Harsco Corporation
Q3 2016 Earnings Call Transcript

Published: 3 Nov 2016

[Operator:]

Good morning. My name is Bridgett and I'll be your conference facilitator. At this time, I would like to welcome everyone to the Harsco Corporation Third Quarter Release Conference Call. All lines have been placed on mute to avoid any background noise. After the speakers' remarks, there will be a question-and-answer period. Also this telephone conference presentation and accompanying webcast made on behalf of Harsco Corporation are subject to copyright by Harsco Corporation and all rights are reserved. Harsco Corporation will be recording this teleconference. No other recordings or redistributions of this telephone conference by any other party are permitted without the expressed written consent of Harsco Corporation. Your participation indicates your agreement. I would now like to introduce Mr. Dave Martin. You may begin your call.

[David S. Martin:]

Thank you, Bridgett, and welcome to everyone joining us today. I'm Dave Martin, Director of Investor Relations for Harsco. With me today is Nick Grasberger, our President and Chief Executive Officer; as well as Pete Minan, our Senior Vice President and Chief Financial Officer. This morning, we will discuss our results for the third quarter of 2016, our outlook for the fourth quarter, and we'll also take your questions. Before our presentation, however, let me take care of a few administrative items. First, our Q3 earnings release was issued this morning, a PDF file of the news release, as well as a slide presentation for this call have been posted to the IR section of our website. Secondly, this call is being recorded and webcast. A replay will be available on our website later today. Thirdly, we will make statements today that are considered forward-looking within the meaning of the Federal Securities Laws. These statements are based on our current knowledge and expectations and are subject to certain risks and uncertainties that may cause actual results to differ materially from these forward-looking statements. For a discussion of such risks and uncertainties, see the Risk Factors section in our most recent 10-K as well as in our 10-Q for the period ended June 30, 2016. The company undertakes no obligation to revise or update any forward-looking statements. Lastly, on this call, we will refer to adjusted financial results that are considered non-GAAP for SEC reporting purposes. A reconciliation to U.S. GAAP results is included in our earnings release today, as well as the slide presentation. Now, I'll now turn the call over to Nick to begin our prepared remarks.

[F. Nicholas Grasberger:]

Good morning, everyone, and thanks for joining us. The market trends that we experienced in the first half of the year largely continued this past quarter and our financial results were consistent with expectations. The exception was cash flow, which was stronger than expected, I'm very pleased to say that we've raised our cash flow guidance for the year. Over the past few months, we've also taken significant steps to improve our balance sheet and liquidity positions, further upgrade our executive leadership team, and also boost our operating leverage. The highlight within Harsco continues to be Metals & Minerals. Despite weak steel production and low commodity prices, M&M margins have stabilized that their highest levels in over 10 years due to cost reduction and a much improved mix of contracts. Underperforming contracts have declined from about one-third of the portfolio two years ago to well under 10%. At the same time, working capital and capital spending efficiency are much improved driving cash flow this year to a level 2 times to 3 times the average generated over the past five years. As we look ahead to 2017, we're hopeful some improvement in market conditions will fuel continued the earnings growth. But in any case, we are excited about the growth opportunities in new contracts, add-on services at existing sites, and in applied products. And in terms of operational excellence, we continue to implement best practices across our sites to both reduce costs and boost our competitive position. The Industrial segment continues to demonstrate its resilience at the bottom of its industry cycles. I've been very pleased with the cost reduction and working capital improvements that have enabled the segment to maintain a double-digit operating margin and solid cash flow despite the sizable drop in revenues. We believe we have seen the trough of these markets and look forward to some recovery in 2017, however modest it might be. The pipeline of project opportunities in heat exchangers, commercial boilers and high security fencing for next year is also encouraging. Volumes in our Rail business are at their lowest level since 2009, consistent with the reduction in capital spending for maintenance equipment by the Class I railways here in North America. In addition, the delivery dates on our equipment orders have been deferred to next year by our customer. Overall equipment sales in the core North American market are expected to be 30% to 40% lower this year than the average annual shipments over the past five years. However, aftermarket sales have held up much better and are up about 10% compared to last year. In terms of our contracts with the Swiss National Railway, the initial delivery of vehicles occurred during the quarter and the early test results are quite good. I met with a customer last week, and they are very pleased with the quality of the vehicles. So despite the recent challenges with the contract, I'm confident that our relationship with SBB will be both long lived and profitable. Finally and most importantly, Jeswant Gill joined us few days ago as the new President of Harsco Rail. Jeswant brings the leadership, energy, and experience that we need to capture the opportunities available to us in the global maintenance-of-way market. So in summary, as we navigate the final few months of 2016 we look ahead to next year with a great deal of optimism. Each of our three principal end markets, steel, energy and rail, likely touched bottom this year, and yet cash flow and EBITDA minus CapEx margins will be at their highest levels in several years, while operating margins remain in the high single-digits. The balance sheet is also the healthiest in many years. Financial leverage is nearing two times, and yesterday we secured committed financing for the next five years to seven years. And with the recent appointment of new leadership in Metals & Minerals and Rail, we have a very strong committed executive team anxious to turn its focus to rowing our company. Before I turn the call over to Pete, I want to take a moment to publicly thank our employees who work so hard and effectively in helping Harsco turn the corner. To be sure, we have more to accomplish, but I also know how far we have come. So I could not be more proud of the Harsco organization. I'll now turn the call over to Pete.

