Good morning, ladies and gentlemen, and welcome to the 2020 Third Quarter Results Conference Call for Russel Metals. Today's call will be hosted by Martin Juravsky, Executive Vice President and Chief Financial Officer, and John Reid, President and Chief Executive Officer of Russel Metals Inc. I will now turn the meeting over to Martin Juravsky. Please go ahead.
Great. Thanks, Chris. Good morning, everyone. I plan on providing a brief overview of the Q3 highlights to give a context around the key business developments. If you want to follow along, I'll be using the PowerPoint slides that were posted last night to our website. Just go into the investor relations section, conference call part of the website. If you go to page three, you can read our cautionary statement regarding forward-looking information. Let me begin with on page five with a few summary observations. This has been really unprecedented times with the changing business landscape. That being said, we couldn't be more proud of how everyone in the Russel family has worked together during these past several quarters. I think it is a real strong testament to the culture that we have within Russel.
In specific relation to Q3, we are really pleased with what our team was able to accomplish, and specifically how we adapted to these evolving market conditions. Talking for a few minutes about market conditions. Q3 looked a lot different than Q2, as we saw the gradual but continuing improvement across all of our business units. The activity level improved not just in Q3 compared to Q2, but also during the third quarter. As a bit of a specific example, our service center volume in September was higher than the Q3 average. That gradual improvement that we saw in activity levels has continued into the early parts of Q4. In addition, the underlying steel prices that started to pick up quite nicely towards the tail end of Q3.
The effect of that is really a bit of a lag element, and those prices that were flowing through to our part of the supply chain, we should start to see that effect kicking in Q4. Second topic is business optimization. We continue to refine our portfolio in a number of ways. We sold some real estate in BC that was part of the rationalization program for that region, and we realized CAD 10 million of proceeds, OCTG and line pipe. We talked in the past about a focus to reduce that footprint over a 12- 18 month period. We have an inventory reduction target of about CAD 100 million. In Q3, we are pleased that we achieved CAD 31 million towards that goal, and we remain committed to the target. We obviously have a little bit more work to be done on that front.
We've also further rationalized some small, unprofitable locations. This will reduce costs and further streamline the management of our inventories in other parts of the business. In addition, our focus has always been, for the last number of years, on value-added processing. That continues to be an ongoing initiative. We completed the Trenton project in late in Q3. We see the business backlog for that operation continuing to grow very nicely. We've got two more laser projects in the U.S. out there being scoped out for 2021. These are the types of projects that allow us to add value for our customers, gain market share, improve margins, and generate really nice paybacks. We're generally targeting paybacks of less than three years for these types of projects. Liquidity and capital structure.
With CAD 81 million of cash from operating activities in Q3, liquidity greater than CAD 500 million, and a cash position that was over CAD 120 million, we had the opportunity to make some improvements to our debt structure. Over the last little bit, we have completed a number of initiatives. We extended our bank deal under favorable arrangements. The borrowing costs under our bank lines is less than 3% today. We're in the process of redeeming CAD 300 million of our 6% notes that were due in 2022, and this is being financed with cash, bank line borrowings, and a new issuance of longer-dated and lower-cost notes. The net result is that we'll have extended our maturities by several years, improved our credit profile, give us a little bit more flexibility, and equally important, reduce our interest costs by about CAD 8 million per year.
If we go forward now to page eight to talk about some of the financial highlights from the quarter, let me start with a few items from an income statement perspective. If we look at Q3 versus Q2 2020, we did see quarter-over-quarter improvement in sales, EBITDA, EBIT, and EPS. Gross margins percentage remain pretty steady at around a 19% level. The one macro observation that I would make in terms of the quarter is that when we look at our expense management philosophy and the flexible business model being core features of our culture, we saw that play out in Q3. Our Q3 employee expenses came down versus Q2 as headcount management and our variable comp model continued to adjust to market conditions.
