Good day, ladies and gentlemen, and welcome to the Shawcor Q3 2018 Results Webcast conference call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session, and instructions will be given at that time. If anyone should require assistance during the conference, please press star then zero to reach an operator. As a reminder, this call is being recorded. I would now like to turn the call over to CFO Gaston Tano. You may begin.
Thank you, Operator. Good morning, everyone. Before we begin this morning's conference call, I would like to take a moment to remind all listeners that today's conference call includes forward-looking statements that involve estimates, judgments, risks, and uncertainties that may cause actual results to differ materially from those projected. The complete text of Shawcor's statement on forward-looking information is included in Section 4 of the Third Quarter 2018 earnings press release that is available on SEDAR and on the company's website at shawcor.com. I will now turn it over to Shawcor CEO Steve Orr.
Good morning, and thank you for joining us on this morning's conference call. Gaston and I are hosting this meeting from our Toronto office right before departing for the Middle East. The trip to the Middle East has been planned for some time and will provide an opportunity to meet with customers, employees, and partners to gain a first-hand update on the opportunities and challenges in this important region. In our two previous quarters, we communicated our expectation that the full year 2018 results would be aligned to Q4 2016 adjusted EBITDA annualized. Additionally, we communicated an expectation that 2018 would prove to be an important setup year for stronger, more stable earnings. Our results this quarter were solid, in line with what we delivered in Q1 and Q2.
Adjusted EBITDA in the third quarter of 2018 was $38 million, an increase of 3% over the second quarter of 2018, and revenue was $351 million, a decrease of 1%. This quarter's results, like the results from the previous two quarters, are demonstrating the value of efforts made to diversify and add sustainability to the company by expanding the portfolio beyond pipe coating. I'll comment in more details on our Q3 results, expectations for upcoming quarters, and overall outlook in a moment, but in summary, Q3 was a solid quarter with support coming from continued strong demand for products and services in our day-to-day or book-and-turn businesses, particularly in North America in our pipeline and pipe services segment, and steady demand in automotive in our petrochemical and industrial segment.
There were some unforeseen activity-related issues that impacted results, so the quarter could have been better, but by far the largest drag was a continued softness in pipe coating in international and offshore markets. For 2018, even with the full expectation that Q4 will be a step down from previous quarters, as it will have a seasonal impact and there will be a ramp-up in costs associated with future pipe coating activity, it will be a solid, but more importantly, a pivotal year. The future performance of Shawcor will be determined by our portfolio and the activity of customers in the markets that we choose to play. With an expanded portfolio delivery, line of sight of the inflection point for international and offshore pipe coating activity, and our positioning in these markets, there is now increasing support for future earnings growth.
I'll now turn the call over to Gaston Tano and ask him to provide some details on the third quarter financial results.
Thanks, Steve.
As Steve noted earlier, third quarter results were positive and in line with our expectations. Revenue in the third quarter decreased by 1% over the second quarter of 2018. The pipeline segment revenues increased by 1% due to continued demand for our composite pipe products, small diameter, large diameter coating, girth weld inspection, and engineering services in North America. Partially offset by lower large project load-out activity in Latin America and lower revenues in EMAR and Asia Pacific. Petrochemical and industrial segment revenues decreased by 10% due to a lower activity for automotive heat shrink products North America and EMAR, and lower revenues for our wire and cable products North America as a result of supply issues for drawn copper wire.
Compared to the third quarter from a year ago, revenue decreased by 11%, mainly due to lower revenues in the pipeline segment, which declined by 13%, reflecting the completion of the Sur de Texas-Tuxpan project in 2017, and lower activity in Asia Pacific. This was partially offset by higher revenue levels in North America, mainly from demand for our composite pipe products, large diameter coating, girth wall inspection, and engineering services. Revenue for petrochemical industrial segment decreased by 1% compared to the prior year third quarter, primarily due to lower revenues for our wire and cable products North America as a result of the supply issues for drawn copper wire. Consolidated gross margins for the third quarter were 29.5%, lower than the 32.2% in the second quarter of 2018, and also lower than the 37.9% in the third quarter a year ago.