[Peter Francis Minan:]

Thanks, Nick, and good morning, everyone. So let me start on slide four of the materials. Operating income in the third quarter was $29 million, and this result was within our guidance range of $27 million to $32 million. As Nick said our Metals & Minerals segment had another strong quarter due to a variety of positive factors. The regions that contributed to a better result included our Europe, Latin America, Middle East, and North American regions. The contributing factors in these regions are varied, and included drivers such as higher nickel volumes in the U.S., service volumes and mix in Europe and the Middle East, steel output in Latin America and lower operating costs at some sites. But again, no single variable helped the quarter given the diversity of our M&M business. Also corporate costs were a bit lower than forecasted due to our continued reduction in staffing and other expenditures. Compared to the 2015 quarter, as was the case in recent quarters, Metals & Minerals realized an increase in operating income as a result of our internal initiatives or improvements despite limited to mill (08

[Operator:]

And your first question comes from Jeff Hammond with KeyBanc Capital Markets.

[Jeffrey Hammond:]

Hey, good morning, guys.

[F. Nicholas Grasberger:]

Hey, Jeff.

[Peter Francis Minan:]

Hey, how are you doing?

[Jeffrey Hammond:]

Doing well. So I guess with the financing in the balance sheet certainly in solid shape, M&M performing well and looks very stable and encouraging. Just maybe update us on how you're thinking about the portfolio discussion in your announcement a little while back about splitting the businesses or looking at strategic alternatives?

[F. Nicholas Grasberger:]

Sure, Jeff, good question. Well, we certainly are as committed to a separation process as we were about a year ago when we announced our intent to do so. Of course, though we're very focused on getting the highest value per shareholder as possible, and therefore with the markets remaining quite weak, we simply don't believe that the timing has been ideal to do that. So we're still focused on it, we're still watching the markets of course very, very carefully, but it's really a matter of timing.

[Jeffrey Hammond:]

Okay, and then just as we – can you hear me?

[F. Nicholas Grasberger:]

Yes.

[Jeffrey Hammond:]

Okay, just as we kind of peek into 2017, can you just talk about what you're seeing from a visibility standpoint in Rail outside SBB, and just kind of the confidence level with kind of stable M&M markets kind of how you're feeling about sustaining these margins that have been much better in 2Q, 3Q? Thanks.

[F. Nicholas Grasberger:]

Yeah, yeah. Yeah, I'll start with that Jeff. With M&M I think we're all quite confident that these margins that we've achieved over the last few quarters in M&M are sustainable. As you know, we have long-term contracts. We're quite confident that the contracts that are maturing next year will be renewed. And so I think we feel quite good about the cost structure, and also the ongoing opportunities to boost operational excellence, there are still many, many things that we're doing. As part of the former Orion Project which are now, I'll say part of our business system, that will continue to yield benefits to us. So quite confident in M&M, less confident of course in where the industry is going, and whether or not we'll see higher production levels that would lead to further earnings growth for us. But margins I think are stable at this high level and if anything there's probably some more upside opportunity even without the lift in the market. In terms of Rail, the visibility into 2017 is not good. As you know, it's a long cycle business. So we look back at the previous trough in 2009, it was followed by a reasonable recovery in 2010. We see no evidence that this cycle will be similar to that. We're of course hopeful, and perhaps a bit optimistic, but we've not really seen any data that would suggest that the Rail market will improve next year. On the short cycle end of the business that being aftermarket, we continue to take share in aftermarket as we further penetrate that market. So I would expect further growth in aftermarket next year, even without a recovery on the equipment side.

