AK Steel Holding Corporation (NYSE:AKS)
Q3 2017 Earnings Conference Call
October 31, 2017 11:00 AM
Doug Mitterholzer – General Manager of Investor Relations and Assistant Treasurer
Roger Newport – Chief Executive Officer
Kirk Reich – President and Chief Operating Officer
Jaime Vasquez – Vice President-Finance and Chief Financial Officer
Timna Tanners – Bank of America
Seth Rosenfeld – Jefferies
Sean Wondrack – Deutsche Bank
Curt Woodworth – Credit Suisse
Carl Blendon – Goldman Sachs
Mariano Beristain – Deutsche Bank
Matthew Fields – Bank of America
Phil Gibbs – KeyBanc
Charles Bradford – Bradford Research
Novid Rbadouli – Cowen & Company
Good morning, ladies and gentlemen, and welcome to AK Steel’s Third Quarter 2017 Earnings Conference Call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session. [Operator Instructions] As a reminder, this conference call is being recorded.
At this time, I will turn the conference call over to Doug Mitterholzer, General Manager of Investor Relations and Assistant Treasurer. Please go ahead, sir.
Thank you, Candice, and good morning, everyone. I too would like to welcome to AK Steel’s third quarter 2017 earnings conference call. With us on the call today are Roger Newport, our Chief Executive Officer; Kirk Reich, President and Chief Operating Officer; Jaime Vasquez, our Vice President-Finance and Chief Financial Officer. In a moment, Roger will offer his comments on our business and overall market conditions. Following Roger’s remarks, Kirk will provide an update on some of the exciting projects and initiatives underway at AK Steel. Following Kirk’s remarks Jaime will review our third quarter 2017 financial results, and together, we will field your questions.
Our comments today will include forward-looking statements within the meaning of Section 21E of the Securities Exchange Act of 1934. Included among those forward-looking statements will be any comments concerning our expectations as to future shipments, product mix, prices, costs, operating profit, EBITDA, or liquidity. Please note that our actual results may differ materially from what is contained in the forward-looking statements provided during this call.
Information concerning factors that could cause such material differences in results is contained in our earnings release issued earlier today. Except as required by law, the company disclaims any obligation to update any forward-looking statements to reflect future developments or events. To the extent that we refer to material information that includes non-GAAP financial measures, the reconciliation information required by Reg G is available on the Company’s website at www.aksteel.com.
With that, here is Roger with his comments. Roger?
Thank you, Doug. Good morning and thanks for joining us on our third quarter investor conference call. I’m pleased to report that overall our company performed well during the third quarter of 2017. While this quarter’s financial performance was not quite as strong as a second quarter. Our third quarter performance was in line with our prior guidance and was very solid in terms of our employee safety, product quality and environmental compliance and operational execution.
For the third quarter, we reported a net loss of $5.8 million or $0.02 per diluted share, and adjusted EBITDA of $69.2 million. However, these figures included one-time charges totaling $13 million, which Jaime will discuss in a few moments. [Indiscernible] charges, we would have reported net income for the quarter. Several notable achievements were achieved in the third quarter as we continue to execute on our long-term strategy. We completed the acquisition of Precision Partners Holding and I would like to extent a very warm welcome to the 1,000 team members at Precision Partners Holding who are now part of the AK Steel family.
We believe this acquisitions will helps speed the adoption of many of our new and innovative steel products. We’ll drive collaborative innovations in materials in metal forming by getting us even closer to our customers and will serve as a platforms for future revenue and earnings growth. We successfully refinance $280 million of our senior notes, achieving a substantially lower coupon and extending the maturity date, and also refinance our revolving credit facility, which also lowered our costs and position us well for the future.
And finally, as Kirk will cover shortly, we continued to make great progress on product and process innovation, guided by the goal of meeting the future needs of our customers. And we will continue to invest in our facilities to ensure the long-term reliability of our equipment to deliver the high-quality products that our customer’s value. Throughout all that we do, the safety of our employees remains our highest priority and once again, our team delivered strong results in this regard with six of our facilities working the entire quarter without a single OSHA recordable case.
I commend all of our employees for making safety such a priority and for continuing to embrace safe work practices in all that they do each and every day. I would also like to recognize the union leadership and our employees represented by the United Auto Workers at our Rockport Works for reaching a new labor agreement that positions us well for the future. It is clear to me that our employees take great pride in what they do each and every day for our customers. Making steel that goes into products that people use every day. But working safely and providing outstanding value to our customers can easily be undermined by the absence of effective trade laws that ensure fair trade.
While I am pleased with attention being placed on unfair trade by the current administration, quite candidly, I’m disappointed with the slow progress in addressing the import situation, which continues to worsen. The steel industry is seeing a flood of imports primarily from South Korea, Japan, Turkey, along with Brazil and Germany. It appears that everyone is rushing to get imports into the United States before any potential remedies stemming from the Section 232 investigation are announced. It is estimated that foreign steel imports comprise about 27% of the total steel consumed in United States year-to-date and as much as 30% in the third quarter alone. Prior trade case rulings have proven insufficient to stem the tide of unfair trade and the threat to our national security remains as strong and as real as ever before.
As we previously stated, we strongly believe the ongoing significant level of imports is a threat to national security of our country. This is especially true for electrical steels, which were used to manufacture power and distribution transformers that serve as the backbone of our nation’s electric power grid. Current events in Puerto Rico, which remains largely without power over a month after a devastating hurricane, serve to remind us how important our nation’s electric grid is to our nation’s safety and security.
It should also might us to why the United States needs already supply of high grade of electrical steels, which is a major component of electrical transformers to power the grid. Yet as the only steel manufacturer Grain Oriented Electrical Steel in United States, we’re battling some of the highest import levels in years. Imports of Grain Oriented Electrical Steel or GOES have increased by more than 260% year-over-year and these imports are coming primarily South Korea, China and Japan. There is no look back clause contained in this Section 232 process, and, thus, it appears as if importers are trying to beat any future remedies by flooding our shores with low price foreign product.
