Stelco Holdings Inc

TSX:STLC

Earnings Call Transcript 2018-Q3

[Operator]

Good day, and welcome to the Stelco Holdings Inc. Third 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 Third 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 third 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 involve 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 to 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 third 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 nonperformance measures of our third quarter MD&A provide definitions and reconciliations of the non-IFRS measures that we use today.Please also note that all dollar figures referred to in 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 would like to ask a question limit themselves to one question and one follow-up question before requeuing. Before turning the call over to Alan, I'd like to highlight we have added additional non-GAAP measures that we believe will be helpful to investors in understanding our underlying financial performance. The non-GAAP measures are tariff-adjusted EBITDA, tariff-adjusted EBITDA margin and tariff-adjusted EBITDA per ton. We hope you'll find the information helpful.With that, I would like to turn the call over to Alan.

[Alan Kestenbaum, Executive Chairman & CEO]

Thank you, Don, and good morning, everyone. We had another great quarter. We continued to drive positive momentum in our business and strategically enhance our company. Revenue increased 84% year-over-year and adjusted EBITDA was $154 million, up from $7 million in Q3 2017. We again generated a North American industry-leading 25% adjusted EBITDA margin in the quarter, which beat the rest of the industry by between 7 to 18 percentage points. This is especially remarkable considering we are the only reporting company in North America subject to 232 tariffs. And even more impressive, without the tariffs of $39 million and without the $10 million costs of the planned outage at the hot strip mill, our adjusted EBITDA would have been $203 million, or approximately 33% adjusted EBITDA margin, which is between 15% and 26% better than our competition.Our tariff-adjusted EBITDA was $193 million, up 4% from Q2, despite a 22% decrease in shipping volumes from Q2 to Q3 as a result of the planned outage. Our tariff-adjusted EBITDA margin in Q3 was 31%. Our tariff-adjusted EBITDA per ton in Q3 was $329 per ton, up 32% from Q2. We believe these metrics are important to add to our reporting in anticipation that the tariff impact will eventually go away either as a result of our ongoing shift in sales away from the roughly 24% of our business subject to tariffs in Q3 or as a result of ongoing governmental negotiations to ultimately remove tariffs altogether. In fact, in Q4, we will already see a meaningful drop in tariff costs.Our ability to get our tariff exposure down to close to 0 is possible over the next 2 quarters while the governments sort the tariffs out has been accelerated and facilitated by: number one, the Canadian government's thoughtful, decisive and prompt actions to impose retaliatory tariffs on U.S.A. producers, rendering them uncompetitive, be in position of safeguard measures on offshore producers of hot-rolled and prepainted coils and the ongoing trade cases on cold-rolled and corrosion-resistant steels; and two, our recent and continued investments to expand our product offerings to fill these supply voids left in the Canadian market as a result of the measures I just mentioned, and especially, in the exciting higher value-added products such as those going into the auto industry, galvanized markets and cold-rolled markets.In fact, I believe as a result of the new NAFTA, or USMCA, it is quite possible that the Canadian industrial markets we serve will actually improve its competitiveness and expand, giving us even more demand than just the void left by the retreating supply from the targeted sources.We are also gaining momentum on selling prices. Our selling price per ton in the third quarter was $980, up 9% from $898 per ton in Q2. The improvement in price, in combination with our efficiency gains, drove adjusted EBITDA per ton to $263 per net ton, up 12% from the prior quarter even on 22% fewer tons.Demand remains strong in the current quarter in all end markets we serve. We are expecting in Q4 significant growth in shipments, stable prices and increased earnings as compared to Q3.To summarize it simply, we have the highest margins by far in the North American industry despite being the only reporting company subject to 232 tariffs. We intend to continue to expand those leading margins in at least 3 ways: one, continued migration of our product mix from hot-rolled coil to value-added products; two, reduction and eventual elimination of tariff expense by the continued migration of sales to Canada and other nontariff markets instead of the U.S.A.; and three, continued focus and execution of reduction of our already low costs.Strategically, we are continuing to advance our efforts to maximize value of our assets. As an example, in June, we completed the purchase of over 3,000 acres of land, including nearly 800 acres in the very strong Greater Toronto-Hamilton Area. During the third quarter, we advanced in our strategy to see that land developed for its highest and best purpose by starting to hire experts