TimkenSteel Corporation

Good morning and welcome to the 2Q 2022 Tin Can Steel Corporation Earnings Conference Call. All lines have been placed on mute to prevent any background noise. After the speaker's remarks, there will be a question and answer session. If you'd like to ask a question during this time, press star 1 on your telephone keypad. If you'd like to withdraw your question, press star 1 again. Thank you. Jennifer Beeman, Director of Communications and Investor Relations.

You may begin your conference.

Thank you and good morning, and welcome to Tim Kinstiel's second quarter 2022 conference call. I'm Jennifer Beeman, Director of Communications and Investor Relations for Tim Kinstiel. 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 and Chief Commercial Officer. 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 Timken Steel 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. Let me begin by saying that I am proud our team delivered strong results in a robust demand environment. I find our employees to be dedicated, flexible, and resilient. Unfortunately, that resiliency was tested last week. As many of you know, we experienced a safety incident at our Faircrest Melk Shop, which resulted in the injury of three employees. Our thoughts are with the employees, their families, and coworkers who were impacted. Safety in our industry is paramount. As you may recall, we kicked off several safety initiatives at the start of the year. During the second quarter, we began safety leadership training for all levels of our operational leaders. Our leadership is committed to taking tangible actions to improve our safety culture. As far as the impact to our third quarter shipments from the Faircrest melt shop incident in late July, we do not expect a significant shipment impact in the near term. given inventories on hand. We also intend to leverage purchase melt to secure additional capacity. We are targeting mid-August to complete the necessary repairs and resume melt operations. Turning to our second quarter results, we reported record adjusted EBITDA and strong operating cash flow in the second quarter. Our success was in part attributed to our ability to increase our base pricing in targeted end markets and products. This is further evidence that our commercial strategy is gaining traction, and I thank our commercial team for their efforts. Our business development efforts remain focused on high-value end markets, including defense, renewables, and electric vehicles. And we continue to drive greater market diversification as we aim to create an optimized portfolio. As I have stated many times, our goal is to sustain profitability through all business cycles while effectively serving the needs of our customers. Touching upon end market demand, our lead times are now to the end of the year. A majority of our customers in the mobile, industrial, and energy markets are telling us they are positive about the back half of this year and their business is steady. However, we have heard from certain pockets of smaller customers that some uncertainty exists as these customers are navigating the challenges of the current economic environment. In Mobile, shipments decreased by 4% sequentially as supply chain disruptions continue to impact these customers. For the first half of 2022, we estimate that our sales have been negatively impacted by approximately $13 million. The current thinking is the supply is expected to continue to stabilize in the second half with recovery starting late this year or early 2023. On a positive note, we continue to win in the EV space. We were recently awarded additional new business for a major OEM, which is expected to launch in 2025. This will be part of the next generation of EV light and medium trucks, as well as commercial vehicles. Our current EV portfolio consists of more than 15 awarded machine component applications and approximately $60 million in annual base sales when fully ramped. Our industrial shipments increased by 8% compared with prior quarter due to strength in all of our industrial categories. Distribution channel inventory levels have been replenished but remain well managed as orders are closely aligned with shipments. In the energy market, we continue to see robust demand from our customers as a result of continued increase in drilling and completion activity. Similar to the first quarter, we've once again more than doubled our shipments on a year-over-year basis. Tempkin Steel has a history of developing and manufacturing materials for our customers in this space. We have proven technical capabilities. long-standing relationships, and the ability to innovate alongside an industry that is focused on a cleaner energy future. Timken Steel's tubing, bars, and manufacturer components are being used in some of the most demanding applications in both onshore and offshore rigs, renewables, and the supporting equipment. Turning to our progress on our strategic comparatives, we remain on track to achieve our targeted $80 million of profitability improvements. In 2022, we expect to realize approximately $25 million of profitability improvements from actions directly linked to our strategic imperatives with the remaining EBITDA improvement expected between 2023 and 2026. As a reminder, profitability improvement actions benefiting 2022 are primarily being driven by continued commercial portfolio optimization, commercial terms adjustment and pricing improvements. Additionally, operational projects are underway to improve safety, yield, quality, efficiency and asset reliability. For example, work is underway to relocate our scrap yard to be adjacent to our melt shop to improve efficiency. This project is expected to be completed later this year and drive a run rate savings of $3 million beginning in 2023. Our information technology transformation has also begun. During the quarter, we've successfully migrated our support services to a third party and have begun the next phase of work aimed at simplifying and modernizing our IT environment. This multi-year project is expected to achieve $7 million of run rate savings when completed. These actions, combined with our previous $100 million of savings achieved in recent years, gives us the confidence that we will execute and deliver on our long-term commitments. With that, I thank employees for their hard work, our customers for their trust, our suppliers for their partnership, and our shareholders for their continued support. As we move forward, our leadership is committed to taking tangible actions