Yet despite these import pressures at AK Steel, we continue to invest in both our electrical steel operations and in the development of new products that will enhance both the reliability and efficiency of our nation’s power grid. We are very pleased to President Trump, Secretary Ross and others in administration agreed to address this serious situation that endangers our national security. While we will continue to fight for fair trade and for steel manufacturing in the United States, we call upon the administration to take action to determine and apply remedies swiftly and broadly in their quest to protect the national interest of our great country.
I would now like to discuss what we are seeing in the marketplace. Our core market of automotive has clearly softened a bit from the record levels of 2016. Although vehicle sales in the month of September were very strong as a result of replacement demand for vehicles damage and recent hurricane. Looking at the full year, most industry sources are now predicting a modest year-over-year decline of approximately 3% in light vehicle build rates in North America. Most of the reduction is driven by decreased demand for smaller and medium-sized vehicle platforms, which affects us to a lesser extent, because we’re more heavily weighted to like trucks, SUVs and crossovers.
The higher dealer inventories have been another factor behind the reduced build rates. Automakers ended the third quarter with a 64-day supply of inventory, which represents a decline from prior months and is basically in line with year-ago levels. We are encouraged to see the auto companies taking the necessary steps to keep their vehicle inventory levels in check.
Turning to the residential and commercial construction. We continue to see slow and steady growth rates. New housing starts reached 1.17 million units in 2016 and recent forecasts call for projected increase of roughly 3.5% in the current year. As new construction accelerates, we expect the general lift in demand for a variety of our carbon, stainless and electrical steel products. Spot market prices for collateral products have remained in a fairly tight band for much of 2017, although some softening has been observed in recent weeks.
We attribute this to general seasonality and expect at the recent price increase announcement will result in near-term improvement in spot market prices. Inventories at steel distributors and service centers remain at rather low levels. The seasonably adjusted inventories are currently estimated at just 2.3 months for carbon products, which suggests that buying activity may increase should spot market prices continue to gain momentum.
Changing gears to electrical steel. Market conditions in United States remained fairly solid, a steady growth continues with housing starts. Internationally, however, we continue to observe generally depressed pricing levels as global oversupply remains an issue. Slight improvement has been noted over the past quarter but we believe that the international electrical steel market will remain volatile for the foreseeable future.
Meanwhile, we are well positioned to serve the NAFTA market with an expanding portfolio of electrical steel products, outstanding product quality, delivery and technical support. As with electrical steels, domestic demand for our non-automotive stainless products remains stable. The seasonably adjusted service center inventories are presently estimated at just 3.1 months for stainless products, which is generally in line with steel mill lead times.
To ensure we are well positioned to serve our customers and markets in the future, we continue to invest prudently in our manufacturing facilities to ensure we are positioned to provide high-quality products in a timely manner to our customers today and in the future. A as I mentioned on the second quarter call, we had a plan – we had planned maintenance outages for the third and fourth quarters in our Mansfield melt shop and caster, Middletown blast furnace and melt shop and our Middletown electrogalvanizing line.
I am pleased to report that we have successfully completed the major hot in outages at our Mansfield and Middletown facilities. I would like to acknowledge the great work of our engineering and operations team for executing these outages in a safe, timely and cost-effective manner. The major outage remaining to complete this year is the electrogalvanizing line, which began last week.
Before turning the call over to Kirk for his comments, I would like to leave you with these thoughts. We continue to execute well on our strategic objectives to build a stronger foundation for our company. This includes making significant investments in our innovation program both in terms of our people and the new state-of-the-art research and innovation center; driving innovation activities across the company, including the launch of new stainless electrical and carbon flat-rolled products as well as new tubular products; taking actions to de-risk our balance sheet and lower our interest cost; expanding our geographical footprint through our tubing operations in Mexico; and completing the acquisition of Precision Partners, another strategic growth platform for our innovative steel products.
While we’re making great progress, we still have a lot of work to do. We will continue our quest to transform our company into an innovative steel solutions provider of a broadening and innovative portfolio of stainless, electrical, carbon and tubular steel’s as well as a solutions provider of tooling and complex hot and cold stamped components. We believe AK Steel is well positioned to provide long-term sustainable steel solutions at are cost-effective, environmentally responsible, and most importantly, meet the needs of our customers.
As we progress forward, I am very excited about the future of our company. We will continue to take actions to strengthen and expand our foundation, to increase the value of our company for our shareholders.
Now I would like to turn it over to Kirk, to update you on the exciting things happening on the research and innovation front at AK Steel. Kirk?
Thanks, Roger. I wanted to take some time today to cover a few things we’re doing at AK Steel that have us very excited about 2018 and beyond. These actions demonstrate our focus on innovation and downstream investments are positioning us well for the future. First I would like to start with an update on our acquisition of Precision Partners. I’m happy to report we have hit the ground running especially on the innovation front. In just two months, we’ve already have 20 new joint projects underway.
The acquisition of this tool is enabling us to quickly get full formed prototype parts with our innovative steel products to customers and showcase through component solutions, through a prototype rather than computer models and flat-rolled steel samples. This approach has had immediate results and is showing our customers we can significantly lightweight existing parts quickly by applying more of AK Steel’s high-strength, highly formable grade to steel through applications where traditional grades are currently used.
We’re well positioned to meet the auto industry’s quest to lightweight. Whether the choices are hot stamped, aluminized, press hardened steels or our cold stamped, advanced high-strength steels and next-generation advanced high-strength steels, like our NEXMET family of products. Our steel solutions will provide them with the most efficient, cost-effective and overall best value.
