Grupo Industrial Saltillo SAB de CV

BMV:GISSAA

Earnings Call Analysis

Earnings Call Transcript 2023-Q3

[Operator]

GIS Investor Relations Manager, Mr. Arturo Morales. Please be advised that this call is for investors and analysts only. During this call, management will be discussing GIS performance as per the earnings release issued on Thursday. If you did not receive the report, it is available at www.gis.com.mx in the Investor Relations section.

[Operator Instructions] There will be a question-and-answer session after the speakers' opening remarks and instructions will be given at that time.

Let me remind you that forward-looking statements may be made during this conference call. These are based on information that is currently available and subject to change due to a variety of factors. For more detail and a complete disclaimer, please refer to the earnings release. Also, all figures discussed are in U.S. dollars, unless otherwise stated. It is now my pleasure to introduce the GIS team. Mr. Jorge Rada will lead off the call.

[Jorge Garza, executive]

Good morning, and thank you all for joining us today. In 2023, we continue to see growth opportunities in the market where we all participate, given the pent-up demand for vehicles and current inventory levels in the supply chain.

In the past 2 years, Draxton has excelled in its commercial strategy, strengthening its global order group. This makes us highly optimistic about our sales volume growth in casting and value-added processes or electrification agnostic parts. Throughout the year, Draxton secured the equivalent of over $120 million annually in new business contracts. As you all have heard, in North America, labor contract negotiations have been intensified as the 3 automakers based in Detroit, resulting in strikes in some of their plants.

As of this moment, the impact in Draxton's operations in North America is not relevant since our customers are increasing volumes in other programs from different platforms. During this process, we will focus on building back inventory and secure the launch of new products. Among the most important developments in the capacity expansion programs, Line 6 in San Luis Potosi is already operating 3 ships. While line #7, second phase of the expansion will be ready for product validation tests in January.

These expansion projects will add approximately 60,000 tons of iron casting per year or more than 20% of our current capacity in North America. The investments in Evercast, our joint venture with ZF have also been deployed, installing the first of 2 plating lines and increasing machining capacity aligned with our customer program products. With the planing investments, Evercast will become the largest planing facility of its kind within the Americas with an estimated output of 30 million parts of braking systems.

In Europe, our business strategy is to grow in value-added processes in addition to customers. This is why we are expanding our machining capacity for both light and commercial vehicles. This approach will allow us to further increase our machining in casting volumes and consequently increase our market share.

To this end, we are developing a new machining hub in Poland that combined with the one we have in Spain will allow us to increase our portfolio of value-added components for our customers.

Moving on to the development of the automotive industry. Beginning with North America, the region continued to stabilize over the quarter, posting an annual growth of 5% in vehicle production. Consequently, vehicle sale recorded a 14% annual growth. This positive trend has led to more adequate inventory levels in the region despite the onset of the strikes against the 3 Detroit-based automakers.

In Europe, production posted a growth rate of 9%, while sales increased 21%. And reflecting an improvement in production and primarily in the underlying demand that followed progress in inventory levels and incremental deliveries. This region is now operating as an net importer, contrasting with its historical position.

Turning to China. The domestic demand has stalled in 2023, resulting in a total vehicle production of 6.8 million units and sales of 6.5 million units, which implies a decrease in growth rates. Nevertheless, exports are expected to offset this effect and boost light vehicle production in the region.

Moving on to Draxton's performance. Casting and Machining volumes recorded significant growth rates of 9% and 63%, respectively. This increase is driven by global vehicle production dynamics and introduction of new programs, which include value-added processes such as machine.

In North America, casting volumes increased by 10% on an annual basis, while machining volumes surged by 97%, both under positive trends. Meanwhile, Europe and Asia delivered incremental casting volumes of 8% and machining volumes of 25%.

During the third quarter, Draxton experienced a 3% annual increase in revenues with North America generating $124 million, and Europe and Asia contributing $107 million, Year-to-date, revenues reached $716 million, recording an accumulated growth of 9% when compared to the same period 2022. Despite the prior year's quarter prices include higher raw materials costs in their indexing formulas.

