Howmet Aerospace Inc. (HWM) Earnings Call Transcript & Summary

Hi, everyone. Welcome back to the Aerospace Defense Track at the 2021 JPMorgan Industrials Conference. We are very pleased to have Howmet Aerospace joining us this afternoon. And so we have CEO, John Plant. We have the CFO, Ken Giacobbe; and we have PT Luther from IR.

And so I think we're going to kick off and just do sort of a more free-form Q&A-type session with you guys. I don't know if there's any kind of -- PT, any kind of forward-looking statement or anything we need to begin with?

No, I think we're okay. Keep going. Thanks, Seth.

Okay. Great. Okay. Well, we'll get started. I guess maybe thinking about it kind of big picture, Howmet's ability to manage execution in the pandemic to provide some visibility. I think that's definitely been appreciated by investors. And if you would ask people in this situation and you asked them back in 2018 or the beginning of 2019 what's the company that's going to be able to do that in this kind of dire situation, I don't think many people would have said Howmet or Arconic. And so maybe, John, if you could kick it off talking about what are the topmost important 2 or 3 things that you and your team have done across the company since you've started that have enabled such an improvement in execution.

Okay. So I guess it goes back to, first of all, trying to diagnose if there was an issue in the former Arconic Inc. And I think many people know that we didn't have a stellar track record of achievement of guidance or a record of good performance. So the question, why was that? When I started in early '19, it was really around the subjects of trying to provide the company with a sense of urgency, therefore, to try to execute with speed; to have clarity of the things which were important compared to the confusion of many things which were unimportant; to provide a level of confidence to people in their own self-worth and abilities so that they could take decisions; and then trying to install into the company that winning and execution as part of that winning was -- is a habit and how did we form those habits. So I think early on, it was trying to define for the company those few things which we should really try to really focus on and maybe list out a lot more things that were not relevant to the performance of the company. And I always believe it's the focus on the few and the exclusion of the many. And I think that list of exclusions is so important because I think successful companies really define themselves by the things that they don't do. And so the question was how do we focus the conversation, the start of the elimination of bureaucracy and committees and with it overhead and to really focus the conversations on the things that if it didn't result in improved speed of execution, it didn't result in an improved cost base, if it didn't give us additional content for our products or the ability to move price positively, then, indeed, why were we discussing those things. And so even the focusing of those conversations helps a lot of people to begin to understand that which is important and really to try to exclude from our conversations things which are largely irrelevant. And in a lot of companies, they tend to discuss a lot of what I call the irrelevant things. So ultimately, it's building a team of people that can really rally around those few priorities, so they have the confidence in the execution and move together with, what I call, the clock speed of the organization in terms of speed of execution because time sometimes is more valuable than money. And also, in anything we've talked about is that -- for myself never -- having people believe that there's nothing that -- if I ask him to do it, that I would not be willing to do it myself, whether that's commercial coverage of the customer or whether it's just the things we need to do. It's people believing and hopefully that I have their backs because I need everybody to be successful because without them, I can't be successful. So that's been the change of culture that we've tried to bring to the company. The definition of the combination of the hard things of the performance and metrics and the soft things by way of confidence and culture.

Yes. I guess, Ken, maybe to ask you a similar question, having observed sort of the before and after, your point of view on some of the changes that have taken place, maybe with a little bit more focus on the finance side and how things have evolved?

Yes. Seth, so good to see you again. As John mentioned, the focus was probably the most important item in terms of what we wanted to do and, just as important, what we didn't want to do and then doing it quickly, as John mentioned. The other thing that I would mention on top of the whole philosophical and cultural change that John went into is just the tools that John brought to the team. We have an operational playbook that we use right now that covers all the different aspects of the business from the top line, revenue growth, pricing, cost-out, capital allocation, you could keep going on and on, asset utilization. But having that playbook, that's just one of several tools that were brought into the company recently. That combined with a really strong cadence in terms of how we keep people focused on the right items -- because at the end of the day, Seth, a lot of the people that are here today were here a couple of years ago as well. Really smart people, hard-working folks, really values-oriented and very resilient, right? They've been through a couple of separations, proxy fight, acquisition at one point. So it's a real resilient group and the tools and the focus and the cultural change that John has brought in here has just been -- brought more of a culture of winning to the team, which is refreshing.

