Russel Metals Inc

TSX:RUS

Earnings Call Transcript 2022-Q2

[Operator]

Good morning, ladies and gentlemen, and welcome to our Second Quarter 2022 Earnings Conference Call for Russel Metals. Today's call will be hosted by Mr. Martin Juravsky, Executive Vice President and Chief Financial Officer; and Mr. John Reid, President and Chief Executive Officer for Russel Metals. [Operator Instructions]

I will now turn the meeting over to Mr. Martin Juravsky. Please go ahead, Mr. Juravsky.

[Martin Juravsky, executive]

Great. Thank you, operator, and good morning to everyone. I plan on providing an overview of the Q2 2022 results. And if you want to follow along, I'll be using the PowerPoint slides references that are on our website, and you can just go to the Investor Relations section.

If you go to Page 3, you can read our cautionary statement on forward-looking information. Before I go into detail on the quarter, let me put a context around a few things. The strong financial performance that we realized through most of 2021 and the first quarter of 2022, continued into Q2 of 2022. Most importantly, we saw relatively consistent performance and strong performance across our business units.

So let's go to Page 5 and begin to talk about market conditions. Steel prices have remained very healthy for the past 18 months or so. As you can see on the left chart, even though there has been some recent price moderation, particularly for sheet and now more recently for plate, the price levels that we realized in Q2 and even the prevailing price levels remain well above historical norms.

Over the past 2 years, we've managed our way through a series of supply chain and logistic issues. While those issues are continuing to some degree, they have improved. The right charts illustrate the recent movements in service center inventories for the industry. Inventory levels in Canada, which is the top right chart and the U.S., which is the bottom right chart, have edged up a bit over the past few months, but they remain at or below pre-pandemic levels.

The key thing from our viewpoint is demand as it remains solid across our regions and most of our end markets. We do expect to see some seasonal slowdown in Q3 due to normal vacation schedules, including the construction holiday that occurs in Quebec in late July and early August, but our customer takeaways remain active.

If we go to the financial results on Page 6. From an income statement perspective, we generated record quarterly revenues of almost $1.4 billion in Q2 that beat the previous record that was set in Q1. Margins picked up across the board as compared to Q1, with the results being sequential improvements in EBITDA, EBIT and net income.

There were 2 noncash items of note in Q2 results. The TriMark joint venture had an earnings contribution of $8 million, but it was offset by an $8 million accounting adjustment for the rise in benchmark interest rates and credit spreads. The net of the 2 factors was a near 0 P&L effect for the quarter. But if we set aside the accounting treatment and look at cash, in July, TriMark declared and paid cumulative preferred and common share dividends to Russel that totaled $14 million. These dividends will be reflected in our Q3 cash flows. Stock-based compensation had a mark-to-market recovery of $4 million in Q2 versus nil in Q1.

From a cash flow perspective, we had $72 million increase in working capital and this was driven by an increase in inventory that was due to higher average prices for inbound product and a little bit higher tonnage, some of which arrived right around quarter end. Looking forward, the lag effect from the recent steel price moderations and flow through to our average inventory cost and ultimately, our cost of goods sold as we move through Q3. CapEx of $8 million is consistent with Q1. We are continuing to advance a series of value-added equipment projects over the balance of '22, '23 and beyond.

From a balance sheet perspective, our net debt declined from $149 million at March 31 to $108 million at June 30 as we continue to generate good cash flow. Our liquidity is almost $500 million, and our credit metrics are strong, and we recently had an upgrade from Moody's to BA1. With the flexibility in our capital structure, we'll continue to look at M&A opportunities. And in addition, we have announced that we are filing for an NCIB.

One point of emphasis to illustrate the change that has occurred to our financial profile over a relatively short period of time is that our book value per share is now almost $23 per share as compared to less than $15 per share at the beginning of 2021. Lastly, we have declared a quarterly dividend of $0.38 per share.

On Page 7, we have our segmented P&L information. The Service Centers. The Service Centers continue to do very well. Revenues were almost $1 billion in Q2 and was driven by good demand in product prices. Tons were comparable to Q1 and average prices were up 6%. Gross margins moved up 2% to 24%, which translated to very strong gross margin dollars. Bottom line results from our Service Centers were strong with EBIT of $120 million.