As a reminder, developing these products and processes represent core competencies where AK Steel and Precision Partners shine. Together, we’re providing cost-effective options for our customers who want a one-stop shop for innovative steel, tooling, die’s and hot and cold stamp in.
Additionally, we’re excited about the collaboration already underway between Precision Partners and our AK Tube operations to find creative solutions that bring even more value to our customers. Along with our applications engineers, we are collectively bringing all three G’s to the lightweighting effort: Gauge, Grade and Geometry, which will maximize of the lightweighting impact.
Let me unpack that a bit. By that, I mean, not only can we provide high strength steel grades that will allow the customer to use thinner gauge, but we also offer excellent formability, allowing four part geometry or shape to be altered with new tubing configurations or die designs. We think this will unlock new doors and optimize the impact of light weighting for our customers. The Precision Partners acquisition is proving itself already and it’s a long-term strategic play that we believe will continue to bear even more fruit over time.
Speaking of our downstream partners, AK Tube is also expanding their reach into the automotive space with solutions, utilizing, advanced high-strength steels and hot stamp steel parts. Long leader in automotive exhaust tubing, they are also providing materials to their customers, demonstrating their ability to form tubes from these higher strength steel grades.
These capabilities are enabling them to win a lot of new business from automotive structural tubing applications, which is another path for vehicle lightweighting. We are also expanding our AK Tube business into other industries such as solar power and agriculture, as well as into new geographic markets such as South America, where we are now able to cost effectively supply tube, fabricate it from steel made in the USA and transformed into tubing at AK Steel’s Queretaro, Mexico operation. These are indeed exciting times at AK Tube.
Continuing in the area of automotive lightweighting, we’re particularly excited about our progress regarding NEXMET, our family of next-generation advanced high-strength steel grades. We continue to refine the manufacturing process and are producing steel with very good properties, high-strength and exceptional formability. We’re providing more material to our customers, who are anxious to perform additional testing.
Our customers are already telling us of that our family of NEXMET products is giving them a great alternative to other materials and they are looking at significant opportunities to utilize these products in their new platform designs. Again, this is another family of products, which we expect to provide great value for a long time to come.
Switching gears, we believe one thing that is often overlooked, but also very important is providing steel solutions, better environmentally responsible. The steel manufacturing process generates significantly lower levels of greenhouse gases compared to the alternatives. For example, did you know that pound for pound, production of aluminum emits on average about 7 times more greenhouse gas emissions and requires about 7 times more energy to produce than steel? Or that the production of carbon fiber results in an average of about 10 times more greenhouse gas emissions than the production of steel?
Additionally, I should emphasize to the severe recyclability of steel. Did you know that each year, there is a – there’s more steel recycled than aluminum, paper and plastic combined. Think about that the next time you throw your aluminum can in the recycle bin or the next time you do your part by recycling that plastic water bottle.
And unlike some other products, steel is continuously recyclable, meaning it maintains its inherent quality, no matter how many times it’s recycled without being downgraded in quality. Also, something neither aluminum nor carbon fiber can achieve. And now that we have improved steels with even more strength and formability and can provide nearly the same weight reduction as aluminum, it makes a decision to use steel even more compelling.
So if you want an environmental responsible and best value product to use in your vehicles, you want steel. Additionally, we are uniquely positioned to help automotive OEMs achieve the important goal of meeting CAFE standards. With our multiple materials, carbon, stainless and electrical steel products, we can provide solutions not just in light weighting but several other ways as well.
For example, our stainless steels in high alloy automotive exhaust systems are designed to handle the higher temperature of the exhaust gases produced by the hotter-burning engines of today and tomorrow. We’re also well positioned to provide stainless steel automotive exhaust products to achieve the increased requirements of more efficient, lower emission recuperative systems which will increase the amount of exhaust components on cars in the future.
Moreover, we produced the highest efficiency non-oriented electrical steel’s in the world, which are utilized in the highly efficient motors of hybrids and battery electric vehicles. This is a significant growth opportunity for our electrical steel business as our automotive partners moved to electric power trains and bring their production to the United States.
While we have launched several new innovative products, we have many other products in the research and innovation pipeline. Case in point is the $1.8 million grant we were awarded from the Department of Energy for a three-year project to create an even more efficient non-electrical steel grade that is targeted to improve motor efficiency by as much as 30%. This will provide an exciting opportunity to improve efficiency of the motor resulting in improved battery life, which in turn should contribute to an increase in the range of electric vehicles.
These are exciting and I would even say game changing steels that will continue to have us well positioned to be a major supplier to our automotive customers, as they continue their growth in electric and hybrid electric vehicles well into the future. And candidly, we believe these are the things that we do that differentiate AK Steel from any of our competition in the eyes of our customers. It’s the unique breadth of product offering and solutions that set us apart and will allow us to provide steel to the automotive industry regardless of the direction taken in order to achieve the CAFE standards. No other North American steel company can make that client.
I hope you can tell we’re excited about the bright future and believe we are doing the right things today to be successful in the long run. We are strongly proud of our regimented approach in maintaining our operations, which includes continuing to properly invest in the maintenance and upgrades of our equipment during the planned major outages we have and will execute here in the third and fourth quarters of this year. We make no apologies for taking good care of our operations. So they can reliably make the high quality steel our customer’s need. This approach ensures that we will be able to maximize efficient production and deliver material on time.
In summary, we believe AK Steel as well positioned now, for the long-term, from an equipment, products, downstream businesses, markets and business relationship perspective. This is a sprint, not an end – this is not a sprint. This is an endurance race. And we have our long distance running shoes on and we’re just getting warmed up.
With that, I’ll turn it over to Jaime to review our financial performance. Jaime?
Thank you, Kirk. As Roger and Kirk mentioned, our team has managed well through our planned half side maintenance outages and Mansfield and Middletown, completing both on time. The electro galvanizing line outage in Middletown is currently underway and will be completed in the fourth quarter as originally planned. As we anticipated during our last earnings call shipments to the automotive market in the third quarter were down due to reduced automotive builds. As OEM sought to better balance inventories with demand.