Although there is progress in operational stabilization and commercial negotiations have begun to recognize inflationary impacts and currency fluctuations in our price. The quarter's EBITDA was affected by the Mexican peso appreciation and expenses linked to the launch of new products and capacity expansions. The quarterly EBITDA reached $19 million, outperforming the last quarter, reflecting the results achieved through the implementation of cost efficiency plans that will continue to enhance productivity and margins in the upcoming quarters.

Draxton will remain focused on improving operational excellence, the successful launch of new programs and capacity expansion and securing new contracts mostly for platforms aligned with hybrid and full electric vehicle platforms. I will now hand the presentation over to Saul Castaneda, GIS CFO.

[SaúlCastañeda de Hoyos, executive]

Thank you, Jorge, and good morning, everyone. Moving on to GIS. The quarter's financial performance reflects stability in sales. A solid casting volume growth trend from Draxton has been the main driver, coupled with the effective execution of our indexation strategy and continued growth in vehicle production of customers across the globe.

In terms of revenue, the third quarter 2023 has shown resiliency, having recorded revenues of $256 million, which represents a 4% growth when compared to the same quarter last year. We post an EBITDA of $17 million for the third quarter. Effects such as the currency exchange rate light below this performance as well as temporary surge in costs related to introduction of new programs and casting lines.

Given the industry dynamics in the automotive markets, GIS remains heavily committed to its expansion and execution of the CapEx program and to continuously secure new contracts, which have resulted in more than $120 million of annual revenues to be launched in the next 18 to 24 months. Both endeavors have certainly allowed to further enhance our global position.

Regarding the year-end outlook, our CapEx is projected to close at $115 million. Required investments will continue to fuel the expansion efforts previously outlined, including the ongoing expansion of our casting, machining and plating capabilities, as well as boosting continuous improvement of production processes.

For the third quarter 2023, our financial position remains strong. Net debt attained $156 million, in line with previous quarters. Likewise, the net leverage ratio reached 1.7x. We will keep focused on cash flow optimization to ensure a healthy financial outlook. I will now hand the presentation back over to Jorge.

[Jorge Garza, executive]

Thank you, Saul. I would like to close these remarks with some highlights of the quarter, which we are very, very proud of. Draxton Europe received the award of Most Innovative Supplier by our customer Schaeffler. This recognition accentuates our commitment to innovation and digital transformation in the scope of Industry 4.0.

In China, Draxton secured a program with a very important Chinese vehicle manufacturer for a casting and machining project focused on differential cases for electric vehicles. With this nomination, we advanced towards our goal to further strengthen our product portfolio with value-added processes aligned with electrification trends.

In GISEderlan, our joint venture with FagorEderlan in Mexico, we initiated an expansion of its production facilities. As this venture has landed additional contracts for strategic components like knuckles and control arms. This contract will also increase the casting volume at Draxton. We are very optimistic about the automotive markets, and we are set to resume our margin growth trajectory, supported by cost saving and productivity enhancing measures that are already in place. Commercial negotiations in line with evolving macroeconomic conditions and rising vehicle production volumes across the regions in which we participate. With this, I conclude my remarks for today. Thank you all for your attention. We can now start the Q&A session.

[Operator]

Thank you. At this time, we will open the floor for your questions. [Operator Instructions] Our first question from Carlos Alcaraz from Apalache. Go ahead.

[Carlos Alcaraz Pineda, analyst]

Hello, good morning, Jorge, Saul, Arturo. Thank you very much for the call, and congratulations for the results. Firstly, I want to ask if you could give us some color on your expectations on EBITDA margin for the next year? And finally, I would like to ask to ask you about the Line 7, San Luis Potosi, what production volume will it be reaching during the next year, considering the validation period you mentioned?

[SaúlCastañeda de Hoyos, executive]

Thank you, Carlos. Yes. Thank you, from Jorge. I will start with the first part of your question. Thank you for those I will say that, first of all, I would like to emphasize that third quarter EBITDA reached, as you know, $17 million. It's a 20% increase against previous quarter. It is an important step on our recovery process of this profitability.