The pipeline segment gross margin for the third quarter decreased to 29.6% from 39% a year ago, reflecting lower large project activity in Latin America and lower facility utilization in EMAR and Asia Pacific. The petrochemical industrial segment gross margin was 28.7%, which was in line with the second quarter of 2018, but lower than the gross margin of 30.1% that was reported third quarter a year ago. We do expect consolidated gross margin in the fourth quarter to be negatively impacted by the continued low pipe coating activity in the international and offshore markets, higher costs to maintain idle assets, reactivate plants, and pursue large projects, and the typical seasonal slowdown of several of our businesses at the end of the year. On a consolidated basis, adjusted EBITDA for the third quarter was $38 million, higher than the $37 million reported in the second quarter of 2018.
The current quarter has been adjusted for the impact from the adoption of hyperinflation accounting for our operations in Argentina, which was required to be applied retroactively to January 1st, 2018. The adoption of this accounting standard had a negative impact on EBITDA of $4.4 million in the current quarter and $7.4 million in the nine-month results. On an adjusted basis, the current quarter performance reflects a continued growth in our North American-based business, partially offset by the impact from a temporary construction stoppage of a U.S. transmission line by a regulatory agency, supply challenges for drawn copper rod for our wire and cable businesses, and a continued low activity for international and offshore pipe coating. The current quarter was also positively impacted by an $11 million decrease in SG&A expenses, reflecting lower costs for the compensation and personnel-related expenses, professional fees, advertising, insurance, bad debts, and other costs.
Adjusted EBITDA for the third quarter was lower than the $63 million reported in the third quarter of 2017. The decrease is primarily due to lower large project activity from the Sur de Texas-Tuxpan project, partially offset by higher activity in our North American-based business. In addition, SG&A expenses decreased by $60 million compared to a year ago, reflecting lower incentive compensation expenses, where the prior year period included an increase related to government-mandated employee profit sharing on large project activity in Latin America, and lower costs for professional fees, advertising, insurance, bad debts, and other items. Let's now discuss cash flows for the quarter. Before changes in non-cash working capital, cash flow provided from operating activities in the third quarter is $35 million, an improvement over the $28 million from operating activities in the second quarter.
This increase is primarily due to the change in non-cash items in the quarter, mainly provisions and unrealized loss on derivatives, which was partially offset by lower amortization of property, plant and equipment. Compared to the $65 million that was provided from operating activities in the third quarter a year ago, the current quarter primarily is down due to lower net income, lower amortization of property, plant and equipment, and change in other cash items compared to a year ago. The change in non-cash working capital in the third quarter was a net cash outflow of $55 million, with an outflow of $1 million in the second quarter of 2018 and an inflow of $1 million in the prior year.
The $55 million cash outflow from working capital in this quarter is primarily due to higher accounts receivable, contract assets, prepaids, long-term accounts, lower accounts payable, and contract liabilities, and negative impact from foreign exchange. Cash used in investing activities in the third quarter was $17 million, primarily due to capital expenditures on property, plant equipment to support current activity levels in our business. During the third quarter, cash used in financing activities was $10 million, reflecting the payment of our regular quarterly dividend. Overall, net cash flow for the third quarter in 2018 was -$52 million compared to -$7 million in the second quarter of 2018 and +$44 million a year ago. With respect to the balance sheet, our financial position remains solid. The company's cash and short-term investments decreased during the third quarter to $190 million.
The decrease reflects the growth in non-cash working capital at the end of the third quarter to $193 million from the $150 mlllion at the end of the second quarter, and higher than the $89 million at the start of the year. The increase in non-cash working capital that occurred during the first nine months of 2018 was expected and reflects the continued investments to support the growth of our base business in North America, while the start of the year balance was positively impacted by the timing of collections related to large project activity in the fourth quarter of 2017. From a debt perspective, the company continues to maintain a low debt leverage ratio, with long-term debt of $254 million and $31 million of standard letters of credit as of September 3rd, 2018. As a result, the company has available unutilized credit facilities of approximately over $440 million.
I'll now turn it back to Steve for his commentary on the company's outlook.
