Arconic Corporation
Q2 2019 Earnings Call Transcript

Published: 2 Aug 2019

[Operator:]

Good day, ladies and gentlemen, and welcome to Arconic's Second Quarter 2019 Earnings Conference Call. My name is Jason, and I will be your operator today. [Operator Instructions]. I would now like to turn the conference over to your host for today, Paul Luther, Director of Investor Relations. Please proceed.

[Paul Luther:]

Thank you, Jason. Good morning and welcome to Arconic's Second Quarter 2019 Earnings Conference Call. I'm joined by John Plant, Chairman and Chief Executive Officer; and Ken Giacobbe, Executive Vice President and Chief Financial Officer. After comments by John and Ken, we will take your questions.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 our company's actual results to differ materially from these projections listed in today's presentation and earnings press release and in our most recent SEC filings.In addition, we've included some non-GAAP financial measures in our discussion. Reconciliation to the most directly comparable GAAP financial measures can be found in today's press release and in the appendix in today's presentation.With that, I'd like to turn the call over to John.

[John Plant:]

Good morning, everyone, and thank you for joining the call today. Let's move to Slide 4. You can see that for the second quarter, revenue was up 3% year-on-year to $3.7 billion, which is a quarterly record since separation. Organic revenue, which adjusts for currency, aluminum and portfolio changes, was up 10% as we continued to grow in all of our key markets. Our adjusted operating income was up 27% year-on-year and operating margin was up 240 basis points.I would like to comment on each segment's year-over-year margin expansion. Engineered Products and Solutions operating margin expanded by 310 basis points. Global Rolled Products margins expanded by 210 basis points. Transportation and Construction Solutions margins expanded by 220 basis points. Moreover, all segments had operating margin expansion sequentially. In addition to revenue, operating income, operating margin and adjusted earnings were quarterly records. Adjusted free cash flow for the quarter was $227 million. And year-to-date, cash flow has improved approximately $89 million from the prior year.We continue to return money to shareholders with the completion of 900 million shares -- $900 million shares repurchased year-to-date. The weighted average acquisition price was $19.80 per share for 45.4 million shares. Our return on net assets improved 450 basis points to 14.1%.Later in the call, I will comment on the regular items that I stated in the February earnings call, namely operating performance, cost reduction, capital allocation and portfolio separation. I'm also going to talk to our 5-year planning process, asset impairments, union negotiations, divestitures and the recruitment and appointment of the two boards and two management teams before I review our updated annual guidance. Adjusted earnings per share and free cash flow guidance will be raised for the second time in 2019. And we'll also provide EBITDA guidance for the first time.Let me turn it over to Ken to give a deeper review of Q2 performance.

[Kenneth Giacobbe:]

