ATI Inc. (Allegheny Technologies Incorporated) — Q2 2017 Form 10-Q
Reporting period: Quarter and six months ended June 30, 2017. The interim financial statements are unaudited and should be read with the 2016 Form 10-K.
Business context
ATI manufactures technically advanced specialty materials and complex components. Its two segments are High Performance Materials & Components (HPMC) and Flat Rolled Products (FRP). Aerospace and defense represented approximately 49% of sales, while aerospace, oil and gas, automotive, medical, and electrical energy collectively represented approximately 79% of sales in the first half of 2017.
Key financial metrics
| Metric | Q2 2017 | Q2 2016 | Six months 2017 | Six months 2016 |
|---|---|---|---|---|
| Sales | $880.2 million | $810.5 million | $1,746.1 million | $1,568.0 million |
| Gross profit / margin | $112.3 million / 12.8% | $48.2 million / 5.9% | $225.1 million / 12.9% | $15.0 million / 1.0% |
| Operating income (loss) | $45.6 million | $(12.1) million | $98.9 million | $(116.9) million |
| Income (loss) before taxes | $11.3 million | $(41.4) million | $34.4 million | $(173.7) million |
| Net income (loss) attributable to ATI | $10.1 million | $(18.8) million | $27.6 million | $(120.0) million |
| Diluted EPS | $0.09 | $(0.18) | $0.25 | $(1.12) |
| Operating cash flow | Not separately provided for the quarter | $(85.5) million | $(33.6) million |
- HPMC second-quarter sales increased 5.6% to $526.4 million; operating profit increased to $68.0 million from $38.8 million.
- FRP second-quarter sales increased 13.4% to $353.8 million; operating profit was $2.9 million versus a $31.8 million loss.
- Cash and cash equivalents were $154.6 million at June 30, 2017, down from $229.6 million at December 31, 2016.
- Total debt, excluding debt issuance costs for management’s leverage calculation, was $1.960 billion versus $1.894 billion at year-end 2016. Net debt to ATI total capital was 56.1%, compared with 55.1% at year-end.
- Capital expenditures were $55.3 million in the first half; management estimated full-year 2017 capital expenditures of $125 million and stated that longer-term annual capital expenditures should average no more than $100 million.
- Net inventory was $1.076 billion and accounts receivable were $538.6 million at June 30, 2017. Managed working capital increased $62.6 million from year-end but declined to 38.0% of annualized sales from 40.0%.
Material changes versus the prior comparable period
- Profitability improved sharply, primarily from higher aerospace demand, growth in next-generation jet-engine products, higher FRP operating levels, cost reductions, and 2016 restructuring actions.
- Prior-year results were adversely affected by approximately $22 million of second-quarter work-stoppage and return-to-work costs, and $1.0 million of HPMC severance charges. The first half of 2016 included approximately $48 million of work-stoppage costs and $10 million of restructuring charges.
- HPMC jet-engine sales increased 15% in Q2, and next-generation products reached 40% of HPMC jet-engine sales. Oil and gas sales increased more than 57% year over year in HPMC.
- FRP benefited from higher shipment volumes, selling prices, cost reductions, and the exit from grain-oriented electrical steel and selected commodity products. FRP’s first-half operating profit improved by $163.3 million year over year.
- Interest expense increased to $34.5 million in Q2 and $68.0 million year to date, mainly because of the 2022 convertible notes and term loan issued in 2016.
- Operating cash flow was pressured by a $135 million U.S. pension contribution and increased working capital. The pension contribution completed the company’s expected 2017 funding requirement.
Debt, liquidity, guidance, and outlook
- In June 2017, ATI amended its $400 million ABL revolving facility and $100 million term loan, extending both maturities to February 2022. The company had $60 million drawn on the ABL and approximately $250 million of additional liquidity under the facility at June 30.
- ATI did not meet the ABL fixed-charge coverage ratio at June 30 and consequently could not access $50 million of revolving capacity until the required ratio is met.
- The ABL requires minimum liquidity of $500 million ahead of the 2019 senior-notes maturity and $700 million ahead of the 2021 senior-notes maturity, with liquidity maintained thereafter until the notes are repaid or refinanced.
- Management expected HPMC to sustain strong commercial-aerospace performance and produce low-double-digit operating margins as a percentage of sales in the second half, although quarterly results may be uneven during the legacy-to-next-generation engine transition.
- Management expected FRP to improve operationally but to incur a loss in Q3 2017 because falling ferrochrome and nickel prices would create out-of-phase raw-material surcharges. FRP was still expected to be modestly profitable for full-year 2017.
- Management expected internally generated funds, cash, and ABL availability to meet liquidity needs, but pension funding was expected to average approximately $135 million annually for the next few years, subject to market, mortality, and actuarial changes.
- The quarterly dividend remained suspended beginning with the fourth quarter of 2016.
Risks, contingencies, and unusual items
- ATI maintained approximately $14 million of environmental remediation reserves and disclosed that recorded matters could reasonably exceed reserves by as much as $19 million. Future environmental costs could materially affect results.
- Approximately 40% of the workforce was covered by collective bargaining agreements. A USW agreement covering approximately 500 employees had expired and was extended through July 31, 2017; negotiations were ongoing.
- Raw-material and energy-price volatility can materially affect margins because surcharge mechanisms may lag price changes. ATI estimated that a $1-per-pound nickel-price change could affect annual costs by approximately $80 million, and a $1-per-MMBtu natural-gas change could affect annual costs by approximately $8 million to $10 million.
- ATI had a three-year cumulative U.S. loss position and maintained valuation allowances against certain deferred tax assets. Q2 included a $2.1 million tax benefit, including $5.4 million of discrete benefits largely related to amended prior-period tax returns.
- Management identified a goodwill reporting unit with $114.4 million of goodwill whose fair value exceeded carrying value by 12% at the 2016 evaluation date; it was to be monitored for impairment indicators.
- The company’s disclosure controls were not effective at quarter-end because of a material weakness involving the calculation and review of deferred tax asset valuation allowances. Management expected remediation by December 31, 2017, but the weakness had not yet been remediated.
- Pending accounting changes included new pension-cost presentation requirements effective in 2018, new revenue-recognition requirements effective in 2018, and lease accounting requirements effective in 2019. Management expected the pension presentation change to increase reported 2016 operating income by $70.6 million on a pro forma basis and projected an approximately $5 million unfavorable pre-tax adoption impact in Q1 2018 from capitalization changes.
Most important facts for investors to verify
- Whether HPMC aerospace growth and next-generation engine demand offset uneven customer order timing.
- Whether FRP achieves full-year profitability after the expected Q3 surcharge and raw-material-price headwinds.
- Progress toward restoring ABL covenant compliance and meeting the $500 million and $700 million future liquidity requirements.
- Cash generation after pension contributions, working-capital investment, and the planned $125 million of 2017 capital expenditures.
- The sustainability of the company’s deferred tax assets and the status of remediation of the material weakness in tax controls.
- Potential environmental, labor, pension, impairment, and raw-material-price exposures not fully captured by current reserves or guidance.