in real estate development, developing a master plan for land development and beginning to market some of our vacant buildings to the very hot Greater Toronto industrial market. We're also evaluating various structures to determine the optimal one for shareholder value creation.I would like to express our gratitude to the Canadian government, who have acted quickly and decisively by introducing retaliatory tariffs against U.S. produced steel, the recent initiation of safeguard measures against offshore imports that cover the import of a number of steel products, including both hot-rolled sheet and prepainted sheet and the ongoing trade cases against China, South Korea and Vietnam on cold-rolled steel and against China, Taiwan, India and South Korea on corrosion-resistant steel such as galvanized steel.With substantial final and provisional duty margins, our investments in the annealing furnaces and the galvanizing lines could not have been better timed. As you know, during the third quarter, we paid $150 million, or $1.69 per share, special cash dividend based upon cash generated in the second quarter. Despite this, we continued to generate substantial cash and ended the September quarter with $347 million of cash and $646 million of total liquidity and expect to continue to generate strong cash flows.Taking our last 2 quarters of adjusted EBITDA on an annualized basis, we are trading at a very low 1.9x EBITDA multiple, a huge discount to our peers, which trade between 4 and 6x. This multiple doesn't take into account any value for the real estate or the fact that we have cash and no debt unlike any of our peers or that we have the highest adjusted EBITDA margin in North America both on the most recent quarter, trailing 6 months and trailing 12 months basis or the significant organic growth opportunities or the strong balance sheet and management track record experienced at building value inorganically.In short, I believe our shares are way undervalued. As such, we are initiating our first share buyback plan for the maximum amount we can at this time of up to 5% of our outstanding stock or up to 4.4 million common shares through a normal course issuer bid.Further, we continue to also return capital to our shareholders by the continuation of our regular quarterly dividend to shareholders of record on November 23 with a payment date of November 28. The buyback and this dividend is consistent with our policy and track record of good capital allocation by taking advantage of our strong liquidity position and returning meaningful capital to our investors in an efficient manner as we continue to be confident in our ability to continue to produce industry-leading EBITDA margins in generating cash in the business to continue to build shareholder value.Before I turn the call over back to Don, as we have just reached an important milestone of our one-year anniversary of being a public company, allow me a moment to recount just some of the incredible achievements of this management team. In just about one year since taking over the company, many people left for dead and breathing life back into the company and establishing a solid platform and great future for its employees, retirees, vendors, its shareholders and all stakeholders.Over the last 12 months, ending September 30, 2018, we grew revenue 55% to $2.3 billion. We increased shipping volume 35% to 2.5 million tons as a result of our capacity expansions. We completely debottlenecked our logistics and have avoided the trucking shortage by strategically investing in our dock to enable barge and ship loading of finished products and adding almost 400 railcars to our fleet, creating the most effective logistics platform in the North American industry. We have made great headway improving our product capabilities and improving the mix of sales to include more value-added products. We have aggressively controlled our costs in order to drive more and more of our revenues to the bottom line, becoming one of the lowest-cost producers in North America. As an outcome, our adjusted net income grew to $382 million for the 12 months ending September 2018 from a loss of $51 million the year before. Our adjusted EBITDA grew 180% to $468 million year-over-year, and our adjusted EBITDA per ton increased 107% to $184 per ton. Our adjusted EBITDA margin is 21% for the trailing 12 months ending September 30 and 25% over the last 6 months. That's 400 basis points higher than the next highest competitor in North America steel market and it's a 1,000 basis points higher than Stelco's adjusted EBITDA margin just a year ago.And finally, in the first year as a public company, we have paid $27 million in regular quarterly dividends, a $150 million in special cash dividend, and we're now executing on an approximately $100 million stock repurchase plan, a total of $277 million returned to shareholders in our first year as a public company. And with all that, we continue to maintain significant liquidity and one of the strongest balance sheets in the industry to enable us to execute on organic and inorganic growth.As a management team, we consider these accomplishments just the early stages of our long-term goal to create and build the best steel company in the world and substantial value creation for our shareholders.Now I will turn the call back over to Don.

