Kaiser Aluminum Corporation (KALU) Earnings Call Transcript & Summary

Great. Good afternoon, everyone. Thank you for joining us today at the Goldman Sachs Annual Industrials and Materials Conference and for the session that we have here with Kaiser Aluminum. I'm Karl Blunden. I run our credit research outfit for metals and mining. And it's a pleasure to have with us here, Jack Hockema, CEO and Chairman of the Board for Kaiser Aluminum. Jack, thanks for joining us today.

Thanks, Karl.

So before we get started, I just want to direct everyone's attention to the relevant disclosures in the slides. Those are there for your reference. Please review them as necessary. And Jack, for this discussion, really been looking forward to it. In my high-yield coverage, I generally spend time with companies that have higher leverage than Kaiser. So I've been interested to hear your perspective really on how Kaiser has been preparing for and managing through a down market and your view on how that will play out over time. With that in mind, I'd like to turn the floor over to you, first, for some opening remarks, and then you have some slides there you'd like to run through, and then we'll switch to Q&A at the end of those remarks. I have some questions of my own, and we'll certainly take questions from the webcast as well. So if anyone in the audience have those questions, please enter them through the webcast anytime, and we'll come back to them. Thanks, Jack. The floor is yours.

Okay. Thank you very much, Karl. It's a pleasure to be involved in your Goldman Sachs conference today. We'll start our remarks on Slide #4 in the deck. And turning to that slide, which covers our investment considerations, we are a leader in attractive market segments that have secular growth, high barriers to entry and high margin compared to most other industry market segments. We have long, deep partnerships with blue-chip customers that, in many cases, span decades. Our business is essentially metal price neutral. Approximately 85% of our shipments are metal pass-through by contract or by industry practice and the remaining 15% pass-through metal price with some time lag. We have very strong liquidity and cash flow with a track record for balanced capital allocation, and our liquidity provides a safety net for times of economic adversity like we're experiencing now. And along with low leverage, we have financial strength and flexibility to be proactive throughout the business cycle. Turning to Slide #5 and just some quick key highlights on the company for those not familiar with us. Last 12 months ending March 31, we had $1.5 billion of revenue, approximately $200 million of EBITDA and low leverage of 0.7x net debt-to-EBITDA. Our market cap as of March 31 was $1.1 billion, but thanks to the pandemic, has eroded some since then. We -- turning to Slide #6. We have 13 plants, all in North America, producing mill products that include sheet, plate, extrusions and drawn products. Turning to Slide #7 and our long-term competitive strategy. We employ a focused strategy with a narrow focus on market segments where we have a defensible competitive position and where there are barriers to entry. We differentiate our products with best-in-class quality, consistency, delivery and customer service and further differentiate with KaiserSelect products that have superior performance attributes. We create value with operating leverage and manufacturing efficiency to grow our EBITDA along with sales over the long term. Turning to Slide 8. We focus on very narrow segments of the total market. The global market for flat-rolled products is a 50 billion pound market in normal conditions. We service less than 10% of that total global market. The North American extrusion market is roughly -- is more than a 5 billion pound market normally. And we focus on approximately 20% of that total market. So we're highly focused, again, on the higher-margin barrier to entry where we have a defensible competitive position. Slide #9 shows our mix of end applications. Our focus is on demanding applications where we, again, have the defensible competitive position. We're well positioned as a leader in our aerospace and automotive applications that, together, represent more than 70% of our value-added revenue and that have underlying secular demand growth. We also serve general engineering demand through service centers, where we are highly differentiated as the premier domestic supplier for these applications. Turning to Slide 10. As I mentioned, we have a blue-chip customer base. Approximately half of our shipments go direct through OEMs, and the remaining half go through service centers. We have long, deep partnerships with most of our major customers. And in many cases, these partnerships span decades. For example, Reliance, who many of you know, Reliance Steel and Aluminum, our founder, Henry J. Kaiser, was selling to their founder back in the 1940s.

I'll just jump in. I think some folks on the webcast, if you're looking at the interface, you might see 1 page number off versus what Jack is referring to. And Jack's referring to the Kaiser slide. I think the webcast has added one, but I think we're following along just fine.

