Earnings Call: Q3 2023

Oct 20, 2023

Summary

Q3 revenue rose 4% YoY to $256 million, while EBITDA reached $17 million, up 20% QoQ. Margin recovery is expected into 2024, supported by price negotiations, new contracts and capacity ramp-ups.

GIS Investor Relations Manager, Mr. Arturo Morales. Please be advised that this call is for investors and analysts only. During this call, management will be discussing GIS performance as per the earnings release issued on Thursday. If you did not receive the report, it is available at www.gis.com.mx in the investor relations section. We encourage you to follow along with the onscreen presentation. All lines have been placed on mute to prevent any background noise. There will be a question and answer session after the speaker's opening remarks, and instructions will be given at that time. Let me remind you that forward-looking statements may be made during this conference call. These are based on information that is currently available and subject to change due to a variety of factors. For more detail and a complete disclaimer, please refer to the earnings release. Also, all figures discussed are in USD, unless otherwise stated. It is now my pleasure to introduce the GIS team. Mr. Jorge Rada will lead off the call. Good morning, and thank you all for joining us today. in 2023, we continued to see growth opportunities in the markets where we all participate, given the pent-up demand for vehicles and current inventory levels in the supply chain. In the past two years, Draxton has excelled in its commercial strategy, strengthening its global order book. This makes us highly optimistic about our sales volume growth in casting and value-added processes for electrification-agnostic parts. Throughout the year, Draxton secured the equivalent of over $120 million annually in new business contracts. As you all have heard, in North America, labor contract negotiations have been intensified at the three automakers based in Detroit, resulting in strikes in some of their plants. As of this moment, the impact in Draxton's operations in North America is not relevant since our customers are increasing volumes in other programs from different platforms. During this process, we will focus on building back inventory and secure the launch of new programs. Among the most important developments in the capacity expansion programs, line six in San Luis Potosí is already operating three shifts, while line number seven, second phase of the expansion, will be ready for product validation tests in January. These expansion projects will add approximately 60,000 tons of iron casting per year, or more than 20% of our current capacity in North America. The investments in Evercast, our joint venture with ZF, have also been deployed, installing the first of two plating lines and increasing machining capacity aligned with our customer programs' rollouts. With the plating investment, Evercast will become the largest plating facility of its kind within the Americas, with an estimated output of 30 million parts of braking systems. In Europe, our business strategy is to grow in value-added processes in addition to casting. This is why we are expanding our machining capacity for both light and commercial vehicles. This approach will allow us to further increase our machining and casting volumes, and consequently increase our market share. To this end, we are developing a new machining hub in Poland that, combined with the one we have in Spain, will allow us to increase our portfolio of value-added components for our customers. Moving on to the development of the automotive industry. Beginning with North America, the region continued to stabilize over the quarter, posting an annual growth of 5% in vehicle production. Consequently, vehicle sales recorded a 14% annual growth. This positive trend has led to more adequate inventory levels in the region, despite the onset of the strikes against the three Detroit-based automakers. In Europe, production posted a growth rate of 9%, while sales increased 21%, reflecting an improvement in production and primarily in the underlying demand that followed progress in inventory levels and incremental deliveries. This region is now operating as a net importer, contrasting with its historical position. Turning to China, the domestic demand has stalled in 2023, resulting in a total vehicle production of 6.8 million units and sales of 6.5 million units, which implied decreasing growth rates. Nevertheless, exports are expected to offset this effect and boost light vehicle production in the region. Moving on to Draxton's performance. Casting and machining volumes recorded significant growth rates of 9% and 63% respectively. This increase is driven by global vehicle production dynamics and introduction of new programs, which include value-added processes such as machining. In North America, casting volumes increased by 10% on an annual basis, while machining volumes surged by 97%, both on their positive trends. Meanwhile, Europe and Asia delivered incremental casting volumes of 8% and machining volumes of 25%. During the third quarter, Draxton experienced a 3% annual increase in revenues, with North America generating $124 million, and Europe and Asia contributing $107 million. Year to date, revenues reached $716 million, recording an accumulated growth of 9% when compared to the same period 2022. Despite the prior years, quarter prices include higher raw materials costs in their indexation formulas. Although there is progress in operational stabilization and commercial negotiations have begun to recognize inflationary impacts and currency fluctuations in our price. The quarter's EBITDA was affected by the Mexican pesos appreciation and expenses linked to the launch of new products and capacity expansions. The quarterly EBITDA reached $19 million, outperforming the last quarter, reflecting the results achieved through the implementation of cost efficiency plans that will continue to enhance productivity and margins in the upcoming quarters. Draxton will