Excellent. Very good. And we're also joined now by Tolga Oal, and thanks for joining in with us. And we'll continue -- I guess, this is the -- in a way, we've kind of gone through that initial part and now try and pull some financial details out of you as we ask a few questions about the model.

Ken, be careful at this point. Here comes the curveballs from Seth.

Seth, Tolga is here.

Well, I guess for John or Ken, when we think about 2019 and sort of 22% EBITDA margin, it would seem that kind of thinking about where the runway is as we get to recovery, the cost takeout that you've done alone would kind of -- has the potential to take things sort of solidly into the mid-20s. And then there's price. And eventually, they'll -- as revenues eventually surpass where they were before, there's a potential for incremental on top of that. Is that sort of a fair framework to think about in terms of where things can go?

Well, as long as you own those numbers, Seth -- because I've never put a percentage forecast for margin out there. So -- and I guess I probably won't start doing it now. But what I do note is that -- I mean the whole of our conversation in 2020 was really aimed at what was the exit rate trajectory for the company because amidst all the things that we didn't know, if we could try to have some view of what the revenue might look like in the back half of the year, and that obviously became increasingly visible to us, then how do we set ourselves up and, in fact, in the end achieved a similar margin in 2020 as we exited to that in 2019? And because that was the only thing I felt that shareholders ultimately get their minds around, which was if Howmet can achieve this under these conditions, then if conditions get better, if revenue begins to rise and the outlook is improved, then things should hopefully get better from there. And so the dialogue really has been, providing we keep faced with the exit and permanent exit of those structural costs we talked about last year, which was 20% of our cost base. And then we talked very much -- well, we didn't call out absolute numbers in the way we did with the structural cost, reflects the variable cost base. And we called out a very high percentage. We said 80% of our cost base is variable. And it's a matter of time before we get there. And a year on, we're at the point where we've almost -- or we will as we exit Q1 have almost got there in terms of what I call the perfect flex, is that if we can be sticky on allowing those -- even those semi-variable costs come back into the business and combine that with a structural cost elimination. Plus if we can move price positively, then when -- for any company, costs go down, prices go up. And if you also are blessed with some form of revenue increase in the future, then margins mathematically have to improve. It's self-evident. The only question that's left of debate is how much and, indeed, what are they. And so I think at this point what we've done is we have tried to give the external market view for 2021. It's difficult as you can -- as you well know. I think everybody knows to be absolutely sure about, let's say, rollout of vaccine, the degree of pent-up demand there is for travel and how that then translates into -- from airlines into aircraft production. But right now, it's as though things are set well such that with the, let's say, trajectory of the vectors that we've talked about there of cost and price, then margins are set well for the company.

Okay. When you talk about those sort of semi-variable costs and keeping those out, can you maybe give some examples of the types of things that are sort of on the border of what might come back versus not? And are they focused in a particular end market or segment or place within the cost base?

So the way I try to explain it is structural costs stay out or at least 95% of them forever, hopefully. On the variable side, because of the timing, you get various things which are -- those which are totally instantaneously variable, so like material cost. You don't consume materials if you don't make the parts. But there afterwards, all of the other parts of your variable cost base varies. And so for example, on the very first dollar of incremental revenue, then we may be able to produce those extra few parts without even bringing certain direct labor back into the company or certainly not indirect labor nor have to refurbish, let's say, slurry tanks or we don't actually necessarily need additional space heating or anything like that. So the incremental margin on the first dollar of revenue can be relatively high. If you move then to the, let's call it, the fifth dollar of incremental revenue, where you've already had to bring the labor back in to make the parts and then you have to put on an additional shift, so you see a third shift where you happen to bring and staff a new shift in terms of plant supervision. And so as you bring those, let's call it, more overhead type of people back in, it's still variable because you eliminated them on the way down. But you have discrete lumps of when you need to bring shifts back in. And clearly, those are costs which don't allow your incrementals to be the same as your first dollar of incremental revenue. So the way I see it is that the incremental revenues vary over time and to make them sticky on the way back up as they were on the way down. So that's the way I see it playing out is that in the short run, hopefully, we'll have very healthy incrementals; in the medium term, healthy incrementals; and in the longer term, reverting to our mean, which was normally around the 40% plus or minus around those incremental. So on the way down, we crushed our decrementals down, I think, last quarter to 24%. And I've said publicly, the incrementals will be higher than the norm on the way back up. And if you think about it, I've just tried to take you through the sequencing of material, totally variable; direct labor, maybe not in the first dollar, maybe more in the third dollar. Then you have to get into bringing shift patterns back in. Therefore, it changes over time. So in our fourth quarter, where you saw genuine demand increase in commercial transportation, $30 million of revenue, $27 million of profit. Now 90% incremental is quite ridiculous. That's just not normal. It's not even material cost. And so you shouldn't be modeling that in. The same is on commercial aerospace. I mean while the revenue dollars increased, it was just less inventory takeout but it's still a dollar of increase of revenue. And then you saw good incrementals. And so I think it follows that path on is that they'll be very healthy, and they're going to be healthy, I think, all the way through. But the first dollar of revenue incremental is very different to the, let's say, hundredths dollar or thousandths dollar. I'm just trying to explain that and get that clear in people's mind is that not every dollar is equivalent over time as we move through this next couple of years of hopefully improving demand.