Thank you, Gaston. Starting with additional comments on Q3 2018. The quarter was solid, was similar to the previous two quarters, and supports our communication that the full year 2018 will be aligned to Q4 2016 adjusted EBITDA annualized. The quarter's results were underpinned by continued demand for composite girth wall inspection, line pipe and field joint coating in North America, land market, and heat and cold shrink products in automotive. Results for the quarter were negatively and unexpectedly impacted by two items. The first was an unexpected suspension of a project due to a halt order on all pipeline right-of-way activities from a governmental agency. The project is now back running, but in Q3 we did see impact in businesses that had work planned in the quarter for this project.
The impact was because of lower day rates while on standby and additional costs added to find and then move resources to infill work. The second was from an unexpected supply chain issue that impacted the availability of drawn copper wiring. This impacted our wire and cable business on both the top and bottom line. Although the problem is still present, it is slowly being addressed as suppliers add skilled headcount and as we adjust. These two items can be classified as unexpected. What was expected and forecasted was the negative impact of soft pipe coating in international and offshore markets and the costs we are taking as a result of idling or warm stacking plants, project pursuits, and plant startups for one projects. In Q3, this exceeded $15 million. In Q3, we announced the conditional award of Liza 2.
Together, Liza 1, which is being executed now, and Liza 2, which is expected to start in the second half of 2019, have a combined pipe coating scope that exceeds $100 million. This award provides me an opportunity to speak about a real example of the changing environment in which work is being contracted, particularly in the offshore and large projects. No longer able to count on $100+ per barrel oil to hide poor execution, expensive customization, poor development and production agreements, E&P operators are making changes in the way they define work scopes and choose and engage suppliers. Additionally, faced with growing cash balances, reserve replacement issues, and stable demand growth, returning to international and offshore developments is now becoming urgent. This has resulted in several changes. The first, suppliers are being engaged much earlier in the field development and procurement process.
The second is the rapid filtering of prospective suppliers and the requirement to sign non-disclosure agreements, or NDAs, that govern products. The third is the introduction of awarded scopes of work that are conditional on the development final investment decision. For Shawcor, this is translating into earlier engagements with EMP operators and EPCs, and hence better visibility on projects. Additionally, with larger work scopes being sourced, it is necessitating a much closer relationship between ourselves and EPCs. The other impact for Shawcor of these changes is a quicker assessment of likelihood of award and a model where work is contracted in advance but is conditional on final investment decision, or FID. Liza 2 followed this process. At the start of this year, we were offered an opportunity to directly discuss the work under an NDA.
An agreement was reached without tender that provided the comfort to put resources in place to work with Saipem on the best execution strategy, which among many items had to address the backlog in Channelview, the preferred plant. With an optimized plan, ExxonMobil moved ahead with conditional awards to suppliers, which led to the many recent industry announcements. With all parties working together well in advance on larger and better defined scopes of work that take into account many interfaces of a project of this complexity, and using what was done before in Liza 1 as a start, ExxonMobil has decreased execution risk and gained cost certainty on the project, which in turn increases the likelihood of a positive FID.
Liza 2's FID is expected in Q4, and Shawcor is focused to ensure we execute as promised and will be positioned to be the coater of choice for future Liza phases. Before I move beyond 2018, I'll expand on the comment that I made earlier pertaining to Q4 2018. Q4 will be a step down from the results we have delivered in Q3. This will be due to two main factors. The first is the seasonal nature of many of our businesses, where Q4 does have several weeks of slower activity. The second, the expectation that pipe coating activity related to international and offshore markets will reach a low point, and our cost to keep, pursue, reactivate, and reposition pipe coating resources will be at a high point.
Backlog at the end of Q3 2018 was $395 million, down from the $447 million reported at the end of Q2 2018. It should be noted that the $395 million does not include the conditional award of Liza 2. Assuming FID in Q4 of 2018, this would bring the backlog to $421 million. I would also highlight that the majority of Liza 2 falls out of the 12-month window for backlog inclusion. Project activity remains extremely strong, with $900 million in firm bids and $1.8 billion in budgetary at the end of Q3 2018. As we have stated before, successful project capture requires the project to be sanctioned or pass final investment decision, and Shawcor to be selected. Offshore subsea projects are now building up, and more importantly, with an increasing number of larger ones visible.
