Stelco Holdings Inc

TSX:STLC

Earnings Call Transcript 2018-Q2

[Operator]

Please stand by. Good day, and welcome to the Stelco Holdings Second Quarter 2018 Earnings Call. Today's conference is being recorded. At this time, I would like to turn the conference over to Don Newman. Please go ahead, sir.

[Donald P. Newman, Chief Financial Officer]

Good morning, everyone, and welcome to Stelco's second quarter 2018 earnings conference call. Joining me on the call today is Alan Kestenbaum, our Executive Chairman and Chief Executive Officer.Yesterday, after the close, we issued a press release overviewing Stelco's financial results for the second quarter of 2018. This press release, along with the company's financial statements and management's discussion and analysis, have been posted on SEDAR and on our Investor Relations website at stelco.com/investors. We've provided a link to the presentation referenced on today's call on our website as well.I'd like to inform everyone that comments made on today's call may contain forward-looking statements, which involves assumptions, which have inherent risks and uncertainties. Actual results may differ materially from statements made today, so do not place undue reliance on them. Stelco management disclaims any obligation to update forward-looking statements, except as required by law.With that in mind, I would ask everyone on today's call should read the legal disclaimers on Page 2 of the accompanying earnings presentation and also to refer to the risks and assumptions outlined in Stelco's public disclosures, in particular, the second quarter Management's Discussion and Analysis section relating to forward-looking information and risks and uncertainties as well as filings with securities commissions in Canada. The appendix of our presentation and the non-IFRS performance measures and review of non-IFRS measures of our second quarter MD&A provide definitions and reconciliations of the non-IFRS measures that we use today.Please also note that all dollars referred to on today's call will be in Canadian dollars unless otherwise noted.Following our prepared remarks, Alan and I will take questions. To maximize efficiency, we'd ask that all participants who'd like to ask a question limit themselves to one question and one follow-up question before requeuing.With that, I'll turn the call over to Alan.

[Alan Kestenbaum, Executive Chairman & CEO]