to improve our safety culture. Now, I would like to turn the call over to Chris. Chris? Thanks, Mike.

Good morning, everyone, and thanks for joining us today. During the second quarter, our collective team delivered record-adjusted EBITDA results and strong operating cash flow while also making progress on our long-term strategic imperatives. Thanks to all of our employees for a successful second quarter and strong first half of 22. Turning to our second quarter results, net sales totaled $415.7 million and net income was $74.5 million, or $1.42 per diluted share. Comparatively, sequential first quarter net sales were $352 million, with net income of $37.1 million, or $0.70 per diluted share. Second quarter of 2021 net sales were $327.3 million, with net income of $54 million, or $0.98 per diluted share. On an adjusted basis, net income in the second quarter improved to $67.4 million, or $1.29 per diluted share. For comparison purposes, adjusted net income in the first quarter was $48.6 million, or $0.92 per diluted share. Adjusted net income in the second quarter of last year was $52.5 million, or $0.96 per diluted share. Adjusted EBITDA improved to a record $84.2 million in the second quarter, an $18.9 million sequential increase. Drivers of the increase included higher base selling prices on an improved product mix, as well as the impact of higher scrap and alloy prices on raw material surcharges. Compared with the same quarter in 2021, adjusted EBITDA increased by $13.2 million, reflective of higher base selling prices and improved mix. Turning now to the details of the financial results in the second quarter. Shipments in the second quarter were 208,900 tons, an increase of 12,500 tons, or 6%, compared with the first quarter and consistent with our expectations. The sequential increase in shipments was driven by higher energy and industrial shipments, partially offset by lower shipments to mobile customers. Comparatively, second quarter shipments decreased by 5,300 tons, or 2%, from the second quarter of last year as a result of lower industrial and mobile shipments, partially offset by increased energy customer demand. In the industrial end market, shipments totaled 102,100 tons in the second quarter, a sequential increase of 7,200 tons, or 8%. The increase in industrial shipments was primarily driven by increased demand from both OEM and distribution customers across the wide range of industrial sectors, such as heavy equipment and rail. Mobile customer shipments were 85,400 tons in the second quarter, a sequential decrease of 3,500 tons, or 4%. During the second quarter, we estimate the supply chain disruption negatively impacted our mobile shipments by approximately 6,000 tons, a similar impact as in the first quarter. Lastly, from NENMarket's perspective, continued momentum in energy demand drove shipments of 21,400 tons in the second quarter, a sequential increase of 8,800 tons, or 70%. The energy end market accounted for 10% of our shipped tons in the second quarter, up from 6% in the first quarter. Net sales of $415.7 million in the second quarter increased 18% compared to the first quarter and improved 27% compared to the second quarter of last year. The sequential increase in net sales was driven by a 32% increase in average raw material surcharge per ton as a result of higher scrap and alloy prices, higher base selling prices, and increased shipments on improved industrial and energy customer demand. The substantial improvement compared with the prior year quarter was driven by higher base selling prices and a 50% increase in average raw materials surcharge per ton as a result of higher scrap and alloy prices. Partially offsetting these items were lower mobile and industrial shipments. Base selling prices increased by $192 per ton, or 18%, in the second quarter on average across our end markets in comparison with the full year of 2021 average. Sequentially, base selling prices increased by 2%, consistent with our expectations. Turning to manufacturing, costs increased sequentially by $13 million in the second quarter, driven by higher plant spend, primarily related to maintenance, as well as higher variable compensation expense. The increase in second quarter maintenance spending was in targeted areas to enhance asset reliability and performance, as well as required repairs at one of our tube mills. In comparison to the prior year second quarter, manufacturing costs were $26 million higher given the current year inflationary cost environment, as well as higher maintenance costs. Melt utilization improved to 84% in the second quarter from 81% in the first quarter, consistent with the prior year second quarter. From an inflation perspective, Pressure is anticipated to remain on non-surchargeable raw materials, manufacturing consumables, and other operational items during the remainder of 2022. We now estimate the 2022 inflationary impact to be approximately 20% over 2021 average prices as compared to a previous estimate of 10 to 15%. Increased costs for spare parts and contract labor are the primary drivers of the inflation estimate change. From an SG&A expense perspective, In the second quarter, SG&A increased $3.2 million on a sequential basis to $21.7 million. The primary drivers included higher variable compensation expense, as well as fees associated with an ongoing information technology application simplification and modernization project. These sequential SG&A increases were partially offset by lower employee expense as a result of prior restructuring actions. In comparison to the second quarter of 2021, SG&A was relatively flat. Overall, SG&A expense remains well controlled and significantly lower than historical levels. Moving on to cash flow and liquidity. During the second quarter, operating cash flow was $50.7 million driven by quarterly net income, partially offset by a use of cash to fund working