Great. Thank you, John. Now let's move to Slide 5 and the key financial results for the quarter. Revenue for the second quarter came in at $3.7 billion, up 3% year-over-year. Revenue was at our highest level since separation. Organic revenue, which adjusts for currency, aluminum prices and portfolio changes, was up $344 million or 10% for the quarter on a year-over-year basis. Revenue growth was driven by volume gains across all of our segments. The reconciliation for organic revenue can be found on Slide 22 in the Appendix.All of our key markets continue to be healthy, and demand for our products continues to be strong. We've included our organic revenue growth rates by market on Slide 23 in the Appendix, and I'll touch on just a few. Organically, year-over-year revenue for the total Aerospace business was up 11% with defense aerospace delivering growth of 25%. Additionally, industrial products was up 12%. Double-digit growth in these markets was supported by solid year-over-year organic revenue growth of 7% in commercial transportation and 5% in automotive.Operating income, excluding special items, for the second quarter was at the highest level since separation at $484 million, up 27% year-over-year. Both EP&S and TCS delivered record segment operating profits. Higher pricing resulted in $41 million of favorable year-over-year impacts to operating income driven by EP&S and GRP. Year-to-date, prices increased $75 million over the prior year. As we mentioned on the first quarter earnings call, we expect favorable pricing to continue throughout the year as demand for our products continues to be strong. Higher volumes in the second quarter also favorably impacted operating income by $39 million mainly driven by aerospace but also in automotive and commercial transportation. Aluminum price was favorable to operating income $19 million in the quarter.The incremental cost-out program that was launched in the first quarter was the main driver of our net cost reductions. On a year-to-date basis, the program has resulted in approximately $66 million of savings on a year-over-year basis. John will talk more about this program later in the presentation. In terms of opportunity, we continue with the transition of our Tennessee plant out of the North American packaging business to more profitable industrial products. The transition negatively impacted operating income in the second quarter. However, this was an improvement from the first quarter, and we expect to be a positive operating income in the fourth quarter.At a consolidated level, operating margin, excluding special items, was up 240 basis points year-over-year. As John mentioned in his opening comments, all 3 segments contributed to margin expansion both year-over-year and sequentially. We have included the reconciliation of operating income, excluding special items, on Slide 34 in the Appendix. Adjusted free cash flow in the second quarter was $227 million or $62 million less than the second quarter of last year. For the second quarter, we continued to focus on days of working capital with an improvement of 2 days year-over-year to 52 days. Lower inventory of 4 days was the main driver of the improvement. The greatest improvement in days of inventory was in our EP&S segment with a 7-day improvement year-over-year.Pension contributions and OPEB payments were $104 million, which was $21 million more than the second quarter of 2018. Capital expenditures decreased $35 million year-over-year to $136 million. Approximately 70% of the capital expense in the quarter was to return-seeking projects as we expand aerospace airflows, aerospace range, industrial products and forged aluminum wheel capacity. We continue to expect capital expenditures to the year -- for the year to be approximately $650 million or 4% of revenue. On a year-to-date basis, adjusted free cash flow is $89 million higher than the prior year. Year-to-date, the improved free cash flow was driven primarily by three favorable items

[John Plant:]

Thanks, Ken. Moving to Slide 8. I'll now comment on the four focus areas that I discussed in the February earnings call, namely

[Operator:]

[Operator Instructions]. Our first question comes from the line of Carter Copeland.

[Carter Copeland:]

Great progress. Congrats. Just a two parter, John. I noticed you guys made some comments around quality -- record quality in Wheels. But I wondered if you might speak to what sort of trends you've seen in EP&S in there on quality and yields. I know that was a particular point of focus. I wondered if you could just give us some insight on that. And to the extent that it impacts your CapEx -- longer-term CapEx planning, I wondered if you could touch on that as well.

[John Plant:]

Yes. First of all, quality within our EP&S business really across the board has continued to improve. In particular, I'd like to note the quality improvements as we've started to come down as we improved rates on the learning curves on some of the engine airfoils, and that's obviously very welcome.Of course, we are bringing into commission 2 new manufacturing plants over the next 3 to 5 months. That's the new plant for the molding process in Morristown, Tennessee for the insert to the airfoil business, and then a new plant in Whitehall, Michigan for the casting of the airfoils. Both of those are on track. In fact, if anything, a little bit ahead. And we're hopeful we may get some modest production out in the fourth quarter, which would be about a quarter earlier than previously anticipated. Everything appears to be on track. Obviously, we're monitoring that to make sure that our future quality is -- also continues to improve.On the second part of the question on CapEx, we've maintained the guidance given. The critical investments that we need for the expansion, particularly in our engine business, has been -- again, everything's on track. Same for the Hungary, for the Wheels business and same for Tennessee, which allows that transition out of -- into the -- more into the industrial market which occurs in the second half of 2020.So at the moment, I'll say everything is in order, and the -- I think the expectation is that we're planning to further trim our CapEx requirements going forward.

[Operator:]

Your next question comes from the line of Seth Seifman from JPMorgan.

[Seth Seifman:]

Wondering, if we think about how cash flow kind of, progresses from here and we think about some top line growth next year dropping through, the lack of severance costs, an incremental $120 million or so from the cost savings that didn't drop through this year, it would seem that there's a path to some nice cash flow growth next year with the one kind of question mark remaining there about pension. So I guess is it that -- can you speak a little bit to the potential for cash flow growth next year?