Thank you, Don, and good morning, everyone. We have followed up our solid first quarter financial results with even stronger second quarter results. Revenue was up 67% year-over-year and 48% from the prior quarter. And adjusted EBITDA was $175 million, up 150% from the prior quarter and well ahead of our guidance, which called for adjusted EBITDA of between $120 million and $150 million. And we generated an industry-leading 25% adjusted EBITDA margin in the quarter. This was achieved with an average sales price of $898 per ton, which is still well below current market prices.In the second quarter, we shipped 748,000 tons of steel. That is nearly a 3 million ton run rate, up 22% from the first quarter and up 49% year-over-year. The sharp increase in shipments resulted from our outage and capacity increase from 2 million to 2.8 million tons taken last September, and our focus on driving efficiencies and volumes and from a strong demand environment for steel in North America.As discussed on our first quarter conference call, recognizing the trucking shortage plaguing the entire industry, and while others whine about missing shipping targets because of it, we have completely debottlenecked our logistic operation by adding more than 200 leased rail cars to our fleet in Q1 and Q2, which shipped product out by rail at the highest level in the company's history; and by commencing operations at our repurposed Lake Erie Works dock, which historically was only used for imports of raw material and is now being actively used to ship our finished product by water. Combined, these efforts have reduced our reliance on trucking and allowed us to ship product that built up into inventory in the first quarter. To put this in perspective, the entire volume increase from Q1 to Q2 of 100,000 tons was done by barge and rail.We continue to be relentlessly focused on total shareholder returns. With our free cash flow growing to $145 million in the second quarter and $219 million for the last 6 months, along with our cash balance of $421 million at the end of the quarter, and uncompletely undrawn $375 million revolver, we are returning cash to shareholders by continuing our quarterly dividend of $0.10 per share and paying our first special dividend of $150 million, or $1.69 per share. We are also maintaining a strong balance sheet to enable us to pursue timely, accretive and opportunistic growth opportunities both organically and inorganically. To put this $150 million special dividend into context, the steel industry has not seen a special dividend of this magnitude in over 10 years. That's the entire steel industry.We are also continuing to make progress penetrating higher value-added markets, such as the auto industry through multiple channels, as well as direct to OEM, as well as the coated markets, and are investing in our facilities to meet ever-critical end-user requirements. To that end, as planned, we are taking a strategic outage to upgrade our hot strip mill. The upgrade will provide for better gauge control and increased rolling for us. These enhancements will enable us to better participate in higher priced auto advanced high-strength steel known as AHSS and high-strength low alloy, HSLA, and value-added coated markets. Even with this outage, we expect second half shipping volumes to be in line with first half shipping volumes subject to accounting differences between the third and fourth quarters.We believe we have demonstrated that with our tactical flexibility, operational model, combined with our low-cost structure and our newly expanded shipping capabilities, we will remain well positioned to continue to create value and deliver industry-leading results. As always, you can expect us to continue to create shareholder value by adjusting our product and geographic sales mix in pursuit of the strongest possible margins. We remain poised to benefit from higher steel prices, as our input costs have remained relatively stable on a sequential basis.As announced on June 5, Stelco completed the purchase of over 3,000 acres of land that were owned by Legacy Land Limited Partnership for approximately $114 million. We believe this deal will benefit us significantly in at least three ways -- one, by enabling us to potentially extract additional capacity and value from our currently idle steelmaking assets in Hamilton by enhancing our flexibility and access to these assets; two, by reducing our cost and limiting our exposure to the impact of further free cash flow sweep; and three, by extracting significant and previously unrealizable value from the development of the excess land and port facilities, especially in Hamilton, which we have acquired in the very strong Greater Toronto area property-constrained industrial market.We continue to closely monitor and actively participate in the regulatory environment. And again, due to our tactical flexibility business model, we believe we remain well positioned to react to all market conditions, including U.S. tariffs on Canadian steel. As we have stated previously, typically around 80% to 85% of our sales are made in Canada, and we will continue to focus on Canada. That includes potentially benefiting from demand created by declining sales of U.S.-produced steel into Canada due to Canada's recently implemented 25% import tariff against U.S.-made steel.We also see opportunities created by the very recently successful initiation of trade cases against China and others on cold-rolled steel and cases against China, South Korea and others on coated steel, such as galvanized steel. Moreover, the Canadian government has announced it will proceed with safeguard measures to prevent transshipment and diversions of steel to Canada. Our investment in our cold mills are perfectly timed to coincide with these actions, as we remain on track to have our new annealing furnaces operational in early 2019, which will expand our presence and product capability in the cold-rolled steel market, now, the most profitable product on a per-ton basis in our portfolio.Our strategic priorities remain to first, optimize production from our assets for our sales, continue to expand our already industry-leading margins and maintain a strong balance sheet. In combination, we continue to believe that these initiatives can meaningfully drive shareholder returns, while maintaining a conservative and manageable capital structure throughout economic cycles. This management team has a strong track record and experience in implementing its unique business philosophy of maintaining a strong balance sheet, be positioned to execute attractive, timely and accretive M&A growth opportunities, and drive total shareholder return.Now, I will turn the call over to Don.

[Donald P. Newman, Chief Financial Officer]