capital requirements. This marks the company's 13th consecutive quarter of generating positive operating and free cash flow. Through the first half of 2022, we generated $64 million of operating cash flow and spent $10 million on capital expenditures. We finished the second quarter with $238.5 million of cash and cash equivalents, and total liquidity was $558.7 million at the end of June. Looking now at shareholder return activities. During the second quarter, the company repurchased approximately 438,000 common shares at a total cost of $9.3 million. Including the recent common share repurchase activity completed in July, the company has repurchased approximately 794,000 common shares to date in 2022 at a total cost of $16 million. As of July 31, 2022, the company had $34 million remaining under its $50 million authorization. Switching gears to convertible notes from a return on capital perspective, in the second quarter, we negotiated the yearly repurchase of $15.2 million of convertible notes due in 2025, at a total cash cost of $40.8 million. The $25.6 million purchase premium was driven by an appreciation in the company's stock price, which was significantly in excess of the instrument's conversion price. This premium was excluded from non-GAAP-adjusted EBITDA as a loss on extinguishment of debt. The convertible note repurchase activity in the second quarter had the effect of reducing delivered shares outstanding in addition to further reducing outstanding debt and interest expense. At this time, the outstanding principal balance on the convertible notes is $20.8 million, and the associated remaining diluted shares outstanding are $2.7 million. This compares with the original issuance amount of $46 million and 5.9 million diluted shares. In comparison to diluted shares outstanding in the fourth quarter of last year, the previously discussed common share and convertible note repurchase activity completed between January and July 2022 represents a 7% reduction in diluted shares outstanding. Regarding pensions, in July the company purchased a group annuity contract from a highly rated insurance company to settle $256 million of pension obligations related to the company's bargaining unit pension plan using existing plan assets. This represents about 25% of the company's outstanding U.S. pension obligations. Following the transfer starting October 1st, the insurance company will pay future benefits to approximately 1,900 participants and beneficiaries who are currently receiving payments from the plan. It's important to note that the gross benefit amount payable to recipients will remain the same as a result of this transaction, and the group annuity contract is an irrevocable commitment from the insurance company to make annuity payments covered under the contract. The annuitization had the effect of reducing total accounting funded status for all pension and retiree medical plans by approximately 3% in the third quarter from approximately 88% to 85%. This annuitization activity was a significant step towards further strengthening our balance sheet and de-risking our pension plans. Moving on to other pension matters, the company recorded a non-cash gain of $35.5 million in the second quarter as a result of the remeasurement of certain pension plans. The gain was driven by an increase in discount rates more than offsetting investment losses on plan assets. Remeasurement of these plans is expected on a quarterly basis for the remainder of 2022. Turning now to the third quarter of 2022 outlook. Customer demand remains stable across our end markets with lead times extended to the end of the year. Similar to prior quarters, periodic customer manufacturing disruptions may continue to negatively impact shipments. From a revenue perspective, our base pricing remains strong, reflective of prior annual increases and continued favorable spot pricing. Given market decreases in scrap prices to date in the third quarter, we anticipate surcharge revenue per ton to decline sequentially in the quarter. Operationally, we expect our melt shop repairs to be completed by the middle of August, which will negatively impact our melt utilization rate and manufacturing costs compared with the second quarter. Current inventory levels and planned purchases of melt capacity from third parties are expected to help us meet the majority of our third quarter customer demand. As a result, we anticipate third quarter shipments to be moderately lower than the second quarter. Lastly, from an operational perspective, Planned annual maintenance shutdown costs are estimated to be approximately $10 million in the second half of 2022, with approximately 25% incurred in the third quarter and approximately 75% incurred in the fourth quarter. This amount and timing is generally consistent with last year. Given these elements, the company expects adjusted EBITDA to remain strong in the third quarter, but lower than the second quarter, primarily driven by a market decline in scrap prices, which will reduce surcharge revenue per ton, as well as impacts from the melt shop operational downtime. From a cash perspective, operating cash flow is expected to be positive in the third quarter, primarily driven by anticipated profitability and a release of working capital. Additionally, we're updating our estimate for full-year 2022 capital expenditures to be approximately $35 million, a reduction of $5 million from the previous guidance due to timing of project spending. To wrap up, thanks to all of our employees, customers, and suppliers who helped Timken Steel deliver record-adjusted results in the second quarter. As Mike said earlier, our leadership team is committed to taking tangible actions to improve our safety culture. We appreciate your interest in Timken Steel and look forward to sharing our continued progress in the future. We would now like to open the call for questions.