In Energy, we are continuing to see positive market sentiment. Our Energy revenues were up 16% versus Q1 despite what is often a seasonally slower period due to spring breakup in Canada. Gross margins were up 27% versus 25% in Q1. Looking back over the past 3 quarters, they reflect -- the gross margins reflect the results since the monetization of the OCTG/line pipe businesses and can see how it's translated into higher average margins across the board. Distributors had another very good quarter. Even though total revenues were down somewhat from Q1, margins were strong and EBIT was up versus Q1.

If I go to Page 8, we've illustrated our inventory terms. The chart on this page shows the inventory turns by quarter for each segment with Energy in red, Service Centers in green and Steel Distributors in yellow. In addition, the black line is the average for the entire company. We've got a few observations.

Overall, our inventory turns remained strong at around 4%, which is solid by historical comparisons as we continue to focus on efficient inventory management, especially in light of volatile market conditions. By sector, our Energy and Service Centers came down a bit from Q1, but that mostly reflects some unsustainably low inventory levels in certain of our business units that occurred at the end of Q1.

For Steel Distributors in yellow, the inventory turns declined in Q2 as there was a sizable amount of inventory that arrived near quarter end, this inventory position should normalize into Q3.

On Page 9, you can see the impact of the inventory turns on inventory dollars. Total inventory picked up to a little over $1 billion at June 30 from $894 million at March 31. This was driven by higher product prices, a pickup in business activity in the field store business and in Western Canada more broadly and the timing of some inventory that cleared the ports for distribution business near quarter end.

As we look forward, I expect there to be some reduction of inventory tonnage as we maintain a proactive approach to managing our volume, as well as the lag effect from the recent price declines that will flow into the average cost of our inventories.

If we go to Page 10, you could see the overall impact on capital utilization and returns. Our capital deployment is up to around $1.5 billion, which is similar to 2018, '19 and early 2022 levels. However, that capital is being used much more effectively. The portfolio changes that we implemented along with favorable market conditions has resulted in strong returns, which have maintained at around 50%. This level is attractive by historical comparisons as well as versus our competitors.

The other takeaway from this slide is that we look over the past 3 to 4 years, we've seen a wide range of market conditions. In periods where markets are strong, we have generated great returns; in periods where market conditions are more challenged, we have generated lower returns, but we're able to realize substantial free cash flow from working capital.

If we go to Page 11, there's a few takeaway observations. One, capital allocation priorities. On our last call, we talked about M&A deal flow. A series of opportunities were evaluated during the quarter, but we remain committed to our criteria and most often, the acquisition valuations have not been attractive as compared to internal opportunities. We've talked about value-added processing equipment projects in the past, and we are advancing both smaller projects, as well as looking at other opportunities that could lead to modernized regional hubs. In addition, I mentioned the NCIB earlier on the call, and we'll be completing the filing shortly as I think it makes sense to have flexibility to opportunistically deploy capital through share buybacks.

From an outlook perspective, we see the same macroeconomic headlines as everyone else, but we actually are positioned very well regardless of market circumstances. Inflation is top of mind, but we have an operating philosophy that is centered around a variable cost model with high operating flexibility so that we can adapt as market conditions evolve, as the last 2 years have shown we adapt very well. Also, an important element of the variable cost model is our variable compensation component. That variable compensation is used across the company and tied to return on net assets. Interest rates have moved up, but our drawn debt is all fixed rate, and we have a large cash position and no drawings under our bank line.

For the Service Centers, I already mentioned our inventory metrics, but history has shown that we could generate a lot of free cash flow from working capital in a countercyclical environment. In Energy, we made a lot of changes to that part of our portfolio in 2021, and we are now starting to reap the rewards from the late-stage recovery of our field store businesses and from the cash dividends that we are starting to receive from the TriMark joint venture.

In closing, on behalf of John and the other members of the management team, I would like to express our appreciation to everyone within the Russel family. It has been a great first half of 2022 and is a direct result of the strong contributions by our 3,000-plus team members.

Operator, that concludes my introductory remarks, and you can now open the line for any questions. Thank you.

[Operator]

[Operator Instructions] First question comes from Michael Tupholme at TD.

[Michael Tupholme, analyst]

Maybe to start a question on the Service Centers tons shipped, which were consistent year-over-year. What would ton ships have looked like on a same-store basis, excluding the impact of the Boyd Metals acquisition?

[Martin Juravsky, executive]

Yes. Boyd Metals represents about 10% of our overall volumes. So that's the way to make that adjustment, if you want to take that into account, Michael.