We also work through our higher cost inventory, especially for certain materials containing chrome, which we also mentioned on our last earnings call. Overall though, our third quarter performance was in line with our prior guidance. For the third quarter, AK Steel reported a net loss of $5.8 million or $0.02 per diluted share. Recent third quarter was impacted by several one-time items including debt refinancing expense of $8.4 million badociated with the repurchase and call of our 2022 senior unsecured notes and issuance of our 2025 senior unsecured notes.
Acquisition related expenses of $4.7 million badociated with Precision Partners transaction. The third quarter also included a $5.6 million benefit from the reversal of charges taken in the fourth quarter of last year and first half of this year. These charges were related to an obligation for the transport of iron ore pellets under pellet offtake agreement that was terminated early. As we mentioned last year when we took the charge, we were exploring actions to help mitigate the cash impact and we’re recently successful in doing so.
Although some of these one-time charges negatively impact at the quarter. The actions behind these charges position us well for the future. Lastly third quarter results include mark to market gains on iron ore derivatives of $4 million. However our financial results do not include gains of $9.3 million from iron ore derivatives that settled in the third quarter. So on a net basis our income statement does not include $5.3 million of iron ore derivative gains. That would help offset the higher cost of iron ore purchases that are requested in our income statement.
As you may recall from previous earnings calls our iron ore derivative contracts no longer qualify for hedge accounting treatment. Therefore we have mark to market fluctuations in our income statement of gains or losses from certain iron ore contracts at settle recorded in previous periods will not be reflected in the income statement. Adjusting for these items net income and adjusted EBITDA would have benefited by $12.8 million or the equivalent of $0.04 per diluted share. In the year ago third quarter, we had net income of $50.9 million or $0.21 per diluted share.
Flat rolled steel shipments in the recent third quarter of $1.4 million tons were down 2% from a year ago, the decline was mostly attributable to reduce shipments into the automotive market due to lower OEM production rates. Despite the lower shipment volume net sales for the recent third quarter increased 3% from a year ago to $1.49 billion. Mostly reflecting an improved pricing environment and higher raw material surcharges, the average selling price per flat rolled ton in the third quarter was a $1,021 or 2% higher than a year ago. Although it was 2% lower than the recent second quarter due to decrease shipments into the automotive market, lower surcharge revenue and slightly reduced spot market pricing.
Our reported third quarter adjusted EBITDA was $69.2 million or 4.6% of net sales. However when adjusting for the items totaling almost $13 million that I previously mentioned our adjusted EBITDA margin was at the mid range of our prior guidance of 5% to 6%. This compares to adjusted EBITDA of $156.6 million, or 10.8% of net sales, in the third quarter, a year ago.
The primary driver of the difference in adjusted EBITDA between the third quarter of this year and last year’s third quarter was higher raw material costs as reflected in LIFO expense of $49 million in the recent third quarter. This compared to a LIFO credit of $24.2 million a year ago, resulting in a year-over-year change of $73.2 million.
While we’ve been able to capture some of the higher raw material cost through selling price increases in our spot market business. We will seek higher prices in our contract business, as those contracts come up for renewal. Also include in the third quarter of 2017, we’re $8.5 million of costs badociated with maintenance outages as compared to $16.9 million in the third quarter of 2016.
Turning to the balance sheet and cash flow. Working capital was a $49.5 million use of cash in the third quarter, which compared to a $60.4 million source of cash in the second quarter. The change primarily reflects a short-term increase in carbon and stainless steel with and finish goods, that were produced in preparation of a third and fourth quarter maintenance outages at our Mansfield and Middletown facilities.
Our capital investments in the third quarter totaled $37 million, as compared to $28 million in the third quarter a year ago. The increase primarily reflects the installation of new equipment at our Mansfield facility. We also made payments into our pension plan, totaling $32 million in the third quarter. And earlier this month, we complete our pension plan funding requirements for 2017 with a $6 million payment.
As we mentioned, we completed the acquisition of Precision Partners during the third quarter. As a result, we had an increase of $280 million in goodwill and intangible badets at September 30, included in this amount will be approximately $55 million to $60 million of intangible badets that will be amortized over approximately six years. We are going through the final details of the opening balance sheet, but do not expect any major changes at this point. And lastly, I would like to thank our accounting, finance and legal teams for completing another capital markets transaction, and refinancing our credit facility, during the quarter.
In August, we issued $280 million of 6.38% senior unsecured notes due 2025, which refinance our 8.38% senior unsecured notes that were due in 2022. And we entered into a $1.35 billion revolving credit facility that will expire in September 2022, which replaces our revolving credit facility that was due to expire March of 2019. These transactions along with our prior recent capital market transactions should result in annual cash interest savings of almost $20 million based on current debt levels.
Let me conclude my remarks for providing you with some insight on our current outlook for the fourth quarter of 2017. We estimate that our fourth quarter lateral to steal shipments will be down marginally, compared to the third quarter shipments into the automotive market are expected to be slightly lower, as OEM’s and tier one suppliers continue to balance inventory levels with demand.
In addition, we expect lower shipments to the infrastructure and manufacturing market, as customers manage year-end inventory levels. Mostly as a result of a decline in shipments to these two markets, we expect that our average flat-rolled steel selling price per ton in the fourth quarter will be marginally lower than in the third quarter.
As we mentioned on our last earnings call, we have a major planned outage at our Middletown facility that began late in the third quarter, and is scheduled to be completed in December. Planned maintenance outage expense for the fourth quarter is expected to be approximately $50 million, compared to $8.5 million in the third quarter. I would also note that for the full year of 2017 capital investments are expected to be in the range of $140 million to $160 million, although, the timing may push some of these expenditures into the first quarter of 2018.