[Donald P. Newman, Chief Financial Officer]

Thank you, Alan. Let's talk a bit more about the Q3 financial performance. Revenues of $619 million in the quarter were up 84% year-over-year and down 13% sequentially due to reduced volumes as a result of the outage, partially offset by the 9% increase in average selling prices. We continued to make progress in driving selling price performance as average selling price during the quarter was $980 per ton for all steel products, net of customer rebates and discounts. This is up $82 per ton, or 9%, from $898 per ton in Q2 2018 and up 24% from $793 per ton in Q3 2017.We 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. We are actively focused on increasing domestic sales as a means to make -- to take advantage of market opportunities that we believe the current trade environment presents.The 3-week strategic hot strip mill outage reduced hot-rolled coil production capabilities approximately 50,000 tons per week for the duration of the outage. We spent approximately $8 million in CapEx related to the outage and recognized approximately $10 million in incremental expense in the quarter due to the outage as a result of lower cost absorption and some incremental maintenance expense.Selling excess coke does directly go to our strategy, which prioritizes optimizing production from our existing assets, growing our sales and expanding our margins. During the quarter, nonsteel sales reached $45 million, up $10 million in Q3 2017 and up $6 million sequentially. This is mostly due to metallurgic coke sales. Gross profits on nonsteel sales totaled $19 million, up from $5 million in Q3 2017 and up $5 million sequentially.During the third quarter, we completed the rollout of our new ERP system. Prior to this, we had been using the U.S. steel system under a transition services agreement, a system that was not designed for our business needs. Our new system provides us with the tools, which we expect over time will enable us to further streamline processes and improve profitability.We generated $154 million of adjusted EBITDA in the quarter and the 25% adjusted EBITDA margin is fantastic, but also positive is the fact that while our revenue decreased $92 million, or 13%, largely due to the volume declines from the outage, our adjusted EBITDA per ton increased 12% to $263 per ton. We also continue our strong conversion of adjusted EBITDA to adjusted net income performance, which in Q3 was 85%.Finally, I would like to add the following: we see Q4 shaping up to be another great quarter. We continue to see strong demand for steel from our customers across all end markets. In the fourth quarter, we are expecting a significant increase in shipment, stable pricing and higher earnings relative to Q3.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] We will now take our first question from David Gagliano of BMO Capital Markets.

[David Francis Gagliano, Co]

First of all, congratulations on what's been a phenomenal turnaround. I look forward to following the rest of this turnaround as it progresses through '19 and '20, hopefully, as well. Just wanted to focus in on your plans to shift volumes to the higher-value products sold domestically in Canada versus the lower-value products exported to the U.S. in 2019. What are your expectations regarding the timing of that shift during 2019? And also, can you just give us a bit of an update on the progress there in terms of qualifying these higher-valued products in Canada?

[Alan Kestenbaum, Executive Chairman & CEO]

Yes. Sure. I'll handle it. So we've already upgraded the hot strip mill to accommodate the advanced high-strength steel markets that we wanted to get into and open the Z-line, which is where we do our galvanized. We're ready to go on that. And with respect to the annealing furnaces, which is basically for the cold-rolled business, that is expected to be in place starting Q2. So when you think about it, we're roughly about 20%, call it, 500,000 or 600,000 tons of shipments to the U.S.A. on an annualized basis. That product, which is a mix of products, but for the most part hot-rolled coil, we expect to ship into the Canadian markets for the markets I just mentioned. And the pace of that will be governed, really, by our ability to access those markets and get these orders. So from the equipment perspective, we're ready on 2 of the product lines, the other one would be ready in Q2. We're already making a significant headway, and you will see in our Q4 a reduction in tariff expense. We're already making significant headway in a number of the markets. When it comes to the auto contracts, for the first time, the doors have been opened to us with all the OEMs and most of the Tier 1s, and we're in conversations with them. Obviously, there's some sensitive nature to those discussions because it's a competitive process. But I will say that contrary to earlier years, where it was difficult to get into meaningful conversations with all of them, although we did have with some of them, now we're able to engage in conversations with all of them. And those contracts turn over from the beginning of 2019 through the first quarter of 2019, and we expect to capture some of that business. So we think that by -- to get into the second quarter of next year, we should get -- be able to get to our target of getting to 0 exposure to the U.S. and most of that conversion in the form of these other products. But we'll see. I mean, the markets are quite good here right now also for hot-rolled because of the -- some of the retreating of some of the some suppliers, and some of the markets have been good here as well. So as always, we run our business on a tactical flexibility model always seeking higher margin. So we will adjust that product where we can achieve that highest margin. But from an equipment capability standpoint and from a market availability standpoint, it's all under process right now.