[John Plant:]

I think all the elements that you've highlighted, Seth, indeed are true. Next year, clearly we're not going to have the level of cash restructuring. I tried to provide a little bit of color of our future CapEx on -- in my response to the -- to Carter Copeland, and certainly the results of the cost reductions and some of those things I talked about in terms of margin improvement really are all positive, I think, not just for future cash flow. Clearly, we shall conclude our negotiations at some point on separation with the PBGC on the pension matter. But outside of that, the underlying theme of what you said is correct.

[Seth Seifman:]

All right. And then apologize if I missed this, but you talked about staying on for kind of, I guess, an indeterminate period of time. Did you specify which company you plan to stay with?

[John Plant:]

No, I did not.

[Seth Seifman:]

Right. Okay. And I guess that perhaps when you give us more information next quarter about the split and who's RemainCo and stuff. But at that point, we'll learn that?

[John Plant:]

Well, I'm sure you're going to press me and ask me in the future about that. Great question. But the important thing is -- was to make sure we had continuity through the separation. And I think that's just -- that's fundamental to making sure that everything is really smooth and performance continues.

[Operator:]

Your next question comes from the line of Gautam Khanna from Cowen and Company.

[Gautam Khanna:]

I heard you say your guidance implies 48 a month on the LEAP-1B. I just wondered, have you actually seen a step-down yet? Or is this just advance caution?

[John Plant:]

We saw a modest step-down of, I think, of two engines. I think in the B, that's the information I have. But it's just being cautious as well.

[Gautam Khanna:]

Okay, two engines from 52, just to clarify?

[John Plant:]

Yes. Yes.

[Gautam Khanna:]

Okay. Secondly, maybe, Ken, I was wondering, discount rates have moved down. Obviously, pension is a bit of a recurring theme. But I was just curious, given asset returns, any preliminary color on where the plan, what the deficit would look like if you snap the line today on the pension and OPEB?

[Kenneth Giacobbe:]

Yes. Yes, Gautam. So a couple of comments. First, when we look at pension and OPEB, we were down about -- or improved $322 million year-over-year. And on top of that, I would say that on the pension side, 90% of the gross liabilities froze into future service accruals and about 75% on the OPEB side. We will restrike or remeasure at the end of the year, but a couple of things that I can tell you. Last year where the discount rate was at about 4%, 4.35%, we're seeing a number more around 3.5%. Right now, we do have for you in Slide 19 of the Appendix the sensitivities. So that's about an 85% bps move on the liability side. But also, I would note that on the asset returns side, we've been doing a lot of work over the last 12 months. Last year, our asset returns were negative 3%. If we look through June of this year, we're in the low double digits. We had moved our investment strategy more to the equity side. So we've also benchmarked those returns against our peer group, and we're at about -- better than about 85% of our peers. So we will have an adverse impact, to your point, around the liability side driven by the discount rate. There will be an offset on the asset side based on our returns most likely, but we will restrike that at the end of the year. And the sensitivities are on Slide 19.

[Gautam Khanna:]

And one last one, if I may. I was just curious, John, if you could speak about the pricing progress you've made on the EP&S side and sort of what opportunities still lie ahead. Is -- how receptive, how difficult were those conversations? And kind of how -- what's your confidence on restriking versus contract buyer?

[John Plant:]

I think we have really tried to ensure that we have a future line of sight for all of these long-term contract renewals. So I can now see that several years out. And it's very much been a process. We spent even more time at -- during our 5-year plan reviews trying to understand the fundamental competitive advantage and where we had true excellence. And so, for example, in the very -- or the first and second and third blade, the hot end of the engine, where we think we have some unique capabilities. And so we think we should be paid appropriately for that level of skill set and value we bring to the capabilities of those aircraft engines. That's just one example.I mean some of these I don't really want to spend a lot of time talking about apart from the discipline has previously been, I think, very deep in the organization. And now it's something that I expect each business unit head to be able to sit and talk to me about because if I have the information, then I expect them to. And, I mean, it's a healthy dialogue, trying to maintain both good relations with our customers but, at the same time, trying to make sure that we do get paid appropriately for the level of value we bring to the engine and to the whole aircraft.

[Operator:]

Your next question comes from the line of Matt Korn from Goldman Sachs.

