TimkenSteel Corporation

Ladies and gentlemen, thank you for standing by and welcome to the Temp Can Steal fourth quarter 2021 earnings call. At this time, all participants are in a listen-only mode. After the speaker presentation, there will be a question and answer session. To ask a question during the session, you will need to press star one on your telephone. Please be advised that today's conference is being recorded. If you require any further assistance, please press star zero. I would now like to hand the conference over to your Speaker today, Jennifer Beeman, Senior Manager of Communications and Investor Relations of Timken Steel. Thank you. Please go ahead.

Thanks and good morning. Welcome to Timken Steel's fourth quarter and full year 2021 conference call. I'm Jennifer Beeman, Senior Manager of Communications and Investor Relations for Timken Steel. Joining me today is Mike Williams, President and Chief Executive Officer, Chris Westbrooks, Executive Vice President and Chief Financial Officer, and Kevin Rakitic, Executive Vice President of Sales, Marketing, and Business Development. You all should have received a copy of our press release, which was issued last night. During today's conference call, we may make forward-looking statements as defined by the SEC. Our actual results may differ materially from those projected or implied due to a variety of factors, which we describe in greater detail in yesterday's release. Please refer to our SEC filings, including our most recent Form 10-K and Form 10-Q, and the list of factors included in our earnings release, all of which are available on the Tim Kinseal website. where non-GAAP financial information is referenced, additional details and reconciliations to its GAAP equivalent are also included in the earnings release. With that, I'd like to turn the call over to Mike. Mike?

