Materion Corporation

Greetings. Welcome to Materion's third quarter 2020 earnings conference call. At this time, all participants are in a listen-only mode. A question and answer session will follow the formal presentation. If any of which require operator assistance during the conference, please press star zero on your telephone keypad. Please note this conference is being recorded. I will now turn the conference over to Steve Shamrock, Interim Chief Financial Officer. Thank you. You may begin.

Good morning. This is Steve Shamrock, Interim Chief Financial Officer. With me today is Jugal Vijayvargiya, President and Chief Executive Officer. Our format for today's conference call is as follows. Jugal Vijayvargiya will provide an update on COVID-19 and key strategic initiatives. Following Jugal, I will review detailed financial results for the quarter, and then we will open up the call for questions. Before we begin, let me remind investors that any forward-looking statements made in this announcement, including those in the Outlook sections, and during the question and answer portion are based on current expectations. The company's actual future performance may materially differ from that contemplated by the forward-looking statements as a result of a variety of factors. Those factors are listed in the earnings press release we issued this morning. Additionally, comments with regard to earnings before interest and taxes, net income, and earnings per share reflect the adjusted gap numbers shown in attachment number five in this morning's press release. The adjustments are made in the prior year period for comparative purposes and remove special items, non-cash charges, and certain income tax adjustments. And now, I'll turn it over to Jugal for his comments.

Thanks, Steve, and welcome, everyone. I hope all of you and your loved ones continue to remain healthy and safe during these unprecedented times. Today, I'll first review the impact of COVID-19. and follow that up with an update on our key strategic initiatives. Health and safety of our people continues to remain our overriding priority. We continue to take input from all available sources to ensure appropriate measures are taken to protect our people around the world. A majority of our office employees are working from home and all of our factories are operating. As you would expect, we continue to experience the impact of COVID-19 in a number of our key end markets, particularly in aerospace, energy, and industrial. Despite very challenging market conditions, we delivered sequential earnings growth for the second consecutive quarter, and all three of our businesses reported double digit profit margins. Semiconductor sales continued on a positive trajectory with sequential and year-over-year growth led by commercial performance initiatives related to new products and stronger demand. We have actively managed our costs in response to the downturn. Sequentially, earnings increased 12% with a sales increase of 4%. I will now transition and review some of our key strategic initiatives. I'm excited to report consolidated quarterly financial results, which include Optics Balsers for the first time. The combination with Optics Balsers creates the world's leading thin film optical coatings provider with a highly complementary geographic, product, and end market portfolio. Our teams are fully engaged with integration activities which are going very well and according to plan. Our commercial teams are starting to work together on identifying synergistic customer opportunities in support of our overall growth objectives. Our engineered class trip project, which I announced earlier this year, remains unscheduled. As a reminder, we entered into a business arrangement with a new customer to expand our manufacturing capacity for a highly engineered clad strip product which will be used in a next generation model of an existing product. The total investment of the project is expected to be approximately $85 million, with the customer pre-funding approximately $70 million. In September, we received an additional $14 million from the customer for a total of $45 million In support of this program, we are actively working to establish a new leading-edge manufacturing facility for future product supply. In addition, we're making good progress on negotiating a long-term supply agreement and expect to finalize in the fourth quarter. We are also on track for shipping product in the fourth quarter from our existing facilities. Lastly, I will provide a quick update on the PAC Facility Consolidation Project. This project remains on schedule to complete all activities by year end. We completed the closure of the Detroit Michigan Service Center in the second quarter. In the third quarter, we shut down production at our Fremont, California location. We expect to complete relocation and installation activity in the fourth quarter. In closing, I want to sincerely thank our global team who is persevering through this pandemic with a determination and focus to drive and turn on forward on our transformation into an advanced materials business. Now, I'll turn the call over to Steve to cover the financials.