Okay. Sorry about that, and I'll try to remember here. So slides 12 to 14, I guess, now. Over our value-added revenue, EBITDA and EBITDA margin trends. Over the past 14 years, our value-added revenue has grown at a 4% compound annual growth rate, and our EBITDA has grown at an 8% CAGR through the end of 2019. We had strong results back in the 2009 Great Recession that illustrate the strength of our business cycle strategy to manage for, not through downturns. And I'll talk about this more later. We're always prepared for a downturn. During that period, 2009, we had a 25% decline in value-added revenue. We still had very favorable EBITDA, and we continued what back then was a major investment for us, in a world-class [ green site ] plant in Kalamazoo, Michigan, that did what we intend to do during these periods of times, which is expand competitive advantage, while our competition was struggling with the adversity just to survive the economic downturn. I'll skip over the next couple of slides that show the same basic trends here and turn to Slide 15, which I just referred to as our business cycle strategy, which is to always be prepared for unexpected economic adversity. We -- every quarter, we show our Board meeting a 5-year liquidity forecast, and we also show them a severely stress tested in case a recession started, as this one just came up out of the blue. We're always prepared for that downturn. Execution of the strategy requires that we be positioned as a preferred supplier, which we are, by differentiating ourselves with customer satisfaction; flexing our variable cost, more than 85% of our cost of goods sold flex with changes in volume; retain a strong liquidity safety net to sustain and enhance our competitive position during any downturn; and maintaining conservative leverage that gives us financial flexibility and access to capital throughout the business cycle. The current actions that we've taken. As a consequence of the pandemic, we suspended share repurchases in mid-March; we have been aggressively flexing our costs to changes in activity level; and we've curtailed our capital spending back to sustaining projects, which would be a pace of roughly $35 million a year under normal conditions and should be less than $35 million with a lower activity level and less strain on our equipment. Turning to Slide 16. We're often asked for perspective from the Great Recession. The graphs on this slide illustrate annual shipments from 2005 to 2019 for each of our end major market applications. In 2009, our total shipments declined 23% from 2008, and it took until 2011 to return to the prior peak. Aerospace and high-strength shipments declined 8% in 2009 from 2008, while airframe builds actually increased in 2009. The lower shipments were a result of supply chain destocking. General engineering shipments declined 27% in 2009, driven by weakening industrial demand and reduced orders for armor plate as the Iraq War was winding down. Industry demand was further impacted by destocking in the long supply chain. Automotive shipments declined 28% from the prior year, driven by a 32% decline in build rates. And shipments for our various cyclic nonstrategic applications declined 37% in 2009 from 2008. Back then, these applications were approximately 17% of our mix. Today, they've been reduced to less than 1% of our total mix. Slide 17 shows historic -- going clear back to the 1960s air traffic -- airline passenger traffic. Commercial aerospace represents approximately 1/3 of our total value-added revenue, and demand is ultimately driven by air passenger travel. The current crisis is one of many over the past 60 years. In previous cases, despite the thought that maybe it's different this time, travel returned to the long-term growth trend within a short time after the crisis. While this currently is a very challenging time for the airlines, we expect that once again, air travel will be restored to the long-term growth trend after a period of adjustment. Turning to Slide 18. In the commercial airframe order backlog, the industry has enjoyed a large and growing backlog since 2005. What we don't often reference is that for decades prior to 2005, a much smaller backlog was normal. While it's difficult to predict what orders and build rates will be during and after the pandemic, the current 8-year backlog could decline more than 50% and still be in line with the long history prior to 2005. Turning to Slide 19 and our outlook. Commercial aerospace and defense represent almost half of our business. We expect value-added revenue for these applications to be down roughly 15% to 20% in 2020 from record value-added revenue in 2019. We've suspended our outlook for automotive and other industrial applications until we get further clarity on the implications of the pandemic crisis. Turning to Slide 21 and our business cycle financial strategy. Two key components. One is to ensure that our liquidity is always sufficient to address an economic downturn. And the second component is to maintain leverage at or below 2x net debt to normalized EBITDA. We allow greater than 2x net debt-to-EBITDA for strategic initiatives if there is a clear plan to delever to 2x or less. And Karl referred to that earlier in his opening comments. Slide #22 illustrates our balanced capital allocation priorities. As we mentioned earlier, our spending pace for sustaining CapEx will be less than the normal $35 million as there's less wear on equipment during a recession. Also mentioned earlier, share repurchases are our last priority to be exercised only when we have excess liquidity. Our first action to begin preserving liquidity was to suspend share repurchases in mid-March. Share repurchases will not resume until we have excess liquidity beyond meeting our investment needs and our leverage guidelines. Slide 22 (sic) [ 23 ] illustrates our history of balanced capital allocation between organic investments, inorganic investments, dividends and share repurchases. And noteworthy is that we sustained the regular dividend through the 2009 recession and we have increased the dividend every year beginning in 2012. And Slide 24, the last slide in my remarks here, summarizes our ESG program, which has been a cornerstone of our value system long before it gained prominence with investors. Our ESG program is described in great detail on our website for those who wish to get more information. And just coming back to the opening slide, Slide #25 here. We're a leader in attractive growing market segments. We have long, deep partnerships with blue-chip customers. We're essentially metal-neutral. We have a strong track record of cash flow generation and balanced capital allocation, and we have the financial strength and flexibility to be proactive through the full business cycle. And with the debt raise we just did in the past few weeks, we're currently sitting with $1 billion, essentially, of liquidity on a business that in normal operations is $200 million plus of EBITDA. Karl, I'll turn it back to you for questions.

