Harsco Corporation
Q4 2014 Earnings Call Transcript

Published: 26 Feb 2015

[Operator:]

Good morning. My name is Benita, and I will be your conference facilitator. At this time, I would like to welcome everyone to the Harsco Corporation Fourth Quarter Release Conference Call. [Operator Instructions] 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. David Martin. Mr. Martin, you may begin your call.

[David S. Martin:]

Thank you, Benita. Welcome to everyone joining us this morning. 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 Chief Financial Officer. This morning, we will discuss our results for the fourth quarter of 2014 and our outlook for this year as well as provide you an update on Project Orion and then we'll take your questions. Before our formal presentation, however, let me take care of a few administrative items. First, our earnings release was issued this morning. A PDF file of the news release, as well as the slide presentation that supplements our remarks 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. Next, 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, please see the Risk Factors section in our most recent 10-K and 10-Q as well as in certain of our other SEC filings. The company undertakes no obligation to revise or update any forward-looking statement. 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 is included in our press release issued this morning as well as our slide presentation. Now I'll turn the call over to Nick to begin our prepared remarks.

[F. Nicholas Grasberger:]

Thank you, Dave, and good morning, everyone. I'll begin with an assessment of 2014, discuss our priorities and outlook for 2015 and then turn the call over to Pete to provide additional color. I'll then provide a more in-depth perspective on Project Orion and our M&M division, after which, we'll be happy to take your questions. So let's start on Slide 2. 2014 was a year of tremendous change at Harsco. Put simply, it was a year we focused on rebuilding our foundation to consistently deliver attractive returns moving forward. We discussed our objectives at the beginning of last year and we executed against them throughout the year according to our plan. So what did we accomplish? The cornerstone of our rebuilt foundation is our talented and dedicated new leadership team. As many of you know, Harsco has had considerable changes in our senior management over the past several years. With the experienced team now firmly in place, we look forward to and expect much greater stability in the future. Second, we launched a broad program in M&M to reduce costs, improve core processes and address underperforming contracts. At the same time, we changed the organizational structure and brought in new leadership. The M&M team has made significant progress toward their goals, so much so that Project Orion will soon cease to be a project and simply the new way of operating the business. Third, our Rail segment has fundamentally changed its scope through international expansion and by penetrating the aftermarket parts segments. In the past, our activity in these markets was opportunistic and uneven. Now we have committed significant resources to these markets, our brand is strong and our pipeline of opportunities is robust. In both Rail and Industrial, we also began to execute on our strategy of growing these businesses through M&A. We made a small acquisition in our Air-X-Changers business early in the year and very nearly made a sizable acquisition in the fourth quarter before we pulled back due to the weakness in the energy markets. Going forward and as macro trends improve, we will continue to assess M&A opportunities in these businesses. 2014 was also the first full year of the Brand Energy joint venture formed late in 2013 from the sale of our Infrastructure business. There is no question the value of our minority stake increased last year even though restructuring cost and FX translation muted the equity income we recorded. The 2 most important levers of value, EBITDA and cash flow, increased and were consistent with the acquisition plan. Finally, but actually foremost, our recordable injury rate declined 20% to a record low level, and we are actively working with major customers to expand our relationships to EH&S matters. As we anticipated at the beginning of 2014, this was also a transition year in financial terms. As expected, we recognized sizable charges as part of Project Orion, mostly severance and impairment costs related to underperforming contracts. We expect such charges to diminish dramatically in 2015 and beyond. Excluding these costs, earnings largely moved sideways in 2014. Although importantly, cash flow and ROIC improved. Pete will provide more details in a minute. I'm now on Slide 3. Turning to 2015, we fully expect to see the beginnings of the financial benefits derived from our actions last year. We anticipate notable improvements in cash flow and ROIC and double-digit growth in EPS. But we are certainly not immune to the macro factors affecting other companies that serve the same end markets and geographies. Over the past several months, the decline in energy and other commodity prices, together with the stronger U.S. dollar, have reduced our projections for 2015 operating income by $20 million and earnings per share by $0.35. Nevertheless, our priorities this year remain solid and largely unchanged, and we look forward to even better execution now that the new leadership team is complete. Cost reduction will continue to be a primary focus within M&M, but we believe the greater benefits will come from having smarter and more disciplined allocation of capital and the consistent application of our new operating standards and processes. So while we expect margin growth of about 150 basis points in 2015, we expect an equally or even greater margin lift in 2016 due to the ongoing improvement in contract mix and operational efficiency. And with Project Orion well in hand, we're able to turn our attention to the long-term strategy of the business. As noted earlier, our Rail business is gaining significant momentum, and we see further opportunities to invest in building this business beyond its traditional scope throughout 2015. We will begin to ship units in the fourth quarter under the first of 2 $100-plus million multi-year contracts with the Swiss national railway. And we'll also be bidding on a few other large multi-year contracts in Europe that should be awarded this year. Finally, we have built a dedicated business development team in our Rail group that is pursuing investment opportunities in related businesses. Due to its exposure to the U.S. energy markets, the Industrial segment will be challenged this year to maintain the level of profitability earned in 2014. The 2 largest businesses in this segment, Air-X-Changers and IKG, are the most exposed to both and are taking meaningful cost-reduction actions. Nonetheless, the long-term outlook for the Industrial segment remains bright, given its strong market positions and the investments we have made in new products and more efficient manufacturing operations. Turning lastly to Brand. Their business will also continue to be affected by the strong dollar and weak energy prices. After growing 5% to 10% last year, Brand's EBITDA could decline 5% to 10% this year due to these factors. Nonetheless, cash flow in Brand remains strong, and we fully expect the business to achieve the equity value assumed when the deal was completed 15 months ago. Before I turn the call over to Pete, just a few words about capital allocation. As indicated many times, our plan is to make a material reduction in capital allocated to M&M this year, while boosting spending in Rail and Industrial. Any M&A activity will also be aimed at providing further balance to our portfolio. But overall, we remain as committed as ever to the dividend paid to Harsco shareholders, and we're pleased with the outlook for cash flow and with our capital structure. Now over to Pete.