Thank you, Jennifer, and I appreciate everyone joining us on the call today. 2021 was without a question a transformative year for Timken Steel. The accelerating momentum in our markets throughout the year resulted in great opportunities and some challenges, namely the supply chain disruptions related to semiconductors and the COVID resurgence. However, our teams worked together to effectively serve our customers and remain committed to cost control and working capital discipline to drive year-over-year improvements in profitability. I am proud of how far our team has come in a short period of time. And I thank the employees of Tempkin Steel for their unwavering focus to transform our business. Now turning to safety, our lost time incident rate improved in 2021 to 0.32, but our OSHA recordable rate of 1.85 was slightly higher than last year. With the full engagement of our employees and the United Steelworkers, we will continue to focus on safety for 2022. and are implementing a number of new initiatives, including special attention to hazard awareness and training, safety leadership training, housekeeping, and continued safety protocols related to COVID-19. Overall, we will continue to drive better safety performance through sustainable process and cultural improvements. As we close 2021 and start 2022, our end market demand has remained healthy, and our order book now extends into the third quarter. However, we experienced a sequential decline in fourth quarter shipment given the planned annual maintenance outage at our Faircrest Melt Shop and unplanned downtime at the Faircrest Melt Shop, which created some disruption to our supply chain that our team has effectively managed. Consequently, we are staying close to customers to fulfill their needs and with lessons learned, technology improvements, and the continued implementation of best practices centered around manufacturing excellence, I expect we'll be better positioned in the future. Before I move on, a quick update on our customer pricing agreement. We are now almost complete in our negotiations and are pleased with the positive outcomes. That said, we expect our average base sales price in 2022 to be meaningfully higher than 2021. As expected, we felt ongoing effects of the global semiconductor shortage on our mobile customer shipments. Nonetheless, customer demand is high and vehicle inventories remain at historic lows. Production continues to be choppy. While most indicators point to a recovery of this market in late 2022, and into early 2023, we continue to serve our customers and remain flexible. Representing 50% of our total ship times in 2021, industrial demand remains strong. In 2022, we expect the demand momentum to continue and are focused on enhancing our product and customer mix while growing our share within targeted markets such as defense, construction, mining, and distribution, as those sectors are experiencing solid growth. Lastly, the energy sector continues to recover, and customers are ordering material to support drilling and completion activities. Re-counts continue to climb as a result of higher oil and natural gas prices. We are optimistic that demand will continue to improve in the coming year. As I have consistently stated, our objective is to deliver sustainable through-cycle profitability and cash flow while maintaining a strong balance sheet and creating value for shareholders. To support these goals, we have unveiled a set of strategic imperatives which are centered around people, profitability, process improvement, business development, and our environmental, social, and governance aspirations. Let me take a few minutes to outline these five imperatives, and then Chris will speak to the financial impact of these actions in a moment. First, we aim to attract, retain, and empower top talent. We will invest in talent and leadership development at all levels of the organization. We are bolstering development initiatives from the leadership level down to the shop floor employees. To drive accountability, our compensation is aligned with goals associated with the strategic imperatives and with living our core values. It is key that we be held accountable for our decision making and our execution while learning from our mistakes. Every employee fully understands that our goal is to achieve sustainable, profitable growth. Through consistent and cross-functional communication, Employees will understand how they can contribute to profit and sustainability. Data, knowledge, and efficient, proactive problem solving will override hierarchy and bureaucracy. Part of profitable growth is to improve our cost competitiveness through manufacturing excellence. By addressing the interrelated functions of manufacturing, maintenance, and supply chains, We will streamline and standardize processes, increase agility, and create a sustainable approach that will allow us to weather down cycles and take full advantage of up cycles. Manufacturing excellence involves implementing industry best practices, investing in technology, and engaging in open dialogue with our equipment manufacturers. I'm confident this work will improve our manufacturing efficiency by increasing productivity, lowering our cost of non-conformance, increasing first-time quality, and improving yield to support customer demand. Another strategic imperative is the thoughtful pursuit of new opportunities to enhance our portfolio of products and services. Over the coming year, we will leverage commercial excellence processes to deepen our relationships with our core customers and standardize our approach, our product offerings, and customer service to provide a more efficient and effective customer experience. We know the ease of doing business is always a priority for our customers, which is why as an imperative, we will standardize, leverage, and fully adopt modern information technology. By reducing technology complexity, we will become more responsive and flexible to support our customers' needs while introducing automation into our business processes to enhance performance. Lastly, we aim to advance our commitment to environmental, social, and governance. In 2021, we developed and communicated our long-term ESG targets. We will invest in reducing our greenhouse gas emissions and energy intensity to progress towards the achievement of our targets. We will improve safety processes and behaviors to achieve industry-leading performance and remain committed to diversity, equity, and inclusion in our workplace. You can learn more about all of these efforts in our first ESG report, which is expected to be released in the second quarter of 2022. This is a pivotal point in our history. We are energized by our recent success, our path forward, and our business outlook. With that, I'd like to turn the call over to Chris. Chris.

