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Arconic Inc. (NYSE:ARNC)
Q2 2020 Earnings Call
Aug 4, 2020, 10:00 a.m. ET

Contents:

  • Prepared Remarks
  • Questions and Answers
  • Call Participants

Prepared Remarks:

Operator

Good day and welcome to the Arconic Corporation Second Quarter 2020 Earnings Conference Call. All participants will be in listen-only mode. [Operator Instructions] After today's presentation, there will be an opportunity to ask questions. [Operator Instructions] Please note, today's event is being recorded.

I would now like to turn the conference over to Shane Rourke, Director of Investor Relations. Please go ahead.

Shane Rourke -- Director of Investor Relations

Thank you, Sarah. Good morning and welcome to the Arconic Corporation second quarter 2020 results conference call. I'm joined today by Tim Myers, Chief Executive Officer and Erick Asmussen, Executive Vice President and Chief Financial Officer. After comments by Tim and Eric, we will have a question-and-answers session.

I would like to remind you that today's discussion will contain forward-looking statements relating to future events and expectations. You can find factors that could cause the company's actual results to differ materially from the projections listed in today's presentation and earnings press release in our most recent SEC filings.

In addition, we've included some non-GAAP financial measures in our discussion. Reconciliations to the most directly comparable GAAP financial measures can be found in today's press release and then the appendix in today's presentation.

With that, I'd like to turn the call over to Tim.

Timothy D. Myers -- Chief Executive Officer

Thank you, Shane. And good morning everyone. We will start this morning's call on Slide 4. I'd like to welcome you to our first quarterly earnings call as a stand-alone company. For those of you who would like to follow along with the presentation slides are posted under the Investors tab on our website.

Let me start by saying, we couldn't have picked a more interesting or a more challenging time to start our journey as an independent company. On April 1, the day we launched the company, the capital markets were struggling and the credit markets were very uncertain. We quickly responded with a series of actions as a new company, with a new management team and a newly seated Board. Throughout all levels of our organization, our people have stepped up to continue operating safely, efficiently, and to deliver high quality products. As a provider of essential goods we have continued to keep our employees safe, meet our customers' needs, and provide value to our shareholders through one of the most challenging periods in our company's history.

I couldn't be more proud of our management team and all of our employees around the world. We're excited to embark on our journey as a premier stand-alone provider of aluminum sheet, plate, extrusions, and architectural product, despite the current challenges posed by the pandemic. We're optimistic about our future as the fundamentals of our business remain strong and we have leading positions in the end markets we serve. Our highly variable cost structure provides us with tremendous flexibility to adjust to the current demand volatility in our end markets.

Today, I'm going to walk through our key accomplishments during the second quarter, which is really about the swift actions we took to protect our business and strengthen our balance sheet. We will then cover second quarter financial results and move to the reasons that our company will create significant value for our shareholders.

Turning to Slide 5. From our beginning, we have moved quickly and aggressively to safeguard our employees and our business as well as support our customers as an essential supplier. During this difficult period, we prioritized the health and safety of our employees, while also taking actions to reduce our overhead and flex our operations to meet lower demand.

Within the first week of ours existence, we identified a $200 million cash conservation program, which we announced on April 8. As the quarter unfolded, we were able to identify additional cash conservation measures to increase our mitigation efforts to $250 million. Shortly thereafter, we recapitalized the company with a more flexible capital structure maintaining net leverage of around 1 times and protecting approximately $1.3 billion in liquidity. We also address outstanding legacy obligations, reducing our gross pension liability by approximately $250 million within the quarter. Continuing to reduce legacy pension, OPEB, and environmental liabilities, will remain a priority for us moving forward.

Despite the challenges of the second quarter secular tailwinds are positive for our industry. In the packaging, automotive and industrial markets, we see a clear path to return to growth. We're excited about our potential on what lies ahead of us, and I will walk you through why that is so later in the call.

Next on Slide 6, we're over achieving the cash conservation program that we announced on April 8, which delivered approximately $65 million of savings within the quarter. We've increased the cost savings projection within the cash conservation program from $150 million to $200 million through the execution of additional restructuring, footprint optimization, reducing procurement and indirect costs and identifying additional opportunities to flex our labor. This brings our cash conservation programs at $250 million, which includes $200 million in run rate operating savings and $50 million in capital expenditure reductions. It is important to note that some of these savings such as the salary reductions, the suspension of the 401K match and the flexing of labor are temporary measures. However, roughly $100 million of the cost savings are structural and permanent and are being achieved through restructuring our workforce, the planned closure and related reorganization of several small facilities, and the building and construction of extrusion segments and selectively idling assets inside of other facilities.