[Peter Francis Minan:]

So thanks, Nick. Let me start by saying that I'm very happy and excited to be here and be part of your leadership team. I joined Harsco simply because I saw the promising and exciting future of Harsco and have in the last 3 months, been working with people that have only reconfirmed my optimism. The strategy for Harsco was well defined prior to my arrival at the company, and its strategy is clearly in line with what I feel is most important

[F. Nicholas Grasberger:]

Okay. Thanks, Pete. The next few slides provide a bit more analysis on the progress of Orion. As mentioned earlier, the process changes will generate the largest benefits over time, but let's first recap the cost reduction component of the program. The total estimated cost reduction of $35 million to $40 million across Phases 1 and 2, $6 million was realized in 2014, another $20 million is expected in 2015 with a balance in 2016. But it's important to note that we've only included identified operational benefits in these figures. The implementation of our new operational standards will certainly generate additional benefits in the future that we have yet to quantify. Turning to Slide 14. We've made considerable progress in underperforming contracts. Our so-called triage teams have finalized their work on over 40% of the 68 contracts that generate unacceptable returns. Several others are in progress. Of those 30 that have been finalized, we expect 21 to become acceptable performers within the next 12 months, and the remainder either will be or have been exited or have been improved, but will remain underperforming until expiration since the cost of exiting exceeds that of continuation. Slide 15, the chart on the top left shows the material difference in return on capital and margin between the underperforming and acceptable performing contracts. The chart on the top right shows the financial improvement of the underperforming contracts over the past year. Once again, we expect these trends to continue over the next few years and furthermore, our new Bid & Contract Management process should mitigate poor contracts in the future. So before we take questions, I think it's important to stress that we remain confident in our long-term financial targets and the expected value of our stake in Brand upon exit. Off of the 2014 base, we expect free cash flow, EBITDA minus CapEx and ROIC to roughly double by 2017 through the consistent focus on the strategic, operational and financial initiatives we have discussed over the past year. And despite the challenges that Brand is facing this year, we are confident that our eventual exit proceeds from our stake in the JV will be between $500 million and $700 million. So we are now happy to take your questions.