[David Francis Gagliano, Co]

Okay. That's helpful. Thank you for the extra info. And then just as a quick follow-up, can you just give us an update on your plans regarding the potential restart at Hamilton works?

[Alan Kestenbaum, Executive Chairman & CEO]

So at this point, we continue not to comment on that potential. That potential is there. We certainly have the equipment capability, the capital capability and, for various reasons, we've not yet made any decision to start that and, therefore, I have nothing really to add on that front.

[Operator]

We can now take our next question from Matthew Korn of Goldman Sachs.

[Matthew James Korn, Senior Metals and Mining Analyst]

Congratulations again on the profitability reached. I have a couple near-term questions. Your expectations last quarter with the outage, you'd see volume lumpiness quarter-to-quarter, but a similar one-half, two-half level of shipments overall. Do you still expect to be able to catch up from this quarter and ship over 700,000 tons or so for the fourth quarter, over 1.3 million for the second half?

[Alan Kestenbaum, Executive Chairman & CEO]

Look, generally speaking, as you know, the outage, instead of 2 weeks, we said that it would take 3 weeks. We announced that in our last filing. So we did lose some tonnage experienced in Q3 as a result of going from 2 to 3 weeks. But consistent with what we said previously, other than that week, which is about 50,000 or 60,000 tons, we still expect shipments to be roughly in line with our first half.

[Matthew James Korn, Senior Metals and Mining Analyst]

Got it. And let me ask on the pricing side, we've seen benchmark hot-rolled prices softening towards the USD 800 a ton level. So as we're halfway through the quarter, given the normal factors of pricing lags, proliferated lead times, variable factors and sales agreements, tied in excess, et cetera, et cetera, how much of your fourth quarter sales are fully exposed? Better way to put it might be, if the crude price drops by $50 by month-end, say, does that soften your expectations for stable pricing next quarter? Or are you situated such that the effect this quarter would be minimal?

[Alan Kestenbaum, Executive Chairman & CEO]

So first of all, the markets have bifurcated. The Canadian market is different than the U.S. market, and our comments around stable pricing is related to the markets we're targeting, which is really Canadian markets, where the prices are stable. In fact, we put in a price increase and announced couple of weeks ago and that has accelerated the order book. We have achieved stable to better pricing in the Canadian market. We do have some CRU contract exposure from old contracts into the U.S. that we took at the end of last year. And -- but we are not taking any new orders in the U.S. We're targeting the Canadian markets, as I mentioned in my remarks. So what we'll see is a drop in exposure to U.S. prices. We will have some exposure, I don't know we'll obtain the exact tonnage, but it's not very meaningful on old contracts that are tied to the CRU. And we are not seeing dropping in pricing in Canada as you're seeing in the States.

[Operator]

We can now take our next question from Ian Zaffino of Oppenheimer.

[Mark Zhang, Associate]

Mark on for Ian. So most of my questions have been answered, but just want to have a quick one with regards to free cash flow. Can you guys speak a bit on capital allocation priorities, given the new purchase -- repurchase program and your thoughts going forward?

[Alan Kestenbaum, Executive Chairman & CEO]

Sure. We will stay consistent with what we've been doing. We always want to have a significant amount of cash on hand because, as I've said, this is really the very, very early stages of a big business we're trying to build, and to do that, we want to have ample liquidity for all markets. So we're generating a lot of cash each quarter. Last quarter, the decision was to take the excess cash and pay a special dividend. This quarter, based on where the share price is, we've made the decision to allocate that -- some of that excess cash to the share buyback. And our plan is to continue to hold ample cash both for a strategic growth, organic growth and capital allocation, shareholder-friendly allocation such as we've done so far.