Thank you. At this time, I would like to remind everyone, in order to ask a question, press star 1 on your telephone keypad. Your first question comes from Marco Rodriguez from Stonegate Capital Market. Please go ahead.

Good morning, everyone. Thank you for taking my questions. Good morning, Marco. Hi. I was wondering, Mike, if you could maybe spend a little bit more time on the strategic initiatives. You sort of touched on it briefly in your prepared remarks specifically around the commercial improvements that you are aiming to make here over the next five years, that maybe you can kind of frame what might be on track, what else was coming up the pipe. I know you mentioned the scrap yard, putting that a little bit closer. Maybe you can kind of walk through some of those efficiency and cost goals.

Sure. Well, around the commercial strategic initiative, it's really focused around our product portfolio optimization, as well as our a participation in more of a diverse, particularly in the industrial space, a more diverse end market participation. There's particular markets around defense, renewables that we're focused on that we have some participation today, but those are really high valued end markets and we're put together and restructured a business development organization with high performing team members that are focused on expanding our participation in those high-end valued markets. On the operational side, I mean, there's a wide portfolio of opportunities there. We mentioned a couple of them, particularly the scrapyard. When we were operating two melt shops, the scrapyard was in between both melt shops, so about a mile, mile and a half away from each melt shop. And we are moving the melt shop adjacent to the Faircrest melt shop. Therefore, we're also contracting out the operation of the scrap yard to a third party versus our internal use, our internal manning. So we bring better variability to business conditions in that scenario. But really, it's really a reduction in operating costs really tied to transportation costs of moving scrap a mile and a half versus a couple hundred yards into the mount shock. But we have a number of projects around yield improvements. We've already started to realize some of those projects, particularly in the melt shop. But we have specific projects focused around our rolling mills where we can improve our yield and our quality. And the quality improvements will reduce our rework costs, which, in my view, are a little bit higher than norm compared to the best in class in our industry. So I could go on and on on this. There are specific projects around our people and skill development and organizational and SG&A optimizations. I mentioned our IT transformation. That's a key project. That's a multi-year project. So there's quite a portfolio, several hundred projects that we have identified in our pipeline. Many of them are in action right now. and many of them will come in the future. But a lot of projects focus around safety and asset reliability improvements as well. So all of that, improving asset uptime, improves productivity, improves yield, improves quality, and also improves safety. Got it.