Got it. Yes. No, that's very helpful. And yes, the commercial -- the Forged Wheels definitely sort of illustrated that in the fourth quarter. Before we -- I had some end market questions, for sure. But before jumping into that, Tolga, I just wanted to ask you kind of what -- since you -- you joined Arconic in 2019. And what sort of struck you most about the company, about working in aerospace? And what are the characteristics of the business you find most appealing? And kind of where do you see the most work still to be done?

Yes. Thank you, Seth. Coming into aerospace from automotive or in other industry, one of the first characteristics you notice are the very long product cycles that are in aerospace. And we, at Howmet, like many of our peers in these long product cycles, have the challenge to continue creating the wealth, additional value, additional content. And when you look at our products, for the majority -- big majority of our revenue, we got through the differentiated technology products where we have very strong leading markets, #1 positions. We are delivering technologies -- advanced technologies for lightweight, reduced emissions, improved fuel consumption as well as strength and durability across the whole aircraft. So we are able to provide our customers with this added value and, of course, creating the added content and the top line growth for Howmet Aerospace. I find this aspect of the market and the positioning of Howmet Aerospace really fascinating and very exciting. And when you look into the second part of your question, we already discussed it a little bit, just started a transition in the company with commercial and operational discipline back in 2019. I worked with John since 2008, and I'm very familiar with his operational playbook for the increased commercial and operational discipline. And not only the margin enhancement that we delivered at the peak of the market in 2019, but also the reduced market environment that we have managed successfully in 2020 have showed the strength of this playbook and how it's positioning Howmet there. And we got time in front of us where markets will start recovering. And instead of decrementals and instead of a down market, we will be talking about incremental margins and we will be talking about the upward management. So our playbook and the implementation of what has John started with our commercial and operational discipline will be even more important than before as we will be going through those stacks. So this obviously is the top priorities for Howmet Aerospace's forward growth.

Excellent. That's very helpful. If we dig into maybe some of the end markets, it sounds like given some of what we've seen in airline bookings, given the pace of vaccinations, perhaps confidence level with regard to demand from your aero customers has increased a bit since the earnings in February. And so I just wanted to kind of, a, confirm that, that's the case. And b, as we kind of think about how that's going to manifest itself this year -- I recall, John, you're talking about sort of a very low, almost a trickle of activity on 737, if you've gotten any increased visibility since then about a pickup in activity on that front.