Thanks, Mike. Good morning, everyone, and thanks for joining us today. I'd like to start by thanking our employees for their hard work and dedication in 2021. We made progress throughout the year to establish and advance our strategic imperatives. These imperatives are aimed to deliver sustainable, through-cycle profitability and operating cash flow for the long term. As an outcome of our work in 2021, I'll be sharing our long-term financial targets and capital allocation priorities towards the end of my remarks today. Turning now to our financial results. On a full year basis in 2021, net sales totaled $1.3 billion and net income was $171 million, or $3.18 per diluted share. Adjusted net income was slightly higher at $172.7 million, or $3.21 per diluted share. Adjusted EBITDA was $245.9 million in 2021, the highest level since 2014. These much improved financial results reflect the continued success of the company's ongoing business transformation. In the fourth quarter of 2021, net income was $57.1 million, or $1.07 per diluted share. Comparatively, the company reported a net loss in the fourth quarter of 2020 of $12.8 million, or a loss of $0.28 per diluted share. Third quarter of 2021 net income was $50.1 million, or $0.94 per diluted share. On an adjusted basis, net income in the fourth quarter was $42.3 million, or $0.80 per diluted share. For comparison purposes, the fourth quarter of 2020 adjusted net income was $600,000, or $0.01 per diluted share. Adjusted net income in the third quarter of 2021 was $55.2 million, or $1.04 per diluted share. Adjusted EBITDA improved to $62.1 million in the fourth quarter of 2021, compared to $20.7 million in the same quarter of 2020. This significant year-over-year increase was reflective of the strong demand in raw material surcharge environments, as well as the company's recent profitability improvement actions. On a sequential basis, adjusted EBITDA declined by $9.9 million as a result of unfavorable manufacturing fixed cost leverage, which I'll discuss shortly. Turning now to the drivers of the financial results in the fourth quarter of 2021. Shipments in the fourth quarter were 198,300 tons, a decrease of 14,400 tons, or 7%, compared with the third quarter. As expected, the sequential decrease in shipments was primarily driven by lower available melt capacity in the fourth quarter as a result of the annual Faircrest Melt Shop maintenance shutdown. Despite the sequential reduction in shipments, customer demand remained strong during the quarter, with shipments across all end markets proportionally similar to the prior quarter levels. Fourth quarter of 2021 shipments increased 34,300 tons, or 21%, from the fourth quarter of 2020, primarily driven by a significant increase in industrial and energy shipments. In the industrial end market, shipments totaled 101,600 tons in the fourth quarter, a sequential decrease of 9,400 tons, or 8%. In comparison to the fourth quarter of 2020, shipments to industrial customers increased 38,300 tons, or 61%, reflecting significant year-over-year improvement in distribution customer demand. Mobile customer shipments were 84,500 tons in the fourth quarter, a sequential decrease of 4,300 tons, or 5%. During the fourth quarter and full year 2021, we estimate the semiconductor supply chain disruption negatively impacted our mobile shipments by approximately 12,000 and 45,000 tons respectively, as mobile customers adjusted their operating schedules and delayed shipments to future periods. Lastly, from an end markets perspective, energy shipments of 12,200 tons in the fourth quarter decreased slightly on a sequential basis, but were nearly three times the level of shipments in the fourth quarter of 2020. Net sales of $338.3 million in the fourth quarter decreased 2% compared with the third quarter of 2021, while improving 60% compared with the fourth quarter of 2020. The sequential decrease in net sales is driven by lower shipments across all end markets, as expected due to our manufacturing schedule, partially offset by higher base selling prices and improved product mix. The substantial improvement compared with the fourth quarter of 2020 is due to an increase in average raw material surcharge per ton as a result of higher scrap and alloy prices, improved industrial and energy demand, and higher base selling prices. Manufacturing costs increased sequentially by $13.7 million in the fourth quarter, primarily due to a decline in fixed cost leverage given melt utilization of 71%. The fourth quarter melt utilization was impacted by the planned annual Faircrest melt shop maintenance shutdown along with some unplanned production downtime. Also contributing to the sequential manufacturing cost increase was a $2 million employee cash bonus related to the labor agreement ratification completed during the fourth quarter. In comparison to the fourth quarter of 2020, manufacturing costs were flat, Now turning to SG&A expense. In the fourth quarter of 2021, SG&A decreased $3.1 million on a sequential basis to $16.8 million, primarily as a result of lower salary, benefits, and variable compensation expense. In comparison to the fourth quarter of 2020, SG&A decreased by $1.8 million, largely due to lower salaries and benefits expense as a result of past restructuring actions. Recent restructuring actions will result in cash severance payments of approximately $5 million in 2022. As it relates to employee variable incentive compensation, 2021 financial results include approximately $19 million of expense related to the successful achievement of profitability and cash flow targets included in the company's annual cash incentive compensation plan, with cash payment expected in March 2022. Approximately half of this 2021 expense is reported in SG&A, and the remainder is reported in cost of goods sold. This compares to approximately $9 million of variable incentive compensation expense in 2020. Moving on to cash and liquidity, quarterly net income drove significant operating cash flow of $90.7 million in the fourth quarter of 2021, a $36.9 million sequential improvement. Additionally, working capital was a source of cash in the fourth quarter of $42 million, with over half driven by lower accounts receivable given the reduction in net sales and strong collection activities to close the year. On a full year basis in 2021, the company generated $196.9 million of operating cash flow and a record free cash flow of $184.7 million. We finished December with a record $259.6 million of cash and total liquidity was a record $510.7 million at the end of December. Regarding pensions, the company recorded a non-cash remeasurement gain of $22.3 million in the fourth quarter of 2021 as a result of the required year-end remeasurement of all pension and post-retirement benefit plans. As a reminder, the impact of pension and post-retirement benefit plan remeasurements is included in GapNet income, but is excluded from adjusted EBITDA results. In total, as of December 31, 2021, the funded status of all company plans was 87%, up slightly from the end of 2020. In terms of required cash contributions to our pension plans, we have no significant