Very helpful. And then also in terms of the comment that you made there about trying to move more towards the renewables, and then also in your prepared remarks you're talking about some wins that you had on the EV side or mobile side. Can you just talk about those two particular opportunities? Would you classify the electric vehicle market as falling into the renewable focus, or is that just more kind of a different type of mobile application?

Well, no, the EV is totally separate from the renewables. And we have a team that's targeted, you know, EVs in the mobile market are very important to us, particularly for our manufacturer components business. As the automotive OEMs move away from the internal combustion engines that require crankshafts and transmissions and all kinds of other components, we are actively pursuing EV programs. As you know, these programs tend to be multi-year programs between 8 and 10 years. And we're working closely with the automotive OEMs and developing our capability to serve the EV market around the motors and some of the smaller transmissions that go with those electric motors. That's our focus. When you look at the renewable side, our focus there is really around wind. There are a tremendous amount of boating applications for offshore windmills. There's also gearing and rotor shafts that are in those turbine applications. So we're actively pursuing and working with, and we've, like I said, we've restructured our sales organization to have dedicated, high-performing team members focused in penetrating those markets and expanding within those markets because we pretty much serve some of those markets in a small way today, and we want to grow that because that's where we see the value proposition for our product portfolio.

Got it. Understood. Then I just kind of want to get a bit of a clarification. You know, in your press release last night, you talk about some operational disruptions and you mentioned a negative impact on the melt utilization rate in the quarter. And you obviously, obviously at the beginning of the call mentioned the accident in the one plant. Were those one in the same or was there something different in relation to this? And if at all, if I missed this or not, can you quantify the the impact on the melt utilization rate in the quarter?

So they are related. So we had an incident and a melt shop is currently under investigation. We're working with the United Steelworkers and the regulatory agencies to investigate the incident and get to root cause and identify any recommended actions we need to take. And our thoughts and prayers are with our employees, their families that were injured, and any other employee that was impacted by the incident. The operational impact, as we've said, is we are in the middle of our repair activities to get the furnace back online.

And we expect that to be around mid-August.

OK. And then I know you made some comments in terms of your expectations of base pricing, at least in Q3. But maybe even share some of your thoughts on what sort of dynamics you might be thinking about for the remainder of the fiscal year.

Sure. Well, again, we see demand steady through the remainder of this year. And even, you know, the communications and interactions we're having with our customers in discussions around 2023 look pretty favorable in regards to continued steady demand, at least I would say from a horizon standpoint, the first half of 2023. And our expectation is, you know, prices are going to align with that steady demand as they have been.

Got it. Thanks, Black Ops. Really appreciate your time. Thank you, Marco. Thank you.

Your next question comes from Seth Rosenfeld from BNP. Please go ahead.

Good morning. Thanks for taking our questions today. Can you give us a bit more detail to better understand how the recent decline in scrap prices, and in particular the narrowing of the prime scrap, which is obviously premium, will impact your surcharge revenues and also profitability? I'm looking for maybe, can you give us a bit more color on your outlook for prime and obsolete as we move through Q3?

Thank you.

Hi, Seth. This is Chris. Good morning. You are correct. We are seeing that decline in the prime as well as the shredded grades, and that will drive some contraction force in Q3. The way I'm thinking about it is the incremental benefit that we received in Q2 that benefited our results. I'd expect that to reverse in Q3 as those contractions continue definitely through Q3. July and into August. September still hasn't settled up yet, so we'll see how that plays out, but that's what we're seeing at least for the first two months.