Thanks, Alan. The steel demand environment remains strong throughout North America and our quarter reflects it. Revenue at $711 million in the quarter was up 67% year-over-year and up 48% quarter-over-quarter. Revenue growth was driven by strong volume and price. Our Q2 shipping volume of 748,000 tons of steel represents roughly a 3 million ton annual run rate, a dramatic improvement from Q1 and a 49% increase from shipping rates in Q2 2017.I want to reinforce what Alan noted regarding the quick success achieved in debottlenecking our logistics. The results of those efforts can be seen in our Q2 results. In addition, our railcar fleet, at the close of Q2, numbered roughly 200. By the close of Q3, we expect to have nearly 400 rail cars in our fleet and continue to find opportunity to take advantage of our repurposed dock. We believe we have created a competitive advantage with our recent investment in rail and dock assets and are in a unique position to move products to customers throughout Canada, North America and the world.Selling price also strongly contributed to our Q2 performance. Average selling price was $898 per ton for all steel products net of customer rebates and discounts. This is up $136 per ton or 18% from Q1, but still well below the current market prices. Note also that our average selling price is an average across all our products and HRC is our lowest-priced product, so we are selling hot roll below that $898 average. Current hot-rolled coil market prices are well above those realized in Q2. The bottom line is that we believe we have substantial upside with these market prices and we are working hard to capture that value. We also remain extremely active on the sales front, opening up new customer relationships in both our existing markets and in markets that Stelco hasn't recently served.Another bright spot in the quarter were non-steel sales and margins. We generated $39 million of non-steel revenue in the quarter, largely from the sale of more than 70,000 tons of coke-related products. Total non-steel revenue increased $24 million quarter-over-quarter and gross profits on Q2 non-steel sales were higher than gross profit margins related to steel sales. Selling excess coke goes directly to our strategic priorities of optimizing production from our existing assets, growing our sales and expanding our margin.The $175 million of adjusted EBITDA in the quarter was well above the top end of our guidance. I would also note that while Q2 was a great quarter overall, we saw momentum building throughout the quarter, as EBITDA grew each month, with June being the strongest month of the quarter, even with the impact of $11 million of tariff-related expenses paid in June. The 25% adjusted EBITDA margin is fantastic and industry-leading. But also positive is the fact that 46% of the revenue increase quarter-over-quarter dropped through to adjusted EBITDA, and we converted 87% of our adjusted EBITDA into adjusted net income in Q2.Finally, we amended the OPEB funding agreement in Q2 and picked up $114 million mortgage note payable related to land purchase. The amendment served as effectively fixing annual OPEB contributions to the independent trust, eliminating the excess free cash flow sweep of 10.7% when annual free cash flows exceeded $200 million. And it provides greater certainty to our employees as to deposits into the trust.In terms of the mortgage note, you should think of it as bringing the previous land and building lease onto the balance sheet. But the cash balance -- cash payments under the mortgage are very similar to the payments under the prior lease arrangement across the 25-year mortgage term.That concludes our prepared remarks. I'd now like to turn the call back over to the Operator for Q&A. Operator?

[Operator]

[Operator Instructions] And we'll take our first question from Ian Zaffino with Oppenheimer.

[Ian Alton Zaffino, Managing Director and Senior Analyst]

Great, really great quarter. Question would be on the selling price. What type of discount were you -- basically to the index price, number one? And then number two, what should we expect as far as selling prices in the second quarter, just given where the market is right now and kind of your actions.

[Alan Kestenbaum, Executive Chairman & CEO]

Yes, I mean, basically like all steel mills, we sell at some discount to the CRU. We try and track the CRU as much as possible. What we can say at this point is that the current prices steel is now are well in excess of what was achieved in Q2.

[Ian Alton Zaffino, Managing Director and Senior Analyst]

Okay. And then as far as uses of free cash flow, I mean, the special dividend, is that something we should continue to expect, just given how strong the business is operating right now, or do you have maybe other uses of that excess free cash flow?

[Alan Kestenbaum, Executive Chairman & CEO]

We've got several uses. We're contemplating what we might do in Hamilton in terms of operations over there. As you know, Ian, you know how I've run the businesses for a long time and M&A is always a big part of our strategy but where we really succeed is doing M&A at the right time. And I like to be able to be the one guy with all the cash and no debt when the market goes the other way, so we get to really buy stuff at deep, deep discounted value. That's what we do. We do it different than anybody else. We're not romanced by chasing high-priced deals at the top of the market.And so we're going to do a little bit of a split. We're going to continue to do dividends, the regular dividends. If we find ourselves in a position with excess cash that we think we might need to execute our long-term strategy of organic and inorganic growth, we will continue to return cash in massive sizes like we did this time. So the answer is, it's a combination of all if we want to do that, but we also want to position the company for a very, very exciting future to meaningfully grow the company over the next few years.

[Operator]

And we'll take our next question from David Gagliano from BMO Capital.

[David Francis Gagliano, Co]

I'm going to try the pricing question again just from a different angle. The slide indicated current hot-rolled prices, $1,168 a ton, which is $270 above your second quarter weighted average realized price. And obviously, you mentioned on the call that that's a weighted average that includes prices that are higher for [ oil ] and galvanized and things like that. So I do think it's important, management execution here. Given that the third quarter prices are basically locked in now with your lags, what is a reasonable assumption for the weighted average realized price for the third quarter Stelco?