Our outlook for the fourth quarter is not take into account, the potential for any actuarial gain or loss badociated with our pension plan and other post retirement benefit plans, under our method of accounting for these plans, we may be required to recognize into the income statement a part of a charge, but it is largely determined by interest rates and pension plans of returns.
As we complete the major planned outages that began in the third quarter, we are well positioned for 2018. As Roger and Kirk mentioned, we are excited about the opportunities for automotive business, as strategies implemented in 2017 should benefit us in the coming year. Additionally, we are working on lightweighting opportunities at AK2 is that business begins to leverage our portfolio of advanced high strength steels. And we are very excited about the multiple product development projects taking place between the team at Precision Partners and the AK Steel Research and Technical Specialists teams that are working on various complex components for the automotive market using our portfolio lightweight materials.
We’ll talk more about these opportunities for 2018 on our fourth quarter earnings call. In closing, I would like to thank the entire AK Steel team for their continued efforts in helping to implement positive change within our company.
At this time, we would be happy to take your questions.
Thank you, Mr. Vasquez. We will now begin the question-and-answer portion of our conference call. [Operator Instructions] And our first question comes from the line of Timna Tanners of Bank of America. Your line is now open.
Yes. Hey, guys, good morning.
Before I start asking question, I just want to make sure that you said $15 million or $50 million maintenance, we thought we should clarify that.
It was $50 million.
Okay. I guess, the biggest thing I wanted to clarify was in this quarter, the surge on LIFO, not the year-over-year change but the quarter-over-quarter change because LIFO is calculated end of year divided by four and the big change in the third quarter reflects an increased expectation of volume, price or both into the of the year. So can you talk to us a little bit about what’s driving that specifically? Is it cost of what? Volume? And why the big…
So raw materials through the quarter continue to move up and so that affects our year end outlook. So you really have and based upon where you think raw material prices will be, where you think your inventory levels would be, you threw up your LIFO calculation and now you’re just balancing that over to remaining quarters. So we did have that pick up about $25 million, I believe, from the second quarter to the third quarter.
And the key drivers are is on the raw material side, as you indicated, scrap, and on chrome. For example, chrome had declined and then it increase again here in the fourth quarter. So it’s the alloy side and the raw material side that’s really driving that.
Okay. Normally when we see big increases in LIFO, they were somewhat offset by a rising price environment. So I think if you could really elaborate more on the timing and ability to being able to pbad through these higher cost rated that graphite electrodes, you’ve got aluminum, zinc. In addition to the ones that you mentioned and yet you’re not talking about much changes in your prices, part of that is mix. How do we get comfortable at AK Steel is able to offset this costs going forward with – and have better margins?
Yes, sure. I can tackle that one. So, yes, about five different things are in one. So electrolyzed, we are — we did announced electro surcharge to recover those costs going forward. Remember that most of our stainless that was on stainless products and most of our stainless products are contract based. So really the next time the contract rolls over, we expect to recover those in more totality and so those will be coming, you mentioned zinc as well, zinc, we recover that in some cases, in spot business and shorter term business, we recover that as part of zinc zone in range, in which the zinc is priced and that will be recovered short-term.
In longer-term, those are built into, I’ll call it, the contracts with automotive folks either they’re build into the base of those contract prices or as they zinc add or extract on those corded products and we will look to do exactly, as you stated and I just recovered those costs going forward. So that – those get covered as well. We have other surcharges clearly that kicked in to different contracts and so, yes, to the extent that we can or that’s exactly what we’re focused on as recovery in those higher costs.
Some of which will be done here short-term but many of which are happened as a result of contracts renewing and if you remember contracts renew some here in the fourth quarter, some at the end of the year, some from the first quarter from an auto standpoint and really the same thing is true kind of across the board. Our contracts do roll off at different times and when that happens, we seek to get higher pricing and recover those costs of raw materials. In addition, the chrome surcharge that dropped a bit here in the third quarter is back up in the fourth quarter and should put a little more win in our sales from that standpoint as well.
And so Timna, you are exactly on point, that’s why we have announce a price increase in early September on the carbon front because of the rising in material costs. So we have done that. As Kirk mentioned, as you go into our contract negotiations, we anticipate getting higher pricing for those contracts to recover those higher costs. So a little bit of this is a little bit of a timing issue, I would say but we would be seeking the higher prices to recover these costs.
Before I handed it off, is it not possible to weave in some of these escalators as you’ve done in the past going forward because there are commodity prices move and certainly there’s stake surges as you point out, recently, can’t you help weave that in to the context that you can have more time sensitive past since going forward?
Sure. And it’s done in some cases, Timna and some of the contracts that we’re negotiating now, will have some of it and some won’t, it’s a double-edged sword, you’ve love to have them in when prices rise and we don’t want them in when prices falls. So we take a different approach on each of the contracts and those are in some of our deals as well, no doubt.
And I’d also comment, too. Example take iron ore, we hedge a lot of our iron ore, however, those hedging – that hedging does not go – get taken into account when we calculate with LIFO is. So that’s a financial hedge. So it’s treated separately. So from a cash flow perspective, as Jaime commented on, we have positioned ourselves to take on a lot of volatility in earnings because of hedging as in line with our customer contracts. However, from the accounting perspective, there’s hedge accounting adjustments that occurred that don’t go into the LIFO calculation. That cause sometimes disconnecting more of a timing issue than anything.
Okay, thank you.
Thank you. And our next question comes from Seth Rosenfeld of Jefferies. Your line is now open.
A couple of questions on Precision Partners, please, I was wondering if you could help us understand better the scale of EBITDA contribution you saw in Q3. I think the deal close mid-quarter, and also expectations for the contribution from Precision into Q4 in 2018. Separately, on acquisition financing, I think at the time of the deal announcement even flag plans are potentially fund this term except both debt and equity. Given where your share prices today, can you walk us through how you consider the pros and cons of those two different options? Thank you.