remain focused on improving operational excellence, the successful launch of new programs and capacity expansion, and securing new contracts mostly for platforms aligned with hybrid and full electric vehicle platforms. I will now hand the presentation over to Saúl Castañeda, GIS CFO. Thank you, Jorge, and good morning, everyone. Moving on to GIS, the quarter's financial performance reflects stability in sales. A solid casting volume growth trend from Draxton has been the main driver, coupled with the effective execution of our indexation strategy and continuous growth in vehicle production of customers across the globe. In terms of revenue, the third quarter 2023 has shown resiliency, having recorded revenues of $256 million, which represents a 4% growth when comparing to the same quarter last year. We post an EBITDA of $17 million for the third quarter. Effects such as the currency exchange rate lie behind this performance, as well as temporary surging costs related to introduction of new programs and casting lines. Given the industry dynamics in the automotive markets, GIS remains heavily committed to its expansion and execution of the CapEx program, and to continuously secure new contracts, which have result in more than $120 million of annual revenues to be launched in the next 18 to 24 months. Both endeavors have certainly allowed to further enhance our global position. Regarding the year-end outlook, our CapEx is projected to close at $115 million. Required investments will continue to fuel the expansion efforts previously outlined, including the ongoing expansion of our casting, machining, and plating capabilities, as well as boosting continuous improvement of production processes. For the third quarter 2023, our financial position remains strong. Net debt attained $156 million, in line with previous quarters. Likewise, the net leverage ratio reached 1.7 times. We will keep focused on cash flow optimization to ensure a healthy financial outlook. I will now hand the presentation back over to Jorge. Thank you, Saúl. I would like to close these remarks with some highlights of the quarter, which we are very, very proud of. Draxton Europe received the award of most innovative supplier by our customer, Schaeffler. This recognition accentuates our commitment to innovation and digital transformation in the scope of Industry 4.0. In China, Draxton secured a program with a very important Chinese vehicle manufacturer for a casting and machining project focused on differential cases for electric vehicles. With this nomination, we advance towards our goal to further strengthen our product portfolio with value-added processes aligned with electrification trends. In GISEderlan, our joint venture with Fagor Ederlan in Mexico, we initiated an expansion of its production facility, as this venture has landed additional contracts for strategic components like knuckles and control arms. This contract will also increase the casting volume at Draxton. We are very optimistic about the automotive markets, and we are set to resume our margin growth trajectory, supported by cost-saving and productivity-enhancing measures that are already in place. Commercial negotiations in line with evolving macroeconomic conditions and rising vehicle production volumes across the regions in which we participate. With this, I conclude my remarks for today. Thank you all for your attention. We can now start the Q&A session. Thank you. At this time, we will open the floor for your questions. Ladies and gentlemen, if you have a question, please use the raise hand function on your Zoom tool. Please make sure that the microphone is turned on. Again, to ask a question, please use the raise hand function on your Zoom tool. Please make sure that the microphone is turned on. Our first question from Carlos Alcaraz from Appalachia Research. Please go ahead. Hello. Good morning, Jorge, Saúl, Arturo. Thank you very much for the call, and congratulations for the results. Firstly, I want to ask if you could give us some color on your expectations on EBITDA margin for the next year. Finally, I would like to ask you about the line 7 in San Luis Potosí. What production volume will it be reaching during the next year, considering the validation period you mentioned? Thank you, Carlos. Yes, thank you, Jorge. I will start with the first part of your question. Thank you for those. I will say that, first of all, I would like to emphasize that third quarter EBITDA, it reaches, as you know, $17 million. It is a 20% increase against the previous quarter. It is important step on our recovery process of this profitability. I will say that during the first half of 2024, we are foreseeing much higher EBITDA margin levels. It is important to highlight that we will grow on a sequential quarterly basis, quarter-over-quarter. I do not know, Jorge, if you would like to add something. No, yes, sure. You will start to see an important recovery trend starting especially fourth quarter this year. The first half of next year, we will start with the launching phase of the line number 7, which is the second line we are installing in San Luis Potosí, as you all know. That line will start from zero in January, production of zero until, let us say, the level of run rate of approximately 20,000 to 25,000 tons on an annual basis from January to December. If we consider the two new lines, this line number 6 and line number 7, together by the end of next year, we will be running practically at 80%-90% capacity, which is according to our original plan. This capacity is about 60,000 tons in total. We will run about 80% of that by the end of next year, and that is approximately 20% volume increase in North America. This is approximately, if we consider the prices of the steel scrap for next year, that will be a run rate of approximately $100 million for next year. It is not the sales of the year, but it is going to be the run rate by the end of the year. In addition to that, we are launching the plating and we are launching the machining, additional capacity that we are