Thank you, Jugal, and good morning to everyone joining us on the call today. During my comments, I will cover third quarter 2020 financial highlights, Review profitability by segment, provide brief comments on the balance sheet, cash flow, and modeling assumptions, and finally, cover the earnings outlook for the fourth quarter of 2020. Following my remarks, we will open the line for questions. Despite the ongoing COVID-19 pandemic, I am pleased to report third quarter results which exceeded the second quarter. Third quarter value-added sales, which exclude the impact of pass-through and precious metal costs, were $167.5 million up 4% compared to second quarter value-added sales of $161.6 million and down 11% versus the third quarter of 2019. Compared to the second quarter, the incremental sales related to the optics falters acquisition and growth in the semiconductor and market. This was partially offset by softer demand in markets impacted by the COVID-19 pandemic, including aerospace and industrial. Telecom and data center end market sales were also lower due to lower demand related to the continued impacts of tariffs and COVID-19. Gross margin was 46.6 million in the third quarter compared to 48.1 million in the second quarter. The third quarter gross margin included 7.3 million of mine development costs. As you may recall, we have historically accounted for these investments as capital expenditures. However, in the third quarter, We returned to expand an existing pit in production for the first time based on the cost to extract the ore and ore purity. Despite the fact that these costs are of the exact nature and type as previous mine development activities, technical accounting rules require us to treat these costs as period costs. We incurred $7.3 million of expense in the third quarter and expect to incur an additional approximately $6 million in the fourth quarter. Once these mine development activities are completed, We expect to extract ore from this pit into 2023. We also do not expect to incur additional mine development costs until sometime later into 2022. Based on these factors and our historical treatment, we identified these costs as special. Excluding mine development and other special items related to COVID-19 and the optics bulgers acquisition, adjusted gross margin was $55.1 million. are 33% of value-added sales, a 200 basis point improvement compared to the second quarter adjusted gross margin of 31%. Our manufacturing team has continued to drive significant operational improvements despite lower sales. Selling general and administrative expense totaled $35.7 million, up versus the second quarter of $32.9 million. Excluding special items related to the acquisition and integration of optics pulsars, COVID-19 and the forfeiture of non-cash stock-based compensation, adjusted SG&A expense totaled $32.2 million. As a percentage of value-added sales, adjusted SG&A expense was 19% in the quarter, consistent with the second quarter. We continue to aggressively manage our SG&A expenses in response to current demand trends. Research and development expense was approximately 3% of value-added sales in the third quarter. consistent with the second quarter as we continue to make investments to drive long-term profitable growth through development of new products and applications. In the third quarter, we recorded restructuring expense of 2.6 million related primarily to the previously announced closure of our Detroit and Fremont facilities for relocation costs and severance. As you may recall, we recognized a 2.2 million unrealized foreign exchange gain in the second quarter related to the purchase of optics fallsers, which was denominated in Swiss francs. We also reported an additional $1.1 million foreign exchange gain in the third quarter related to the same item, which we also classified as special. We reported third quarter earnings before interest and taxes of $1.8 million. Excluding special items I mentioned previously, adjusted EBIT was $15.4 million or 9% of value-added sales. Looking at income taxes, we recorded an income tax benefit of $6 million in the third quarter of 2020. Excluding the tax impact of special items and special tax expense items of $5.8 million, our adjusted tax expense was $2.8 million, or an effective rate of 19.8%, in line with our previous guidance. The tax special items primarily relate to the acquisition of optics fallsers and federal tax law changes enacted in the quarter. Finally, net income in the third quarter totaled $6.5 million. On