I will say that during the first half of 2024, we're foreseeing a much higher EBITDA margin levels. But it is important to highlight that we will grow in a sequential quarterly basis quarter-over-quarter. And I don't know, Jorge, you would like to add something or...

[Jorge Garza, executive]

No, yes, sure. We are -- you will start to see an important recovery trend starting especially fourth quarter this year. In the first half of next year, we will start with the launching phase of the Line #7, which is the second line we are installing in San Luis Potosi, as you all know. And that line will start from 0 in January, production of 0 until, let's say, the level of a run rate of approximately 20,000 to 25,000 tonnes on an annual basis from January to December.

So if we consider the 2 new lines, the Line #6 and Line #7, together by the end of next year, we will be running practically at 80% to 90% capacity, which is according to our original plan. This capacity is about 60,000 tons total. We were on about 80% of that by the end of next year. And that is approximately 20% volume increase in North America. And this is approximately -- if we consider the prices of the scrap steel scrap for next year. That will be a run rate of approximately $100 million for next year.

It's not the sales of the year, but it's going to be the run rate by the end of the year, okay? In addition to that, we are launching the plating and we are launching the machining, additional capacity that we are installing in Evercast, and that will represent another important increase in rating revenue and EBITDA for next year.

[SaúlCastañeda de Hoyos, executive]

And Carlos, just let me add that we have a very clear path on how to reach our EBITDA levels and margins that we have to. And we are improving, as I already mentioned, an important or a major progress during this quarter, but as Jorge mentioned, we are confident that we will reach a better level on fourth quarter and so on.

[Carlos Alcaraz Pineda, analyst]

Okay. Congratulations on the results.

[Jorge Garza, executive]

Thank you, Carlos.

[Operator]

Our next question comes from Emilio Fuentes from GBM.

[Emilio Fuentes, analyst]

Good morning. Thank you for your time. First of all, I would like to ask you on a recent call where Jorge mentioned sustained supply chain connections in Mexico towards its Kentucky plant. As of today, is there any impact on your supply chain related to the strike at this plant?

[Jorge Garza, executive]

Thank you, Emilio, for the question. We have not seen relevant impacts on our production volumes so far. And the reason is that the OEMs, and in this case for, for example, as you are mentioning, are increasing volumes of other platforms that they are still producing and they are -- the plants have not been impacted by the strike. So we have not seen relevant impacts. We will be definitely observing very closely the situation to see if there is going to be any additional strikes because the UAW as you have seen, is not stopping. They are continuing to negotiate very strongly with the 3-based automakers. And we don't know what is going to happen.

However, so far, we are still producing, let's say, normal rate and we haven't seen any relevant impacts in any of our operations in North America.

[Emilio Fuentes, analyst]

And related to that, a second question, what are your views going forward on labor inflation in the entire industry, specifically in North America? And how can OEM and suppliers offset that impact?

[Jorge Garza, executive]

Well, yes, we have seen that in Mexico, there are 2 main impacts. One is exchange rates that -- we know that we have several years experienced an exchange rate of around 20, 20 pesos per dollar. And recently, it was at [ 70 ], which is, let's say, an important increase in labor cost when you measure it in dollar terms.

In addition to that, we have inflation, which is another impact in the operations in all the Mexican operating companies. For this, what we are doing is we are negotiating with our customers, these 2 impacts, and we are adding or looking for adding all these 2 impacts into our prices.

So we have closed already some negotiations and some of them will start January next year. And some of them, we are continuing in discussions and negotiations with the customers, and we are very optimistic that we will definitely reorder all these impacts gradually in the next months and definitely during the next year.

[Emilio Fuentes, analyst]

Very clear. And regarding the FX impact in your renegotiations with your clients, I am curious, as you mentioned on the report that you're trying to give a -- to pass through those FX impacts. But given that if we eventually see a devaluation -- appreciation of the peso back to normal levels. Will that pass-through impact you going forward? So will the relationship be like 2-sided?