A few other items of note for Q3, some of which were positive, some of which were negative, but we wanted to highlight a number of these items for discussion. One, wage subsidies were just below CAD 20 million for the quarter, which is a level that was very comparable to Q2. We think that this government program was very helpful in creating a bit of a buffer time period to adjust to the evolving conditions and allow for markets to recover and internal cost structures to adjust to the circumstances. Property sales of CAD 10 million, which I mentioned a little bit earlier, resulted in a gain of CAD 6 million. We had some preexisting capital loss carry-forwards, most of that CAD 6 million was shielded from tax. In terms of some incremental costs for the quarter, we're starting down the path of a new ERP project.
This is the first quarter where we've discussed the magnitude of the cost as the project just started off in July. The cost for the quarter, around CAD 2 million for the quarter, and we expect that order of magnitude to continue through to 2021 with the implementation plan for early 2022. We've always focused on systems as a key factor to managing our information and working capital effectively, and this project is part of that ongoing focus. Lastly, we had a couple of non-cash expenses that negatively impacted EBITDA. We provided for a CAD 2 million increase in our energy reserves, and in addition, there was a CAD 2 million expense related to stock-based compensation. That's a mark-to-market adjustment, and in the quarter, our stock price went up by about CAD 2 a share, which resulted in that increased expense for purposes of mark-to-market.
From a cash flow perspective, CAD 41 million reduction in working capital, with the biggest shifting from inventory to about CAD 67 million. That reduction of inventories was across all of our business segments, but the energy side was the largest as we have a targeted path to reducing that footprint, as I've mentioned earlier. Accounts receivable moved up by CAD 19 million as a function of improved business activity and sales, but our credit metrics continue to track really well, and the pace of collections remains strong. CapEx, about CAD 6 million, is relatively modest. From a balance sheet perspective, net debt declined from CAD 368 million at the end of Q2 to CAD 324 million at the end of Q3, a CAD 44 million reduction. As a result, we are sitting on a net cash position of CAD 122 million at the end of Q3.
As I discussed earlier, this provided a really nice opportunity for us to redeem our 6% notes that were due in 2022, and in the process, reduce our interest expense. For shareholders' equity, there's an accounting adjustment because of the FX shift at the end of Q3 versus the FX at the end of Q2. Final item, we've declared our quarterly dividend of CAD 0.38 per share. Bottom line is that we have made really nice progress in this quarter and the last quarter as well in undertaking a number of initiatives. Those initiatives are focused around driving free cash flow. Notwithstanding the fact that I believe that we've made really nice progress, I think there's still more on the come. We flip to the next page, to page seven, we include some of our segmented P&L information. The service centers did really well as the market improved.
Our revenues increased, and our gross margins held in at 21%, and we did generate a higher operating profit in Q3 versus Q2. Ton ship, we're up 9% versus Q2, which is actually better than the industry data that we have seen, so we continue to make inroads in terms of gaining market share. Price realizations were down 3% in Q3 versus Q2 of this year. As I mentioned earlier, there is a lag effect in terms of steel price increases, and we expect that to be realized as we move into Q4. In energy, the market conditions, revenues, operating profit improved versus Q2, but remain challenged versus historical levels. As I mentioned earlier, the focus is on inventory and cost containment generally, with an emphasis on downsizing the line pipe OCTG part of that business.
In the quarter, the field stores realized an CAD 8 million profit, whereas the OCTG line pipe loss was CAD 6 million. We are starting to see improvements in the pipe pricing part of that business into the early stages of Q4, which is helpful as we move that inventory in a prudent and thoughtful manner. Our distribution had very comparable results in Q3 versus Q2. If we go to page eight, we have segmented inventory information to provide a frame of reference for some of our recent capital allocation shifts. If you look at our segmented inventories, they've declined from CAD 884 million at the end of the year to CAD 790 million at the end of September or a CAD 94 million reduction. The biggest portion of this decline is in the energy, generally in OCTG line pipe in particular.