[Alan Kestenbaum, Executive Chairman & CEO]

Yes, the one that you're referring to is the CRU price; that's the $1,168, that's the CRU price. And as we noted earlier, we can sell at a discount to the CRU price and we don't give out line item price information for a whole bunch of reasons. But as I said before, it is significantly higher than where we were in Q2.

[David Francis Gagliano, Co]

Okay. One other try at this -- we backed into a quarter-over-quarter after assuming some discounts, et cetera, about an 80 dollar Canadian -- $80 price improvement of weighted average 3Q versus 2Q. Does that sound accurate or are we being way too conservative on that $80 number?

[Donald P. Newman, Chief Financial Officer]

It's -- as we've talked about, we don't like to give guidance in terms of price. I think that we've seen continued strength in the steel prices. And as you look at the business, I'd have to know more about your math, but expect that we would have some modest improvement in Q3 is a possibility relative to what we captured in Q2. Part of that has to do with us working --

[David Francis Gagliano, Co]

Okay. And then --

[Donald P. Newman, Chief Financial Officer]

Part of that has to do with us working through in early Q2, our backlog, the remaining backlog and some of low-price sales.

[Alan Kestenbaum, Executive Chairman & CEO]

And I think also, bear in mind that we do remain 85% exposed to the spot market. You can track the spot market on various indices and other publicly available information. And as previously -- we don't like to give pricing information.

[Donald P. Newman, Chief Financial Officer]

Yes, those indices that -- those indices are helpful, I think, in terms of just understanding trends in terms of what's happening with steel prices.

[Alan Kestenbaum, Executive Chairman & CEO]

And I'll also highlight that we are, as a result of the way the market has shifted, putting more and more emphasis on our downstream operation to galvanized, for instance, Z-Line product. And we are seeing very, very meaningful price increases quarter-over-quarter in those products. So we report an average price, so the average price is impacted by the -- the general market price that you see is also impacted by a migration of some of our products into further downstream products, particularly on Z-Line and galvanized, which -- a lot of that is being helped by the trade cases that I mentioned, which are tightening the market here in Canada, and given that's a good opportunity there.

[David Francis Gagliano, Co]

Okay. That's helpful. And then just the two-part follow-up and then I'll turn it over. First of all, can you just help us with our modeling, a little more detail? Can you quantify the volume impact in 3Q from the outage in September? That's part one. And part two, just to try and pin you down a little bit more on the capital allocation question. Should we be expecting additional special dividends in 2018?

[Alan Kestenbaum, Executive Chairman & CEO]

We don't know yet. I don't think we can -- I don't think we want to promise that. That's an exceptional-sized dividend. It's a special -- it's called special dividend because it's special both in terms of size, but we'd like to. I mean, if we -- depending on how business conditions can exist and go on, if we can, we'd love to do that. So it's not something that we're planning on doing once. Whether another one happens in '18 or not, we don't know at this point.In terms of the volume, what we're saying here is that the second half is going to be more or less the same shipping volume as the first half. Hard to break down Q3 to Q4 because the outage is going to be a couple of weeks; it's going to start in the early part of September. It's going to meaningfully impact our ability to make some of these higher grade products. And so we don't really -- we don't have enough information at this point yet to answer the other question, but for the half, we expect more or less the same volume as we did in the first half.

[Donald P. Newman, Chief Financial Officer]

The other thing we'd point out about the outage is this was planned; it is a strategic outage. And it's part of our overall strategy and expanding product offerings' both depth and breadth.

[Operator]

And we'll take our next question from Matthew Korn with Goldman Sachs.

[Matthew James Korn, Senior Metals and Mining Analyst]

Hey, good morning, Al and Don. Congratulations on the shipments that the team achieved. Changing track a little bit here, could you elaborate a bit more, Alan, on what the opportunities are from the Land Package purchase? First, what does enhancement -- previously unavailable flexibility really mean? And then when you're thinking about the cost savings, can you quantify that at all and how we'd be thinking about that? And then last, and the third piece, is it your intent to develop parts of this land? Are you looking to partner with someone? Like what would the environmental work or permitting work look like as far as that goes? Thanks.