[Jorge Garza, executive]

Well, it has been always by that, that when there is a, let's say, a devaluation of the Mexican peso against the dollar. Normally, customers come and ask you for, let's say, a price reduction. So we are exposed to that. At the moment, we are asking for, let's say, recovery of the exchange rate in the future if something happens on the opposite direction, definitely, we will have to discuss with customers if there is a possibility for them to get any price reduction.

Of course, this is always negotiated. This is always -- let's say, these costs, and it's not unilateral. That's why we -- at this moment, there is a very specific situation, and we never saw that before. And that's why all the suppliers of the automotive industry located in Mexico are doing the same. Going with the OEMs and Tier 1s and disclosing this application of the new formula for prices because it's really difficult to absorb, let's say, 15%, 18% cost increase in the Mexican, our peso costs, right, that in dollar terms are much higher than already like 15%, 18%. And you need to show to your OEM customers and Tier 1 customers that this is impossible to absorb.

And as I mentioned, we have closed already several negotiations and we are still talking to customers to the rest of the customers, so we can start definitely by January 2024 with the new prices. And you will see that in the results of the first, second and third quarter next year, which is going to be a gradual ramp.

[Operator]

Our next question comes from [ Gonzalo ] from GBM.

[Unknown Analyst]

I was wondering if you could give us some color into Draxton strategies to improve the EBITDA margin, manage free cash flow burn from expansions and align these efforts with long-term shareholder value through buybacks and dividends.

[Jorge Garza, executive]

Well, you start and I complement it?

[SaúlCastañeda de Hoyos, executive]

Okay. Sure. Sure. Thanks for your question. As Jorge just mentioned, we have a very clear path on how to improve this EBITDA for our major business unit. I will say we have different drivers. First of all, the price adjustments that just Jorge mentioned, mainly all related with FX and inflation effects. But also, we will have improvements from higher volumes and also a very important for our -- from our value-added processes. Mainly -- probably you can recall that we launched an expansion projects for machining and also plating processes, both value-added processes we have higher margins.

So we are going -- we are in the ramp-up of those processes that will bring us on next year a higher EBITDA, but also operational improvements of our scrap, productivity and all the operations, KPIs. And I don't know, this is the second part of the question.

[Jorge Garza, executive]

How we are going to improve the shareholder value?

[SaúlCastañeda de Hoyos, executive]

Okay. Yes. And that's related with the EBITDA. And just to finish that part, just let me add that. As we mentioned, we are going to see a sequential progress, and we feel very confident that we'll be in a better position during the first half of the year. So that will bring us additional room for the processes that you were mentioning, such as buyback programs.

Just let me remind you that we have been very active on the buyback programs during the past, I will say, 4 years and probably more than that. And we will keep on that strategy once we are back on the margins that we need to be or we need to have to be there. And also, just let me add that we are optimizing our cash flow during the year. We are having a pretty close projections, and we are having -- assessing this subject, I will say, weekly to have a strong cash position. But I will say that it's probably in our second priority, but to be taken back in the next year. I don't know how.

[Jorge Garza, executive]

He is also asking about dividends.

[SaúlCastañeda de Hoyos, executive]

Sure, about dividends. As you know, GIS is one or has probably the -- one of the highest dividend yields on the market. We are foreseeing to keep it in that way. Regardless of this situation, we are improving our operations to be in the same line. So we are not foreseeing any major impacts on dividends so far.

[Jorge Garza, executive]

In addition to that, I would like to add the launching of the Line #6 and #7 is San Luis Potosí. The launching of the expansions in Evercast [ Quattro ] plant, which is machining and plating will bring us a big step-up in volumes and these volumes come with additional EBITDA.

So as we continue increasing our volumes in North America, you will see an improvement in EBITDA. But also in Europe, we are launching additional projects with machining. We are filling up our order book with additional orders, especially from the commercial vehicle market in Europe. And in China, we are also growing. Actually, we foresee that we will have to add some additional capacity to continue growing in China, not another line, but just to break some bottlenecks that we have in the production.