Sure. With respect to the EBITDA contributions, as we’ve been talk about since we made the acquisition, it is playing a very niche space and we are very sensitive to their EBITDA. And so like our other businesses with AK Tube and our electrical steel, which plan those kind of very small or niche markets, we’re not going to disclose it separately but we’ll say, we are happy with how we’re working with Precision Partners at this point. Kirk and Roger mentioned a lot of multiple projects ongoing. So we’re looking forward to further integrating that acquisition. With respect to the acquisition funding, we recognize to leverage position that we’re in. Our still stated objective is to bring leverage down, but right now we have more than ample liquidity. As you noted, we funded the acquisition under the revolver. It’s a very low cost financing alternative at this point but we are cognizant of the debt levels and we’ll continue to watch the market. But right now, we’re just going to keep it under the revolver.
Thank you. And our next question comes from Sean Wondrack of Deutsche Bank. Your line is now open.
Hi, there. Correct me if I’m wrong, if I missed it. Did you guys provide kind of a bandwidth for EBITDA margin for the fourth quarter?
No. We do not provide any range of EBITDA margin for this quarter.
Can we talk about it directionally? Do you think we should see sort of kind of sideways movement there? Or any kind of directional guidance you can give us there?
Sean, I would note that we have a large amount outage expense in the fourth quarter. From the third to fourth quarter, it’s probably $42 million delta. That’s going to be a big difference. And then as we noted in the guidance, we do expect automotive to be down slightly and overall volume to be down slightly. So you have those impacts.
Right. Okay, It seems like a little bit of pressure in the fourth quarter. How about we think about outages next year? Do you expect to have as many outages as you basically had this year?
We wouldn’t say we’d have as many major outages. Certainly, we take major outages on our glbad furnace on a more infrequent basis and those are well planned. Right now, we don’t have any of those in scope for next year and the large outage that we are undertaking here at our electrogalvanizing line is a one-shot deal as well as our big investment we made in Mansfield. None of those would be repeating. We’ve certainly got other capital needs and other improvement projects that will be underway next year, but outage wise, those expenses should be fairly reduced.
Okay, great, that’s good to hear. And then do you think that CapEx will likely come down a little bit next year? It seems like it’s up a little bit this year from prior years?
We’re still going through our process for 2018, probably, we just fall back to our kind of normal guidance or normal CapEx range. We say it’s typically in the $100 million to $120 million, you know, probably be some other projects in there but it’s a little bit too early for us to give an outlook on 2018. But right now, we don’t expect anything too unusual.
Okay, fair enough. Thank you very much.
Thank you. And our next question comes from Curt Woodworth of Credit Suisse. Your line is now open.
Hi, good morning, Roger and everyone.
I totally understand that the whole LIFO issue and sort of the need to reevaluate the inventory based on the inflation we’ve seen. But in terms of the cash flow impact on your business, I was always understanding that certainly for the stainless business, you have, the nickel and alloys base surcharges that functioned fairly quickly. You talked about the surcharge on the electrodes, you get the zinc. I think zinc extras flows through pretty quickly. So can you talk about sort of this delta between selling prices in raws that you’ve seen, in terms of what you think the cash flow impacts, say, it was, this quarter or where you see on a run-rate basis, just to help us get a little bit of understanding of the magnitude of kind of the underlying cash impact of this?
Yes. It’s probably hard to quantify the cash flow impact of that. But I would go back to predominantly 30% of our business is going to be exposed to kind of spot market pricing. Some of that this is will have surcharge effects on it. I would say, more so especially when you look at our automotive business as it really fixed base price contract, some of them have certain mechanisms like the zinc mechanism in them. So there is a lag between one, we’re seeing a higher raw material costs and inflations that we can’t capture. But I think that’s why it’s very important and we stress that today, as we going to 2018 on all of our contract business, we will be looking for price increases.
And then I guess where you sit today, that the selling price versus raw delta sequentially into the fourth quarter, you talk about the chrome surcharge is getting better. So do you think that, sequentially, this mismatch would be similar or do you think you can recapture some of the headwind that you saw in the third quarter and into the fourth quarter?
Well, to be fair on the chrome side, because this happened kind of in reverse a quarter ago. Now you are buying lower cost in chrome right now and you’ll have a higher surcharge on it. But there are other things that will probably offset that carving, scrap is at still at relatively high dollar value. I think based on everything we’re reading in the various trade magazines, it looks like November could be flattish. So carbon is still relatively high. So I think there is pluses and minuses as we get into kind of the commodity side.
But as we’ve indicated, we have auto contracts that expires throughout the year including some expiring in the fourth quarter and a lot that will – a majority expire in the first quarter or to be end the year the calendar year contracts and we expect to get higher prices to offset these higher raw material costs. So a little bit again of a timing issue but we’re seeing higher prices as we go into next year.
Okay, great. Best of luck. Thank you.
Thank you. And our next question comes from Carl Blendon with Goldman Sachs. Your line is now open.
Hi, good morning guys. Thanks for the time. You made some comments on Section 232 in your prepared remarks and I was interested what evidence are you showing to support the view that imports are up, in essence a pull forward relative to what steady-state would be so people can beat 232. Do you have any sense for what that magnitude is?
I would say, I can give a specific example just on electrical and steel front, demand here in the U.S. has been pretty steady and kind of going with what’s happening in the construction markets and also some of the impacts from the hurricanes. So we have a pretty good handle on what the demand is here but we’ve seen a surge of imports coming in and we’ve actually seen imports go up roughly 260% year-on-year. And if you look and the tonnage coming in, that’s not aligning what we would say is demand – overall demand for electrical steel here in North America. So at least looking at the numbers would indicate that there is some inventory build occurring here. So that would be the specific example I’d give you.