[Operator:]

[Operator Instructions] And your first question is from the line of Jeff Hammond with KeyBanc Capital Markets.

[James Picariello:]

This is James filling in for Jeff. Quick question on the new contracts, the new sites that you mentioned that are ramping up early for the Metals & Minerals. Can just speak to the process there? And where those contracts, these new contracts might rank in your existing portfolio in terms of ROIC?

[F. Nicholas Grasberger:]

Yes, certainly we expect the new contracts to be accretive to our -- or above our threshold target for return on capital. And they're in various stages of being commissioned and ramped up. And they're, as you might imagine, in many different geographies. So yes, we do expect a contribution from those new contracts this year and going forward. But again, in terms of 2015 performance, the larger driver is the cost reduction and the improved overall mix of our contracts.

[James Picariello:]

Got it. And then turning to the Industrial segment. Can you size the oil and gas exposure for both Air-X-Changers and IKG?

[F. Nicholas Grasberger:]

Yes, in terms of operating income, I'll put it in the simplest terms first. We're thinking that the impact on earnings this year from lower oil prices, energy prices, will be about $5 million.

[James Picariello:]

Okay. And in terms of the breakdown between maybe upstream versus downstream, I mean, should IKG be a little more resilient assuming a greater downstream exposure? And how should we be thinking about it in terms of that?

[F. Nicholas Grasberger:]

Yes, that's certainly true. And as you likely know, the Air-X-Changers business is much more exposed upstream.

[Operator:]

And your next question is from the line of Glenn Wortman with Sidoti & Company.

[Glenn Wortman:]

Can you just go into a little bit more detail on your various revenue assumptions for each of your Industrial businesses?

[Peter Francis Minan:]

Yes, with respect -- sorry. Go ahead, Dave.

[David S. Martin:]

And just digging up those details, Glenn. Our overriding revenue assumption for the business, which is on Slide 11, is that Industrial revenues will be down mid-single digits in the year, and that includes a number of moving parts. That assumes that our boiler business is going to continue to grow quite nicely while there's going to be some modest decline in revenues, both at our IKG or grating business and our heat exchanger business.

[Peter Francis Minan:]

So in summary, both those businesses, as Nick mentioned, the energy-related impact that is, say, roughly $5 million to $7 million, but we do anticipate that there's some cost cutting and other actions being taken place to kind of mitigate some portion of that. And that's incurred predominantly at the Air-X-Changers and the IKG business.

[Glenn Wortman:]

Okay. And then I'm not sure if I have this right, but it looks like you're expecting Industrial operating margin to be up a little bit in '15, and I think you said you had a sale of a facility within that segment in your guidance. If so, what is the expected contribution there?

[Peter Francis Minan:]

'15 operating margin is flat or decline single digits. But there is an expectation that we will sell our facility in Q1, which we recognize in Q1, but it will be more or less offsetting the cost that are expected to be -- resulting from the moving and transition cost as we consolidate our 5 facilities at Air-X-Changers into the 1 central manufacturing location.

[F. Nicholas Grasberger:]

Yes, I think the way to look at it, Glenn, is that the top line will be down mid-single digits most likely. But operating income should be flat. And so what's driving the margin is the cost reduction.

[Peter Francis Minan:]

Correct.

[Glenn Wortman:]

Okay. And then just the ratcheting back of the expectations for Brand, can you break that down a little further between, say, the impact from FX and then perhaps your exposure to the energy markets?

[Peter Francis Minan:]

Yes, roughly, first of all, the breakdown is for those factors. But roughly, $0.06 is attributable to the foreign exchange translation aspect and the rest of it is attributable to the decline and the expectations with respect to energy pressures.