Thank you.

Maybe can you give us a bit more color with regards to the, or quantify the scale of benefit you saw in Q2? I know in the past we talked not just about surcharge revenue, but the fact that you're able to have a surcharge based on prime, but purchase a mix of obsolete. How large was that if you quantified in the course of Q2?

And Q2 is about a $23 million benefit is what we lay out in earnings release. Okay, thank you.

And one more question, please. With regard to working capital, as you see scrap prices and surcharges decline in H2, can you give us a bit more color in your application for scale of working capital release that could be realized?

That definitely has an impact on it. I'd say the bigger impact is the operational disruption that Mike mentioned and us continuing to work through inventory on hand. We had quite a bit of inventory and receivables on hand at the end of June, and that would get released into Q3 and drive a more significant working capital release is what we're expecting.

Okay. Thank you very much.

Thanks, Seth.

Again, if you'd like to ask a question, press star 1 on your telephone keypad. Your next question comes from Phil Gibbs from KeyBank Capital Markets. Please go ahead.

Good morning.

Good morning, Phil.

Mike and Chris and team, the inflation raised for the year to 20% from 12.5%. Just curious what changed so drastically in the last three months in terms of primary versus maybe secondary drivers there.

Yeah, Chris can provide some additional color, but my perspective has been the maintenance repair parts and supplies that come in at a higher level than we expected. The other area is we've seen, you know, we tend to use contractors on an ad hoc basis for surge maintenance activity. We're seeing those rates increase. And that's not what we really anticipated when we put our prior outlook together for Q2. So, Chris, do you have any more color you want to add there?

Those are the two primary areas. The majority of our other spend is contracted on a fixed rate, primarily for the full year as volumes change and you need a little bit more, you pay a bit of spot rates there. But it's those two areas that Mike mentioned, the contractors and the spare parts, that drove most of that change for us.

Thank you. It was good to hear the volume impact being reasonably benign given the use of inventories and purchase melt in the third quarter following the accident. But is there any way to couch the cost impact to the third quarter due to the accident and cost to serve the customers versus what you would have been expecting a few weeks ago?

Well, again, that's really undetermined yet because we're still in the recovery process and the repair process. What I do expect is we are going to see higher costs predominantly tied to the repair cost as well as the fixed cost leverage being lower and the third-party purchase melt is also slightly higher than our manufacturing capability. So that's how I see it, Chris. Do you have anything to add there?

Those are the drivers, yeah. Wish we could quantify it better for you, but we're working through it real time and going to manage it the best that we can as we go through the quarter to drive that profitability.

So I know a lot of your grades of bar typically are higher alloy content and very specialized, and you guys own the secret sauce to a lot of the chemistry, so... Just curious how easy it is to supplant that with purchase melt unless you're just kind of buying the base substrate and then, I guess, remelting it yourself and alloying it. So, you know, maybe just talk through that.

Well, you know, we have been working with a partner in developing, particularly around small, high alloy grades. We've been working in developing a partner since earlier this year, and that partner is a fantastic partner, and they're stepping up to help us through this situation even more. So we've already done some of the great development with them, and we're looking to others. One of the unique things from my perspective about this industry, when you have somewhat of a situation that occurred like ours, your competitors step up to try to help you. You know, so we're seeing that. We appreciate that. And, you know, we're going to acquire what we need to try to satisfy all our customers through this time. And then we're going to be back up and running again very soon.

If I could just add to that, Mike, the mobile space we're supporting with inventory on hand, that's not where you go outside for this purchase. What we do expect back online is that we're going to need to allocate our tons first to there, given the contractual arrangements. So we may see a bit of a mix shift in Q3, a little bit heavier mobile, and maybe even into Q4.

Good point, Chris.

Thank you.

And there are no further questions at this time.

I will turn the call back over to the presenters for closing remarks.

Thanks, everyone. And that concludes our call today.

This concludes today's conference call. You may now disconnect.