an adjusted basis, we reported net income of $11.3 million, or $0.55 per diluted share, compared to $0.49 per share in the second quarter. The increase compared to the second quarter was due primarily to manufacturing performance improvements, aggressive cost management, and the addition of optics falsers. Now let me review 2020 third quarter performance by business segment. Looking now at our performance alloys and composites business. Value added sales were 81.9 million, a decrease of 7.9 million compared to the second quarter. The sequential decrease is due to a continuation of soft demand in select end markets impacted by COVID-19, particularly aerospace and industrial. In addition, raw material hydroxide sales were down $3 million compared to the second quarter. EBIT excluding special items was 10.4 million or 13% of value-added sales compared to 12.3 million or 14% of value-added sales in the second quarter. The sequential decrease in EBIT is due to lower sales volumes, partially offset by manufacturing performance improvements. This business has been impacted the most by the ongoing global pandemic given the exposure to the aerospace, energy, industrial, and automotive end markets. Although we are focused on making further improvements to EBIT margins, we have made tremendous progress in this business. PAC reported double-digit EBIT margins for the 11th consecutive quarter. I also remind investors that at comparable sales levels in 2016, this business reported EBIT margins which averaged in the low single digits. Moving to advanced materials. Value-added sales in the third quarter of 2020 were $57.6 million. up 5% versus the second quarter and 4% versus the prior year driven by growth in the semiconductor end market as commercial performance initiatives and increased end market demand drove the growth. EBIT excluding special items was 6 million in the quarter compared to 5 million in the second quarter. EBIT margins also improved sequentially from 9% in the second quarter to 10% in the third quarter. The improvement in EBIT margins was due to favorable sales mix and manufacturing performance improvements. And we remain focused on continuing to improve this metric going forward. Turning finally now to the Precision's Coding segment. Third quarter value-added sales were $28.3 million, up 59% compared to the second quarter due to the acquisition of Optics Balsers and strength in our legacy Precision Optics business. Partially offset by lower sales of blood glucose test strip products in our large area coatings business and reduced demand for projection display products. As you may recall, we announced our intention to sell our large area coatings business in the first quarter. After going through the sales process, we have made the determination to wind down the operations of the business and sell individual assets. We expect to substantially complete these actions by the end of the year. EBIT excluding special items was 3.5 million or 12% of value added sales compared to 2.4 million in the second quarter. The increase in EBIT was due primarily to higher optical filter product sales. Moving now to the balance sheet and cash flow. The company ended the third quarter of 2020 with a net debt position of only 10.9 million and approximately 234 million available on the company's credit facility. We continue to have more than adequate liquidity to manage in this challenging environment. Our capital spending increased in the first nine months to $46 million. The increase versus the prior year is related to the customer-funded engineered strip growth opportunity Jugal mentioned. For financial modeling purposes in 2020, capital spending should run approximately $25 million net of customer prepayments related to the new engineered strip project, Annual depreciation and amortization should run approximately $42 million and assume an 18% to 20% effective tax rate, excluding special items. And finally now, the earnings outlook for the fourth quarter. The impact of the COVID-19 pandemic continues to create heightened levels of uncertainty, making it very difficult to predict the extent to which our business, results of operations, financial condition, or cash flows will ultimately be impacted. We will continue to aggressively manage our cost structure in the current environment. At this time, based on current order entry levels, we expect fourth quarter adjusted earnings to be slightly better than the third quarter. This concludes our prepared remarks. We will now open the line for questions.