[Jeffrey Hammond:]

Okay. Thanks, guys.

[F. Nicholas Grasberger:]

Yeah.

[Operator:]

And your next question comes from Rob Brown with Lake Street Capital Markets.

[Rob Brown:]

Good morning. Thanks for taking my call.

[F. Nicholas Grasberger:]

Yeah. Hi.

[Peter Francis Minan:]

Hey, Rob.

[Rob Brown:]

Hi, on the Industrial segment you talked about some signs of recovery, and maybe the first kind of backlog stability and growth in a number of quarters. How does that sort of line you up for 2017. Should that be a – could that be a growth year or how does 2017 look in Industrial?

[F. Nicholas Grasberger:]

It could be, but I think if it is, it's going to be fairly modest at least based on what we're seeing at the moment. So yes, backlogs are increasing, order rates have improved, but not at dramatic (24

[Peter Francis Minan:]

Rob, it's Pete, to give you a little color on the backlog figures for Air-X-Changers, I mean, there – we're seeing a modest increase quarter-on-quarter, but they're still down 30% plus year-on-year in terms of backlog. So we're cautiously optimistic, we're moving in the right direction. But it's not going to get back to the 2014 levels quickly.

[Rob Brown:]

Okay. And then in terms of margins, can you still see margin expansion in a stabilized environment or just sort of where you are at (24

[F. Nicholas Grasberger:]

You're speaking about Industrial?

[Rob Brown:]

Yes, correct.

[F. Nicholas Grasberger:]

Yeah, I think that there's margin opportunity in next year in Industrial for sure.

[Rob Brown:]

All right. Thank you. I'll turn over.

[Operator:]

And your next question comes from Bhupender Bohra with Jefferies.

[Bhupender Bohra:]

Good morning, guys.

[F. Nicholas Grasberger:]

Good morning.

[Peter Francis Minan:]

Hey, Bhupender.

[Bhupender Bohra:]

Hey, just a question on M&M here on the exit revenue, I think, Pete, you mentioned about you gave the number on exit – the impact of exit revenue on operating income. Can I have the exit revenue?

[Peter Francis Minan:]

Yes, for the quarter Bhupender it's about $20 million year-on-year, which it translates to the $1.5 million of the operating income level and for the full year we're looking about $80 million of revenue, which is consistent with our $10 million of operating income effect.

[Bhupender Bohra:]

And how should we think about that number going into 2017 – I think Nick talked about like some of the contracts coming up for renewal next year. Can you give us some color in terms of like any contracts, which will not be renewed or the risk is higher or lower?.

[F. Nicholas Grasberger:]

As we've looked at each of those contracts, we are fairly confident that each will be renewed. So I do not see any significant impact of site exits on revenue next year.

[Peter Francis Minan:]

Yes, this impact has been diminishing, ebbing in the last couple of quarters Bhupender, and next year we're not expecting it to be any real significant effect of contract churn.

[Bhupender Bohra:]

Okay, got it. And that the second question on Industrial, I think Nick you mentioned about some opportunities over there, as you are looking at heat exchanger business, the Hammco business. If you can give us how that business is doing and from the fencing side, I think that was one of the opportunities we have talked in the prior calls to if you can update us on that? Thank you.

[F. Nicholas Grasberger:]

Well, in terms of Air-X-Changers the team there has done a tremendous job continuing to take cost out of the product and find additional operating cost reduction opportunities. So I think and I alluded to it in my prepared remarks the operating leverage in Air-X-Changers has really never been higher, the new facility that we're in, and its ability to really produce much higher volumes is something that's really going to benefit the business over the next couple of years as the market recovers. So very optimistic about, about the Air-X-Changer business. In terms of security fencing we've had an awful lot of both positive press and potential customer increase into the product and received very high praise for its uniqueness and its value proposition, it's just a matter of now that budgets for 2017 for these large projects are being constructed. As we look into 2017, we certainly are optimistic that some of these projects similar to the one in Mexico at the Mexican City – Mexico City airport, which we were awarded this year.

[Bhupender Bohra:]

Okay. And lastly on the Rail side I mean you guys have talked about some decent opportunity like SBB, which you are bidding for, any updates on those like in the Europe, Asia and some of the geographies you've been bidding for those contracts?