[Alan Kestenbaum, Executive Chairman & CEO]

So first of all, in terms of the first question in terms of what we mean by flexibility, in order for us to expand operations at Hamilton and restart a certain piece of equipment that we own, we didn't own the land underneath it. So in order to get those going, there would've been some complex negotiations around rent, easements, utility sharing, data usage. All that stuff goes away. So now, we have the ability to focus on an economic decision on what we want to do there without having the complications involved in negotiating with another party.With respect to the cost savings, as we pointed out in the press release when we first announced the transaction, over the -- between the payments of the rent and the obligations that would go into the legacy plans, the total payments now amount to something like $78 million. So that's a savings of $78 million over the course of those many years of payments. But the bigger part, which we can't put a number on, is we had -- we no longer do -- but we had an obligation to deliver 10% of the free cash flow above $200 million. I mean, when we made that deal, we thought $200 million was a blue-sky number; now we're shooting through that on a regular basis so -- and that would've been a very, very expensive price to pay. And so we've eliminated that.So you can start at $78 million and probably go up into the hundreds if you start thinking about the avoided payments on the free cash flow sweep that we no longer have to make. In terms of the land development, look, we're a steel company. We're staying very, very, very focused on our steel business, but at the same time, we're entrepreneurs. We have not advanced enough plans at this stage, just having owned the land for a few weeks, but let me just give you a couple of things to dream about, what could be here, because it could be quite incredible.First of all, the area here in what's called the Greater Toronto area is a very, very hot industrial market. The cap rates was not a term that we use in the steel business, but a term -- a real estate term -- are 5%. It's the best cap rate in the real estate market, which is equivalent to a 20 multiple. So when you think about it, we've got buildings, land that could be developed. A dollar earned at Stelco -- and we firmly believe we deserve a 6.5 multiple -- so a dollar earned at Stelco is worth $6.5 million in market cap. A dollar earned in the land is worth $20. That gives you an idea of some of the financial opportunities here in what's here with the land. Land in Mississauga, which is the last remaining piece in the Greater Toronto area, goes for $2 million an acre. Land in Hamilton is substantially cheaper, but there really is no large parcel of land in the entire Greater Toronto area like this.So given that everything combined, the fact that the industrial market is super-hot; the fact that there is no land in the Greater Toronto area like this; the fact that we have ports in -- a port on top of just industrial land; we also have the port, really leads to all kinds of exciting potential values for this land. The land I'm talking about basically is the 800 acres of land in Hamilton and 200 acres of which are going to our steel operations, and 600 acres is what's developable land. Look, the potential is enormous, but it's early stage. We'll have a subsequent call to talk about that in more detail once we've kind of narrowed down exactly what we're going to do here, but the potential is enormous.I want to reiterate though that we are focused on steel. We're a steelmaking company; that's our core business. And when and if we do decide to pursue the opportunity I've just described, you can be sure that we'll staff it with a completely focused, independent, experienced, best-in-class management team to do this.

[Matthew James Korn, Senior Metals and Mining Analyst]

Got it. I appreciate it. That's really helpful color. Let me then follow up this way. Regarding everything that happened with trade with the tariff, and the Canadian government's statements in the past, is there any support, financial support, direct or indirect, that you expect, or that is coming to you from the Canadian government?

[Alan Kestenbaum, Executive Chairman & CEO]

There are a variety of programs that have been announced, so the answer is yes. And we've got some people that are involved in pursuing those and making them available to us. But the thing that's really most important here that they've done, I mean, financial is one thing. The bigger thing that they've done is they had the -- they put the 25% tariffs on the U.S. steel coming in, I mean, steel produced in the United States. Let's keep in mind that more steel moves over the border into Canada from the United States than Canada ships into the United States. So that means net-net, the market expands for us here in Canada. So that's one.The second thing I mentioned is the unrelated, but equally important, trade cases on the downstream product for cold-rolled and coated. And the third element is the safeguards, which the government has announced are being pursued, though they've not been specific yet on what products will be included, when it'll happen, but those are very important too. Actually fixing the problem with the United States right now because one of the complaints that the U.S. has is that shipments flows through Canada potentially and then finds its way into the United States, which we actually don't think is actually true, but that's something that's been said.These safeguards [ field ] the border and enable the Canadians to, I think, have a better shot at negotiating NAFTA basically the same. We've put these things in place to prevent the diversion of steel, transshipment of steel through Canada. So these are the measures that are -- that on the one hand, help the -- help that negotiation, but more immediately, create a supply and demand balance in Canada that remains healthy.