I would say in the carbon steel, we’re looking at 27%, 28% of our flat-rolled steel is imports and more traditional would be 18% to 23%. So despite all of the successful trade cases those imports are still surging and we think getting in here under the wire.
That’s helpful. And just on the domestic front. As you think about going into your heavier contracting season in 4Q and then in 1Q, trade reports and industry reports indicate that there will be potentially more competition for many mills into auto product around about that time. Can you comment on that at all and any implication that has for pricing in contracts.
Yes. I don’t know if anything coming up is going to change the pressures that we’ll see in the automotive world because of more – many mill penetration they’ve certainly been making inroads there and we see them and have seen them for a fair amount of time competing in those businesses. We don’t expect that to change. We know that between integrated and domestics and foreign folks who want to be in that business. It’s a good spot to be. It’s a more consistent margin business and one that we think differentiates on your product quality and your delivery and your customer service.
And that’s where we think we shine and distance ourselves from them. Those steels required – that are required to supply those needs now and will be required to supply them in the future require a heck of a lot of research and innovation and know-how in that regard. We’re uniquely positioned and differentiated from the many mills in that area. And again, we think it’s a space that we’re very comfortable competing in.
And I would say, the auto market it’s not the one that would change like month-to-month or quarter-to- quarter. You’re working on platforms both current and future platforms. So you’re awarded business based on the platform draw, so it’s sounds like it changes because the calendar changes or the quarter changes. And we’re positioning ourselves, as Kirk mentioned, on the new and innovative products are getting our products aligned with the customers that will have a demand for some of those new innovative products coming out. I don’t see any material change that’s occurring, as Kirk said, nothing major occurring when the calendar changes. We’re well positioned with our product mix to serve our customers.
That’s helpful. I was just clarifying because there is a mill indicated may have certification to that point in times. So it sounds like no step change expected. I appreciate the time. Thank you.
Thank you. And our next question comes from Mariano Beristain of Deutsche Bank. Your line is now open.
Good morning gentlemen. Maybe just a follow-up question on your disclosure. You seem to have stopped including a tubular segment shipments, which were about 30,000 tons previously per quarter. Is there any reason why you’re no longer disclosing that?
We wanted to focus on the metrics of the steel operations and now that we’ve acquired Precision Partners, given the size of them both AK Tube and Precision Partners together we’ll distort the steel operating metrics. So that’s the reason why we pulled it out.
I’m sorry. Could you give me an example of how that would be distorted? Are you saying there’s double counting because it’s going to be a downstream process?
If you put in the revenues of Precision Partners, they don’t count in tons. So you’re just adding revenues but not really changing your base of tons. They’re more parts company as opposed to a tons company.
Got it. Could you then – just circling back to one of the first questions, just give us some more color, obviously, I understand you’re sensitive to disclosing EBITDA at Precision Partners but could you just comment if the third quarter was an unusual quarter in the sense that you had those M&A charges, which I would imagine it should be below the operating line but we’re just trying to understand when we could expect to see some contribution from PP and if there was any reason why it would be lower than normal in the first quarter out?
No, I think really big driver in the third quarter, and if I could look at it either way, year-over-year or sequentially. LIFO was the big change. So the change in raw material cost was a big driver. And then I would say, whether you’re looking sequentially or year-over-year, it was a combination of mix and volume. And that’s from automotive declining. So I think it’s just a combination of maybe those three items that drove the changes.
No, sorry, I was trying to specifically ask Precision Partners would have had an abnormally low EBITDA quarter in the first quarter that you just consolidated these operations?
No. I mean, we acquire them in early August. So I would say, it was nothing that had to do anything with Precision, it was more of just raw material costs that caused the sequentially lower performance.
From a Precision specific standpoint, it’s a normal integration take over challenges and transition time from that standpoint. I haven’t seen anything unusual or abnormal. I think they had a little impact, as did we, some of the inventory adjustments that the automotive folks took but they’re still on track. We think they’re exactly what we expected when we bought them and so it will be a very positive acquisition for us.
Thank you. And our next question comes from Matthew Fields of Bank of America. Your line is now open.
Hey, Roger and Jamie Doug. I’m still trying to process the answer you gave to Mariano about the tubular disclosure. So is the revenue from tubular now not in that sales and it’s just recognizing some kind of contribution of income?
No, no, no. When we do the – what we call now the flat-rolled steel shipment and we look at average selling price. So both the tons and the revenue badociated with AK Tube are not included in that calculation anymore and likely the revenue from Precision Partners not in that calculation anymore. So it really just focuses on the steel operations.
Our goal is to be more transparent, and there’s always a lot question that asked about, what’s happening on the flat-rolled side with the selling prices. So we felt this approach and you look at this even now in the quarters – so prior quarters reflective this, as you have an apples-to-apples comparison on what’s happening just on the side. So you’re not getting an impact of the mix in tubular products or anything related to Precision Partners, which is truly what’s happening on the flat-rolled steel shipments.
And will you follow-up that up with disclosure about your sort of downstream operations now, so we have some – or is it just going to be back out revenue that we have to make a guess about?
Yes, I think as we said before, given the sensitivity of these businesses and space that they play in, we get qualitative use on them, guidance on them but not quantitative. Obviously, as the segment becomes larger as we implement our downstream strategies, we would put up more metrics. But the big driver of the business right now is still the steel operations.
Thank you. And our next question comes from Phil Gibbs of KeyBanc. Your line is now open.
Thanks very much. Just one other question for clarity. Jaime, it sounds like there wasn’t a lot of purchase price accounting in this quarter from Precision Partners outside of what you outline? But did you mention there was a $5.6 million benefit reversal in the quarter, which would’ve been a headwind to cost of goods in the quarter?
