Howmet Aerospace Inc

NYSE:HWM

Earnings Call Transcript 2019-Q4

[Operator]

Good day, ladies and gentlemen. Welcome to the Arconic's Fourth Quarter 2019 and Full Year 2019 Earnings Conference Call. My name is Nicole, and I will be your operator today. As a reminder, today's conference is being recorded for replay purposes.

I would now like to turn the conference over to your host for today, Paul Luther, Vice President of Investor Relations. Please proceed.

[Paul Luther, executive]

Thank you, Nicole. Good morning, and welcome to Arconic's Fourth Quarter 2019 and Full Year 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 the 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. Reconciliations 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, executive]

Good morning, everyone, and welcome to the call this morning. A lot of ground to cover today, and I do recognize that we have lots of moving parts between the cost reductions, performance program, restructuring, asset sales, the share count movement, aluminum and metal assumptions, and then finally, Boeing MAX, and I intend to provide as much visibility into these as possible. I plan to cover the quarter and the full year performance and the results of these major priorities and then move on to discuss the approach that we've taken to the 2020 outlook.

Let's start on Slide 4. Today, we are announcing that we are targeting the separation to take effect on the 1st of April. The majority of the work has been completed, and we're on track with all separation steps. The planned operating date for the 2 future companies is next week, the 1st of February and the legal separation into the 2 listed future public companies is April 1. Regarding the strategic priorities, including capital structure, capital allocation and financial outlooks for the 2 future companies, we're targeting an Investor Day on February 25 in New York for both companies.

Let's move on to Slide 5 to cover the fourth quarter results. The results were solid. We had record fourth quarter performance for operating income, excluding special items, and record operating margins and earnings per share. Operating income, excluding special items, was $444 million, and the effective tax rate was 29.7%. This was an unusually high number for tax and to prior quarters and driven essentially by the geography of earnings.

In the quarter, Engineered Products and Forgings year-over-year operating margin expanded 480 basis points, while GRP expanded by 370 basis points. Both EP&F and GRP demonstrated progression in year-over-year margin for every quarter this year and in EP&F sequential a quarter. Fourth quarter earnings per share was $0.53, up 61% year-over-year and at the maximum end of our guidance range. Earnings per share for the year was odd at $2.11 and up 55% year-over-year.

Free cash flow was $870 million, up 87% year-over-year, and this exceeded the midpoint of guidance by $120 million and has made a very [ meaningful ] improvement in free cash flow for Arconic from prior years and achieved a free cash flow conversion of 90% of net income. Please note that the free cash flow conversion guidance I provided for the 2 separated companies at the time of the last earnings call. The year-end cash balance was $1.7 billion after $1.15 billion of share repurchases and the repayment of $400 million of convertible notes. The $1.15 billion of share repurchases included a fourth quarter market share repurchase of 1.6 million shares. For the year, we repurchased approximately 55 million common shares at a weighted average price of $20.97. This leaves open share repurchase authority of $350 million, which will carry over into the future Howmet Company, if not utilized before separation. Net debt to EBITDA was 1.81x, which was a record low and an improvement from fourth quarter 2018, which was 2.05x. And lastly, after return on net assets improved year-over-year by 450 basis points to 13.7%, another record.

Now let me turn it over to Ken to provide a more detailed view of Q4 and the year.

[Ken Giacobbe, executive]

Thank you, John. Now let's move to Slide 6 and financial results for the quarter. In the fourth quarter, organic revenue was up $38 million year-over-year with EP&F up 2% and GRP flat. EP&F had 5% organic growth in aerospace, which represents more than 70% of its revenue, while commercial transportation declined 8%. GRP was flat as industrial products had 21% organic growth; packaging, 6%; and aerospace, 3%. These increases were offset by a decline in automotive of 9% as the Ford F-150 is transitioning to the next-generation model, and we had lower volumes due to the GM strike. Building and construction was down 8% due to softness in Europe and intentional exits of less profitable products.

Operating income, excluding special items, for the fourth quarter, was $444 million, up 37% year-over-year. We delivered the fourth consecutive quarter of price increases with a $42 million favorable impact year-over-year. Price increases span across both segments driven by aerospace, industrial and commercial transportation, and we expect favorable pricing to continue. Weakness in our automotive and commercial transportation markets unfavorably impacted operating income by $29 million in the fourth quarter. Favorable raw material costs, including aluminum price, was a benefit to operating income of $34 million in the quarter. Similar to price, we had our fourth [ consecutive ] quarter of net cost reductions. Net cost reductions were led by cost-out program, which generated $76 million of year-over-year benefit in the quarter. This was partially offset by higher variable compensation and equity costs, which were driven by improved performance on profit, free cash flow and equity value. As expected, the transition of our Tennessee plant to more profitable industrial products showed a year-over-year improvement in the fourth quarter. The impact was $13 million. We have included the reconciliation of operating income, excluding special items, on Slide 35 of the appendix.