Turning to second quarter results on Slide 7. Revenue in the quarter -- in the second quarter of 2020 was $1.2 billion, down 38% from the second quarter of 2019, 32% organically as the global pandemic drove disruption across most of our end markets. Of the 38% revenue decline, 28% was associated with volume and mix and the balance of the decline was related to changes in aluminum price, foreign exchange and divestitures.

The company recorded a net loss in the quarter of $92 million. This included $76 million special items primarily related to a charge to annuitize UK pension obligations, debt issuance costs and restructuring and plant closure cost announced during the quarter. Adjusted EBITDA was $94 million, down 55% versus second quarter 2019, driven by the combination of pandemic related demand reduction and related disruptions to our operations, partially offset by our cost reductions. Our EBITDA margin in the quarter was 7.9%, down 310 basis points year-over-year. While the company does have a highly variable cost structure, there was a lag to flex our cost against the steep and sudden demand decline. We did see meaningful improvement in our margins by quarter's end.

Our adjusted EBITDA decremental margin in the quarter was minimized to 16%, demonstrating the highly variable nature of our cost structure. Additionally, given our strong performance in the first quarter, year-to-date decremental margin is only 6%. We expect second half margins to improve versus the second quarter as end market demand improves from the trough of the pandemic.

In spite of the pandemic related disruptions experienced throughout the quarter, we delivered positive free cash flow. Cash from operations in the quarter was $30 million and capital expenditures were $21 million, resulting in free cash flow of $9 million, up $11 million year-over-year.

With that, I'd like to turn it over to Eric to discuss second quarter results in more detail.

Erick R. Asmussen -- Executive Vice President, Chief Financial Officer

Thanks, Tim. Moving to Slide 8. As Tim stated, we were impacted by the sharp volume fall off in the quarter. As we stated, we took action to offset the volume falloff leveraging our highly variable cost structure. Also the cash conservation actions we announced in early April represent a large part of the cost actions and the balance is lower spend and continued improvement in scrap utilization and other ongoing productivity initiatives, which we will continue to leverage in the future. Additionally, as shown on the bridge, we are normalizing for the divestitures of our Brazil rolling and South Korean extrusions facilities.

Turning now to Slide 9, I'll provide more color on what occurred in each of our key end markets for the quarter. Ground transportation, which historically is about 34% of our revenue, was the hardest hit of our end markets and represented only 22% of our second quarter organic revenue. In this end market, we experienced a 57% decline in organic revenue year-on-year, primarily due to the shutdown of automotive production in the second quarter. Turning to aerospace end market, organic sales were down approximately 26% year-over-year, reflecting the challenges that face the large commercial aircraft manufacturers and the continued grounding of the 737 MAX.

Next, our sales in the industrial end markets, declined 16% organically on a year-over-year basis reflecting the volume impacts from the pandemic. Our building and construction and market was down about 20% due to construction project delays, resulting from the quarantines that went into place in Europe and North America. Lastly, our organic packaging revenue increased slightly year-over-year as we experienced resilience in this end market, which we currently service through our China and Russia operations. Our ability to future capitalized in the package opportunities is currently limited due to the non-compete, which expires at the end of October of this year.

Moving to our segment results on Slide 10. Similar to what we saw across the end markets, we saw disruption from COVID across every segment. Starting with our Rolled Products segment, our sales were $880 million, down $606 million or 41% from the prior year or 33% on organic basis, which was essentially all volume and mix related, and partially offset with the cost actions we took during the quarter. Adjusted EBITDA was down $78 million or 58% year-over-year and adjusted EBITDA margins were 8.9%, down 350 basis points from the same time as last year, reflecting disruptions in ground transportation, industrial and aerospace markets.

Sales in our building construction segment in the second quarter were $230 million, down $62 million or 21% year-on-year, primarily due to the pandemic related disruptions in construction projects. Adjusted EBITDA of $38 million was flat year-over-year and adjusted EBITDA margins were 16.5%, representing an all-time high, which were up 300 basis -- 350 basis points year-over-year as a result of the swift actions -- cost actions we took in the quarter to maintain profitability and the structural changes we've made to improve our mix in this segment.