Thank you. If you would like to ask a question, please press star 1 on your telephone keypad. A confirmation tone will indicate your line is in the question queue. You may press star 2 if you would like to remove your question from the queue. And for participants using speaker equipment, it may be necessary to pick up your handset before pressing the star keys. Our first question is from Marco Rodriguez with Stonegate Capital Markets. Please proceed.

Good morning. Thank you guys for taking my questions. Good morning, Marco. I was wondering if maybe you could spend a little bit of time on optic fallsers here. First, if perhaps you can provide what sort of a revenue benefit it had in Q3. And then from a bigger picture standpoint, just wondering if you can talk a little bit about the sales team's efforts there, how that integration is going, what that structure is going to sort of look like to drive the top line synergies you're looking for. And then if maybe you could touch on any sort of incentive structure that might be somewhat different to try and drive that line out of there for the acquisition.

Yeah, Marco, let me just first give a quick update on the integration activity itself. You know, we've had our day one for this business. And then since then, we've really excited to have the integration led by teams from both the Optics Pulsar side as well as the teams from the Materion side. I can tell you the integration has gone extremely well. We have a couple of outside firms that have been working with us. We have a seasoned integration leader that we put in place who is helping lead this activity. So I'm pleased to tell you and everybody else that all the things that we expected from this so far, and of course it's early stage, but so far everything is progressing per plan. With regard to the revenue for this business, keep in mind we had about 10 weeks of the quarter when we took over this business, so not a full quarter. We don't specifically call out what the revenue is, but I'm sure that if you look at some of the historical information that we've provided and try to look at it from that perspective, you may be able to understand at a high level. Keeping in mind that the historical information, of course, did not have COVID impact, so that would have to be factored in. This business really gets integrated into our precision coatings business. It's roughly about half the size of the overall business of precision coatings, and so we'll continue to manage this at a business unit level with precision coatings in total and continue to report all the information at that level. You know, on the sales structure, I can tell you that's a really exciting phase right now. We actually have a firm that Optic Folgers, in fact, has worked with in the past to help drive some of the sales activities on their side. We've been employing that firm to work with us and integrate the two sales organizations. It's going very well, developing a global organization that can have global customer accounts, at the same time can provide the regional service that is needed. And that team is, I would say, at a phase where the structure has been outlined. We're starting to put some names in place now with that structure. And we're starting to identify some initial projects that we can start to work on. But as you can imagine, first and foremost, we have to make sure that we get the proper structure in place, the names in place, and then start driving the sales synergies which we are so hungry for in this acquisition that we did. Incentive structure, I mean, that clearly is going to be an important element of what we go forward. I mean, we have a very good disciplined incentive structure that I believe we've created for the Materion side in the last couple of years. And so that's one of the things that our HR organization and our sales organization is looking at is studying the incentive structure that Optics Bulgers employees have and then what the Materion employees have had and we will be looking at opportunities to merge those if it makes sense to drive it. But clearly that will be an important part of helping drive our growth initiatives as we move forward. So in general, going well, quite excited about it and look forward to reporting future progress in future calls.

Understood. And then in terms of the merging of the sales teams with Materion and Optic Fallsers in the PC segment, can you describe a little bit about the training efforts, the cross-training efforts? Is that something that's very difficult or is it something that's pretty easy when it comes to the cross-selling there?

Yeah, no, I think it's going to be a fairly easy task in terms of the cross-selling because, you know, both of these organizations, these businesses are experts, you know, at optical filters and optical filter technology. You know, a lot of the customers that we actually work with, you know, are similar, are same customers. And I think, you know, the regions that we're working in, we're going to leverage the actual local expertise for the region so we don't have as much training let's say necessarily that's needed from a regional perspective so I think it's a good start with the team that we have I don't expect it to be a lengthy process I expect these people to be able to pick up the technologies from each other quite rapidly and move forward and I think from a customer standpoint I expect the teams to be able to operate fairly quickly

And then, Jugal, in your preferred remarks, I didn't quite catch all of it, but you had made a mention about one of the pillars of your strategy on commercial excellence and specifically brought out some new products and some strong demand, I guess kind of helping out the quarter. Can you maybe provide a little more color around that statement there?

Yeah, I mean, when we look at the quarter, you know, a couple of areas that I think were good, you know, good positive movements for us. One, clearly the semiconductor side continues to be a strong market in general, both from a general marketful standpoint as well as products that we're introducing. So we've talked about an aluminum scandium product a couple times actually on the calls, and we continue to be quite excited about that product. That's one that – can be used for 5G and for other semiconductor applications. And so we continue to see robust demand on that. And that's, I think, helped in some of the offsetting some of the downturns that we've had with the other markets. When you look at some of our pickup in the consumer application, consumer electronic side, some of the mobile handset devices and applications. So we have some pickups there with some of our new products. There's some softness that's also happened in the consumer electronics side with some of our projection display business. So the net isn't necessarily as strong as the semiconductor side, but we have a segment of the consumer side that, you know, is doing well on a sequential basis.