installing in Evercast, and that will represent another important increase in revenue and EBITDA for next year. Carlos, just let me add that we have a very clear path on how to reach our EBITDA levels and margins that we have to, and we are improving, as I already mentioned, an important or a major progress during this quarter. As Jorge mentioned, we are confident that we will reach a better level on fourth quarter and so on. Okay. Thank you very much for the information, and again, congratulations on the results. Thank you, Carlos. Thanks, Carlos. Our next question comes from Emilio Fuentes from GBM. Please, sir, go ahead. Good morning. Thank you for your time. First of all, I would like to ask you on a recent call where Ford mentioned strong supply chain connections in Mexico towards its Kentucky plant. As of today, is there any impact on your supply chain related to the strike at this plant? Well, thank you, Emilio, for the question. Good morning. We have not seen relevant impacts on our production volumes so far. The reason is that the OEMs, and in this case, Ford, for example, as you're mentioning, are increasing volumes of other platforms that they are still producing, and the plants have not been impacted by the strike. We have not seen relevant impacts. We will be definitely observing very closely the situation to see if there is going to be any additional strikes because the UAW, as you have seen, is not stopping. They are continuing to negotiate very strongly with the Detroit-based automakers, and we don't know what is going to happen. However, so far, we are still producing at the, let's say, normal rate, and we haven't seen any relevant impacts in any of our operations in North America. Thank you. Related to that, a second question. What are your views going forward on labor inflation in the entire industry, specifically in North America, and how can OEM and suppliers offset that impact? Well, yes. We have seen that in Mexico, there are two main impacts. One is exchange rate, that we know that we have several years experienced an exchange rate of around 20 pesos per dollar, and recently was at 17, which is, let's say, an important increase in labor cost when you measure it in dollar terms. In addition to that, we have inflation, which is another impact in the operations in all the Mexican operating companies. For this, what we are doing is we are negotiating with our customers these two impacts, and we are adding or looking for adding all these two impacts into our prices. We have closed already some negotiations, and some of them will start January next year. Some of them we are continuing in discussions and negotiations with the customers, and we are very optimistic that we will definitely recover all these impacts gradually in the next months and definitely during the next year. Very clear. Regarding the FX impacts and your renegotiations with your clients, I am curious, as you mentioned on the report that you are trying to pass through those FX impacts. But if we eventually see a devaluation, an appreciation of the peso back to normal levels, will that pass-through impact you going forward? Will the relationship be two-sided? Well, it has been always like that when there is, let's say, a devaluation of the Mexican peso against the dollar, normally customers come and ask you for, let's say, a price reduction. So we are exposed to that. At the moment, we are asking for, let's say, recovery of the exchange rate. In the future, if something happens on the opposite direction, definitely we will have to discuss with customers if there is a possibility for them to get any price reduction. Of course, this is always negotiated. This is always, let's say, discussed, and it is not unilateral. That is why at this moment, there is a very specific situation, and we never saw that before. That is why all the suppliers of the automotive industry located in Mexico are doing the same, going with the OEMs and tier ones and discussing this application of the new formula for prices because it is really difficult to absorb, let's say, 15%-18% cost increase in the Mexican or peso costs, right? That in dollar terms are much higher and already like 15%-18%. You need to show to your OEM customers and tier one customers that this is impossible to absorb. As I mentioned, we have closed already several negotiations and we are still talking to customers, to the rest of the customers, so we can start definitely by January 2024 with new prices. You will see that in the results of the first, second and third quarter next year, which is going to be a gradual ramp. Thank you for your answer, and once again, thank you for your time. Thank you. Thank you. Our next question comes from Gonzalo Uribe from GBM. Please, sir, go ahead. Hello, Saúl, Jorge. Good morning. I was wondering if you could give some color into drivers and strategies to improve the EBITDA margin, manage free cash flow burn from expansions, and align these efforts with long-term shareholder value through buybacks and dividends. Well, you start and I complement you. Okay, sure. Thank you for your question. As Jorge just mentioned, we have a very clear path on how to improve this EBITDA for our major business unit. I will say we have different drivers. First of all, the price adjustments that Jorge mentioned, mainly all related with FX and inflation FX. But also we will have improvements from higher volumes and also, and very important from our value-added processes. Mainly, probably you can recall that we launched an expansion projects for core machining and also plating processes, both value-added processes with higher margins. So we are in the ramp-up of those processes that will bring us next year a higher EBITDA. But also operational improvements of our scrap productivity and all the operations, the KPIs. I do not know the second part of the question. How we are going to improve the shareholder value. Okay. Yes, that's related with the EBITDAs. Just to finish that part, let me add that, as we mentioned, we are going to see a sequential