[Matthew Korn:]

Just a couple from me. First, we heard from one of your competitors that a certain jet engine customer is becoming more aggressive with inventory management. Are you seeing anything similar? And then second, having completed all these 5-year plans for each segment, could this turn into more clarity on medium-term targets for all the segments into year-end? Is that something we could see and understand a bit better before the split?

[John Plant:]

Okay. So let me deal with the second one first. I haven't decided yet, but I'm thinking about possibly giving some 2020 revenue guidance at the next earnings call. And obviously, we'll be giving 2020 guidance when we announce the fourth quarter in the early part of 2020.Personally, I'm not particularly a fan of giving out future hostages to fortune in terms of giving growth and margin profiles. It assumes a level of knowledge, which inevitably is imperfect. I prefer to that achievement, and the directional vectors give guidance to that. And I can't imagine me breaking out a pattern to do that in -- during my leadership of the company. So I think that deals with that one. The first question, I'm trying remember what it was now.

[Matthew Korn:]

Inventory.

[John Plant:]

Oh, inventory management. No change I've seen.

[Operator:]

Your next question comes from the line of David Strauss from Barclays.

[David Strauss:]

I want to ask you about the EBITDA guidance that you gave. The margin, I think, implied in that in the back half of the year is lower than obviously what we saw in Q2. And I know you have normal seasonality in the back half of the year, but what you're talking about with Tennessee and the BCS improvement, can you just give a little bit more detail on the margin outlook in the second half?

[John Plant:]

I have to say I didn't know that it gave that impression. So rather than me grapple for numbers as we speak, here, David, I'll say, I don't recognize it. So maybe I'll get you to recheck your math or we'll do it, and we'll have a separate conversation with you. But that's not something that's in tune with my thinking.

[David Strauss:]

Okay. All right. And then I think in Q4, you have this convert that's coming due. How do you -- what's the plan for that at this point?

[John Plant:]

So I'm going to pass that across to Ken, but essentially will be -- my expectation is we'll pay that off and redeem them.

[Kenneth Giacobbe:]

Yes. The only thing I'd add to that, David, is on Slide 18 in the Appendix you can see the share count by quarter. And to John's point, included in that is for us to settle the RTIs in cash.

[David Strauss:]

Okay. It's what I thought. I just want to confirm.

[John Plant:]

And so it's going to take both our gross and net debt -- our gross debt.

[Operator:]

Your next question comes from the line of Josh Seaport from -- or Josh Sullivan from Seaport Global.

[Joshua Sullivan:]

Just within GRP on the automotive body-in-white vertical, Arconic was a pioneer in that market. I know you've been able to swap the assets, and now you've got the 5-year review. Curious on what your capacity needs in the auto sheet are at this point. And then just as a follow-up, can you talk about growth expectations for auto sheet over the next 12 months or so?

[John Plant:]

Okay. I think the underlying secular trend of lightweighting is certainly going to be a feature in the automotive market for the next decade. And if I look at it like an average for last year, there's somewhere between 6% and 9% conversion on an annual basis. And I'm going to say on a normal order cycle, it should be enough to overcome, I'll say, auto cyclicality. Obviously, of course, you can't say that. But roughly, year-to-year, you can.We intend to -- so if I look at the GRP segment, I mean, it really falls into 3 in the future, which is

[Operator:]

Your next question comes from the line of Chris Olin from Longbow Research.

[Christopher Olin:]

You might have touched on it a bit on an earlier question, but I just want to maybe zero in a little bit here on maybe your confidence level in keeping the market share on the next Airbus titanium contract. Seems like all 4 companies are submitting bids. In the past, there have been some reliability issues with the old RTI. Just wondering if you're going to keep it and would pricing hold. Anything there would help.