Sales in our extruded segment in the second quarter were $81 million, down $64 million or 44% year-over-year and organic revenue was down 36%. This decline was across all end markets this segment services. Adjusted EBITDA was a loss of $13 million versus breakeven last year. And during the second quarter, we took structural action and cease production at our Maryland location and took charges of approximately $12 million related to inventory write-offs and customer credits. We continue to focus on improving this segment and we anticipate the results will improve in the financial performance over the next few quarters.

Turning to Slide 11. We will provide a view of the end markets for the back half of the year. Ground transportation has two subsets, including automotive and commercial transportation. In the automotive market, there was a V effect, rebounding from the quick decline in Q2 with steady improvement from our auto customers. We expect the second half demand in automotive to reach levels near the second half of 2019. In the commercial transportation market, we expect the balance of the year to remain challenged.

In the aerospace end market, the supply chain is adjusting to reduced build rates. We expect the second half to continue to decline and we anticipate a year-on-year decline in aerospace sales of roughly 50% in the second half. Continued improvement is expected in the industrial end market, which will benefit from the ramp up of capacity from our investment in our Tennessee operations coming online in the second half of this year as well as the uplift from ongoing international trade actions.

For the building and construction end market, we expect this to remain somewhat challenged for the rest of the year and our current view is it should be flat to modestly down for the second half. Lastly, in the packaging end market, the second half expected to be roughly flat with the first half has the non-compete expires at the end of October. While the non-compete expiration is expected to provide opportunities for our Tennessee, China and Russia facilities, it will take some time to qualify customers and ramp up production.

Turning now to the balance sheet on Slide 12. We ended the quarter with total debt of $1.3 billion, total cash and equivalents of $595 million, resulting in total net debt of approximately $700 million. Net debt to 12 -- to the trailing 12 months EBITDA is approximately 1 times. As Tim mentioned, soon after launching the new company in April, we undertook an initiative to overhaul our capital structure. This essentially entailed issuing a $700 million first lien note due in 2025 to replace the $600 million Term B note and also involved replacing our revolver with an $800 million ABL facility, which capitalize on our high quality working capital for liquidity. As of the close of the quarter, we have total liquidity of approximately $1.3 billion.

Turning now to Slide 13. We took action to address legacy pension obligations in the quarter, reducing gross pension obligations through purchase of group annuity contracts for certain UK pensioners. The transaction required approximately $10 million of funding to reduce the gross obligation by approximately $250 million. The accounting for the settlement in the quarter from this transaction required approximately $55 million of non-cash charge, primarily related to the buyout premium utilizing surplus and the acceleration of actuarial losses in the quarter.

As shown on the chart on this slide, our gross liability after the new annuitization [Phonetic] of the UK pension completed in the quarter is now $4.6 billion and the net obligation is approximately $1.9 billion, primarily related to legacy US pension and OPEB obligations. In this regard, we have 2020 funding requirements of approximately $280 million for our global pension plans and approximately $55 million of cash funding for our OPEB obligations estimated for the year. While we have more to do to reduce our gross and net pension and OPEB obligations, our current funding along with anticipated market returns should meaningfully reduce our US obligations over time and we expect the cash funding will step down by approximately $80 million in 2021. We have provided a table in the appendix to assist a better understand the net US pension obligation.

With that, I will now turn it back over to Tim to talk about the value creation opportunities that are in front of us.

Timothy D. Myers -- Chief Executive Officer

Thank you, Eric. Let's move to Slide 14. Despite the challenges created by the pandemic in the near term, Arconic is well positioned to increase revenue, expand EBITDA, deliver free cash flow, and drive future value for our shareholders. We're focused on three primary profit drivers, all of which we are pursuing vigorously. The first is organic volume growth. As I shared at Investor Day, back in February, we have an incremental 600 million pounds of annual capacity coming online across the North American rolling mill network. To put this into perspective, we shipped approximately 3 billion pounds in 2019. So this is an uplift of approximately 20% from our prior run rate. Of course we need to secure orders to backfill our order book to 2019 levels, but the key takeaway here is that we can flex our capacity in the rolling business 20% above 2019 levels, without significant capital investment. This capacity will serve a combination of the industrial, packaging and automotive end markets, which we believe will deliver approximately $100 million to $120 million of incremental profitability. On the slides to follow, I'll discuss why we have confidence that this capacity can be filled by taking advantage of ongoing macro trends driving incremental demand into each of those end markets.