[Operator:]

Your next question is from the line of Bhupender Bohra with Jefferies.

[Bhupender Bohra:]

Just wanted to -- if you can give us like what were the LSTs in the quarter? And how -- what's the tone of the business in M&M actually going into your kind of like 2 months into 2015? If you can give us a color.

[F. Nicholas Grasberger:]

Yes, I think as we look at LSTs at our sites, we're expecting them to be largely unchanged in '15 versus 2014. So we don't expect that to really be a driver of performance at all, one way or another. Again, the big components in M&M year-over-year are the cost reduction and the improved mix -- contract mix of the business offset by the impact of a stronger dollar, lower nickel prices and some lost income from exited contracts. Now keep in mind that our threshold for a performing contract is return on capital. So we have exited contracts that do contribute to operating income that are profitable, but given the capital that they consume, they don't meet our threshold for returns. So we've exited those. So I think there's $5 million or $6 million of OI of a hit in '15 versus '14 from those contracts that we've exited.

[Bhupender Bohra:]

Okay. And can you give us the number? What was the dollar number for exited contracts in the quarter?

[David S. Martin:]

Yes, I can. Hold on one moment. I'll -- sure, I'll look that up.

[Bhupender Bohra:]

And in the meantime, just wanted to wrap up this with the last question. The free cash flow, we are seeing a significant increase in the free cash flow. If you can discuss the uses of free cash flow in 2015. You talked about capital allocation. If you can just kind of give us a little bit deeper color on that.

[F. Nicholas Grasberger:]

I think the increase is large -- well, it's doubling, right, roughly from $50 million to, let's say, $90 million to $100 million or so. I mean, it's really driven by cash income, which is higher because of business performance, but also because of lower restructuring expense in '15 versus '14. So cash income is one component. CapEx, as we discussed, is also down year-over-year, and then working capital should also improve. So those are the 3 components that lead to kind of a doubling of free cash flow.

[Peter Francis Minan:]

So the loss on those contracts in exiting businesses in the quarter is roughly $5 million.

[Bhupender Bohra:]

$5 million? Okay.

[David S. Martin:]

That was the OI impact.

[Peter Francis Minan:]

Sorry, on OI, on OI.

[David S. Martin:]

Gross revenue impact, just to be clear, was about $25 million. Net of new contracts, it was about $15 million and the net OI impact was a very small negative amount in the fourth quarter. For 2015, we expect net contract churn to be a modest positive to OI.

[Bhupender Bohra:]

Okay. And my question regarding free cash flow was what are you thinking about the free cash flow use in 2015? Any color on like share buyback or how does your M&A pipeline look? If you can just give us some color on that?

[F. Nicholas Grasberger:]

Yes, I think if you look at our free cash flow guidance in 2015, it's roughly equal to our common dividend as well as the payment that we make to our joint venture partner in Brand. Beyond that, the focus would be M&A and perhaps some share repurchase. We have bought back some stock over the past several months. But again, given our strategy to balance the portfolio over time and the fact that we pay a sizable dividend today, our priority would be M&A first, and then share repurchase [indiscernible] reduction after that.

[Operator:]

[Operator Instructions] There is a question from the line of Bryan Carlson with Atlantic Investment.

[Bryan Keith Carlson:]

Can you talk to us a little bit about how much restructuring charges you absorbed through the Brand joint venture in 2014 and what's anticipated in 2015?

[F. Nicholas Grasberger:]

Yes, in terms of the impact on our fee income...

[David S. Martin:]

Bryan, just to give you a sense, there were impacts from the FX, the intercompany transaction or translation impacts and then there were some restructuring items in total. These totals for the full company were about $30 million. So that means the share attributable to us was roughly $10 million.

[Bryan Keith Carlson:]

And that was in 2014 or that's in 2015?

[David S. Martin:]

That was 2014.

[Bryan Keith Carlson:]

And then my impression was that we were going to see much lower restructuring charges in 2015. Is that correct?

[Peter Francis Minan:]

That is correct.