And in addition to that, we won recently a very important project for a Chinese automaker for exporting electric vehicles, and that is for a differential cases and that is an additional volume for the casting plant, and this is an additional machining process that we will launch in China. And this is a very strategic, let's say, product that we will continue going on. Because differential cases is one of the product that Draxton is pursuing as a strategic product globally. And this is always -- or not always, but most of the time, we are going to produce these cases which is part of the electric drive of the people, and that will add normally foundry and machining.

And that is an additional, let's say, strategic step when you talk to customers because that gives you more bonding with the customer, and that creates a stronger relationship with the customers for a longer term. And in China, it's very important to mention that we are working mainly with Chinese automakers as customers, which they are gaining market share in the Chinese, it's an automotive market.

And that's another advantage because we are getting used to work with the speed of the Chinese automakers with, let's say, cost demands of the Chinese automakers in China -- and we are seeing that they are, let's say, innovating the world with cars. So they are trying to enter into Mexico to Latin America, Europe and other markets. And we are in China already, and we are delivering to them. So we are very optimistic also about our Chinese operation.

[SaúlCastañeda de Hoyos, executive]

And another important aspect that I would like to add is that even when the next important debt payment is scheduled until 4 quarter 2024, we are foreseeing a major and a comprehensive refinancing on the first half -- during the first half of 2024. That will also give us a better balance sheet or cash position will give us a strength to support not only working capital, also CapEx and these stakeholders interest also.

[Operator]

[Operator Instructions] Our next question comes from Alejandro Azar from GBM.

[Alejandro Azar Wabi, analyst]

I was just wondering if you can talk about the changing relationship that you are seeing with your customers in the past 2 years, you guys have had to sit down at the negotiating table each year or each quarter on different topics. How do you see that evolving in the next couple of years? Are we going to have each year to have GISSA or Draxton to sit down with customers to negotiate either a benefit or an impact on the operations.

And on regards to that, it seems that a lot of your costs -- if you already had the pass-through on materials, which is significant. I don't know if you can share -- how much of your current costs are already hedged in terms of percentage, I don't know, [ 70%, 80% ] when you account for materials, energy, I don't know if you can put labor into that or a portion of your labor. That would be my first or 2 first questions.

And the third one is related to your comment on Europe becoming an importer of vehicles or components. Does that change the dynamics of suppliers? Is there any impact in Europe for becoming a net importer?

[Jorge Garza, executive]

Yes. Well, Alejandro, thank you. Nice talking to you. First, the situation definitely has changed in the last couple of years because we never saw what we saw. We had first the pandemic, and then we had the supply chain bottlenecks and all the disturbances in the supply chain across the world. Price increases, inflation, exchange rate situation, et cetera.

So it has been many, many things that were put together at the same time. And I believe that the situation will be solved by negotiating with customers definitely. There is a big supply chain in which the OEMs are at the end. Then you have the Tier 1s. In some cases, we are Tier 1s. In some cases, we are Tier 2. And in some cases, we are Tier 3 actually in very small products, but we are still Tier 3 in some cases.

So we definitely have to talk to the customers and our customers to the OEMs because definitely Mexico is producing and exporting more than $100 billion to the U.S., and it's very clear that all the companies that are operating in Mexico are suffering from the same situation. So they are aware. They know that it's going to happen and they need to keep the supply chain is healthy. That is why this -- at this moment, everybody is trying to settle in a way that it will keep the supply chain in a healthy way.

We don't know if in the future, this will continue to be like that if inflation comes down, interest rates go down also gradually. Maybe we will come back to the normal situation like in the past, where OEMs were asking for actually productivity improvements and price reductions and things like that. The moment for the next, I would say, 18 months, we still see that the turbulence will continue and the supply chain will be in the same word of negotiating new terms and try to transfer inflationary over the cost -- additional cost to the OEMs. And there is going to be at the end of this turbulence stabilization. This is what we foresee, okay?

Then the next question?