In the fourth quarter, adjusted free cash flow was a record at $728 million or $250 million more than the fourth quarter of last year. Please note, consistent with our guidance, we have excluded $2 million of unfavorable cash flow in the quarter related to planned separation. Days working capital improved 1 day on a year-over-year basis to 43 days with the main driver being collections. The year-over-year cash improvement was $103 million. Pension contributions and OPEB payments were $69 million in the quarter, which was $38 million more than the fourth quarter of 2018. Capital expenditures in the quarter were $167 million, which was down $104 million on a year-over-year basis.

Diluted earnings per share, excluding special items, was $0.53 per share and 61% higher than the comparable period. The higher diluted earnings per share were primarily driven by operational improvements of $0.13, lower share count of $0.05 and lower raw material costs of $0.05.

Now let's move to the year-over-year margin expansion on Slide 7. In the fourth quarter, Arconic's margin improved 380 basis points on a year-over-year basis, while EP&F improved 480 basis points, and GRP improved 370 basis points. It is noteworthy that the year-over-year margin expansion has improved each quarter in 2019. This improvement reflects the trajectory of ongoing operational improvements, improved pricing and cost reductions.

Now let's move to the special item summary on Slide 8. In the fourth quarter, our reported results included a net favorable impact of $75 million in special items. The special items in the quarter primarily related to 3 items. First, we recorded a $94 million tax benefit related to a U.S. tax election which caused the liquidation of a foreign subsidiaries assets into our U.S. tax parent. The second special item was a cash charge of $34 million associated with the planned separation. Third, we received [ $21 million ] in closing cash related to an earn-out associated with the Texarkana plant that was sold in the fourth quarter of 2018. I would point out loss incurred in the quarter for legal and other advisory fees related to Grenfell Tower and the fire at our fasteners plant in France were largely offset by related [indiscernible] proceeds. More details concerning special items for the quarter can be found on Slides 28, 29 and 35 appendix. For the year, the majority of the special items have been consistent with the stated plan of divesting assets or businesses that do not fit our focus, require significant capital investment with unacceptable returns or are not material to our bottom line. As you would expect, approximately 1% of the charges for the year were noncash.

Now let's move to the segment results on Slide 9. In the fourth quarter, EP&F's revenue was $1.7 billion. Organic revenue was up 2%. Segment operating profit was a record for the quarter at $354 million, up 32%. The increase in segment operating profit was driven by several favorable items, including volume growth in aerospace, higher pricing, lower raw material costs and net cost reductions. The resulting segment operating margin expanded by 480 basis points year-over-year to 20.4%.

In the fourth quarter, GRP's revenue was also $1.7 billion. Organic revenue was flat year-over-year. Segment operating profit was a record for the fourth quarter at $150 million, up 61%. The favorable year-over-year improvement in the segment operating profit was driven by favorable pricing in the industrial and commercial transportation markets, lower aluminum prices, net cost reductions and improvement in internal scrap utilization. The Tennessee transition to industrial products helped offset the declines in automotive and commercial transportation. Despite the challenges in aluminum extrusions and flat organic revenue growth, GRP segment operating margin increased 370 basis points year-over-year to 9%.

Let me move to the fourth quarter key achievements on Slide 10. Our EP&F business had record fourth quarter revenue and segment operating profit on a year-over-year basis. Aerospace organic revenue was up 5%. Favorable pricing improvements in EP&F continued in the fourth quarter as we achieved $29 million in year-over-year price increases. For the year, price improvements in the segment were $78 million. Finally, in EP&F, our expansion of the aerospace airfoils, aerospace rings and forged wheels capital expenditures are complete and ramping up in 2020.

Our GRP business had record fourth quarter segment operating profit. GRP's industrial revenue was up 20% organically year-over-year. Price improvements in industrial products and commercial transportations drove $13 million of year-over-year price increases. For the year, price improvement in the segment were $75 million. GRP's internal scrap utilization improved 180 basis points versus the same quarter of last year.

Arconic's full year free cash flow of $870 million resulted in a free cash flow conversion of 90%. Return on net assets for the year was 13.7%, was up 450 basis points year-over-year. CapEx for the year was $579 million, approximately 4% of revenue and was down $189 million year-over-year. Approximately 65% of the CapEx was spent on return-seeking projects. A majority of our growth CapEx projects are now complete, and we expect CapEx as a percent of revenue to be less than 4% in 2020. Our cash balance was approximately $1.7 billion after we repurchased $1.15 billion of outstanding shares and paid down approximately $400 million of debt.