[F. Nicholas Grasberger:]

That is true. Yes, so we, in '15, let's say, we -- relative to where we would have been thinking about equity income several months ago, we're down $15 million to $20 million of equity income in '15 versus what we had been thinking because of FX and oil. And again, the FX impact there is not only on its translation, but below the operating income line because they have foreign currency dominated intercompany loans. There's a translation effect of those as well, which affects our equity income. So the combination of those items have reduced our outlook for equity income in 2015 by about $15 million to $20 million. Most of that, of course, is not cash, and I don't think longer term will affect the EBITDA in the business upon exit.

[Bryan Keith Carlson:]

Okay. You, as a, I guess, board member there and the management team, would you characterize the situation as happy with the progress made at Brand integration is going well? Markets and FX, a little bit challenging right now, but sort of on track and good trajectory?

[F. Nicholas Grasberger:]

Yes, I think, absolutely. As I mentioned, they achieved their plan for EBITDA and cash flow in 2014. The integration, given my knowledge of the Infrastructure business that they combined with, actually went much better, I would say, than any of us expected it to. And if not for these current challenges on energy and, by the way, they are exposed -- about 50% of their business is downstream, about 10% is upstream. And they're exposed to both maintenance and CapEx. So the CapEx piece is providing the most significant challenge for them. But as I mentioned earlier, I don't think any of what's happening today in the business really affects our long-term view of the business.

[Bryan Keith Carlson:]

Okay. And then I just wanted to ask about the backlog within Industrial as well. Can you -- is it possible for you to break that out for us? Is that largely Air-X-Changers? Or is that like 1/3, 1/3, 1/3? Or how should we think about that?

[F. Nicholas Grasberger:]

That would be largely Air-X-Changers. And again, given the lead times there, the order book is very full for kind of the first 6 months of the year. It's the second half of the year that would be affected by the reduction in the order rate.

[Operator:]

And there appears to be no further questions. Are there any other closing remarks -- I apologize. We do have Jeff Hammond with KeyBanc Capital Markets.

[Jeffrey D. Hammond:]

So just a quick follow-up. Can you talk about what you're seeing in the M&A? How the pipeline looks? And ultimately, what incited the decision to forego the sizable transaction in the fourth quarter?

[F. Nicholas Grasberger:]

Well, I'll take the second part first. Yes, as you can imagine, as we got late into the fourth quarter and we were feeling at the time quite good about the transaction, certainly, strategically, but also financially. When oil began to decline rapidly, it was just clear to us that given its exposure -- this business' exposure to oil, that the projections were really no longer valid. And since we're in a similar business, of course, we had good insight into what was happening with their business. So the strategic merits of that business remain as valid as they were a few months ago. I think we just need to see some more stability in the market, so we have more confidence in the projections. And then it's a transaction that could well come back. We'll see. But beyond that, I would say the pipeline for M&A is probably most robust in the Rail business. I mentioned that we now have a dedicated business development team there and they've done a terrific job of building that pipeline. And, as you know, as we diversified that business, both geographically and also in terms of products and services, the landscape of businesses might make sense has broadened as well.

[Jeffrey D. Hammond:]

And what kind of leverage will you guys feel most comfortable with for M&A?

[F. Nicholas Grasberger:]

Yes, I think over time, we're comfortable in kind of 2.5 to 3.5x EBITDA range. We would go higher for the right acquisition. But it would need to be one that was highly profitable with good cash flow, such that we could delever in a reasonable period of time.

[Operator:]

And there are no further questions. Are there any closing remarks?

[David S. Martin:]

Yes, please. Thank you, Benita, and to those that listened and participated in the call this morning. We appreciate your interest in Harsco. A replay of this call will be available later today through March 26, and the replay details are included in our press release this morning. Lastly, if anyone has any follow-up questions, feel free to contact me. My contact details are included at the top of today's earnings release. And lastly, we look forward to speaking with you in the future, and have a great day.

[Operator:]

And this concludes today's conference call. Thank you for your participation. You may now disconnect.