[Michael Tupholme, analyst]

Okay. Perfect. And then how do you -- we have to follow on, how do you see the same-store tons shipped evolving in the second half and into 2023, if you have any visibility on that at this point?

[John Reid, executive]

Michael, I think what we see going forward, your normal seasonality will be in Q3, but we see everything moving really on a pretty flat basis. So we think it's pretty stable out there right now. Demand is solid. So again, outside of your normal seasonality, we don't see a lot of change.

[Michael Tupholme, analyst]

Okay. Perfect. So obviously, gross margins in the quarter were very strong. With steel prices having pulled back, as you noted in your outlook, can you help us think about Service Center gross margins in the third quarter? What should those look like given the pullback here?

[John Reid, executive]

On the gross margin, you'll go back and probably normalize to historical levels during the quarter and then start to rebound as they flesh out. And based on the turn number, you should see that -- things flesh out in the third quarter as long as we don't continue to drift south on pricing.

[Michael Tupholme, analyst]

Okay. So sorry, just so I'm clear, John, are you saying -- yes, I understand they should moderate, but then hence you back up once that -- once you sort of fleshed out some higher cost inventories? Is that the suggestion?

[John Reid, executive]

Yes. I think you've seen modest entries when they flesh it all out because you've got people racing to -- trying to race to the bottom right now. So we'll flesh out as we get through the higher cost inventory that will start to move back up just a little bit, probably in Q4.

[Michael Tupholme, analyst]

Okay. And normalized run rate margins for that business, once we sort of look through all the volatility Service Centers gross margins, is that still kind of in the 22% range or something thereabouts? Or what is that looking like these days?

[John Reid, executive]

Yes. That's -- Mike, that's a fair order of magnitude. And obviously, it moves around a little bit, but in the low 20% range.

[Michael Tupholme, analyst]

Okay. Maybe I can just squeeze one more in here, just on...

[John Reid, executive]

Just one last number. That's in percentage terms, obviously, in dollar margins, the dollars are higher than they have been historically and probably should continue to be higher than they have been historically just because we're talking about a higher top line.

[Michael Tupholme, analyst]

Right. Fair enough. And then just, I guess, carrying on with the same type of question just on gross margins. Can you also help us with thoughts on Energy products and Steel Distributors here in the short-term? And then I'd also be curious if you could shed a bit of light on what you think Energy products normalized gross margins look like given all the changes in the business that have occurred over the last several years.

[Martin Juravsky, executive]

Why don't I deal with that last question first and then John can talk about more of the macro. In terms of Energy products margins on a normalized basis -- going forward basis, if you look at the last couple of quarters, that is a pretty good reflection of how that business -- those businesses should operate now that the OCTG/line pipe business has been stripped out.

If you looked in the past, you saw a blended margin in the mid-teens, give or take, sometimes higher, sometimes lower, with a lot of volatility. Now that we stripped out the OCTG/line pipe business, which was single-digit margins, it brought down the average. And for the last 3 quarters, where the divested business is gone, you see margins in the mid-20%s. And so that is the new norm.

[Michael Tupholme, analyst]

Okay. So there wasn't a lot of -- you had a lift in Service Centers due to the pricing environment. That same dynamic wouldn't have been at play to a material degree in Energy. And so what we're seeing is actually representative of kind of a normalized market?

[Martin Juravsky, executive]

Yes. Like it was a pretty true reflection of how that business is operating.

[Michael Tupholme, analyst]

Perfect. And then maybe if John has any thoughts on the first part there, just around -- I mean, I think you sort of answered it to an extent with your comments there on Energy, but anything further on Energy plus Steel Distributors over the short-term here?

[John Reid, executive]

Yes. I think Steel Distributors will come down. They'll normalize down to more historical levels, but Martin categorized it, what you see right now is what you get with the Energy side. That was the reason that again, we pulled away or exited the OCTG/line pipe. The volatility was really there. This is more of a service-driven business. I think we've said it in the past, but it looks and feels like our Service Centers has got a little bit higher margin, gross margin profile in the mid-20% range.

[Operator]

Next question comes from Frederic Bastien at Raymond James.

[Frederic Bastien, analyst]

Just wondering, how do your activity levels at the Energy products field stores compared to where they might have been at the -- in prior peaks of activity?