Okay. So we sort of look at a variety of leading indicators and try to determine where we're going. It's certainly true that as each month or each quarter has gone by during last year, we became to know more and become increasingly confident about where the pandemic was, what the incidence of, let's say, fatalities or mortality was. And also we understood the shape of the crushing effect on, I'll say, the commercial aerospace demand. We did give guidance early February. And since then, it's been a good 6 weeks to see the advancement of the leading indicators, and so it does appear that things are playing out as expected. What we've seen is continued, I'll say, improvement in takeoff and landing between China and the U.S. in the domestic, say, travel. So that's good. We've looked at the quantity of people going through TSA and noted the recent pickup there. When we look at the, I'll say, the inquiry through Google over air flights, then we see a vast increase in the inquiries and booking of tickets. That's good. We see the same for car rental and for hotel reservations. So all of that speaks to improvements in domestic demand, particularly in the U.S., if not Europe. And then we look at aircraft ticket pricing and see that that's strengthening to the benefit of airlines significantly as we go out to the year. So there are many leading indicators, which are showing positive signs, including improvement in the rollout of the vaccine, particularly here in the U.S. that we've seen over recent weeks. And so while I'd said it's fundamentally underwhelming in early February, I find it more encouraging now, [ not had the ] vaccine myself, but also when I see other people of different age groups also finding their way through to gaining access to it. So there's a lot of really positive things happening. Now having said all of that, it's not going to cause me to change any view I've given in terms of outlook on today's discussion. Maybe I'll feel different in early May when we give a next earnings call and talk to where we think markets are headed then. For the moment, I don't think it affects aircraft production this year. And so I'm not yet convinced that it changes, let's say, the Airbus narrow-body plan or the Boeing 737 MAX plan of production. But I mean we are looking at other things like what's the liquidation path of the Boeing 737 inventory of aircraft. And should we see that moving and Boeing solidify their production plans and, heaven's above, if they were to increase them, then that would be really good news for us. And so we're looking at all of those things to give us the increased confidence that these early shoots are really going to translate into a rapid revenue improvement for us.

Right. Okay. And then just to level set, sort of my understanding coming out of the call was sort of that, particularly on the narrow-bodies that Howmet was producing below both Boeing and Airbus. And so even perhaps with no change to the rates of production at the OEMs and what their plans were for 2021, there was opportunity -- let's say, on a Q4 '21 over Q4 '20 basis, there was opportunity for growth at Howmet just as the fact that the company was lagging versus where the OEMs were to kind of move toward closing that gap. Is that a fair...

Yes, that's a fair characterization, Seth. So the way I talk about it is there's 3 levels of demand improvement for Howmet. And so I'll give you the 3 different scenarios. The question is when. So the first one is just to match one -- let's say, delivery of an aircraft shipset of parts equal to 1 aircraft. So that's what you just talked to is that if we've been supplying, let's say, the MAX at half the production rate of 7 months, then obviously, we do see revenue improvement should we match the rate build. The second improvement would be should that 7 months go to 10 or to 20 or 30 in '22 or as in the case of Airbus from the stated 40 to the 43 to the 45, I mean every one of those steps would be a second level of improvement for us. So first step is shipset value equals 1 aircraft. And then second step is to match the increasing rate builds as caused by the aircraft manufacturer skylines. The third level, and this is where it gets really interesting is should we gain confidence that the views of 2022 aircraft production become real. And secondly, certainly, maybe in the second half of '22, then those are probably call for actually an increase in inventory in the pipeline. Because today, while there's plenty of inventory around, that will very quickly dissipate under those growing scenarios, particularly narrow-body. And therefore, inventory will have to be put back in the system. And therefore, that would be a level of production above rate. So the question is when each of those steps occurs, it's going to be different between wide-body and narrow-body, the way we see it.

Right. Okay. No, that's very helpful. And as you pointed out, the narrow-body side sounds -- obviously, be cautious but cautiously encouraging. On the wide-body side, in the time since earnings, as you've had a chance to gain more insight into what kind of inventory may be in there in the channel for 787 given the fairly sharp decline in the production rate, what have you gleaned about that? And what does that indicate for Howmet's own 787 activity, maybe especially in fasteners, where I know there's a number of titanium fasteners on the aircraft?

Yes. We've gained no information since the earnings call regarding wide-body production, and indeed, don't see any change to the current levels for 2021 at all. And the question will be whether we see any improvement in wide-body by the second half of, I think, 2022. So we're pretty cautious on that. We fully expect the 787 to have the production problem resolved and start shipping aircraft again. I think there'll be another shoe to drop in terms of, hopefully, some easing of the U.S.-China, say, geopolitical tensions that have occurred and that I think matters to the 787 in terms of its requirements for delivery to China, et cetera. And I think the next step is we do have to see some form of reemergence of international travel, which I think will come. But then I think we're going to have to go to the system of -- some form of COVID passports where people can prove they've had the vaccine or COVID-free to be able to put those flights back on. So I think it's really important that international travel comes back both for business and for leisure purposes. And I think it will. Again, I think it'll look quite different 6 months from now to where it is today. And I fully expect to be one of the early adopters of international travel because I'm really busting to get out there and busy to not only make some customers, but also to also actually have a vacation as well, maybe even visits some relatives back in Europe. How is that?