Now let's move to Slide 11 and the key financial results for the year. For the year, organic revenue was up $894 million with both EP&F and GRP up 6%. EP&F had 8% organic growth in aerospace and 4% growth in commercial transportation. GRP's organic revenue increase was driven by double-digit growth in aerospace, industrial products and packaging.

Operating income, excluding special items for the year was $1.8 billion, up 29% year-over-year. Price increases were $153 million for the year and split almost equally across the segments. Higher volumes also favorably impacted operating income by $80 million for the year, mainly driven by aerospace. Lower raw material costs, including aluminum price, was favorable to operating income, $99 million for the year. Net cost reductions were led by the cost-out program, which generated approximately $213 million of year-over-year savings. This was partially offset by 3 items: the transition of our Tennessee plant, operational challenges at one of our aluminum extrusion plants and higher compensation costs driven by improved performance.

Adjusted free cash flow in 2019 was $870 million or $405 million more than 2018. Pension contributions and OPEB payments were $345 million, which was $33 million less than 2018. At year-end, the pension and OPEB net liability was approximately $3.2 billion, up approximately $200 million year-over-year as lower discount rates impacted the liability by approximately $900 million. U.S. pension asset returns were approximately 20%, and these returns partially offset the impact of the lower discount rate. Capital expenditures for the year were $579 million, which were down $189 million compared to 2018 while making significant investment in aerospace airfoils, aerospace rings, forged wheels and industrial products.

Diluted earnings per share, excluding special items, was $2.11 per share and 55% higher than 2018. The higher diluted earnings per share were primarily driven by operational improvements of $0.47, lower raw material costs of $0.15 and lower share count of $0.12.

Before turning it back over to John, let me briefly provide an update on our capital structure, which is on Slide '19 in the appendix. We finished the year with approximately $1.7 billion of cash after executing the $1.15 billion of share repurchases and reducing debt by $400 million. Gross debt is approximately $5.9 billion, and net debt stands at $4.2 billion. Net debt to EBITDA continues to improve year over year despite the cash outflow associated with the share repurchases. Net debt to EBITDA stands at 1.81x, which is an improvement of 12% compared to the fourth quarter of 2018.

With that, I will turn it back over to John.

[John Plant, executive]

Thanks, Ken, and let's move to Slide 12, where I'll give you the results of the key focus items. Price increases for the year were $153 million, and we saw good progress at both EP&F and GRP. Operating cost reductions were $213 million for the year and ahead of our annual commitment of $180 million. The annual run rate operating costs are projected to be reduced by $300 million, which is a full $100 million higher than our original commitment.

As a result of the share repurchases, which are detailed on the slide, year-end diluted common stock share count was 440 million shares, down 13% year-on-year. Capital expenditure was $579 million, excluding $7 million associated with separation. CapEx was approximately 4% of revenue. The major focus of our 2019 capital expenditures was the expansion of airfoils and rings capacity in the Engines business, the European wheels expansion and the Tennessee industrial expansion in Rolled Products.

Annual divestiture of proceeds of approximately $190 million are expected to exceed the operating and CapEx cash cost of separation. Divestitures signed or closed will reduce annual revenue by approximately $350 million with limited operating income impact. Two previously announced transactions will close in the first quarter of 2020 with proceeds of approximately $100 million.

Now let me move to separation. We're targeting separation for the 1st of April. We filed an amendment to the Form 10 on the 22nd of January, where we provided greater visibility into management, capital structure and pension allocation. The next step is the financing of Arconic Corp.'s spin entity. This financing commences today and is planned for completion by February 10. The Form 10 is planned to be made effective by mid-February. The planned operating date for the 2 companies is the 1st of February, where everything will be done by the 2 entities; and legal separation into the 2 listed future public companies on the 1st of April. This will have accomplished a rapid execution of separation from the time that I announced the plan upon taking the CEO role in February 2019. One last but very important item on separation is related to pension plans. The separation does not trigger any incremental cash contributions.

Let's move to Slide 13. As you know, this earnings call precedes the Boeing call, which, while it's not ideal, is important in effecting the separation timing and the debt financing starting this afternoon. We have had many exchanges with Boeing during late December and every week throughout January and hence have a reasonable feel for their current plans in 2020. Naturally, I will not provide any details of those conversations, except to guide the Arconic numbers. Today, I will provide Q1 and earnings per share guidance numbers, plus a view of revenue and free cash flow for Arconic. At our February Investor Day, I will provide additional insight into Howmet Aerospace and new Arconic Corp., which, naturally, will be of more interest going forward. The split, as stated, is set for the 1st of April. And hence by achieving this early timing, we will be able to see 3 clean quarters in 2020.