[F. Nicholas Grasberger:]

Yeah, none of those opportunities have been awarded. They continue to be pushed out, but they remain active. And we're very involved whether it's in Europe or in Asia. So I think given the learnings of the SBB contract, and the much stronger team that we have in place, we look forward to future opportunities like SBB.

[Bhupender Bohra:]

Okay, and lastly on the Hammco, do you have that number like how much that business grew in this quarter?

[F. Nicholas Grasberger:]

It was double-digits for sure. I'm going to say it was 20%-plus.

[Bhupender Bohra:]

Okay, got it. Thanks a lot.

[Operator:]

And your next question comes from Rob Norfleet with Alembic Global Advisors.

[Robert F. Norfleet:]

(29

[F. Nicholas Grasberger:]

How are you doing?

[Robert F. Norfleet:]

I'm fine. So just question for I guess for Pete and Nick, with the recent refinancing of the balance sheet and the debt reduction, as well as improving free cash flow, how should we look at capital allocation priorities in 2017? I mean, you guys have been clearly plain decent with debt maturities being an issue now, clearly you've gotten flexibility to do some other things. I mean, should we expect you guys to look at M&A and buybacks with a little more enthusiasm as we move into 2017 or is it still about debt reduction?

[F. Nicholas Grasberger:]

Well, I think it's primarily debt reduction. We certainly do have the ability now to focus on both on M&A and also putting some growth capital back into M&M. And as we look at growth opportunities in M&M, there are some that are quite compelling. So I think you will see us invest in growth, in M&M, and new contracts next year. In terms of M&A, any M&A would be similar to a Hammco or Protran, two acquisitions we've made in the past few years that have been highly successful, very much bolt-on type opportunities and kind of below $100 million type probably price tags.

[Peter Francis Minan:]

So, Rob, it's Pete. So the pro forma leverage ratio for after the refinancing, is just maybe in the 2.2 times to 2.3 times range and we feel pretty comfortable operating at that debt level – at that leverage ratio. So anything that – Nick was referring to in terms of growth whether it's in investment in additional capital in Metals or bolt-on acquisitions, we'll still be targeting to be in that leverage range.

[Robert F. Norfleet:]

Okay. Perfect. And that goes to Pete in terms of the free cash flow, obviously, great improvements this year. As we look into next year, looking at working capital, or your CapEx (32

[Peter Francis Minan:]

Yes, I think there is – that's a reasonable assumption and certainly we are keeping eyes on, but the initiatives that we put in place in terms of working capital and the discipline we put around capital spend certainly are going to sustain in the future.

[Robert F. Norfleet:]

Okay, great. My last question just on the M&M, I know you all talked about some of the exit revenues and the impact on operating income. Based on what you said Pete, should I – should we assume that there are no longer any contracts in a loss position or are there still some exits which we should expect going into 2017?

[Peter Francis Minan:]

Yeah, we're not anticipating any exits of any magnitude in 2017.

[Robert F. Norfleet:]

Great. That's all I have. Thanks.

[F. Nicholas Grasberger:]

Thank you.

[Operator:]

And your next question comes from Jeff Hammond with KeyBanc Capital Markets.

[Jeffrey Hammond:]

Hey guys, just a couple of housekeeping items. So, versus the $50 million to $51 million interest expense, how are you thinking about that in 2017 with the new financing, and just with the JV gone, what's kind of the normal ongoing tax rate?

[Peter Francis Minan:]

Yes. So the first question in terms of interest with the average debt levels coming down significantly and with the terms we've gotten on the financing. We should expect a modest decline in interest expense year-on-year. As far as the – what's the other question...?

[Jeffrey Hammond:]

The tax rate.

[Peter Francis Minan:]

Yeah cash taxes should be under 20% and the other tax rate should 40%-plus, roughly consistent with the current year.

[Jeffrey Hammond:]

Okay. Thanks, guys.

[Operator:]

And we have no further questions at this time and I would now like to turn the call back over to Dave Martin for closing remarks.

[David S. Martin:]

Thank you, Bridgett, and to those that joined the call this morning. A replay of this call will be available later today through November 17, and the replay details are included at the top of our earnings release – I'm sorry, at the back of our earnings release. If you have any follow-up questions, please do contact me, my details are also on the release. And again, thank you for joining and have a great day.

[Operator:]

And thank you, this does conclude today's conference call. You may now disconnect your lines.