As we continue to adjust our portfolio composition going forward, I expect to continue the shift in the coming quarters. In terms of outlook, let me just give a couple of summary observations. One, the market is better today than it was three months ago, with the early signs in Q4 more promising. That said, we often do see some seasonal slowdown as we get to the latter part of the quarter, given the Christmas and year-end period and fewer operating days at that point in time. Secondly, and perhaps more importantly, we have a lot of flexibility built into our business model, as well as the enhanced flexibility in our capital structure. Therefore, we're really well-positioned to adapt to the economy as well as take advantage of opportunities.
In closing, on behalf of John and other members of the management team, I'd like to express our appreciation to everyone within the Russel family for their tremendously hard work and nice accomplishments over the course of the past quarter. That concludes my introductory remarks. Chris, if you can open the line now to any questions, that would be great.
Thank you. Ladies and gentlemen, we will now begin the question-and-answer session. Should you have a question, please press star followed by one on your touchtone phone. You will hear a three-tone prompt acknowledging your request and your questions will be pulled in the order they are received. Should you wish to decline from the pulling process, please press star followed by two. If you are using a speaker phone, please lift your handset before pressing any key. Your first question comes from Mona Nazir, Laurentian Bank. Mona, please go ahead.
Good morning, and thank you for taking my questions. Just firstly here, we're seeing some sequential improvement revenue contraction in kind of the high 20% range versus 37% in the prior period. In your outlook commentary, you've stated that you're seeing some improvement, particularly in the latter part of Q3, that may not be fully depicted in quarterly results. I'm just wondering if you could speak about revenue contraction exit rates or where things are sitting currently. Thank you.
Sure, Mona. Hey. Yeah. Your comment about exit rates, I think that probably the best way to characterize that is particularly on the service center side of it. We saw, within the third quarter, progression during the quarter. Said another way, the September activity was actually at a higher volume than we saw for the Q3 average. Generally speaking, we saw August was higher than July, September was higher than August, and September, by definition, then was higher than the Q3 average. In fact, when we look at September of this year, our volumes were very similar to September of last year. Notwithstanding in a whole bunch of noise and a whole bunch of moving pieces, our exit rate coming out of the quarter using September as a benchmark was quite nice.
We are starting to see some of the data points for fourth quarter continuing on with that same path. We've never had a view that this is going to be a step function change in terms of economic recovery, but the way we've been characterizing it is a slow and gradual recovery, and we've seen that through Q3, and we're starting to see it in the early signs of Q4 as well.
Thank you. Your next question comes from Michael Doumet, Scotiabank. Michael, please go ahead.
Hey, good morning, Marty. Good morning, John.
Hey, Mike.
Hey. Just started on the MSC margins. I guess were it not for the CEWS of CAD 20 million in the quarter, I'm assuming there would have been alternate cost action. I'm just trying to get a sense for or maybe a little bit more clarity on the underlying margin performance. I guess maybe another way to ask is, as we go into Q4, with steel prices up and volumes improving, could we expect MSC EBIT margins to fall within the more typical 5%-6% range, let's say, excluding CEWS?
Let me give a couple of data points to break that down before I give you the answer. When we talk about the little less than CAD 20 million in the wage subsidies for the quarter, that was across all of our businesses. Probably about CAD 14 million-CAD 15 million of that is related to the service center part of the business. If you want some segmented constructs, that gives you an order of magnitude. That being said, there are a bunch of moving pieces, though. That is a piece that is migrating down, but it's at the same time that other things are migrating in a different direction. Volume is picking up, pricing is picking up, margins are picking up, which is why we tend not to look at an individual data point in isolation. We look at it kind of holistically. Directionally, you're right.
If you just took that line item out and assumed everything else being equal, the margins would come down. We're actually looking at it where there's other things that are mitigating effects going the other direction.