required cash contributions through 2031 based on current assumptions. Recently, we kicked off projects to transfer over $300 million of company pension plan obligations to insurers through the purchase of annuity contracts. This pension de-risking strategy is expected to further strengthen our balance sheet as it's completed in phases over the next several years. We look forward to sharing further details when available. Transitioning now to a discussion of our long-term financial targets. Following a year of strong profitability combined with continued working capital discipline, we're excited to announce our long-term through-cycle financial targets, which incorporate the impact of the strategic imperatives Mike highlighted earlier. In the following comments, I'll compare our long-term through-cycle targets to historical averages. The historical averages reflect the years 2017 to 2021, a five-year period marked by highs and lows in the steel business cycle. Similarly, our long-term through-cycle targets assume a five-year time horizon from 2022 to 2026. For reference, details can be found in the investor presentation that was recently posted on our website. Our long-term through-cycle targets include the following five items. First, we're targeting an average melt utilization percentage in the mid-80s over the next five years in comparison to 61% during the historical period. Second, we expect adjusted EBITDA margins in excess of 12% on average through the business cycle in the future in comparison to 8% on average historically. Adjusted EBITDA margin is expected to be aided by $80 million of targeted profitability improvement opportunities associated with our strategic imperatives that are currently in process. Third, we expect through cycle return on capital employed between 15% and 17% on average in comparison to 11% historically. Fourth, we're targeting capital expenditures between $30 and $40 million with a balance between profitability improvement, maintenance capex, and ESG projects. And fifth, we plan to maintain a net leverage ratio less than 1.0 times, reflecting our desire to maintain a strong balance sheet through the cycle. We believe that these long-term three-cycle targets are achievable and representative of our commitment to sustainable profitability and resulting operating cash flow generation. With our recent strong financial performance and confidence in achieving our long-term three-cycle targets as the backdrop, our capital allocation priorities include investing in profitable growth, maintaining a strong balance sheet, and returning capital to shareholders. As it relates to our investment in profitable growth, in December, we announced our 2022 capital expenditure budget of $40 million, a significant increase from 2020 and 2021 spending levels. Over half of the 2022 CapEx budget is allocated to high-return organic projects with returns in excess of our cost of capital. Examples of such projects include the relocation of our scrapyard next to the Faircrest melt shop later this year to drive manufacturing efficiency, as well as a multi-year investment in modern information technology tools. The IT investment is expected to reduce system complexity, enhance the ease of doing business with Timken Steel, and drive process simplification and cost reduction. Additionally, included in our targeted CapEx is an important investment of approximately $3 million per year to make progress towards achieving our 2030 ESG targets. In terms of maintaining a strong balance sheet, we have no outstanding borrowings on our $400 million credit facility and continue to maintain working capital discipline, as evidenced by significant process improvements implemented and maintained over the last several years. Additionally, we have no significant near-term required cash pension contributions. Returning capital to shareholders is also a critical element of our capital allocation priorities, and we recently announced the $50 million share repurchase program. Based on our recent stock price, the $50 million buyback program equates to approximately 7% of our common shares outstanding. Our share repurchase program is intended to return capital to shareholders while also offsetting dilution from annual equity compensation awards, which are valued at approximately $7 million per year. We look forward to updating you in the future quarters on our share repurchase program. Switching gears to convertible notes from a return on capital perspective. In January, we negotiated the yearly repurchase of $5 million of convertible notes due in 2025 at a cash cost of approximately $12 million. The approximate $7 million repurchase premium will be excluded from our non-GAAP adjusted EBITDA reporting in the first quarter of 2022 as a loss on extinguishment of debt. The repurchase had the effect of reducing diluted shares outstanding by approximately 600,000 shares in addition to reducing outstanding debt and interest expense. At this time, the outstanding principal balance for the convertible notes is $41 million and includes approximately 5.2 million dilutive shares. We may repurchase more convertible notes in the future depending on the repurchase price and holder interest, among other factors. Both the share repurchase program authorization, as well as the recent convertible notes repurchase, reflect our board and management's confidence in Timken Steel's outlook and desire to return capital to shareholders. Turning now to our 2022 outlook. First quarter shipments are expected to be down slightly from the fourth quarter of 2021. Annual price negotiations with customers were constructive and are nearly complete, representing approximately 70% of the 2022 order book. The realized increase in 2022 average base prices is in excess of $100 per ton compared to 2021 average base prices. Conversely, surcharge revenue per ton is expected to decline sequentially in the first quarter as a result of lower scrap prices. From an operations standpoint, melt utilization is expected to be at or above 80% during the first quarter of 2022. Additionally, inflationary pressure is anticipated on non-surchargeable raw materials, manufacturing consumables, and other operational items in 2022. Based on current assumptions, the expected inflationary impact is in the range of 10% to 15% over 2021 average prices. Lastly, from a cash outlook perspective, operating cash flow is expected to be near break-even in the first quarter of 2022. This is primarily driven by higher working capital following a significant release in the fourth quarter of 2021, as well as the payment of variable compensation earned in the prior year. To wrap up, thanks again to our employees who helped Timken Steel deliver solid 2021 financial results. We're well positioned to continue to deliver strong profitability and operating cash flow in 2022 while executing on our strategic imperatives and delivering on our long-term through-cycle financial targets and capital allocation strategy. Thanks for your interest in Timken Steel. We look forward to sharing our continued progress in the future. We would now like to open the call for questions.