Now let me turn to the specific numbers but noting, firstly, that given the uncertainty to that which Boeing will exactly announce and their future increases in production plans, this causes me to provide a wider bandwidth of guidance than would be normal. Revenue is targeted to be in the range of $13.9 billion to $14.2 billion with organic growth in the range of 1% to 3%. Aerospace revenue is expected to increase year-over-year when we exclude the Boeing 737 MAX situation. If we were to include the impacts of the 737 MAX, aerospace revenue is expected to be flat year-over-year. We expect continued aerospace price increases in 2020 and growth year-over-year in industrial products driven by the transition of our Tennessee plant into more profitable industrial products. Commercial transportation is expected to experience headwinds in 2020 driven by slowing manufacturing and freight growth, lower new truck orders and the increased current inventory levels. We are targeting to mitigate those margin impacts for our forged wheels business by gaining market share, supported by our differentiated lighter-weight products. We continue to penetrate the steel wheel market with aluminum wheels. Moreover, our low-cost manufacturing wheels expansion in Hungary is now fully operational, and we will leverage our global footprint. The global rolled products business will mitigate commercial transportation headwinds with cost reduction actions.

Earnings per share, excluding special items, is expected to be in the range of $2.22 to $2.42 per share. At the midpoint, year-over-year growth is approximately 10%, including our current view of the impacts of the 737 MAX. Year-over-year growth in earnings per share will be driven by run rate cost reductions actioned in 2019 as well as incremental cost reductions in 2020, plus the continued price increases. Earnings per share for the first quarter is expected to be $0.47 to $0.53, which is an increase of approximately 16% year-over-year at the midpoint.

Adjusted free cash flow forecast is to be between $800 million and $900 million driven by earnings, capital expenditures of less than 4% of revenue and favorable year-over-year restructuring payments. Pension and OPEB cash contributions are expected to be approximately $220 million higher than in 2019 driven by the drop in the discount rate. Free cash flow conversion is expected to be 80% with greater detail to be provided at Investor Day on February 25. Finally, regarding Grenfell, there has been no activity this quarter, and nothing has changed regarding our stance towards the matter nor our view of the expected outcomes of the litigation nor liability.

And with that, I'd like to open the line for your questions.

[Operator]

[Operator Instructions] Our first question will come from the line of David Strauss with Barclays.

[David Strauss, analyst]

John, want to follow up on the MAX. So I understand you're not going to talk about exactly what you assumed, but can you help us at all on what your shipset content is. It looks like it's maybe around $2 million. And what kind of decremental margins would you expect to see on lower volumes there?

[John Plant, executive]

Those are probably the questions which I'm unwilling to provide answers on. I've always been reluctant. And, in fact, on any earnings call, I've never provided shipset values. I've read, I'll say, guesstimates in analyst reports which I say probably aren't too far, but I don't really want to give specificity of what the shipset value and what the margins are by any aircraft because the next question to follow will be on the next aircraft and the next aircraft, and I feel disinclined to do that at this point.

What I would say to you is our assumption is we've got about a $400 million revenue hit, plus or minus, for the MAX. I've tried to take a fairly conservative view to guidance, especially in the light of -- it's only when we actually know what the Boeing published position is that I think we can be -- have that greater certainty. And then how we address our cost structures, we've made assumptions. And in particular of importance to us is what will be the profile exactly of the future Boeing build, both in 2020, and really importantly, in 2021 because the -- while it's, I'm going to say, relatively easy to shed labor, getting the sort of skills back given the, I'll say, very high employment level in the U.S., I mean, those are all things which are really important for us to consider. And so you've got to see the whole thing and then also how the Boeing position itself evolves over time. I mean what we've seen, as you know, over the last 6 or 9 months is fairly -- what has resulted in fairly optimistic assumptions, and we've seen many changes to those. And now we're in a situation where the production is currently halted with a view to restart and what's now viewed as a fairly conservative assumption regarding when the FAA will release the aircraft and according to statements made in the last week by the Chairman of the FAA.

So I mean all I can say is that it's pretty confusing. And when we have that greater clarity -- and I tend to be in the optimistic camp, but at some point, the aircraft production may rise above what we think it is. And therefore, we need to be prepared for that. And how we manage labor is critical to it, what the carrying cost of that is and what we've built into the assumptions. And that's why guidance itself is particularly difficult at this point in time. But neither have I given you something that I don't feel confident in our ability to achieve, and I did call out the fact that I provided a little bit wider guidance than normal to take account of some of this uncertainty. And clearly, we're going to be updating you as we go through the year. We're going to give you further updates, hopefully, on the Investor Day on February 25. And as the -- I'd say the clarity emerges and that tries to give you color of how we've approached this whole situation and the fact that we're having to come out really a little bit earlier than normal just to affect the financing that we're in the market for starting this afternoon and enabling that, I'll say, debt raise to occur to meet the separation timing. So all these things are pretty much interlinked. And I guess, preferably, I'd have been a week or 2 later. But the most important thing for the company was to achieve, I believe, the earliest possible separation timing. So hopefully, that gives you a pretty wide view of where we've been thinking on this and how we approach it, David.