Got you. No, that's helpful. Then maybe into Q4, just a little bit of a sense just with the moving parts that we have to consider. Typically, when steel prices have moved up as much as they have, the volumes, given your comments around September, just to push you a little bit harder, should we get margins sort of go back to the normal weight in the next quarter, or do we have to wait a little bit into 2021 to see that happen?
Michael, I think we're moving back that direction pretty quickly back to normal margins, actually improved gross margins in the service centers due to our value-add process. I think you'll see that in the quarter. The demand is improving. If you use a steel mill production rate as a proxy, they went from 60% - 70%. I think that you're seeing the broader industry move in a similar fashion. We are seeing margin improvement. We are seeing steel prices increase. As Marty said earlier, as we've talked on previous calls, you're aware that Canada's a slower turn inventory just because of the logistical challenges to get product into Canada from the United States or from others. It's about a four-turn inventory, so that lag really hit us late September. We're starting to see those margin improvements now.
Again, we turn quicker than our competition in both the U.S. and in Canada. We'll work through that, but we are definitely seeing those improvements. I think you can use a normal gross margin % and a more similar bottom-line margin percentage for Q4.
That's great. Thanks, guys. No, I appreciate it. Maybe just turning to the energy business or just the OCTG. You've done a great job there drawing down capital. Martin, and to your comments, there's more to go. I guess this is a bigger picture question. Do you think you can reinvest the capital back into the business and maintain the company's overall earnings power? If you look back to the last cycle, call it 2015 - 2018, operating income averaged about CAD 200 million. Do you think you can reallocate that capital and maintain those profit levels or near those profit levels through the next cycle?
Yeah, I think so. If you look at that cycle in 2018, OCTG and line pipe were a large contributor. Their returns were subpar compared to the rest of our business when we looked across all segments of our business. We think we can, through our value-added processing potential acquisitions, we think we can reallocate that into a position for us that's going to put us in an improved return for our shareholders.
Right. And if I can just-- Go ahead, Mike.
Sorry, just the related point, too, that I'd say is, it's also going to reduce the volatility. There's some nice highs, but there's some lows as well. If we look at the last couple of quarters, that part of the business was generating negative operating profits. It's reallocating capital in a way that can not only sustain our mid-cycle earnings power, but also reduce some of the volatility along the way.
That's a great point. That was the good segue, I guess, to the last question I wanted to sneak in here. Just on the pipeline and the OCTG operating losses in the quarter, any sense whether higher steel prices or maybe reduced industry inventories are starting to alleviate some of the margin pressure into Q4? Should we expect continued losses the next couple of quarters for that category, at least until you guys have sold down your inventories to a desired level?
There's two dynamics going on there. We are getting inventories down. However, the industry as a whole is still overstocked just due to the level of fall that you're seeing. Again, the rig counts at 296 in the U.S. and 86 in Canada as of last Friday. Those are still extremely low numbers for the U.S., although they're better in Canada than it's been in 2015 and 2009 during the fall. The other is pricing is improving. As you're seeing flat-rolled pricing, plate pricing go up, that's the substrate that makes the pipe. As there's starting to be replacement and replenishment from North American mills, that should drive the price up. We'll work through the inventory, I think, probably through Q4 as an industry, maybe lag into Q1 as an industry as a whole in OCTG and line pipe distribution.
I'm optimistic that we're going to see price increases. We're seeing worldwide flat-rolled and plate increase as well. That will start to lift the pricing. I think we should start to come out of that as we continue on our path to exit some of that business. I think it gives us a better path to do that in a more profitable fashion.
Got you. All right, guys. Thanks a lot for the answers. Appreciate it.
Thanks, Mike.
Thank you. Your next question comes from Mark Stuebing, TD Securities. Mark, please go ahead.
Hey, good morning. It's Mark on the line here for Michael. You talked about seeing a gradual but uneven recovery across Russel's segments. Just for the service center segment in particular, just wondering if you can provide some commentary on what sort of trends you're seeing across your different end markets and regions.
