainly outside the U.S. so some of the, some of the shutdowns that occurred in the U.S. didn't have as much of an impact on us as perhaps the outside. So for example, Asia, we're starting to come back and so some of our businesses in Asia and then of course, in the Europe. So, I think those factors contribute to us, maybe perhaps from your view, maybe not having as dramatic of an impact on our work.

Marco Rodriguez -- Stonegate Securities -- Analyst

Got it. That's helpful. And then switching over to the AM segment. Last quarter, you guys had talked a little bit about the negative impacts you saw in Q1 due to new product launches, kind of weighing on manufacturing efficiencies. Just maybe if you could talk about or update us there, whether or not those new product launches that sort of work their way up the ramp and there is less of an impact on your margins there or anything you can kind of provide in terms of color would be appreciated

Stephen F. Shamrock -- Interim Chief Financial Officer

Yeah. So I would say that in general, we're continuing to make progress. As you can imagine the progress is not as much as we would like because of I think some of the challenges that we're facing, of course on the pandemic side. So, one of the things that we're having to do in our manufacturing facilities, is implement many-many safety procedures and protocols to protect our people. So social distancing, shift structure changes and other things. So, there is a lot of, I'll call negative impact that is happening across the board, not just in our advanced materials business. Now of course we're offsetting that and continue to drive performance improvements on advanced materials. So, just to give you an idea sequentially, our sales were down 8% on advanced materials. However, our earnings were up 2%. So, despite the 8% down in sales, we actually were able to improve our earnings and that is clearly due to the improvements that our teams are making and tell me of course, those that -- those improvements are being masked by all the -- some of the other issues that we're dealing with, as well as the sales drop of roughly 8%, that I mentioned. So, progress sequentially and we will continue to make progress into Q3, Q4, etc. from that perspective.

Marco Rodriguez -- Stonegate Securities -- Analyst

Got it. And then on the Optics Balzers acquisition and maybe Jugal if you can kind of paint a picture here in terms of a blueprint, if you will, in terms of the integration efforts that you'll start undergo here and then how you're kind of thinking about the synergies. I know that we talked before that the expectation is to have those synergies in a few years to such that just the $20 million, EBITDA type business. But maybe if you can talk a little bit more now that the Company is under your umbrella now.

Jugal K. Vijayvargiya -- President and Chief Executive Officer

Yeah. So, as we have just brought the company, as you said sort of using those words, under our umbrella, this week. Our teams have started to work very actively together. We have a integration team that we formed with an Integration Director, we recently hired just within the last week or so, a executive that has come on board will lead the integration efforts dedicated to this very-very important initiative. In that integration team, we have work stream owners from various functions and from various regions that we've defined what the level of integration is that we're going to do as well as, what the level of synergies that we will accomplish. As you can imagine, integration involves synergy related items and then I'll called non-synergy related items, right. So just making sure that our teams for example, can work together effectively. We have -- we are starting to drive maybe some common processes and common tools and at the same time driving more top-line improvements and perhaps some cost level improvements and those are more quantifiable synergy items. So we have a integration team that has been established, they have started to meet. They are developing their sort of 30, 60, 90 day, 6 month, 12-month type of plans and then it is our intent to drive that in a very, very disciplined basis.

With regard to the synergies, as in general that we've talked about in the past as well, it's our objective that we really want to focus all of our attention on growth and being able to profitably grow the combination of Optics Balzers and our business. And I can tell you that, that's one of the key work streams that we have in integration process. We're starting to look at what kind of objectives we can set for ourselves for next year and the year beyond so that the teams can put energy around those objectives. So it's very, very exciting, but of course very preliminary right now with just as having it here in the first week and we look forward to be able to provide you and others update in future calls.

Marco Rodriguez -- Stonegate Securities -- Analyst

And the last question, just from a housekeeping item on the balance sheet, inventory levels have been ticking up here sequentially for the last few quarters. Can you maybe just talk a little bit of the drivers there?

Stephen F. Shamrock -- Interim Chief Financial Officer

Yeah, sure, Marco. I would say from my side, if you think about it, especially with COVID-19 and some of the shutdowns that we had in the second quarter, I think basically, there were a lot of customer orders that were canceled. So from that perspective, it left us in a little higher inventory position. I can tell you looking forward, looking ahead, we are clearly focused on managing our working capital and actually I'd point out, if you look at our cash flow statement, we actually had less use of working capital this year versus last year. So again, it's something we're very focused on and expect to try to work down on those inventory levels in the second half of the year or so.

Marco Rodriguez -- Stonegate Securities -- Analyst

Alright, thanks a lot guys. Appreciate your time.

Stephen F. Shamrock -- Interim Chief Financial Officer

Thanks, Marco.

Operator

We have no further questions at this time. Mr. Shamrock. I would now like to turn the floor back over to you for closing comments.

Stephen F. Shamrock -- Interim Chief Financial Officer

Thank you. This is Steve shamrock and this concludes our second quarter 2020 earnings call. A recorded playback of this call will be available on the Company's website, materion.com. We would like to thank all of you for participating on the call this morning and your interest in Materion. I will be available to answer any follow-up questions. My direct number is 216-383-4010. Thank you very much.

Operator

[Operator Closing Remarks]

Duration: 34 minutes

Call participants:

Stephen F. Shamrock -- Interim Chief Financial Officer

Jugal K. Vijayvargiya -- President and Chief Executive Officer

Philip Gibbs -- KeyBanc Capital Markets -- Analyst

Marco Rodriguez -- Stonegate Securities -- Analyst

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