Yes. Thanks a lot, Jack. As a credit guy, I'd be inclined to jump into the balance sheet first. But I think there's a lot of questions right now. And the biggest focus that I sense in the market is around the end markets. And some of your comments that you've made on recent earnings calls that said, well, you don't know exactly what's going to happen, of course, right? And so you're building a fort and you have that liquidity to manage through it. But what can you tell us about what you're seeing right now, mostly focused on the aerospace side and the automotive side in terms of the ramp back up? And thoughts on where things sit in the supply chain and the impact to Kaiser?

Yes. Well, there's still not much that's new on the earnings call. I characterize it as we're in a foxhole and the battlefield's covered with smoke, and we're just waiting until the battlefield clears a little bit to see where we're headed. We're getting a little bit more clarity, but not much. In commercial aerospace, we've been pleased with the optimism from the CEO of Boeing. It looks like they're going to start building 737-MAXs again here in the next few weeks. And they're talking about ramping up build rates. So that's a positive sign that at least we're starting to get some positive momentum in terms of builds there. Airbus has also talked about their builds going forward. Defense is a bright spot for us and is dampening in that 50% that's commercial aerospace and defense. Very strong demand and visibility for at least 5 years of strong growth in the Joint Strike Fighter. And the pressure that the administration has put on our NATO partners to increase their spending as well as increased defense spending in the U.S. has created demand for a lot of the legacy military airframes as well. So we see really strong and growing demand in defense, which is helping to offset a little bit what we're seeing in commercial aerospace. In automotive, other than the big 3 plants, the other North American manufacturers are beginning to ramp up now, and the big 3 is expecting to ramp up later this month. So we're looking at auto getting back in business. Most of what we do goes through Tier 1s. But we'll -- so there'll be a bit of a lag, and there was a lag going down. There will be a little bit of lag going up. But we're expecting to start to get some demand pull here over the next few weeks for our automotive applications. And industrial is pretty much waiting for the economy to open. We still have demand in the industrial sector, but it's relatively anemic right now, just as we said on the earnings call, just waiting to see how this all unfolds.

That's helpful. To follow up on the automotive side, we've heard various different comments on the earnings calls for folks involved in the auto supply chain. So I'm saying they're hopeful because we're going to have a return to driving, right, and less mass transit, maybe less use of ride sharing, for example. Do you have thoughts on where we head to in 12 to 18 months from now? And if not a general thought, just a thought on what kind of -- how you're positioned in terms of the mix of vehicles that you sell into?