progress, and we feel very confident that we'll be in a better position during the first half of the year. That will bring us additional room for the processes that you were mentioning, such as buyback programs. Let me remind you that we have been very active on the buyback programs during the past, I will say four years, probably more than that. We will keep on that strategy once we are back on the margins that we need to be or we need to have to be there. Also, just let me add that we are optimizing our cash flow during the year. We are having pretty close projections, and we are assessing this subject, I will say, weekly to have a strong cash position. I will say that it's probably in our second priority, but to be taken back in the next year. I don't know, Jorge. He was also asking about dividends. Sure. About dividends, as you know, GIS is one or has probably one of the highest dividend yields on the market. We are foreseeing to keep it in that way. Regardless this situation, we are improving our operations to be in the same line, so we are not foreseeing any major impacts on dividends so far. In addition to that, I would like to that the launching of the line 6 and 7 in San Luis Potosí, the launching of the expansions in Evercast in Irapuato plant, which is machining and plating, will bring us a big step up in volumes, and these volumes come with additional EBITDA. As we continue increasing our volumes in North America, you will see an improvement in EBITDA. But also in Europe, we are launching additional projects with machining. We are filling up our order book with additional orders, especially from the commercial vehicle market in Europe. In China, we are also growing. Actually, we foresee that we will have to add some additional capacity to continue growing in China. Not another line, but just to break some bottlenecks that we have in the production. In addition to that, we won recently a very important project for a Chinese automaker for exporting electric vehicles, and that is for differential cases. That is an additional volume for the casting plant, and this is an additional machining process that we will launch in China. This is a very strategic, let's say, product that we will continue growing on, because differential cases is one of the products that Draxton is pursuing as a strategic product globally. This is always, or not always, but most of the time, we are going to produce diff cases, which is part of the electric drive of the vehicle, and that will add normally foundry and machining. That is an additional, let's say, strategic step when you talk to customer, because that gives you more bonding with the customer, and that creates a stronger relationship with the customers for longer term. In China, it's very important to mention that we are working mainly with Chinese automakers as customers, which they are gaining market share in the Chinese, let's say, automotive market. That's another advantage because we are getting used to work with the speed of the Chinese automakers, with the, let's say, cost demands of the Chinese automakers in China. We are seeing that they are, let's say, inundating the world with cars. So they are trying to enter into Mexico, into Latin America, Europe, and other markets. We are in China already, and we are delivering to them. So we are very optimistic also about our Chinese operation. Another important aspect that I would like to add is that even when the next important debt payment is scheduled until fourth quarter 2024, we are foreseeing a major and a comprehensive refinancing during the first half of 2024. That will also give us a better balance sheet or cash position. It will give us the strength to support not only working capital, also CapEx and these stakeholders' interest also. Thank you very much. Have a great day. Thank you. Thank you. Once again, if you would like to make a question, please use the function Raise Your Hand from Zoom. Our next question comes from Alejandro Azar from GBM. Please, sir, go ahead. Hi, good morning, Saúl, Jorge. Thank you for taking my questions. I was just wondering if you can talk about the changing relationship that you are seeing with your customers. In the past two years, you guys have had to sit down at the negotiating table each year or each quarter on different topics. How do you see that evolving in the next couple of years? Are we going to have each year to have GISSA or Draxton to sit down with customers to negotiate either a benefit or an impact on the operations? On regards to that, it seems that a lot of your costs, if you already had the passthrough on materials, which is significant, I do not know if you can share how much of your current costs are already hedged in terms of percentage. I do not know, 70%, 80%, when you account for materials, energy. I do not know if you can put labor into that or a portion of your labor. That would be my first or two first questions. The third one is related to your comment on Europe becoming an importer of vehicles or components. Does that change the dynamics of suppliers? Is there any impact in Europe for becoming a net importer? Thank you, guys. Yeah. Well, Alejandro- Thank you Thank you. Nice talking to you. First, the situation definitely has changed in the last couple of years because we never saw what we saw. We had first the pandemic, then we had the supply chain bottlenecks. Right All the disturbances in the supply chain across the world, price increases, inflation, exchange rate situation, et cetera. It has been many things that were put together at the same time, and I believe that this situation will be solved by negotiating with customers, definitely. There is a big supply chain in which the OEMs are at the end. Then you have the tier ones. In some cases, we are tier ones, in some cases, we are tier 2. In some cases, we are tier 3, actually, in very small products, but we are still tier 3 in some cases. We definitely have to talk to the customers and our customers to the OEMs, because definitely Mexico is producing and exporting