[John Reid, executive]

Sorry, you said in prior peaks, Fred?

[Frederic Bastien, analyst]

Yes.

[John Reid, executive]

Yes, we're still -- it's down from where prior peaks were. So we've seen obviously an uplift from the trough. But in some ways, I'll characterize it we might be in the middle innings of a 9 new ball game.

[Frederic Bastien, analyst]

Got it. And okay, that's helpful. Also, just curious about your normal course issue a bit. What sort of -- what's driving this decision? And it seems not counterintuitive, but it seems to go against some of the philosophy of the firm dating back a few years. So maybe I'm off. But if I am, please correct me. Just wondering what the philosophy is beyond that?

[John Reid, executive]

Yes. Well, the philosophy is in trying to reconcile the history. It's trying to look at the current. And in the current environment, we've been very fortunate as we've generated a fair amount of cash flow. We have an extremely strong balance sheet, very high liquidity, and we see a disconnect in our share price. So we think it's appropriate as we look at where our share price is trading at relative to other opportunities to deploy capital, we think it makes good value sense for our shareholders.

[Operator]

Next question is the follow-up from Michael Tupholme at TD.

[Michael Tupholme, analyst]

So maybe just picking up on Fred's last question there. Can you maybe just more broadly talk about the thinking around capital allocation priorities? So to Fred's point, historically, NCIB hasn't really been -- it's been an option, I guess, but you haven't had that sort of a top tier option in the mix. So where does that kind of rank now? And when do you wonder what scenario do you get active with that versus directing capital to other priorities?

[Martin Juravsky, executive]

Yes. Well, in some ways, I view it less as what's #1, that's #2, what's #3 in terms of priorities. We have a capital structure that gives us flexibility to do multiple things, and we think it's appropriate to push on a number of levers as it relates to capital allocation. So our priorities haven't really changed.

So we're continuing to push on value-added projects, internal investments. We continue to actively look at M&A opportunities externally. We continue to pay our dividend. And now we're also putting in place the NCIB that gives us one other lever to look at how to be opportunistic and how to -- had to push on the various levers of capital. So for us, it's not one or the other or the other. It's -- we have a lot of flexibility to do whatever makes sense or multiple things in this case. That makes sense.

Going back to my comment before about our liquidity, we've got net debt to invested capital of about 7% today. We've got $500 million of liquidity. So we could do multiple things right now that makes sense for shareholders.

[Michael Tupholme, analyst]

Okay. That makes sense. And then on the value-add side, just looking at the CapEx year-to-date, I think you're at $16 million. Are you still looking at $50 million for the year? Or is that number maybe come down a bit?

[Martin Juravsky, executive]

It's a good question, Mike. It's probably come down a little bit. The projects that were embedded in that $50 million are still on the table and are still going to be completed. There's just some timing slippage that rather than they're perhaps being done in the fourth quarter of this year, they'll leak into 2023. But for all intents and purposes of this year's number will probably be down from the $50 million, but it doesn't change the specific projects that we have underway other than the timing of them.

[Michael Tupholme, analyst]

Okay. Perfect. And maybe one more here. Just jumping back over to the Energy products segment. Are you able to comment on what the like-for-like underlying revenue growth in that business segment was in the second quarter, if we exclude any drag on sales from the OCTG/line pipe businesses that you've exited or vented into the JV?

[Martin Juravsky, executive]

We can -- I don't have that number in front of me, Mike, but it's up. Let me get back to you with that number. I just don't have it handy.

[Michael Tupholme, analyst]

Okay. And then maybe just one other part to that. Like when have you fully lapped the divestitures of the business you've exited such that we wouldn't have to make an adjustment like [indiscernible]?

[Martin Juravsky, executive]

For all intents and purposes, next quarter. So the joint venture was set up in early July of 2021, and there was still some cleanup of the U.S. OCTG/line pipe business, but it was relatively insignificant. So when we look at Q3 this year versus Q3 of 2021, that will be a fairly cleaner comparison.

[Operator]

[Operator Instructions] No further questions, you may proceed.

[Martin Juravsky, executive]

Great. Thanks, operator. Well, I appreciate everybody dialing in. If you have any follow-up questions, please feel free to reach out. Otherwise, we look forward to staying in touch during the balance of the quarter. Take care, everybody.

[Operator]

Ladies and gentlemen, this concludes your conference today. We thank you for participating and ask that you please disconnect your lines.