It is forecasted that the number of sanctioned projects that are offshore that have greater than 500 million barrels of reserves will return to sanctioning levels when oil was at $100 per barrel. This is positive. Although timing is never certain, and individual projects do tend to move to the right, our engagements with our customers on active projects are supportive of increased demand for our coating services. To better understand project timing and regions of interest, I will provide the following color. A large $100 million+ project that is in our bid that was expected to FID in Q4 2018 is seeing challenges with local geopolitical issues. This project is associated with a large land greenfield development in Africa. Shawcor will continue to pursue this opportunity fully, but the FID is likely to be delayed well into 2019.
FIDs of several projects in Asia regions related to gas reserve replacements, such as Ichthys, Barossa, and Myanmar. Sanctioning of these is expected to start in the first half of 2019. Field developments that were under watch pre-2015 that are now under review, such as IDD in Asia and Roseb ank in North Sea. These projects in many ways are reworks or may have new ownership. The timing of their sanctioning is variable, but are expected to start progressing in 2019. New LNG supporting projects that will be required to address the pending gap in supply and demand that is estimated to occur as soon as 2020. Some of the markets that are related to this are in Western Canada, East Africa, and Papua New Guinea. Started already in Western Canada, we expect project sanctioning to occur in 2019 in East Africa and Papua New Guinea.
On watch are FIDs in offshore oil-based developments, such as those in the Gulf of Mexico, Brazil, and Guyana. Mad Dog, Peregrino, and Liza 1 and 2 are examples of this, and all have been sanctioned. We expect more projects will be decided as we move through 2019. And finally, movement of offshore gas developments positioned to supply gas into the European markets, such as those in Romania and the Caspian. We expect sanction of projects in both these regions to occur in early 2019. Beyond 2018, we expect continued strengthening in our base business. This strengthening is with the expectation that we will continue to benefit from our diversification strategy, and North America well completion and large diameter transmission line activity will remain stable.
Starting in Q1 2019, with the work we have in hand, coupled with current project timing outlook, and our expectation that we will win our share of the international offshore available pipe coating work, the business will start to show quarterly improvements from the low point of Q4 2018. With the base business and pipe coating supporting, and project wins building the backlog, there will be support for stronger business performance as we exit 2019. In summary, 2018 will be a pivotal year for the company, as we will have delivered solid results without a large $100 million pipe coating project, and more importantly, with pipe coating, a late cycle business at the bottom but starting to book orders to reload.
In 2019, we are forecasting pipe coating project sanctioning to accelerate and pipe coating to start to recover, and once again to start to contribute meaningful to our bottom line. We expect 2019 results will be an improvement over 2018, but the real uplift will be in 2020. Shawcor's strategy is to build a company that is recognized for integrity, technology, and execution. The strategy is supported by long-term fundamentals: aging infrastructure, reservoir depletion, and energy sustainability. With increased visibility on future earnings that are now supported by a diversified base business, global projects moving forward, and a strong balance sheet, Shawcor's is executing its growth strategy, which involves both organic and inorganic initiatives.
For clarity, and as I have communicated in past calls, organically we are focused on continuing to look to bring new products and services to market, for example, new composite line pipe products, advanced girth wall inspection, and next-generation flow assurance coatings, and to bring on additional capacity where it is justified and has an acceptable level of return. Inorganically, Shawcor continues to evaluate opportunities that are aligned to our enterprise strategy, are sustainable businesses, and have clear identified cost and revenue synergies. The businesses or technologies that we are currently focused on are in the areas of material science, digital enablement, and sensors, and in adjacent spaces such as water. I'll now turn the call over to the operator, Michelle, to open it up for questions you may have for Gaston and I.
Ladies and gentlemen, if you'd like to ask a question, please press star then one.
If your question has been answered and you'd like to remove yourself from the queue, please press the pound key. Once again, to ask a question, that's star then one. Our first question comes from Greg Coleman of National Bank. Your line is open.
Hi, gentlemen. Congratulations on the quarter.
Thank you, Greg, and good morning.
I'd like to start with a couple of quick ones here talking about the results themselves before we look into forecasts. Just a few clarity ones. Steve, you mentioned expected costs in the quarter of $15 million regarding warm stacking, staffing up facilities, etc. Can you just clarify, was that $15 million inclusive or excluding the unexpected costs, including the government shutdown of one of the projects in the U.S. and the copper supply issues?