Second, we continue to expand our margins through a range of productivity initiatives, including more casting capacity, increased scrap utilization, physical and digital automation and debottlenecking of critical assets. We expect these initiatives in combination to drive between $70 million and $80 million in annual benefit on a normalized basis when compared to 2019 levels, as the market demand returns. And third, as previously discussed, we're reducing $100 million in structural costs, which we intend to maintain moving forward.

Also to Eric's point on pension actions within the quarter, while we pursue these opportunities on the operational front, we will also continue to reduce legacy obligations. This combination of adjusted EBITDA growth and lower cash needs will result in a significant free cash flow uplift as we recover from the pandemic.

Turning to the packaging market, on Slide 15. The compounded benefit of a tight domestic market for can sheet and the pending expiration of a four-year non-compete currently limiting our participation in this space, creates a significant opportunity for the company. The ongoing shift away from plastic packaging is driving incremental demand for packaging material as well as can shortages in the market right now. According to industry monitor, HARBOR Aluminum, North American demand for can sheet is expected to grow by more than 1 billion pounds over the next five years, on top of the 1.2 billion pounds of can sheet that is projected to be imported into North America this year. This trend has been highlighted recently by the Wall Street Journal, USA TODAY, NASDAQ, and HARBOR Aluminum in recent weeks. While we're not able to participate in this trend in 2020, it is clear to us that we would be a welcome supplier in this industry moving forward.

The non-compete we have in packaging expires at the end of October of this year. At that time, we will be able to explore reentering packaging production in North America and many other countries. While we do have packaging operations in Russia and China, October expiration will also open attractive export up opportunities outside of those countries. We currently have idle packaging capacity at our facility in Tennessee, which we can bring online with minimal capital outlay as well as incremental capacity we can bring to bear in both Russia and China to service this market. If we are able to achieve favorable terms to service this market following the expiration of the non-compete, the packaging market can represent a meaningful part of the EBITDA potential associated with the 600 million pounds of latent capacity we have in our North American network.

Moving to Slide 16. In the automotive market, CRE projects North American auto body sheet growth of approximately 900 million pounds from 2019 through 2024. This is a result of ongoing lightweighting across the automotive industry and especially in the growing truck and SUV segments. Greater penetration for aluminum is anticipated and currently underrepresented portions of the vehicle, including door panels, Liftgate, and center. CRU also projects higher aluminum adoption in electric vehicles versus gas and diesel powered vehicles. Anticipating an uplift of 15% to 27% of content in those vehicles as the transition to electric vehicles evolves.

As the technology leader in the industry, Arconic is poised to gain share of additional auto body sheet growth. We currently anticipate participate on more than 60 vehicle programs and have auto body sheet production at four different facilities. Our A951 bonding technology has become an industry standard since we first implemented in 2014. And we continually coordinate with OEMs on new opportunities to push the boundaries of lightweighting, safety, and styling across their product offerings.

Earlier this year, we announced an important contract win with General Motors on the revamped large 2021 SUV programs, which is ramping up as we speak. This win is a subset of eight new programs that are launching this year with [Indecipherable] and an important example in a very healthy segment in the industry. In fact, latest production rates saw light trucks and SUVs, comprising about 72% of the 2019 North American vehicle market with expectations that this percentage will grow reaching 78% by 2025. And light trucks are the largest users of aluminum in the industry, particularly Ford's aluminum intensive F-Series pickup trucks, which have been America's Number 1 selling vehicle for over four decades in a row. They have recently announced keeping this truck all aluminum. There are other highly successful aluminum intensive vehicles, the Super Duty, the Navigator, and the Expedition, all continue to sell very well in the marketplace, and we are a significant supplier on all of those platforms.

Pulling that altogether, we project continuing to grow above market in 2021 and beyond. For reference, the latest IHS Markit projections for 2020 North American automotive production is 12.6 million vehicles, increasing the 14.6 million vehicles in 2021, which would be an increase of 15%. If those projections are met, our sales in this segment should grow by more than 20% year-on-year.