Understood. And then, you know, in the past, you guys have talked about, you know, the R&D pipeline, new products, etc. Thank you very much.

Thank you very much. for this year. I mean, you know, one of our biggest areas for that was clearly, you know, TuffNet and all the new product activities that we had on TuffNet. As you know, TuffNet is a very, very high growth area for oil and gas and for aerospace segments, both of which have been significantly hit. Thank you very much. making sure that our R&D spending stays intact. And it's our intent to every dollar that we can find, we're going to continue to spend towards R&D.

Got it. And just last real quick, kind of a housekeeping item here. I believe I caught it, but I just want to confirm here. The gross margin impact that you guys saw on the PAC side, at least on a reported basis, you had the mine development cost, which is a one-time item. That's correct, Marco. You understand it correctly. Got it. Great. Thanks a lot, guys. I appreciate the time. Thanks, Marco.

Our next question is from Phil Gibbs with KeyBank Capital Markets. Please proceed.

Hey, good morning. Morning, Phil. Morning, Phil. For advanced materials, it was good to see the margin progress that you're making entry year. Is your goal, Jugal, to still try to get that business back to mid-teens operating profit and and what do you think it's going to take to get there, particularly given the fact that semi-demand has been really strong?

Yeah. Well, I think, first of all, from a goal standpoint, absolutely. I mean, our objective really at a company level, you know, we've talked about it at the company level that we would like to continue our journey towards an advanced materials company and we believe an advanced materials company is one that is in more of a mid-teens type of a margin company. So, All of our businesses have to deliver good, strong margins for us to be able to then have mid-teens type of margins at the company level. So, yeah, absolutely, our goal is to do that. Of course, as you know, we're on the road to progress, and then due to some of the challenges that we faced here recently, we had a setback, but we have continued to make progress. Just reported 10% double-digit margins, which was, I think, a great... Thank you very much. Thank you very much. Thank you very much. sort of the skills and capability that we bring to the table. So I think all those things will be important factors as we move forward in driving this business to the mid-teens margins.

So in terms of a timeline, Jugal, when do you think that you can start to see more, I guess, sustainable improvement, you know, getting the you know getting to 11 getting to 10 that that sort of thing just in terms of the timeline so you know we don't get you know we don't get ahead of ourselves.

Yeah so you know if the pandemic wasn't wasn't here I believe me I think I would tell you that that that I would be able to give maybe a more specific timeline but but the uncertainties around what's going to happen in Q4 and Q1 and and is there a second wave or not? I mean, I think those kind of, you know, bring some uncertainties into the picture. But our goal is to continue to have good sequential improvement, you know, in this business. And so into 21, I mean, we want to continue to drive sequential improvement and get to those mid-teens margins. So I don't have a specific sort of day or quarter I can give you, Phil, that we're prepared to communicate at this time, but I can tell you it is a very, very important part of our focus.

Kind of a macro question, but on the side of foreign exchange, the dollar has been weak the last several weeks. How does that impact you guys one way or the other?

Bill, from that perspective, I would tell you that, you know, really it's, you know, we've managed that exposure quite well. I mean, if you look even at our year-to-date results, right, they really haven't had much of an FX impact there. And as you know, you know, we've got hedging programs in place in terms of our Euro-denominated receivables in, or Euro-denominated sales, I should say, in Europe, and then our Yen-denominated sales in Asia. So, We really try to balance that out from a risk perspective so don't see any major impacts from that going forward.

Next question is just on telecom infrastructure and obviously we see a lot of headlines backing the fourth thing on Huawei but how should we think about the telecom infrastructure business over the next couple years?

Yeah, I mean, we would expect, I think, over the next couple of years, you know, as 5G continues to take hold, I mean, we would expect that market to sequentially increase, you know, similar to what had happened, I think, when we went through the last take, which was, you know, on 4G. So I think that's a market that, in general, we expect to continue to have improvement sequentially over the next couple of years.

So do you think this is a low point in that business you're seeing right now?