[Donald P. Newman, Chief Financial Officer]

So Operator, this is Don Newman. We have time, I think, for one more question.

[Operator]

All right. And we'll take our next question from Michael Gambardella with JP Morgan.

[Michael F. Gambardella]

Yes, congratulations, Alan and Don. Congratulations on not just the quarter, but the turnaround in this company from the very beginning that you guys started. It's pretty remarkable.

[Alan Kestenbaum, Executive Chairman & CEO]

Thank you.

[Michael F. Gambardella]

Just a question regarding the land purchase. When you announced that you were leasing the land, one of the benefits you talked about was that you're distancing yourself from the potential environmental liability of the past from the land. Can you talk about the environmental liabilities going forward, now that you've repurchased the property?

[Alan Kestenbaum, Executive Chairman & CEO]

Yes. So first of all, as part of the land purchase, we have inherited the lease. If you remember, when we did the acquisition about a year ago, we got a release from the environmental folks called MOECC. And we have inherited that release. So the same release that existed before that was in favor of LandCo, the entity that we bought it from, that benefit of that release continues to us. That's one.The other very important point here is when we did the acquisition, we had to go very, very quickly, and we really were not familiar with the environmental status of the property; and therefore, opted in the interest of speed and focus on the steel industry to simply not take the land. And more specifically, there were piles of product, like slag and stuff like that, that we really didn't know if that was a liability or if that was something that was negligible. We couldn't quantify it, and so that's why, as you correctly point out, we structured the transaction like that really with belts and suspenders. One was the release; two is non-ownership.Well, the release we'll call the belt in this example, we inherit. The suspenders are not needed, and the reason is that since that time, we've been able to identify actually within those piles, and in fact, not only are those piles not a liability, we're actually shipping out those piles right now at a profit to companies like cement companies that can actually use that product. We had a remediation and plan that we also inherited for a rather de minimus amount of money, from recollection, something in the $5 million range. But it seems that we will not even need to avail ourselves of that remediation plan. We actually should be able to ship that stuff out and sell it at a profit and that's what's happening right now. So between those two points, we got very, very comfortable, which is something we did not have the opportunity or the time to get comfortable with when we first made the acquisition.

[Michael F. Gambardella]

Okay. And just a follow-up question regarding the land purchase. You must have an enormous amount of square footage under roof that's not utilized by the steel company on the property. Could you give us an idea how much you have under roof that could be used for other purposes on the site, and what potential is there?

[Alan Kestenbaum, Executive Chairman & CEO]

Yes, just to give you some idea -- and we've got to get this number nailed down -- but just to give you order of magnitude, we're talking something like 8 million to 9 million square feet under roof. There's also land available for further building. It's interesting, as we started to get into this, some of these buildings, they looked like big -- well, they are -- big steel buildings with high roofs. And like the immediate knee-jerk reaction is, oh, let's knock those down.Well, then, we got contacted by movie studies that said, "Oh, no, no, no, we love those high ceilings. We get to -- we can't even -- we can't build those buildings; we can't find those buildings." So this is really, really early stage and I don't want to give you any kind of guidance or anything in terms of what we think the value is here. But just to give you an idea, we've been swamped with inbound inquiries. The answer to your question in terms of what's under roof at the moment is about 8 million or 9 million square feet.

[Operator]

And this concludes today's question-and-answer session. I'd like to turn the conference over to Mr. Alan Kestenbaum for any additional or closing remarks.

[Alan Kestenbaum, Executive Chairman & CEO]

Thank you. So in summary, I'm excited by the results we are reporting today. We are on the right path and the wind is at our back. Stelco remains ideally positioned in a growing industry with one of the newest and one of the most technologically advanced, integrated, steelmaking facilities in North America, and a skilled management team with a proven track record of creating shareholder value. Have a good day.

[Operator]

And this concludes today's call. You may now disconnect.