more than $100 billion to the U.S., and it's very clear that all the companies that are operating in Mexico are suffering from the same situation. They are aware, they know that it's going to happen, and they need to keep the supply chain healthy. That is why at this moment, everybody's trying to settle in a way that it will keep the supply chain in a healthy way. We don't know if in the future this will continue to be like that. If inflation comes down, interest rates go down also gradually, maybe we will come back to the normal situation like in the past where OEMs were asking for actually productivity improvements and price reductions and things like that. Right. At the moment, for the next, I would say 18 months, we still see that the turbulence will continue and the supply chain will be in the same mood of negotiating new terms and try to transfer inflationary, or the additional cost to the OEMs. There is going to be, at the end of this turbulence, stabilization. This is what we foresee. Okay? Then the next question. Including labor indexation formulas. How much indexation we have. Normally, we had, in the past, only the scrap. The scrap is part of the raw material. It's not 100% of the raw material. Now, what we have included in the indexation formulas is also other materials like ferroalloys, which, in addition to the scrap, are used to produce the alloy we pour into our molds to produce the castings. Okay? Now, the full raw material that is part of the casting is included in the indexation formula. Later, we started to index also electricity. In most of our products, I would say 90% plus, we are already indexed in the electricity cost, which is also very important because electricity in the recent years has been, especially in Europe, very volatile. With this volatility, it's very unpredictable what you can do. Sometimes we can remember the price of the electricity grew five times in Europe during the pandemic, after the war started in Ukraine. So that had to be negotiated. It was impossible to continue without any negotiation. So now that we have indexed the electricity, we are much more protected. Labor is not indexed in any of the products. It is not common in the industry. What we really want to show to the OEMs and tier ones is that there is definitely an inflation and there is definitely exchange rate. And with this, you have to sit down and negotiate. There is not a single formula that you can use for this, and there is so much you can do. What you have to demonstrate to the customers is that you are productive, that you are efficient, because they will never be able, or they will never be willing to pay for any inefficiencies. For that reason, this is a negotiation because you can be more productive than others using more technology, more automation, et cetera. So that is why other costs are not indexed yet. We don't expect that will be a full indexation on the labor cost, but definitely there is something that has to be recognized by the customers. And then there was a last question, right, Alejandro? Yeah. The last question, and let me add another one. The last question was about on your comment on Europe becoming a net importer. Does that change the dynamics of your business or might change into the future? And the other one is related to the Ministry of Economy, I think, or Hacienda announcing fiscal benefits or subsidies for companies wishing to relocate to Mexico and being exporters. Have you guys looked into that? Does that also benefit the Mexican companies currently or bringing in some of those products like it is your case? Regarding Europe, let's say if we look into Draxton's business. We don't see a big impact because we have been able to diversify our business into two industries. One is the light vehicle industry, and the other one is the commercial vehicle industry. So what we have seen in the recent years is a very successful commercial relationship with new customers, and our order book has been growing. And now we see that our plants in Europe will be operating at a very high level of capacity utilization for the next years. So even though Europe is not exporting more than importing cars, we have been very successful in commercial negotiations with customers to get new businesses. So we don't expect any negative impact on Draxton. I think that's important for you to know that we are in Europe growing, and our capacity is going to be, let's say, basically full. We are adding capacity for machining, which is value-added processes, and we are not concerned about this, what we mentioned in our, let's say, quarterly report. In terms of the Mexican tax incentive for installing plants in Mexico, I don't know if you want to Sure. Thank you, Jorge. Probably I can comment a couple of aspects. Nice talking to you, Alex. First of all, I will say that if we take a look of this like a threat, I will say that our competitive advantage, Draxton competitive advantage, it's definitely the know-how, the casting know-how. It's not easy for any competitor to be here and be profitable in the short term. I will say greenfields will take more than two, probably three years to be on the utilization capacity at a good level and in a profitable way also. But on the other side, I will say we need to take a deeper analysis to try to identify if that can be a positive or an advantage or a benefit in a fiscal perspective or a tax perspective. We are, as you know, with organic growth, so probably we need to take a deeper analysis in that aspect. I'm not sure if we are going to be benefited from that, but it's already in an ongoing analysis. Gracias. Thank you. Thank you, guys. Thank you, Alex. Thank you, Alex. For one last time, if you would like to make a question, please use the function raise your hand. With no further questions, I would like to hand the call to the management for the close of this conference. Thank you, and thank you everyone once again for your interest in GIS. Please do not hesitate to touch base if you have further questions. Have a nice day. Thank you.