That sounds -- we'll look forward to it, and that sounds excellent. I guess maybe 2 questions about sort of the business environment since the pandemic started. First is in aerospace, how -- if at all, how your share has evolved. Have there been opportunities to pick up share? Have you seen more competition for share? And then I guess the second part of that is as long-term agreements come up and you negotiate those -- I'd imagine, in 2019, it was very different. Everyone had a set of assumptions that everyone agreed on about where things were headed, and it all looked very good, whereas now there's a lot more uncertainty. Does that make negotiating these agreements different? And if so, what's the impact?

Okay. I don't think it got any easier as the result of the declining end market demand because everybody -- I say when food is scarce, so the production is scarce, things tend to be more difficult commercially. At the same time, you have to take a longer view through the aerospace cycle. It isn't instantaneously normally, I'll say, famine to feast and [ beast of burden ] are back again. It's longer run rhythms for this industry compared to some albeit, obviously, we've seen a sharp demand shock with the pandemic, which I don't think anybody had really factored into their plans. So when I look at 2019, it certainly was an environment where everybody was struggling to make more. And so the conversation was more about can you make more rather than any other part of the conversation, which really overshadows most commercial negotiations. But I mean right now, I don't really see that the current, let's say, demand, let's say, reductions have made a huge difference. It didn't make it any easier. And so we've all been battling through the normal things you go through in an LTA negotiation. What's the price? What's the share? What's the share of future platform, the terms and conditions? And I do note that at the time, Howmet was pretty unique in bringing additional capacity to bear in the engine business in committing to invest $250 million for our customers in, let's say, over 2019. And of course, just as it came to fruition, then the pandemic hit. So we couldn't have had a worse situation than we did. And I'm hopeful that we are able to increasingly deploy that capacity over the next few years. And it's needed. That is -- I think we end up with achieving any of the rate forecast that people are talking to out there. So the stepping through the, I'll say, the whole commercial situation has been not made easier. But we've all approached it sensibly and try to make sure we maintain our relationships throughout all of this.

Well, one thing we haven't talked about is the aftermarket. And I know it's a fairly small piece of the puzzle at Howmet. I think maybe at the peak, it was about $400 million of commercial aero aftermarket revenues concentrated in airfoil. But that is where you have added some capacity, and it is kind of a shorter cycle piece of the industry. And so will we look for that to balance relatively quickly with flight hours, even understanding that, that's a smaller part of the business?

Yes. The previous metric, which is $800 million of aftermarket for our engine business and about $50 million of other stuff. When I think about the $800 million, half of it was defense and industrial, which continued to grow. So it went from $400 million to $450 million last year, give or take, or $470 million. The first quarter of 2021, we had our normal commercial aerospace aftermarket, so about $100 million a quarter. And then it collapsed. And then for the last 3 quarters, it's been, let's say, $20 million plus or minus during Q2, 3 and 4 of 2020. Our planning assumption is that we see continued growth in the -- depends on the industrial aftermarket in 2021. So the $450 million grows towards $500 million, but our planning assumption has also been that we don't see any change at all for the baseline guidance we gave for the aftermarket for 2021. So continuing to be around that $20 million a quarter. Now of course, we gave upside. We gave asymmetrical guidance, so baseline which was different to our normal words about -- this is the outlook as a baseline with a very small downside to the solidity of that guide we gave and then more to the upside. Now if it turns out that in the second half of this year that the aftermarket does begin to pick up or maybe -- see if not second half, by fourth quarter, then we shall begin to enjoy that revenue. So maybe year-to-year, it will be the same revenue. Whereas 2020, we started out really high, and I'm hopeful that we end 2021 relatively higher. And for me, it's never about the absolute level. It's always about the trajectory. And the trajectory means everything to us. So even the way I think about 2021, my real view at the moment is that the more I think about it -- it's not the guide I give for the year. But I think it's going to become really important is the guide I give for the second half of the year or maybe it's the exit rate for 2021, which really determines the value creation opportunity as we go into 2022. And I just increasingly come to the view is that putting up a respectable '21 and then if we can show the benefits of that revenue trajectory and what it means, that's going to really set the platform for '22 and beyond.