Turning to Slide 17. We have an update on the industrial market, and specifically common alloy products. Common alloy products are precisely the part of the industrial market, we are targeting with the investment we are bringing into production in Tennessee in the back half of this year. Earlier this year the Aluminum Association, of which we are a party, filed the trade case against the unfair imports of common alloy products from 18 countries. In 2019, those countries improperly exported into the US more than 1.4 billion pounds of subject goods, which had the effect of suppressing prices and volume for domestic producers. In April, the US International Trade Commission affirmed that this behavior has harmed domestic producers. Preliminary duties are expected from the Department of Commerce later this year. And final determinations are expected in early 2021. As a result, exports from those 18 subject countries are already declining significantly in 2020 and are down 44% year-over-year through May. We expect them to fall further if preliminary duties are enacted in August and October accordingly.

Using history as a proxy, the 2018 trade case against Chinese producers of common alloy products resulted in an 88% decline, depicted in yellow on the chart, from the year prior to the trade case to the year after the trade case, which opened up roughly 700 million pounds to the domestic market. If we apply this to the 1.4 billion pounds imported in 2019 from the 18 countries participating in unfair trade, depicted in aqua on the chart, the decline would be approximately 1.1 billion pounds in imports from these countries, roughly 25% of the entire North American common alloy sheet market. This provides a significant opportunity for domestic producers such as ourselves capture volume and restore pricing in this market.

Moving to Slide 18, I'll explain why we at Arconic are excited about our future. In times like these, it is clear that there are many other things that are outside of our control. But putting those aside, there are three key value drivers that we can control and we have a decent track record of doing exactly that. First, we estimate EBITDA opportunity associated with bringing 600 million pounds of additional capacity to market to be between $100 million and $120 million of incremental profitability. In order to secure it, we need to capture roughly 20% of the 3 billion pounds of demand that was covered on the previous three slides. In all three of these markets, we are ready to serve.

Next, as I mentioned earlier, approximately $100 million of the savings target we announced in April are permanent structural savings associated with workforce restructuring, elimination of rooftops and other structural measures. Finally, we're pursuing $70 million to $80 million of cost improvements, driven by increased casting capacity, higher scrap utilization, debottlenecking of critical assets and physical and digital automation.

We use the very same levers that drove the significant financial improvement we delivered in 2019 and through the first quarter of this year. We already have a playbook to unlock these savings and have a track record for delivering on them. Of course, this assumes a return back to more normal conditions in our markets. And at this point in the recovery, it is difficult for us to predict the timing across all of our end markets. However, some of them are showing recent signs of recovery and the North American packaging market in particular is a space we don't currently occupy. Despite the near-term challenges presented by the pandemic, Arconic is well positioned to capitalize on growing demand for aluminum products and we are taking the actions necessary to drive margins and cash flow across the business.

In closing, on Slide 19 Arconic was very productive in our first stand-alone quarter. We moved swiftly to initiate a cash conservation program and I've already upsize it from $200 million to $250 million within the quarter. We recapitalized our debt structure to improve liquidity and flexibility and we meaningfully reduced legacy gross pension liability by $250 million. Our quick reaction and highly variable cost structure allowed us to remain free cash flow positive throughout the quarter. This was a result of our prudent working capital management and low capital spending, which delivered positive cash flow and maintained our cash balance throughout the quarter. Finally, we've delivered -- we've identified clear line of sight on three levers that will drive nearly $300 million of fundamental EBITDA improvement to our results, which we will be actively harvesting while the end markets recover.

At this time, we'd like to take some questions. I'll turn it back over to Sarah to help facilitate those.

Questions and Answers:

Operator

Thank you. We will now begin the question-and-answer session. [Operator Instructions]

Timothy D. Myers -- Chief Executive Officer

Okay. Well, at this time we don't have any questions in the queue.

Operator

Showing no questions. I would like to turn the conference back over to Tim Myers, CEO for any closing remarks.

Timothy D. Myers -- Chief Executive Officer

Thank you, Sarah. And thanks to all of you for joining us in the call today. As I stated earlier, we're very excited about the beginning of our journey as a new company and the bright future in front of us. We look forward to providing you with another update next quarter.

Operator

[Operator Closing Remarks]

Duration: 32 minutes

Call participants:

Shane Rourke -- Director of Investor Relations

Timothy D. Myers -- Chief Executive Officer

Erick R. Asmussen -- Executive Vice President, Chief Financial Officer

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