[David Strauss, analyst]

Yes. That's helpful. And as a follow-up, it looks like based on your guidance, your EPS guidance, you're assuming EBIT and EBITDA relatively flat at the midpoint, maybe up a little bit. Can you just help us with the walk there? Obviously, you have the cost savings and pricing and Tennessee benefit, but what are some of the offsets that you've got baked into that?

[John Plant, executive]

Okay. Well, I'll start then hand it across to Ken. I mean, essentially, compared to where we thought we would be for a start, then, clearly, the reduced production of the 737 is the most significant negative item. There is some reduction associated with the -- I will say, the commercial transportation business, and that's just essentially the assumption on truck and trailer build, both in the -- in North America and in Europe.

I'll say, on industrial, fairly flat in terms of volume. And so that gives you some guidance on how we think about the drags on our EBITDA development. And then countering that are the cost reductions, both the ones we have currently and the ones that we are trying to continue with going forward. And then there's the price, which I've mentioned. So those are the major, I'll say, bridges.

And with that, anything else you want to add to that, Ken?

[Ken Giacobbe, executive]

I think, to your point, John, that 737 MAX is the biggest items, but we did enjoy a little bit of an aluminum tailwind in 2019 that won't repeat in 2020. So that's a bit unfavorable. And then an offset to that would be variable comp was higher in 2019, just driven by improved performance in the free cash flow, so you have a little bit of an offset there. But the 737 MAX is the biggest driver.

[Operator]

The next question will come from the line of Seth Seifman with JPMorgan.

[Seth Seifman, analyst]

Wanted to ask about the new aerospace capacity coming online for airfoils and in rings and sort of the timeline on which you expect that to be sort of qualified and profitably producing during 2020 and the degree to which any of that is kind of -- had been expected to be directed toward the MAX or not.

[John Plant, executive]

Okay. The critical engine assets, which are in Whitehall, Morristown, for, say, the casting and coal production. And then, as you know, we've invested a 10,000-ton press for our Rings business in California. The trials and the initial production has commenced for each of those assets. And in fact, first shipments occurred in December, obviously, in small numbers. Those assets, in particular, say the airfoil assets will see significantly increased production in the first half of 2020. And they were not -- those investments were not there solely for the LEAP engine. It's going to provide welcome capacity relief for many of the -- for the airfoil and ring programs that we have. And so I see those assets coming on progressively during the year. Shipping increasing quantities quarter-by-quarter. By the time we get to the exit rate of the end of the year, I'll say, everything will be, I think, running -- I expect to be running at a very high capacity utilization but still leaving something left for 2021 as we also increase our normal productivity programs.

I just see them as -- as critical, not just, I'll say, strategically important investments that are actually going to make big contributions to the bottom line as well in the year.

[Seth Seifman, analyst]

Great. And then as a follow-up, just a similar question on the rolling side and Tennessee. When we think about what -- on the can sheet side, what that facility was doing a few years ago, think about kind of where things might ramp up to from here. Now that we're kind of closer to it and in positive territory, is there any way to kind of size the impact that, that new capacity will have, either in 2021 -- or sorry, in 2020 or beyond?

[John Plant, executive]

Yes. I -- first of all, I do welcome the -- I'll say the sequential improvement in those Tennessee industrial assets during the course of 2019. I see that continuing in 2020. You'll recall from the previous commentary that the major impact of that is in the second half of 2020 when the majority of those assets would go onstream. I'm not saying there won't be improvements along the way because there will be, but in the second half is when we begin to deliver in quantity those -- that industrial production for which we've contracted with distributors. And I'm going to look to Ken because I've got so many numbers here in mind. I'm thinking it's a -- capacity of 300 million pounds but with about 100 million coming on in 2020 with the back end being the most -- of the year, the most important part of that. And clearly then, the run rate into 2021 is highly beneficial.

[Operator]

The next question will come from the line of Carter Copeland with Melius Research.

[Phillip Copeland, analyst]

John, just to expand a little bit on the -- just in principle how you're planning on managing the production capacity and the staffing. I mean you hinted that it's hard to put labor back on after you take it off, but it sounds like you're going to staff in 2020 or plan to staff or resource those facilities in a way that had some stranded costs, but you're doing that purposefully for 2021. Is that fair?