The reversal was badociated with charges that we took in last year’s fourth quarter. And this had to deal with the Magnetation railcars that we had. And in the contract we have liquidated damages. And so from an accounting perspective, since we weren’t using those railcars any more, we had to recognize those charges and there are some other charges badociated with it. But through some good negotiations with our team, we are able now to utilize those railcars. So they do have economic value to us. And that was the reason for the reversal of the liquidated damages charge.
So that was a headwind in the quarter, correct?
No. It was just a P&L, it was a benefit. We talked about adjusted EBITDA, we backed it out.
Got it. That’s helpful. And then just a higher level question – on just the capital structure, is there any greater clarity that you can provide around your sense of timing for a potential equity offering? I know that most of us were expecting something following the closure of the deal. So anything strategically could provide us on that?
It’s more of the same, I mean, if you recognize the leverage level, and we need to take that down, especially as we want to implement other strategies. We’re not going to put the balance sheet at risk by bringing on more debt. So we’re going to have to balance it. But right now, we got to funded under the revolver. We got more than ample liquidity there and it’s a cheap source of funding. So we’re just going to continue to watch the markets and wait for the opportune time to do anything from a capital markets standpoint.
Thank you. And our next question comes from Charles Bradford of Bradford Research. Your line is now open.
Good morning. Could you talk a bit about the impact of the NAFTA negotiations? And what kind of volumes you have of steel going into Canada? And especially Mexico, which could be impacted by whatever happens?
Comment in general, it’s too early to say on what’s happening on the NAFTA front, there’s a lot of negotiations going on between the three countries. And I think there will be a resolution on all items out there, basically. And that it shouldn’t be – we don’t see any major concerns at this point. It’s still early in discussions, but I think, overall trade factors will play into that too. But on the NAFTA front, I think, we have a good relationship among the three countries and there’s probably some things that can be enhanced to improve it and we’ll see how things will play out. But really, chucked to, guess right now, what it would mean, not a big. I really couldn’t comment on. But what I would say is that if you look as a company around 10% of our sales go outside of our U.S. Part of that goes overseas and part of that would be sales to Canada and Mexico. When you look at it as a relative percentage of our business, it’s in the single-digit range of our sales.
We certainly supply automotive OEM steel to our friends in Canada, to all those OEMs and some to Mexico as well.
And I’ve been hearing a lot about attempts by the Chinese, especially Wuhan to get the grain oriented price up for the fourth quarter maybe as much as $300 a ton. What do you hear?
I would say, if you look at the international market, we have seen a recent increase in electrical steel pricing in the spot market over there. And part of that could be driven on currency, but part of it is when we seen a decline, it remains very volatile over there. So we have seen some improving pricing on that front, still lower than what we see here but heading in the right direction.
Thank you. And our final question comes from the line of Novid Rbadouli of Cowen & Company. Your line is now open.
Hi, guys. Thanks for taking my question. So first off, I just wanted to see, you guys mentioned service and inventories being low basically throughout the year, and still low, what I think you mentioned, 2.3 months. Is there anything that you are seeing that would indicate maybe a change of this behavior?
I would say, if you look at service center inventories, they’ve pretty much remain relatively flat throughout the year, and so both on the carbon side and stainless steel side. We haven’t seen any material changes even month-to-month. So it seemed like service centers are making sure, they keep their inventories in line with where the market demands are at. So no material change, otherwise, no.
So I guess – what I was trying to get is – there has been talk about them being low and depending on kind of what your sources, that can alter. But I’m just wondering, I mean, if they’re low and they are staying low, I’m just trying to get a sense of, is this is the new normal? Or is this some sort of a temporary effect?
Nothing. If you look over the last couple of years, it range probably in the around $2.1 million up to probably still a couple of years ago, $2.7 million, something like that. It remained low. What you normally see is, it starts declining a little bit as they see pricing falling, but if they see an uptick in pricing and obviously, it increase a little bit. So they’re looking at what’s happening in the marketplace.
Yes. I think they’re paying more attention to working capital, there’s less big bets and speculations. I think we’re – we expected to continue to hover around that range.
Okay. And then my second question. I was wondering, if you guys could discuss the – I guess, you’re stainless steel and electrical shipments, maybe just the quarter-to-quarter decrease and then looking at – you guys have mentioned the national disasters, just wondering what you guys think, you could see incrementally from a normal year-over-year growth rate that could be driven either tonnage or percentage, whatever you guys are comfortable with, with respect electrical steels? Thanks.
I’ll try the hurricane one first. So couple of things that’s done, certainly, it has brought an increase in auto sales in September and while that has surged and that seems to be encouraging, it has not necessarily resulted in more automotive production, which is where we would be impacted. What it did do is, however, we drove the inventories down from – I think it’s around 70 days to 64 days in one month, that was a positive move as those inventories drop, obviously that leads to what you would think less opportunity taken by the automotive folks to reduce their inventories or to reduce further production levels.
So it has helped in that regard. It hasn’t helped us far as making more vehicles, but at least stemming the tide from not taking more idle time. One of the things that is done certainly in the electrical spaces is that’s – by little wind in our sales and we’ve had a couple of good months now of sales through or domestic producers of Transformers as they have big to restock and supply for that. And there are probably some more tailwinds as those recoveries continue and as inventories get rebuilt. So we think that continues to look positive for us going forward.
As far as the shipments, I don’t think there was a noticeable change, as Roger said, electrical wise, we’ve made some headway with some improved pricing internationally that has helped as well and I would say the only thing that may have dipped a bit would’ve been our automotive chrome or automotive exhaust areas where, obviously if you built less vehicles, you have to attached less automotive exhaust to those. That was probably about the only change there.
Thank you. And this concludes our question-and-answer session. I will now ask Mr. Newport for his closing comments.
Well, thank you for joining us in our call today. We appreciate your continued interest in AK Steel and we look forward to updating you on the progress that we are making in January. Thanks.
Ladies and gentlemen, this concludes our conference call for today. Thank you for participating, and you may disconnect at this time. Everyone, have a great day.
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