So the $15 million refers to only pipe coating.
So it would have been the startup of projects that we already have in hand, the underutilization that we're seeing in plants that we have decided to keep ready, and costs associated with pursuing large projects. So it does not include the impacts on the quarter that were unexpected, such as the drawn copper or the large project that I happened to talk about last quarter, which was an example of having many services on one project that was stalled in the quarter.
Can you hazard a guess or give us an indication as to what the dollar value impact of those unexpected portions of the quarter would be?
$4 million-$5 million.
Great.
Keeping it on the quarter, the Argentina hyperinflation, just wondering if we can ask a direct question on that, which I probably could have figured out if I'd dug in super deep on all the results, but was that a cash or non-cash impact? And is it tax-related?
No, it's totally non-cash, Greg. It's basically just an accounting adoption where we have to basically restate non-monetary assets and liabilities using an index every quarter. We have provided some reconciliation information at the back of our press release and MD&A that gives you the impact by line based on that adoption.
Got it. Okay. Thanks, Gaston. That's great. Then now looking forward a little bit, you mentioned there was about $11 million decrease in SG&A sequentially, which is great to see.
Should we be thinking about this high $60 million in SG&A, which is what you put up in the quarter, as a good run rate for the next couple of quarters absent sort of an uplift in large project activity, or are some of those $11 million in savings likely to reverse, or conversely, should it continue to grind lower? Just trying to get a feel for that line.
Yeah. I think if you look at SG&A expenses on our quarterly basis over the last few quarters, I think there is a one-time impact that happened in the current quarter. So the run rate should be pretty similar for going forward closer to the run rates that we experienced in Q1 and Q2 of this year.
Okay. That makes sense.
Now looking forward a bit to the bid activity, Steve, you mentioned that costs in Q4 for repositioning or preparing resources are expected to be at a high point, and also probably gave us more color than we've ever heard on potential areas that you're pursuing. Just sort of mosaicing those two things together, is it reasonable to assume that we should be expecting announcements from you within the next 3-6 months if your costs are ramping as you get your gear ready to go? Similarly, you're kind of pursuing projects where just reading the tea leaves here, Q4 and Q1 seems to be a pretty critical time for it. Should we be monitoring the next 6 months as a key period for large contract awards?
Yeah. But maybe I tried to allude it. And so I think we're going to have greater visibility on projects earlier.
So I think in the next six months, you'll certainly see announcements of projects. But the projects maybe I would couch should be thought of in two ways. So we will, and I think Liza was the example I called it, we will start to provide clarity on work that is secured that is conditional for the development of the project. So we are in discussions on work that actually has scopes that are substantial that are in the year 2021 right now. But we expect to have similar to the Liza format in the next six to seven months being able to give clarity on those projects. So that will happen.
In addition, I do expect that now that we're in advanced stages and all the information that's out there would be supportive, that FIDs on offshore projects that play to our strengths that have scopes of work that include insulation that therefore are larger and beyond the level of the $30 million that we normally would announce are starting to come. To answer your question, not only are we going to start announcing work that is expected to impact the results in 2019 as we get closer to the end, I would expect that we're going to start giving more comfort to the market on securing of work that isn't even to the 2021 timeframe now.
That's great to hear.
Keeping on that tone and staying within 2019 for a minute here, at the conclusion of your commentary, you said that you have an expectation for an uplift in 2019 over 2018. I'm assuming that means EBITDA. Is that based on the currently awarded large projects, including Liza 2, or is that expectation for a lift sort of conditional on additional large projects being won, which would therefore contribute in 2019?
So I'll start first. The uplift that you should expect is we're going to get back to $30 million plus EBITDA very early in 2019 on a quarterly basis. So we're going to have a little bit of a drawback because of the two reasons that we stated in Q4, seasonal and large spend. You're going to see early part of 2019, we're going to get back to it.
And then we have high confidence, of course, with Liza going ahead, and that's in the second half of H2. So all of a sudden, pipe coating starts to contribute instead of being a drag, and we're going to spend less money. So our confidence comes from what we have in hand, but also it's hedged because we expect projects to move ahead. So as we exit 2019, the performance will be stronger.