Yep. Construction has held up relatively well throughout this entire COVID-19 pandemic, and it continues to hold up well. We're seeing some manufacturing is starting to return gradually. Again, as I mentioned earlier, it's in line with GDP starting to come back as well. We're seeing gradual improvement. Heavy equipment has shown some signs of life in North America that we weren't anticipating, so that's been helpful. Obviously, wind towers, solar panels have picked up. We do participate in those markets, although on a limited basis just due to geography, but we do participate in some of those markets. We're starting to see people coming back to work in mid-third quarter, where we saw just general manufacturing coming back. Bus manufacturers are coming back to work and getting started.
Again, we think that'll continue forward barring any other shutdowns or anything out there from the government, that we think we'll continue to see that just climb forward as people really resurge into work right now.
Great. That's great color. Thank you. Can you talk a little bit about the electric steel prices? Obviously, we've seen a pretty strong increase in hot rolled coil, and plate has also followed. Are you able to comment at all on your expectations for pricing over the coming months and also into 2021?
Again, the steel prices jumped significantly. You've seen in the last six to eight weeks coil prices jump CAD 200-CAD 250 a ton. You've seen plate increase, not as much, but increase. Part of that is due to demand is improving. Again, we're still at 70% mill utilization, which typically you would see pricing power around 80%. They are booked well into right now, the steel mills, through December. For the most part, you could maybe find a little bit of steel now, but for the most part, they're booked up through the rest of the year. Scrap prices, which again, are the main input for steel mills, continues to be strong. It looks like they'll either be sideways or up for November. Historically, they go down in November. Again, that's going back to demand kicking back up, so there's more demand for that product.
I think we're good going into first quarter. From there, we'll just have to see how things progress.
Okay, great. I guess lastly from me, you continue to make some progress in bringing inventory down in energy products. You also closed several locations related to the realignment underway. I was wondering if you could talk about how far you are into this realignment and how much more action we can expect to see over the coming quarters.
Yeah. We closed two pipe yards that were smaller yards for us. We also closed a handful of the energy field stores where we just had people shut-in wells and they're not working. Again, that's a nice low-risk business. It's got a very small lease, typically one to two-year lease in a 5,000 - 10,000 sq ft facility, so we can just move inventory around. We've closed some of those, but those wells pick back up, and we can move back into the area. I think there'll be continued closures there, and we'll see in the limited three, maybe three more stores in the U.S., maybe one or two in Canada in Q4. We'll continue, though, to push on the OCTG and line pipe to bring that inventory down. Our goal is to get that down over 12- 18 month period, CAD 100 million.
Initial period, we got it down CAD 31 million, and we'll continue on that target to get that down CAD 100 million over the next 12 - 18 months in OCTG line pipe inventory.
Great. Thanks for your time, guys.
Thanks, Martin.
Thank you. Your next question comes from Felicia [Struther] at Raymond James. Felicia, please go ahead.
Good morning. I'm just wondering if you can provide some commentary on how you're viewing M&A in this environment?
Yeah, we've seen a lot of activity in M&A. We've seen a lot of things come across. Obviously, our focus is service centers, U.S. being first, Canada being second. Canada, with our larger footprint, it would need to be either a niche market that we're not in or a very strategic bolt-on type of acquisition that would make a lot of sense for us. We are seeing, though, a lot of activity there. We have seen activity in the OCTG and line pipe that we've elected to pass as we're trying to shrink our footprint there. Again, I think the activity is fairly robust right now.
Great. Thank you. That's all I have.
Great. Thanks, Felicia.
Thank you. Your next question comes from Mona Nazir, Laurentian Bank. Mona, please go ahead.
Hi. Sorry, just a follow-up in regards to the M&A. It may be early days as you're starting to see a recovery in the end market, and you're progressing with a plan to reduce your energy footprint. I'm just wondering if you could speak about the pipeline of potential targets, and have you seen potential targets come up on the back of current COVID-19 challenges, and just potential timing of such?