Yes. Well we hear those comments as well. We hope they're true. Don't know if they are. I mean this is a whole different paradigm that we're dealing with as we go forward. But in terms of our mix, we're more -- well distributed across all the platforms that are built, but we're more heavily weighted to the SUVs and light trucks that are heavier, first of all, and they have greater aluminum content as well compared to some of the smaller vehicles. So -- and that appears to be the segment that has the most demand right now, especially with the low oil prices and the low gasoline prices. So we're somewhat optimistic here. But again, who knows how this all unfolds? But most of the forecasts we've seen shows a pretty prompt upturn in automotive after we get through 2020 here, with 2020 yet to be determined.

Okay. That make sense. And then something that has gotten some focus since the call is with regard to your shipments into the aerospace end market. And you made some comments about mutually agreed-upon reduction, probably a temporary reduction, in shipments to some customers but that the commitments over the contract life haven't changed. Could you go into that in a bit more detail?

Yes. We -- these are long-standing partnerships that we have with our customers. And we work together for mutual success here. I know this is cliche, but that's really how we view our business, and that's how we earn our position as a preferred supplier. So we respond, and we're working with our suppliers, but we fully expect it will be made whole over the long-term course of the contract. So that was the source of those comments.

Okay. I don't know if you can go into that further, is that -- it's specific to the contract? Or are you thinking more generally as providing the type of flexibility that's required right now positions you better for additional platforms, contracts beyond those that are flexing presently?

Yes. Well, if we make concessions compared to what was due to us, we expect those to be made up in the long term. I'll just leave it that way, regardless of how they get made up. So we work together. We say, "Look, we help you here. You need to help us there."

Got you. Fixed and variable costs, you've come out with some fresh disclosures. And I think a lot of companies have felt the need to get that breakout out there. And certainly, Kaiser screens really well from a variable cost versus fixed cost standpoint, if you look across the metals and mining space and even the aluminum space. I think you mentioned 2/3 of your nonmetal costs are variable over time -- are variable right now. Probably can bring that up a little bit as some fixed costs become variable as you go into kind of a medium to longer-term horizon. Could you talk through some of the different levers that you could pull to improve that if we get to go into a more extended recession?

Well, it's, as you say, if this really goes on for a long time, there are levers we can pull like reducing overhead and those things. But frankly, we have no plans to do that. We're -- we have strong liquidity. We -- and we have the ability to be proactive here and go back to 2009 when we were building Kalamazoo. So we're focused right now. We're confident we've got sufficient liquidity to survive just about anything that comes down the pike here in terms of this downturn, but we're focused on being ready a lot of times when these turn. Especially in industrial and automotive, they turn very rapidly, and some competitors can't respond to that if they've stripped themselves too bare as you go through the downturn here. So we're trying not to get into the muscle at all in terms of what we're reducing to maintaining our -- fully maintaining our operations, fully maintaining our capital capability or our key employee capabilities, continue to spend on R&D, continue to be proactive and looking for opportunities that pop up here. So frankly, we're not focused on slicing at this point. We're focused on reducing our variable costs pragmatically as we always do, but not getting into the muscle here. We want to keep the muscle and build muscle as we go through this.

And speaking of some of the opportunities, I'd like to come back to M&A in a sec when we talk about your liquidity and if you don't need it, if it turns out that the liquidity raise was more insurance in this -- the COVID situation prices relatively quickly. But first, you've previously announced plans to expand capacity at Trentwood and have indicated that market conditions, to some extent, would influence the speed with which you grow that out and invest. What's the latest thinking there in terms of the timing of the spend and the capacity coming online?

Well, that's exactly it. It's -- as we said when we announced it, the timing would depend upon market conditions. And obviously, market conditions here in the short term have changed dramatically. So we've curtailed back to -- as I mentioned, back to sustaining CapEx, and we'll go forward, continue to monitor market conditions and if the aerospace market has a robust rebound here, we'll be prepared to meet that with investments. And if this lingers for some point in time, we'll just keep pushing that spending to the right until the market develops and the demand is there. Our customers need that capacity.