Okay. That makes a lot of sense. I think gives us a good.
But it does, again, we should clarify, right? It's with the assumption that the North America business activity will remain stable.
True. Yep. Yeah. Okay. And then last one for me, and then I'll stop and hand the mic back. Gaston, just a quick question on working capital.
Despite the absence of large projects, we've seen the company contribute strong cash flow from operations for the year, something like $85-$86 million for the first nine months, but that's been entirely drawn up in working capital draw of over $100 million. Seasonally, we start to see a release in Q4. Is that the sort of thing we should expect this year as well, or is there a reason that we will continue to see the working capital soak up that cash flow from operations?
Yeah. As I stated earlier, the increase in working capital is directly related to the growth in our base business. But with the step down that we expect in Q4 and the natural slowdown in the business, we do expect working capital for Q4 to stay at the current levels and slightly decrease.
So we are not going to invest more working capital in the fourth quarter.
Excellent. That's it for me. Thanks very much.
Once again, if you'd like to ask a question, please press star then one. Our next question comes from Elias Foscolos of Industrial Alliance. Your line is open.
Good morning. Good morning. Good morning, guys. I just, first of all, wanted to say thanks very much for the enhanced color for repeating Greg's comment. It is very helpful. Focusing on a couple of questions of which Greg got to a couple. Steve, communicating to the market is one thing, and looking at the data that you've got in front of you is another. Given that Shawcor is now being pulled in earlier, signing NDA agreements for potential work, has your outlook over the last quarter changed in terms of longer-term projects?
And really, I'm looking beyond the 2019 timeframe.
Yeah. Maybe just to step away, if we try to get it, and I like the question because it's not a quarterly-based question or a yearly question. I think some of the fundamentals that bring some confidence beyond 2019 and 2020 is the reality that, in particular, LNG, the supply gap, is going to happen in 2020. LNG, especially offshore-sourced LNG, is quite positive for our pipe coating businesses. And so that brings confidence. So when we kind of look at the projects that we're pursuing, a lot of them have a tagline of LNG in them now. The second part that is related to LNG is LNG that is sourced from unconventional, so for example, coastal gas in Canada. The pipe coating opportunity is not exceptionally large for us.
But what is quite helpful is LNG sourced from unconventional will drive an upstream activity that will require drilling and completion to be quite strong to match it. And there it helps our composite business, our drilling-related tubular inspection businesses. It helps small diameter pipe coating, field joint gathering line type opportunities. So that's a longer-term one. I think the second comment I would make is that there's no question right now that the IOCs in particular now are building up substantial cash balances, and reserve replacement is going to be a concern. And you do this really in two ways. One is you do it by the checkbook and you buy reserves by buying companies, and I think we're seeing that now. And the second way to do it is you have to invest in and book reserves by the drill bit, which drives field development programs.
And that's why I think the comment that I made, there are reserves and projects that we were pursuing pre-2015 that all of a sudden now are back on the table again because operators have cash. The economics have changed and the way that they procure supplier contracts have changed. So I'm quite optimistic that the offshore and large project activity will continue to build from here beyond 2020.
Okay. Thanks very much for that. Looking forward to your comment on the inflection point. I kind of see two inflection points. One is a backlog inflection point, and the other is an EBIT inflection point or maybe hockey stick. Would you care to comment on timing on the first inflection point, although that one might be hard?
Then if not, can we see the second inflection point of EBITDA being the typical 9-12 months after the backlog inflection point?
So we're signaling, and the message that we're passing is 2020 will be the uplift. For that to happen, as we exit 2019, you will have to see a larger volume of secured work. So that would be the flow, right?
Okay. I think that answers all the questions that I've had. I'll turn the call back over. Thank you very much.
There are no further questions. I'd like to turn the call back over to Steve Orr for any closing remarks.
Well, thank you very much for joining us on this quarter's conference call. We look forward to speaking with everybody on next quarter. So thank you.
Ladies and gentlemen, thank you for participating in today's conference.
This has concluded the program, and you may all disconnect. Everyone, have a great day.