[Alejandro Azar Wabi, analyst]

Including labor indexation.

[Jorge Garza, executive]

How much indexation we have. Normally, we had in the past, only the scrap. Scrap is part of the raw material. It's not 100% of the raw material. Now what we have included in the indexation formulas is also other materials like ferroalloys, which, in addition to the scrap are used to produce the alloy we pour into our malls to produce the customs, okay? Now the full raw material that is part of the casting is included in the indexation formula.

Later, we started to index also electricity. And in most of our products, I would say, 90% plus, we are already indexed the electricity cost, which is also very important because electricity in the recent years has been, especially in Europe, very volatile. And with this volatility, it's very unpredictable what we can do. Sometimes remember, you can remember the price of the electricity grew 5x in Europe during the pandemic after the war started in Ukraine. So that has to be negotiated. It was impossible to continue without any negotiation.

So now that we have indexed the electricity, we are much more protected. Labor is not indexed in any of the products. It is not common in the industry. What we really want to show to the OEMs and Tier 1s is that there is definitely an inflation and there is definitely exchange rate. And with this, you have to sit down and negotiate. There is not a single formula that you can use for this. And there is so much you can do what you have to demonstrate to the customers that you are productive, that you are efficient because they will never be able or they will never be willing to pay for any inefficiency.

For that reason, this is a negotiation because you can be more productive than others, using more technology, more automation, et cetera. So that is why other costs are not indexed yet. We don't expect that will be a full indexation on the labor cost, but definitely, there is something that has to be recognized by the customers. And then there was a last question, right?

[Alejandro Azar Wabi, analyst]

Yes. The last question, and let me add another one. The last question was about on your comment on Europe becoming a net importer. Does that change the dynamics of your business or might change into the future?

And the other one is related to Ministry of Economy in [ Siena ] announcing fiscal benefits or subsidies for companies wishing to relocate to Mexico and being exporters. Would that -- have you guys look into that? Does that also benefit the Mexican companies currently or bringing in some of that -- of those products like it is your case?

[Jorge Garza, executive]

Regarding Europe, in our -- let's say, if we look into Draxton's business, we don't see a big impact because we have been able to diversify our business into 2 industries. One is the light vehicle industry and the other one is the commercial vehicle industry. So what we have seen in the recent years is a very successful commercial relationship with new customers and our order book has been growing. And now we see that our plants in Europe will be operating at a very high level of capacity utilization for the next years.

So we -- even though Europe is not exporting more than importing cars -- we are -- we have been very successful in commercial negotiations with customers to get new businesses. So we don't expect any negative impact on Draxton. And I think that's important for you to know that we are in Europe growing and our capacity is going to be, let's say, basically full. We are adding capacity for machining, which is value-added processes. And we are not concerned about this what we mentioned in our, let's say, quarterly report.

In terms of the Mexican tax incentive for installing plants in Mexico, I don't know if you.

[SaúlCastañeda de Hoyos, executive]

Sure. Thank you, Jorge. Probably I can comment a couple of aspects and nice talking to you, Alex. First of all, I would say that like if we take a look of this like a threat, I will say that our competitive advantage, Draxton competitive advantage is definitely, we know how casting know-how. And it's not easy for any competitor to be here and be profitable in the short term.

I will say greenfields will take more than 2, probably 3 years to be on the utilization capacity at a good level and in a profitable way also. But in the other side, I will say we need to take a deeper analysis to try to identify that to be positive or advantage or a benefit of our fiscal -- in a fiscal perspective or a tax perspective. We are, as you know, with organic growth. So probably, we need to take a deeper analysis in that aspect. I'm not sure if we are going to be benefited from that, but it's already in an ongoing analysis.

[Operator]

[Operator Instructions] With no further questions, I would like to hand the call to the management for the close of this conference.

[SaúlCastañeda de Hoyos, executive]

Thank you, and thank you, everyone, once again for your interest in GIS. Please do not hesitate to touch base if you have further questions. Have a nice day.

[Jorge Garza, executive]

Thank you.