Yeah. We're seeing potential acquisitions, as I was saying to Felicia there, in both service centers and in energy. Our focus is on the service centers. Some of it may be COVID-related, but I think it's more of a timing issue in the service centers, where there are a lot of private service centers, third, fourth, fifth generation, that were looking to exit. I think they've been considering this for two or three years, maybe longer. They're just going through that timing. We've seen from small to medium-sized service centers out there right now. Again, we're very diligent and disciplined in our process as we go through looking at acquisitions, and we're looking for things that make the right fit for us, either geographically, obviously, culturally is number one for us, that it fits.
Typically, we like well-run businesses, but we will occasionally go in and try to improve a business, but we typically like to buy well-run businesses.
Thank you. Just a clarification, the targets really haven't changed much on the back of COVID. Would that be correct?
That's right.
Okay. Just secondly, you received CAD 39 million in government subsidies for the period of March - September. I appreciate your kind of quarterly breakdown for CAD 20 million for the period. I'm just wondering if you've been able to tally COVID-19-related costs incurred year-to-date and have it on a quarter-by-quarter basis or even if it's similar to the amounts that you have received. Thanks.
Yeah, it's something that's difficult to quantify. We definitely have some COVID-related expenses where we can go through with things we've implemented, either via, obviously, the PPE that we've done, the social distancing protocols we've put in, and the plastic guards and the things that protect us in the field, the additional staffing that we've had to bring into play just for COVID and to deal with COVID, the expense of medical, and the testing that we've done for our employees. Those things can be quantified. It's the difficulties that are hard to quantify and what it's done to the business and the effects of where we've had to have multiple people where we would've just had one before. With 141 locations, as decentralized as we are, we're running those location by location. We haven't spent a tremendous amount of time pinning that number down.
Again, it's a substantial number to our operation, but we are seeing that wane as well. We've now got everything in place. We've kind of got our routines down. There will be some continued protocols that have to stay in place to deal with this. Obviously, they'll be helpful during flu season, or at least we hope so. There will be some that stay in place, but I think they'll be more mild as the wage subsidies move down, but there will be a natural offset there.
Perfect. That's very helpful. Thank you.
Thank you.
Thank you. Ladies and gentlemen, as a reminder, should you have a question, please press star one on your touch-tone phone. Your next question comes from Anoop Prihar, GMP. Anoop, please go ahead.
Yeah. Good morning. Marty, most of my questions have been answered. I just have two quick ones. Number one, do you expect to receive wage subsidy relief in Q4 as well?
Yeah. We do. It's a bit of a moving target in terms of the revised government program and what that means. Our expectation is it will come down a fair amount, but the exact precision of it is a bit of a mug's game to guess at this point. If I was to give orders of magnitude, it'd probably be CAD 5 million-CAD 10 million for Q4, somewhere in that zone.
Okay, perfect. My second and final question. Post a quarter, on a net basis, you retired CAD 150 million worth of bonds. Can you give me a sense of that CAD 150 million, how much of that was funded by cash versus your available lines?
Yeah. Well, most of it was from cash. As you can appreciate in this environment, cash is earning virtually zero return. On our September balance sheet, we had about CAD 120 million of cash, and as the actual redemption kicked in, that gives you some order of magnitude. It was mostly cash, a little bit of revolver, and then the balance was basically replacing CAD 150 million worth of notes with a new issue of CAD 150 million of notes at a lower interest rate and a longer maturity. That's where the CAD 8 million of annualized interest expense savings comes from.
Great. Thank you.
Yeah. Thank you.
Thank you. There are no further questions at this time. Please proceed.
Well, thank you, everybody, for paying attention and following us for the quarter. If there's any follow-up questions, feel free to give myself or John a call either this afternoon or anytime. Other than that, we look forward to staying in touch and catching up over the course of the next quarter. Thanks very much.
Thank you. Ladies and gentlemen, this concludes your conference call for today. We thank you for participating and ask that you please disconnect your lines.