It's probably not a simple formula to give you -- give the green light to go ahead with that expansion. But at what point do you feel comfortable with that? Is it order rates are picking up? Customers feel confident you're seeing airline miles go up? What are the key inputs that you'd be watching?

Well it will be all of those macro factors, but it will also be close conversations with our key aerospace partners in terms of what their needs look like over the next 3 to 5 years. So we just -- again, these are close partnerships, and we work with them to make sure we've got what they need when they need it. So it will be based on market conditions.

Let's touch on liquidity briefly, and you mentioned that you have a strong liquidity position, partly thanks to a recent bond offering that you did in April and raised $350 million with that offering. It's an unusual offering in the sense that it was done at the unsecured level, where we're seeing a lot of secured bond deals come through the market these days, so maintaining flexibility for the forward. But when you thought about doing that deal with potential use of proceeds over time, what was top of mind there? And what made you think that was the right time to come to market?

Top of mind is that even though we already had strong liquidity, not knowing how severe this downturn could be, priority one liquidity is king in a situation like this. And so it was to further strengthen that safety net. So make sure we had a safety net that was strong enough to take just about anything that would come down the pike. And we feel like we've certainly accomplished that. We feel pretty confident that we can take whatever is coming here. But then the second priority, as I said, frequently, these things turn rapidly and that potentially, we could have a V here. If we have a V, it's very challenging to ramp back up as well. And having that liquidity enables us to stay strong, as I said, keep the muscle and build the muscles we go through this and be ready to respond if it's a rip-roaring V recovery at some point in time down the road. But then the third is to be opportunistic. When you get into a situation like this, if it drags on, you just don't know what kind of opportunities are going to pop up. There could be unique organic investment opportunities or inorganic investment opportunities, and we think we're in a position potentially to capitalize on those as well. So there really were 3 prongs to the thinking, starting with strengthen the safety net, but then be proactive.

If the opportunities don't arise, the call structure on those bonds, the callable in 2 years, so you can take that debt down again pretty easily with some call protection, is that primary use of capital? Or do you -- would you think that other elements take precedence in a kind of a moderate ramp up?

Well, we -- first of all, we hope we have investment opportunities that use some of that dry powder that we have. But then, as I said, in terms of our capital allocation priorities, share repurchases are last on the list after we're assured that we still have enough safety net, which means it's excess cash. And secondly, making sure that we don't violate our leverage guidelines. So we're going to manage through our leverage guidelines first before we would do anything beyond good investments, proactive investments.

Got it. Just want to switch to -- before we go into more detail on some of the operating items, we have a couple of questions coming in from the webcast. So I'll kick it off with this one here. Could you please provide some color on aero inventory in the chain? In particular, do you expect destocking to impact the velocity of your recovery?

Yes. So I'm going to give you a long answer that says, "I don't know." The [Audio Gap] happened recently. We went through a period in 2017 and 2018, where we anticipated destocking. The destocking went much longer and much deeper than what we expected. We thought it was overdone and started to give some hints of that early last year, and it turned out it was overdone. And there was panic buying in the second half of the year because the destocking had gone way too far. And even with the 737 builds reduced and then curtailed, there still was very heavy unexpected buying to beef up the supply chain. And now we've had curtailments at both Airbus and Boeing. There's been some take over that period of time. So one would think inventories are building. But again, this supply chain is so long and so opaque, it's really difficult to tell. We think there's probably some destocking. It would certainly seem that way now. But whether that's got taken in to excess inventory levels, it's hard for us to see. We don't think so. There may be some excess inventory. We don't think it's going to be a major depressant for shipments, but it remains to be seen as we've not been good at predicting it, but neither is anyone else.

So on that -- a little more granular here on cash flow and working capital. And you mentioned you'd need to invest some cash into working capital as you ramp back up. Do you have a sense for how working capital could trend by quarter through this year or some kind of framework for understanding the size of the swings you can see?