[John Plant, executive]

Yes. It's the current way we're thinking about it. We're flexing -- obviously clearly deleting over time. We're looking at other means of trying to contain that labor, whether it's by -- I'm going to say some maybe partially paid vacation. We're looking at our shift patterns. And also, my expectation is that we will actually be reducing headcount as well. The most difficult decisions that I see coming up are going to be as we move into the middle of the year and when we have greater clarity regarding the production when indeed Boeing themselves have greater clarity regarding production. And I've commented that -- because we have seen a lot of noise and different assumptions. And then critical to that decision, the [ finality ] of how much we're going to flex labor, both the direct and indirect labor and our cost structure is going to be our view of 2021. And if we feel as though -- and if we are clear that the production is going to become much more healthy in '21 and potentially with upside, then that's going to affect and color our views upon our willingness to hold labor or not. And if we're not thinking positively, then we're going to -- I'm going to call it dive for the floor and just gut the cost structure as necessary because that's what we should do as good custodians of shareholders' money. But now it's a very balanced approach, trying to be as responsible and responsive as possible while protecting the future because I have to say, personally, I'm optimistic even though we're not planning -- we're not assuming that in our guidance.

[Phillip Copeland, analyst]

Okay. No. It makes perfect sense. And then as a follow-up, just when you think about the offset embedded in the $400 million worth of growth to offset the $400 million headwind, how should we think about the biggest contributors to that given what's happening on the 787 and the A380 and whatnot? Where -- can you give us a sense of where the lion's share of that growth is coming from?

[John Plant, executive]

I'm going to say the bright spot because, as you say, you can tick through the assumptions like what's 787 and we've all seen, I'll say, recent rumor about whether that would be further cut or not, and there's no certainty around that. We know it was the 777X, as I say its first flight and where does that go. And then we have the 737, the -- I'll say the big decision. Obviously, Airbus is a brighter spot and then defense. I mean that has really been a bright spot for us. In fact, in the fourth quarter, sales into the defense sector were up 27%. And we see that as a very strong, bright spot for us in 2020, particularly around the F-35 and increasing our levels of deliveries for that aircraft and engine program.

[Operator]

The next question will come from the line of Gautam Khanna with Cowen and Company.

[Gautam Khanna, analyst]

I have a couple of questions. First, I was wondering, on the 737, I know you can't speak to specifics on a rate, but can you talk about differences between the engine side and the structure side and how different your assumptions are for each, just giving us the delta? You've given that in the past.

[John Plant, executive]

Yes. The -- in the early part of the year, I'm thinking that the opportunity that we have, I'll say, in discussion with GE around the ability to bring forward and build some of the spare engines is going to be important, both to push in their production and our production to have a smoother approach to this because while it's difficult to move production up and down on, let's call it, the structural side of the aircraft, but on the engine side, you flex up and down at your peril. And if we were to cut that and then try to rebuild it back to a number of 42 or 52 or 57, then that will become almost impossible, not just for Arconic, but for the whole of the industry. So that does not flex -- this is a matter of production, I'll say, difficulty and complexity. That doesn't flex anything like the structural side, even though neither side are difficult. And therefore, what we are thinking about is with, I'll say, some of the spares, clearance and building of spare engines, which I believe is being considered and planned, that should help smooth the year and, in particular, provide the ability to move engine production back up again as we move into 2021. But again, it's cloudy. I wish it were -- we had greater clarity of what exactly those builds will be for the next 24 months and beyond, but we don't. So we -- living in this world that we inhabit. And so at the moment, obviously, we're cushioning it, both ourselves and within GE, and then seeing how we can manage the overall production, both with a view of both the material input for the specialty metals and also the critical skills that we have in that business.

[Gautam Khanna, analyst]

That makes sense. Has there been any discussion around cash terms on the shipments you make in the interim while we're at a lower rate with GE or the structural guys? I know GE burned cash right now on the 777. I'm wondering if that's flowing down to you guys.

[John Plant, executive]

We've had no discussions with GE on that. When -- we get paid after we ship after a certain time, of course, and there's been no dialogue around that at all.

[Gautam Khanna, analyst]

Okay. And last one on the guidance. You did mention you're expecting to offset some of the commercial transport downturn with share gain. Can you put a finer point on what is embedded in your expectation for the decline in commercial transport sales at EP&F?

[John Plant, executive]

Okay. Let me look at Ken for affirmation. I'm thinking that we have around about $75 million, plus or minus $20 million, baked into our year-on-year assumptions for revenue. And then how it transpires to the bottom line is all to do with cost management, using new capacity and how successful we are in terms of both the share gain against steel and also the ability to influence fleet managers to take the new opportunity of even further lightweight wheels. So we're actively working it, trying to, I'll say, maximize our sales while not deteriorating margins for the business.

[Ken Giacobbe, executive]

One thing that's going to help us out a lot is the Köfém, Hungary plant expansion that came online at the latter part of '19 rolling into this year. Cost structure is much more favorable there. So that, in combination, like John said, penetration of steel wheels. If you look at all the wheels right now across the globe, only 19% of them, approximately, are aluminum. So there's an opportunity there, and we think we have a differentiated process. But the team has a bunch of triggering events here, depending on how fickle that market could be. So there's triggers already bundled up, ready to go if we have to take more costs out of the business.