Great. Great. No, that's very helpful. And now maybe we'll step into an area in which I know very little about. So hopefully, these questions will still be useful. But in the commercial transportation and Forged Wheels business, I guess, the margin performance there, obviously, was quite impressive. But I wanted to ask a little bit about the revenue and sort of -- I think you've talked about when we can sort of expect a return to prior peak in 2019 and surpass it. But I think there was also a view that maybe that 2019 level was fairly elevated and even without a pandemic that there was some pressure coming into 2020. It tends to be a shorter cycle business. Is there a structural level of sales and maybe of growth that people can think about in Forged Wheels? Or is that business going to be where we could see a stellar 2021 and things looking good into 2022, but then as you look beyond, it's maybe more choppy?

Okay. Well, first of all, it's certainly a shorter-run cycle business than aerospace on average. So I'm aware of that. But I think it has many of the hallmarks of a business that I generally really like in that, first of all, it has the opportunity to grow in several ways. And so it makes it more of a secular growth story than is a cycle growth story. And when I look at where we define the market, it's the truck wheels and the trader wheels business. So if we can increase penetration against steel wheel, that helps us. And so on average, we increased penetration against steel wheels by about 1% a year in the U.S., maybe between 1% and 2% in Europe and a similar number in Asia. So that gives us growth above markets. Then we look at can we grow relative to our competitor or competitors, and we tend to pick up a fractional improvement there albeit our market share is already fairly high. So the second led to the growth. There's a third level to the growth, which is driving the technology and its content, whether it's lighter, stronger and therefore bring value-added content in that way and price to the equation. And then fourthly, the coatings finishes that we do as well. So where we apply, let's say, Dura-Bright or Dura-Black and give either a functional coating quality or a cosmetic coating quality, that also helps drive value for the business. And so I see in 4 ways that we grow revenue difference to just going with the cycle of the truck and trailer market. And therefore, when any business has those characteristics of growth opportunity beyond just following the cycle, we add value. And it's a strong, good, highly performing, great margin business. So I quite like it.

Excellent. I think we're -- a number of additional questions. We're running up against the time, unfortunately. One that I did want to ask is just in terms of cash deployment and talked about the -- you talked before about the various things that the company can do with its cash. And I think it's pretty well understood. When you look at the landscape and you think about the potential for consolidation in terms of what you do in aerospace and for M&A, just given that from an operational performance perspective, you have a playbook for good execution. Does it make -- would it make sense over time to try to deploy that at other companies? Or is the industry not necessarily structured for that?

I think M&A is an important part of the top level growth of any company. But I always think it's secondary to organic growth. And we should see organic growth. And if you can flesh out by relevant acquisition in a bolt-on sense, that's the most important aspect rather than, let's say, large-scale company acquisition and take all the risks that entails. What I also see is given the fact I still believe that given the difficulty on comps, separation is that -- it's another quarter before we get clean comp comparison for Howmet year-to-year. And therefore, there's still value to come from the Howmet multiple because we're still at a discount, I believe, to the average. And maybe we should not be just an average, but maybe we should be above average. And so I see a lot more value buying my own stock than paying a control premium for somebody else's and take that risk at this point in time, albeit I think we should have an open mind to adjacent bolt-ons. Just to buy something to run it differently or better, I don't know if I'll buy that as a thing to do. Maybe you're far better off waiting till I fade away from Howmet and go do something else and whichever industry it's in or whichever industry my wife tells me to go to, to keep out of our her hair, I don't know, but something like that. And rather than just add on something that doesn't -- it doesn't take Howmet anywhere in its mission. So I think it's going to be highly relevant rather than largely irrelevant just for the discipline.

Okay. I could definitely keep asking questions, but unfortunately, we're up at the time here. So I will let you all go. But appreciate you -- all of you joining, and appreciate the insight and the time, and look forward to being in touch again.

Great. Well, great talking to you. Thank you so much for inviting us, and see you soon. Thanks, Seth. Bye-bye.

Thank you.

Thank you, Seth.

Bye-bye.