Yeah, I don't know if I would necessarily say it's a low point because there are certainly customers that are still, you know, still ordering, but it's not at the level that I think, you know, we expected. I mean, some of the COVID issues have certainly slowed that down, but I think we expect it to continue to, you know, improve over the next couple of years.

Okay. And then lastly, and I apologize if you mentioned this already, but the CLAD program, The CLAD investment appears like it's on track. We don't have a site yet, and we haven't disclosed a customer, and I wouldn't expect you to do that if you haven't done it already. But on your existing business, on your existing capacity, are you still anticipating some sort of pull from that CLAD customer in, you know, call it 4Q or the first quarter next year?

Yeah, we expect that we will have shipments here in the fourth quarter and then into the first quarter. So we're quite excited about it. I mean, our teams are working, I can tell you. I just had a review yesterday, and I mean, they're working on the clock to ensure that we have a good product that we can build and supply to the customer here in the fourth quarter and then into the first quarter.

Thanks, guys. Appreciate it.

Hey, thanks so much, Bill.

As a reminder, just star one on your telephone keypad if you would like to ask a question. Our next question is from Christopher Hillary with Rubox Capital. Please proceed.

Hi, good morning.

Hey, good morning, Chris. Thanks for taking the question. Obviously, an exciting time for the company with the cloud strip investments. Could you take a minute or two and just give us some of the qualities that that product will have and maybe what some of the applications might look like. And I appreciate you can't be too specific, but maybe in generalities. And then either with that or after that, if you wouldn't mind then maybe sharing some thoughts on some of the longer term demand drivers with both this product and then your broader specialty portfolio. Are there certain industry trends that you see kind of being the growth drivers over the median term for the company?

Yeah, Chris, we're certainly excited about this product, and I just want to remind everybody that we do this today, and we do it quite well. We supply to a number of different markets today. We supply to the consumer electronics market. We supply to the automotive market. We supply to a number of different markets, and we're going to continue to do that. The issue that I think we've talked about is that as we had basically demand from a customer, we were not able to fulfill that demand with our existing capacity and capability. And so we're putting in new capacity and capability to be able to provide that demand that the customer has asked. So I think in terms of the applications, I mean, there's applications that go across a number of different markets. We are Our sales team is not stopping here because one of the things I think that you have anytime you make investments and anytime you make new facilities that you put in place is it gives you greater flexibility, greater opportunity to go and market this product and this technology to customers around the world. We're challenging our sales teams to go out and talk to customers around the world and see what other opportunities we can pick up over the next one, two, three years and hopefully putting the additional capacity in place will give us some more credibility, in fact, in the marketplace. And so that's what we plan on doing. And so we are quite excited about it. As I said, the application is in a number of different areas, and our sales teams are working those.

And is there anything specific you might flag like around electric efficiency or the Internet of Things applications or certain parts of the semiconductor market that you'd give us some, I guess, kind of a pivot point to think about where some of the extra growth is going to be coming from?

Yeah, I mean, you know, look, I think a couple of the areas that are really good areas for us to look at are clearly consumer area and automotive. I mean, those are, I think, two important areas for us to point at. I mean, when you look at, for example, a lot of the devices on the consumer side that the people are using, I mean, these types of clad strip type of product is an important enabler in those devices. Thank you very much. but I think our primary focus has been on consumer and auto and it will certainly continue to be in those two markets but we'll continue to look for other markets like energy and industrial that we can go after as well.

Thank you and great job managing through a difficult period.

Okay, thanks very much Chris.

Thanks Chris.

We have reached the end of our question and answer session. I would like to turn the call back over to management for closing remarks.

Thank you. This is Steve Shamrock, and this concludes our third quarter 2020 earnings call. A recorded playback of this call will be available on the company's website, materion.com. We would like to thank all of you for participating on the call this morning and your interest in Materion. I will be available to answer any follow-up questions. My direct number is 216-383-4010. Thank you very much.

Thank you. This does conclude today's conference. You may disconnect your line at this time and thank you for your participation.