[Operator]

The next question will come from the line of Matthew Korn with Goldman Sachs.

[Matthew Korn, analyst]

First, a question for Ken. I just want to confirm, in your guidance for free cash flow, should we assume that excludes any of these expected divestments that you're incorporating over the first half of the year?

And then secondly, on that, looking over at your -- at the separation cost expenses outlined in the bottom of Page 12. How much of these should actually be full of cash drags over 2020? Like, for example, is this $130 million, $160 million expense, is that a fiscal year '20 number only? Does that exclude any costs over the last quarter? Any clarity there would be great.

[Ken Giacobbe, executive]

Yes. So the divestitures, Matt, are excluded from the cash calculation. If you look at the cash drag on separation, about $50 million of that was hitting in '19, and the rest of it will hit in 2021 in the first quarter.

[Matthew Korn, analyst]

Got it. Great. I appreciate that. Second thing regarding some of the end markets. Expectations into 2020, particularly for automotive and building and construction, you mentioned and highlighted the state of the 4 transitions. What's your expectations for autos overall? Are there any tailwinds into Europe into the spring that you're seeing, particularly on the building and construction side?

[John Plant, executive]

So for BCS, we're assuming roughly in line with GDP. And we've taken our lumps now in terms of moving out of some of that low-margin business that we talked about. And therefore, that gives you a picture for BCS. So I'm going to say small growth in 2020 with the -- I would say, overall, an improved margin given the actions that we took during the course of last year. And we more than achieved the basis points improvement in margin that I talked about on previous quarters. I think it's Q2 when I called that out.

In terms of auto, it's difficult to gain anything. If I called it out at 17 million for North America, as an example, you wouldn't gain much on that. You need to look more -- be more specific in terms of what the underlying trends are of, let's say, truck versus pass car because we're mainly aimed at the SUV and pickup truck market. And in fact, the really, I'll say, notable changes in 2020 is one is less of a drag from the Ford changeover, less of a drag because hopefully -- well, I can't think of any reason why there will be another strike at GM seen as the contract is all done, and it's a multiyear contract. So that's behind us. And then, as you may recall from previous commentary, we were successful in increasing our business with a major U.S. OEM coming onstream in the middle of the year. I don't think we ever called the name out, so I won't this morning, but that business comes onstream around about the sort of late May, June time, ready for the next model year of a major SUV and pickup truck introduction.

So that gives you a picture of how we think about automotive. So a fairly -- I'm going to say, honestly, a fairly good outlook for that as it pertains to Arconic Corp. in 2020.

[Operator]

The next question will come from the line of Martin Englert with Jefferies.

[Martin Englert, analyst]

Can you provide a little bit more detail to maybe help us understand the lead times as it relates to your products in the airframe side and the engine side? Specifically kind of how far ahead does this demand pull come for you when you look at units being built by the major commercial aero OEMs?

[John Plant, executive]

Well, it's quite different by each of the products. So when we think about that reduction that was applied to 787 from, I think, it was 14 aircraft per month down to 12, I think that was taking effect towards the end of 2020. So in terms of the impact on our fastener business, it's in the -- really starts in the first quarter of 2020. So there's, let's say, at least a 9-month lead time on those sort of, let's say, more structurally based parts.

For engine, again, it's in months, in fact, ultimately, longer than the structural side. But those builds, a big change for the end of this year, then we will see the impacts of that in the first half of 2020. So it's long lead times, both for our own, I'll say, scheduling, getting material availability and then the whole processing into an aircraft build, an engine builder. And I think 9 months, plus or minus, and many plus.

[Martin Englert, analyst]

Okay. And then the same would hold true for aero heat treat plate on the aerostructure side?

[John Plant, executive]

Yes.

[Martin Englert, analyst]

Okay. And if I could, one last one here. Can you discuss potential positive...

[John Plant, executive]

It takes a long time to get it pulled in. But obviously, they -- it can be cut off much more quickly, like don't deliver.

[Martin Englert, analyst]

Okay, understood. And if I could, one last one. Can you discuss the potential positive implications from increased metals content, post USMCA, plus recent revisions on Section 232 on the 232 side, wherein it's going to include more downstream aluminum products like body stampings and autos?