No. But again, our focus is liquidity. So what happens in the situation we're in now, with sales going down, we're going to throw off working capital. So that will generate some cash. But in terms of liquidity, it has very little benefit because our borrowing base is an asset base that is tied to working capital. So as our working capital goes down, our borrowing base gets reduced. So we gain cash, lose borrowing base, and we end up basically in the same place in terms of liquidity, and the opposite will happen when we go the other way. So when it starts to ramp up, we'll have a draw on cash for working capital, but our revolver is tied to that. So our liquidity will go up or our borrowing base goes up. So our liquidity remains stable as we go up and down the cycle, if that answered the question.

Yes. That makes sense. You've seen some other participants in the auto and aero end markets shift towards ABL just recently as well. So I think that makes sense. A question here on the automotive opportunity. Can you talk about the aluminum content opportunity in autos longer term? And should we expect any changes to the market with consolidation driven by Novelis?

Yes. So again, our market is automotive extrusions. We're not in body sheet, which is where Novelis is. But in terms of automotive extrusions, we've said for several years that the industry was expecting a 5% to 6% compound annual growth in terms of aluminum extrusion content on vehicles. That outlook remains in place. We had a downturn last year with a number of model changeover. So we actually lost content last year, but we were expecting double-digit growth this year and next year in terms of content per vehicle. Remains to be seen what happens there. But in terms of the macro, looking long term, we still see this as a good, steady, solid, secular growth market in terms of a 5% to 6% CAGR in aluminum extrusions content per vehicle.

Question coming in here on ESG, increased focus on the space. Can you talk about some of the ways that Kaiser is differentiated in the space in terms of its current ESG initiatives?

Well, we frankly don't look at others in terms of how we differentiate in terms of ESG. It was -- it's part of our DNA. It was part of our value system long before any investors started asking us about ESG. We're very environmentally conscious. We've had long-term objectives to increase our energy efficiency, and we have data on the website that shows our effectiveness in driving that down. As we've improved our productivity in our facilities, we also become more energy efficient. We have very robust programs in terms of our human resource management. We'll stack our labor relations up against anyone in any industry. We seek to be a preferred employer, and we generally are regarded as a preferred employer. We have deep training programs, our management development and training programs. We would stack up against most Fortune 100 companies. So we have very diverse and broad ESG programs that -- and it goes back to our philosophy on how we manage the business. The fact that we prepare for downturns where we look at the sustainability of the enterprise and all aspects that are considered in the sustainability of the enterprise. And I should say that goes with governance as well. Our Lead Director is a national leader. He runs the Director Training Program at UCLA, he's an experienced director with a number of companies and is renowned as an expert in corporate governance. So we have a strong Board in terms of governance as well. So we're satisfied we're meeting those criteria and spades across the board.

The next one coming in dovetails a point that I'd wanted to come back to. As we're heading into the final couple of minutes, it seems appropriate. With regard to M&A, you've outlined some of the criteria that need to be met for acquisitions to be attractive to Kaiser. Are there -- can you give some specifics about end markets that might be attractive or product lines where you see potential to increase margins or market share over time?

Yes. So we have a pretty fine filter on our strategic -- or fine screen on our strategic filter. We start with it has to be a business that we understand and that's compatible with our existing business. So that could be extensions of the current markets or it could be other markets that we understand or technologies that we understand. And then from there, if we determine that it fits and it's culturally compatible and something that we can integrate reasonably efficiently, then it gets down to does it create value -- long-term value for our shareholders? Meaning that we're not going to pay outrageous prices for these assets. And frankly, we're generally the preferred buyer in assets that would fit us. But we've walked away because the acquisition prices have been, frankly, outrageous in the past, as has been demonstrated by what's happened with a lot of the recent acquisitions. So anyway, we've done several small bolt-ons that have filled white spaces in our product offering. So it's those kinds of acquisitions that make sense for us.

I think as we hit 2:25 now, we're out of time. But I want to thank everyone who dialed in for joining us for this online conference, then also Jack and Melinda from the Kaiser team for participating and discussing everything with us. Thank you very much.

Thank you, Karl.