Business Context and Reporting Period
Allegheny Technologies Incorporated (ATI) filed this unaudited Form 10-Q for the quarter and nine months ended September 30, 2017. ATI manufactures technically advanced specialty materials and complex components, with approximately half of sales from aerospace and defense. Its two segments are High Performance Materials & Components (HPMC) and Flat Rolled Products (FRP).
Key Financial Metrics
| Metric | Q3 2017 | Q3 2016 | 9M 2017 | 9M 2016 |
|---|---|---|---|---|
| Sales | $869.1 million | $770.5 million | $2,615.2 million | $2,338.5 million |
| Gross profit | $93.3 million | $50.2 million | $318.4 million | $65.2 million |
| Gross margin | 10.7% | 6.5% | 12.2% | 2.8% |
| Operating income (loss) | $(87.3) million | $(498.9) million | $11.6 million | $(615.8) million |
| Net loss attributable to ATI | $(121.2) million | $(530.8) million | $(93.6) million | $(650.8) million |
| Loss per diluted share | $(1.12) | $(4.95) | $(0.87) | $(6.07) |
| Cash used in operating activities | Not provided for quarter | Not provided for quarter | $(53.8) million | $(111.7) million |
Q3 sales increased 12.8% year over year, while nine-month sales increased 11.8%. Segment operating profit was $54.4 million, or 6.3% of sales, in Q3 and $195.2 million, or 7.5% of sales, for the nine months, compared with $26.2 million and an operating loss of $47.3 million, respectively, in the comparable periods.
- HPMC: Q3 sales increased 11.1% to $512.9 million and segment operating profit rose to $61.7 million, or 12.0% of sales. Aerospace and defense represented 76% of HPMC sales; commercial jet-engine sales increased 13%.
- FRP: Q3 sales increased 15.4% to $356.2 million, but the segment recorded a $7.3 million operating loss, primarily because falling nickel and ferrochrome prices created unfavorable surcharge timing. Nine-month FRP operating profit was $14.6 million versus a $162.2 million loss in 2016.
- Liquidity and capital: Cash and equivalents were $124.9 million at September 30, 2017, down from $229.6 million at year-end 2016. Total debt, excluding debt issuance costs, was $1.929 billion, and net debt was $1.804 billion. Net debt to ATI total capital was 57.2%, compared with 55.1% at year-end 2016.
- Working capital: Net inventory was $1.101 billion and accounts receivable were $525.9 million. Managed working capital increased $81.5 million from year-end, although it declined to 39.0% of annualized sales from 40.0%.
- Pension: ATI contributed $135 million to its U.S. pension plan in March 2017. The company estimated approximately $50 million of 2018 funding and approximately $100 million annually for the following few years, subject to market and actuarial changes.
Material Changes Versus the Prior Comparable Period
- Profitability improved substantially because of stronger aerospace demand, improved product mix, higher operating levels, cost reductions, and the 2016 titanium restructuring actions.
- Q3 2017 included a $114.4 million non-cash goodwill impairment charge for ATI Cast Products, reducing goodwill to $531.9 million. The impairment reflected lower projected revenues, profitability, and cash flows.
- Q3 2016 included $499.9 million of restructuring and other charges, primarily associated with idling the Rowley, Utah titanium sponge facility, plus a $173.1 million deferred-tax valuation allowance charge.
- Cash flow remained negative despite the earnings improvement. Nine-month operating cash use improved from $111.7 million to $53.8 million, but included the $135 million pension contribution and increased working-capital investment.
- Interest expense increased to $102.2 million for the first nine months from $91.2 million, primarily because of the 2022 convertible notes and term loan issued in 2016.
- The quarterly common dividend remained suspended, following the board’s decision effective with the fourth quarter of 2016.
Guidance, Outlook, Risks, and Unusual Items
- Management expected Q4 HPMC results to be modestly better than Q3 and projected continued HPMC revenue growth and margin improvement in 2018 from aerospace demand, jet-engine build rates, castings improvement, and completion of the new nickel-alloy powder facility qualification process.
- Management expected FRP to be modestly profitable in Q4 and for full-year 2017, supported by stabilizing or increasing raw-material prices, improved operating levels, product mix, and restructuring benefits.
- Management estimated 2017 capital expenditures of approximately $125 million and stated that longer-term capital expenditures were expected to average approximately $100 million annually.
- The ABL facility was amended to extend its maturity to February 2022. ATI had $25 million drawn and approximately $280 million of additional availability at September 30, 2017, but could not access $50 million of revolving capacity because it did not meet the required fixed-charge coverage ratio.
- The ABL agreement requires liquidity of at least $500 million before the 2019 senior-note maturity and $700 million before the 2021 senior-note maturity, with required liquidity maintained thereafter until those notes are repaid or refinanced.
- ATI maintained valuation allowances on U.S. federal and state deferred-tax assets because of a three-year cumulative loss position. The company could not reliably estimate an annual domestic effective tax rate and used the year-to-date actual rate.
- Environmental remediation reserves were approximately $14 million; the company stated that recorded matters could ultimately exceed reserves by as much as $13 million. Environmental and litigation outcomes could materially affect results in a particular period.
- Approximately 40% of the workforce was covered by collective bargaining agreements. Negotiations were ongoing for an agreement covering approximately 500 employees, creating potential labor-disruption risk.
- Key operating risks include aerospace and other market conditions, specialty-metal and energy-price volatility, surcharge timing, pension funding, labor disputes, equipment outages, and execution of strategic investments.
- The previously disclosed material weakness related to deferred-tax asset valuation allowances was reported as remediated after implementation and testing of enhanced controls.
Most Important Facts to Verify
- Whether HPMC aerospace growth and the new nickel-alloy powder facility translate into the projected 2018 margin improvement.
- Whether ATI achieves the expected FRP profitability and avoids further unfavorable raw-material surcharge timing.
- Available borrowing capacity, compliance with the ABL fixed-charge coverage covenant, and the company’s ability to meet the $500 million and $700 million future liquidity requirements.
- Refinancing or repayment plans for the $350 million of 9.375% notes due 2019 and $500 million of 5.95% notes due 2021.
- Actual pension funding requirements and sensitivity to discount rates and investment performance.
- Whether ATI Cast Products or other reporting units require additional impairment charges.
- Progress toward positive operating cash flow after pension contributions and working-capital investment.
- Potential exposure from environmental obligations, litigation, collective-bargaining negotiations, and raw-material or energy-price movements.