[John Plant, executive]

Yes. We saw the announcement this weekend regarding that inclusions for additional, say, secondary products. And obviously, as a producer of those parts and some of the metals going as parts, it's a welcome move because it's been very clear to us is that the effectiveness of some of those protections for the common alloy trade case, in particular, didn't really have the desired effects that was expected. I mean it had a short-term impact. But then not only were other countries importing into the U.S., but it appears that some of those metals in terms of secondary parts has also been able to find its way into the U.S. So in natural fact, the total North American aluminum production was actually negatively impacted, and I think the current administration is trying to deal with some of that. And so we've seen it. What we don't yet have is the listing of what those products are. And therefore, it's really difficult today to give you clarity over what additional tonnage that may result in for the, I'll say, the rolled and extruded business in the U.S. It's something that we've obviously noted, hasn't been part of the -- our thought process for the guidance today where, hopefully, it has a positive impact, but to quantify it right now is just not possible.

[Martin Englert, analyst]

Okay. I appreciate all the color there, and congratulations on the execution and progress with the separation over the past year.

[John Plant, executive]

I guess I should apologize to everybody for my voice today. It's got a thicker tone than normal. Must be the cold.

[Operator]

And we do have time for one additional question. This question will come from the line of Curt Woodworth with Crédit Suisse.

[Curtis Woodworth, analyst]

Yes. So the $400 million negative impact from the MAX, is that a gross or a net number? I.e., I assume you can offset some of the MAX issues by pivoting more capacity into Airbus or defense? And then could you just comment on the cadence of that revenue impact? Do you assume a much higher weighting of the revenue hit first half of the year versus second half?

[John Plant, executive]

First of all, it is the, I wouldn't say, the gross number. It's not really very easy for us to suddenly flip and say, "Oh, let's go make a few more Airbus parts." It doesn't really work like that. The constraint around tooling and then, I'll say, specific specialty alloy requirements is such that you don't say, "Well, we're making less of these, and then so we can flip it up and make more of those." We do see Airbus trying to make more, and we see -- decide to build more engines, and that will be great, and that will be also for the Geared Turbofan, but we know that some of the issues there, which we can read about recently in India. So it isn't as though that capacity is fungible. You move it to somewhere else. It really doesn't work like that.

Clearly, if it's a rolled sheet and that was there, but the aircraft itself is constrained by many other factors. So it just doesn't -- you can't say it's a $400 million, but that's now, let's go and offset it by $100 million so we can go sell elsewhere. So hopefully, that gives you that one.

And what was the second part of your question?

[Curtis Woodworth, analyst]

Just the cadence of the $400 million, given comments from the FAA and others that it's probably more like a midyear billing ramp. Would it be safe to say that the majority of the revenue impact would be in the first part of the year? Or how are you thinking about that?

[John Plant, executive]

I think it's going to -- again, I'm going to say to you, probably what is -- this sounds like a pretty unacceptable answer in that it's going to be pretty cloudy at the moment because one thing is for sure, we know that the Boeing announcement about cessation of production. And then I'm not going to comment on which month they said that they will recommence. That's not for me to talk about on this call and then neither about the rate. So if you think about it in a strictly logical sense, it would be, obviously, more impact in the first half of the year, just because we're not producing any. It's going to have a bigger impact when the assumption may be they're building a certain quantity in the back half -- end of the year. At the same time, that may be smoothed a little bit by the willingness or not of -- to carry inventory, particularly by Boeing themselves. And so we're in those -- in that dialogue at the moment to try to see what -- how it flows exactly from the aircraft and what part of inventory management taken into account of all this to -- again, all with a view to trying to help the labor management situation that I've talked about, which is really the -- probably the most complicated part of this in trying to come up with the right judgment. And then with my comment, which I provided earlier, which was the critical thing is going to be how we see the exit rate for the year and what will be the 2021 production. So there's -- I'll say it's a lot of things to consider. It's not just the -- strictly the aircraft build per se or the currently no-build situation to inventory management and labor management in all of this, affecting both top and bottom line and its profile during the course of the year.

[Curtis Woodworth, analyst]

Yes. No. That makes sense. And then just one quick one on Tennessee. It seems like at Tennessee, you still have at least 100 million pounds of capacity or more there. Can you talk about your plan to fill that? And are you having any discussions with beverage can sheet suppliers? Because it seems like there's a real clear emerging deficit in terms of what's going on, on the aluminum can side in the U.S.?

[John Plant, executive]

Okay. We've had no discussions with any canning manufacturers at this point in time. In fact, we're precluded in doing so by the agreement with Alcoa through the third quarter of 2020. What we do note is the continued movement, let's say, particularly from the antiplastic movement, which I think is going to be a net benefit to both glass bottle and to aluminum can. And therefore with the capacity which has been taken out of the North American market by ourselves and others, then that might result in a position in the future which might be interesting. But currently, we're not participating in discussions with them about it. So the assumption for this year is all about the industrial market and not beverage can.

[Operator]

Ladies and gentlemen, this does conclude today's conference call. We thank you for participating. And you may now disconnect.