[Mark Zhang, Associate]

Okay. Terrific. And then just a quick follow-up in terms of any M&A opportunities you guys are seeing in the markets right now that are attractive and, specifically, if there is any, I guess, like, specific area you guys are particularly interested in, whether it's on the growing the core business or growing into more value-added products, capabilities. Anything there would be greatly appreciated.

[Alan Kestenbaum, Executive Chairman & CEO]

Well, on the value-added products, as I explained, most of that is organic, investments that have either been completed or near completion. And that's revolving around the advanced high-strength steels for the auto sector, on the hot strip mill that we just completed, the corrosion-resistant steels and the cold-rolled. On the M&A front, certainly, there's a lot of things to look at. But as you know from many years of working with us, we're extremely selective and careful on what we do. And so certainly, there are interesting opportunities out there, and we will select the ones that provide the greatest value to shareholders.

[Operator]

[Operator Instructions] We will now take our next question from Michael Gambardella of JPMorgan.

[Michael F. Gambardella]

Congratulations on really repositioning this company in a great spot, but, Alan, I'm not surprised based on your great track record of doing similar things. Just a question on the quarter. Can you estimate what type of hit or penalty you took in terms of the 232 tariffs on your shipments into the U.S. and realizing, I know that importer of record pays that, but can you calculate some type -- or estimate some type of number of penalty on your earnings?

[Alan Kestenbaum, Executive Chairman & CEO]

Yes, $39 million is the amount for the quarter. And just to add to that, we didn't expect these tariffs to hit -- they hit at -- they were announced at the end of May. I think they wanted to [indiscernible] and we had a bunch of commitments. As you see in the fourth quarter, that number is going to drop because we're not taking new orders from the U.S. other than shipping existing commitments.

[Michael F. Gambardella]

A $39 million hit from the third quarter numbers for that. Okay.

[Alan Kestenbaum, Executive Chairman & CEO]

Right.

[Michael F. Gambardella]

And then when do you think you'll have this master plan for the real estate ready?

[Alan Kestenbaum, Executive Chairman & CEO]

We should have that available in about 2 or 3 weeks. So we're -- it's been a big effort. The master plan is not only what it looks like on the outside and all the pretty pictures, but it's also engineering work and other assessments that are made. So that's been ongoing for about 3 months now, and we should have that report in hand pretty much by the end of the month.

[Michael F. Gambardella]

And when do you expect to see the tariffs between Canada and the U.S. eliminated?

[Alan Kestenbaum, Executive Chairman & CEO]

Well, I mean, obviously, we don't know. What -- all we do know is what else is out there publicly is that there is ongoing discussion. I do think that there is a desire on both sides of the border to -- for that to happen. But Mike, I have to tell you, right now, the status quo is pretty good for us. So we're not in a hot rush right now. And -- but at the same time, on our mind, we'd like to see them either go away completely. And we'd rather see the right deal done than a bad deal. And I think the Canadian government is very, very effective at articulating that position, which is shared not just by us here at Stelco, but other steel companies in Canada as well. And the only thing I'll add to that, Mike, we're not sitting here relying on governments and waiting for them to what moods they wake up and what political considerations they have. We're taking our own actions here by assuming that they're going to be here and take actions to reduce our exports and reduce the tariff exposure as quickly as possible to 0. And we have the tools to do it.

[Operator]

Thank you. As there are no further questions, I will hand it back to our host for any closing or additional remarks.

[Alan Kestenbaum, Executive Chairman & CEO]

Well, thank you, everyone. I know the hour is late. I just want to say again, we thank everyone for their time. We're continuing to make progress on our strategic initiatives, which are all ultimately focused on creating shareholder wealth. We're on the right path. We're well positioned. We're one of the most technologically advanced integrated steel-making facilities in North America, and this skilled management team, I think, has shown here at Stelco what its capable of and, really, this is just the beginning. We've got very ambitious plans ahead of us, and we'll pursue them diligently, carefully and thoughtfully. Have a good day, everybody, and speak to you all very soon.

[Operator]

Ladies and gentlemen, this concludes today's conference call. Thank you for your participation. You may now disconnect.