[John Plant:]

Of course, I mean, nobody knows at this point whether we keep that contract. There's one specific. Of course, there are multiple contracts for titanium with the increased use of titanium in future aircraft. We're confident of the future revenues and order book for our business. I have been paying particular attention to our titanium business. And indeed, it's actually a very -- the major site, which is Niles in Ohio, is the very first site that I visited in Arconic. And during the last few months, I've tried hard to dedicate resources to that plant to have fundamental improvements in terms of quality, in terms of OEE and throughput and in terms of customer compliance and combined also with the significant inventory reduction, which I think is a fundamental part of quality improvements as well.So I think very positively about our titanium business. It's an area which I think we need to continue to focus on. I was really pleased that we were able to conclude agreements with the steelworkers on that contract and really trying to reset the -- and I think have to logically reset or at least attempted to reset the relationship between management and the steelworkers in that site. So I think it's a really important site for us, and I see plans and expect plans and achievements to improve the future profitability of it. But having said that, which I say a very positive backlog to the business, on the Airbus contract, we're all in a bid situation. We're incumbents. We are hopeful to retain our share. But I'm sure that, and I've read the same stuff that you've read about, other people think that they're going to win. I'm never so bold as to make those predictions when we're looking at bidding against other people. I don't see why I need to beat my chest and say that sort of stuff.

[Christopher Olin:]

Okay. Helpful. And then I just want to make sure I understand your comments about Boeing and the MAX. I think you said 42 on the frame and 40 in the engine. I had always been under the impression that Arconic's lead times on finished products are pretty far out there. Are you shipping at those levels? Are you shipping at where Boeing is going to be in like the fourth quarter and 2020?

[John Plant:]

We'll ship whatever Boeing, Spirit and GE want us to ship out. I'm just trying to give you guidance to what we've assumed in our plans financially going forward. So if people were to build fuselage at a higher rate, then obviously that's good for us -- or engine at a higher rate, that's good for us. Clearly, if the engine rate was lower, then we'll be moving some of that capacity to clear some of the other arrears and meet the demand on other engines that we have and in particular for the military requirements of the -- of those engines as well. And so we're sort of trying to balance everything out at the moment, but I was just trying to give you the best guidance I could in terms of our financial assumptions.

[Christopher Olin:]

That makes sense. And congrats on the success that you had.

[John Plant:]

Thank you.

[Operator:]

[Operator Instructions]. Your next question comes from the line of Seth Seifman from JPMorgan.

[Seth Seifman:]

Guys, just one follow-up here in terms of understanding the cost cutting plan. Sort of my understanding that it was directed kind of primarily at overhead. Now if I look back at like the run rate corporate cost in the back half of last year, it looks like annualized that was about $200 million. So when we think about where the cost cutting is directed, clearly the corporate costs are not going to 0, obviously. So do you consider that there was a fair amount of overhead in the segments that that's also where the cost cutting is kind of directed? Or maybe I was sort of overestimating the degree to which overhead was playing a role here.

[John Plant:]

I'm going to pass the majority of that question across to Ken. Essentially, there was significant cost cutting at the corporate level. But we also planned at a reduced percentage cost cutting at the businesses. In particular, something which we did which, I guess, maybe we haven't publicized enough is that between corporate and the six individual businesses, there were three sub-HQ levels, 1 for each of those reporting segments. So 1 for the rolled products, 1 for EP&S and [indiscernible] and 1 for TCS. Those have been eliminated altogether. So there has been cost cutting at every level.One of the reasons why you may not see a full effect of, if you do the math, SG&A is that we've also had a good problem to deal as the share price has improved, is that we've needed to remark and put through to the P&L additional charge for that, for the share compensation. So I just wanted to make sure we got that fact out, that as well it's all taken care of in the results year-to-date. And Ken, I'll pass the cost to you.

[Kenneth Giacobbe:]

Yes. Just a couple of other things, Seth, to build on John's comments. You'll see in the Q that we'll file later on today that there's multiple pieces that come out of this cost restructuring program. The biggest part is labor, and you'll see in there that about 40% of the labor reduction is coming at corporate. But it's not just limited to labor. We're looking at other items like indirect cost savings, which relate to energy, maintenance, transportation. We've also exited the aircraft that I talked about earlier on there, but we've also looked at the balance sheet. So on the retiree side, retiree life, we eliminated. We reduced some of the Medicare subsidy programs as well. So it's an all-encompassing program, and you'll see some more detail of that in the Q.

[Operator:]

Thank you, everyone, for joining today's call. We are now concluding the call. You may now disconnect.