As a reminder, to ask a question, you will need to press star 1 on your telephone. To withdraw your question, press the pound key. Please stand by while we compile the Q&A roster. Your first question comes from the line of Seth Rosenfeld with BNP.

Good afternoon. Congrats on a strong set of results, and thanks for taking our questions today. If I can kick off, please, with the question on the outlook for volumes. I'm a bit surprised by the guidance for volumes potentially down in Q1, recognizing the bullish outlook on demand, normal seasonal strength in the first quarter, and also cessation of the outages from Q4. Can you walk us through the sequential bridge, what's driving that shipment guidance for the first quarter, please?

Sure. So the biggest impact is we had some unscheduled downtime that did not allow us to position our working capital or our supply chain to maximize shipments to the ordered demands that we have on us. Does that answer your question, Seth?

Was that the downtime in Q4 now impacting your working capital position into Q1 shipments?

Predominantly it was a downtime in Q4, but we did have some unplanned downtime carried over into early Q1. We have those issues resolved and behind us, and we will satisfy all our customers' needs immediately.

Okay. With that in mind, I know it's quite early, but on a normalized basis, assuming that you didn't have any of those unplanned issues continuing through Q1, what would that imply for a Q2 improvement so we can understand, I guess, where the real demand is going to lie for the year?

Well, again, we have strong demand. Our lead times are out into the third quarter, so that should give you a perspective of based on our melt shop capacity and utilization rate, similar to Q3 of last year, could kind of position you to where those potential shipment levels will be?

Okay, very clear. And if I can ask a second, please, with regards to the outlook for scrap pricing that's impacting your business. You commented earlier with the expected decline in surcharge revenues on sequentially lower scrap prices. Can you perhaps give us a bit of quantification, the range of pressure there? And then also on the scrap, we've seen a meaningful compression of the prime versus obsolete scrap price premium. If I remember correctly, in the past, when there was a wide premium for prime scrap, that aided your margin performance. What sort of headroom do we expect going forward?

So as you know, over the last quarter, there was significant scrap compression between prime and obsolete. So we continue to see that effect going into Q1. And from my perspective, we'll see what develops for Q2. Very difficult to forecast. There's some things out there that I've read recently We've had some pretty difficult weather conditions, so the collection's probably been strained. We see demand for scrap increasing domestically as some of these other EAFs come online through the remainder of the year. So it's really hard to forecast that, but there has been compression. We're expecting further compression in Q1, as Chris had mentioned in his remarks. Very hard to forecast what it'll look like for Q2.

Any way that we can quantify how much of a benefit that perhaps was historically that we shouldn't expect repeating going forward?

Again, very difficult to forecast. There's a lot of moving parts with the scrap markets and some complexity, as you know, so very difficult for us to forecast that beyond the next month.

That's right, Mike. And just to add, if you look at the fourth quarter, for example, it was a $7 million headwind to us, something similar to that to be determined. But January, February, definitely we're seeing that compression. March to be determined based on the dynamics that we're all experiencing right now.

Okay. Thank you very much. Thanks, Seth.

Your next question comes from the line of Phil Gibbs with KeyBank Capital Markets.

Hey, thank you. Good morning. Good morning. So the targeted $80 million of run rate profitability improvement, I see that $50 million of that is essentially cost and efficiency goals and $30 million of that is commercial. How much of that are you expecting to glean in 2022 and how much of that is you know, maybe we get a little bit this year, we get a little bit next year. I mean, what, what's the timeline where, where are you in terms of achieving, achieving that 80 million? Because obviously the a hundred million you already got is, is, uh, seemingly, you know, in the bag. Yeah.

So yeah, good question, Phil. Um, you know, I'll start and I'll turn it over to Chris. Um, he'll give you a more quantitative, uh, information, but it is spread over that five year period that we're looking at. Um, And I'll let Chris give you some more quantitative information on the timing of that.

Well, good morning. For 2022, we have a clear line of sight to 20% to 30% of that 80 being realized in our P&L in 2022. A significant portion of that's coming from the commercial category as it relates to product mix, optimizing that mix, as we've talked about in the past. It helped with the 70% targeting for the base price contracts, and that gives us 30% to work for our customers in the spot market. So that's what we're seeing for 22. And then the other piece there is the manufacturing investments that we're making this year that's included in our CapEx. That's when you're going to begin to see those benefits in 23 and beyond for those significant investments.

Thank you. And And I just wanted to drill down a little bit into or clarify the comments you made on consumable costs. I think you said 10% to 15%. So trying to think about what that's relative to, frame it up in terms of dollar impact or something and how that stages in over the course of the year. I'm just trying to make sure I got my thought process correct here.

Most of our consumables and our non-surchargeable alloys, we have those under contract for 2022, so we have locked in those prices. That's what gives us the confidence in the range of 10% to 15%. To put it in dollar terms, every percent's worth about $3 million of cost. So you can do the math there on what a 10% to 15% incremental inflation would be relative to our overall financial results.

Got it. That's really helpful. And then on the side of the EV transition, I noticed you had in your slides that you're actually viewing it as an opportunity, which I think is somewhat counterintuitive. But maybe you guys can touch upon that.

Sure. So what's really come to light as we continue to participate and work with the EV OEMs is that we see certain vehicle platforms that actually contain more SPQ weight than the traditional combustion engine platforms. So we view that as an opportunity because we can actually put more Timken steel into the EV vehicles on certain platforms versus the internal combustion ones. So that's kind of why we're highlighting that as an opportunity.

Add to that, if I could, Mike, the margin profile on this business that we've been awarded to date is higher as well. You're seeing higher prices on the piece that we do have.

Is that because the parts are more complex?

That's correct.

Okay.

And they weigh more, too. The individual parts weigh more.

Good news. Thanks very much.

And once again, if you would like to ask a question, please press star 1 on your telephone keypad. And there are no further questions at this time. Do you guys have any closing remarks?

No, not at this time. Just thank you everyone for joining and we look forward to updating you in the future.

Thank you for participating. This concludes today's conference call. You may now disconnect.