Quarterly Report — Form 10-Q — Sect. 13 / 15(d) – SEA’34 Filing Table of Contents
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Stockholders' Equity
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Pronouncements
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40: R54 Leases (Supplemental Balance Sheet Information) HTML 57K
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Securities registered pursuant to Section 12(b) of the Act: None
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes ¨ No þ
(Note: Registrant is
a voluntary filer of reports required to be filed by certain companies under Sections 13 and 15(d) of the Securities Exchange Act of 1934 and has filed all reports that would have been required during the preceding 12 months, had it been subject to such filing requirements.)
Indicate by check mark whether the registrant has submitted electronically every Interactive Data File required to be submitted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit such files). Yes þ No ¨
Indicate by check mark whether the
registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company, or an emerging growth company. See the definitions of “large accelerated filer,”“accelerated filer,”“smaller reporting company,” and “emerging growth company” in Rule 12b-2 of the Exchange Act.
Large accelerated filer
¨
Accelerated filer
¨
Non-accelerated
filer
þ
Smaller reporting company
¨
Emerging growth company
¨
If
an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. ¨
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ¨ No þ
The
accompanying notes are an integral part of these unaudited consolidated financial statements.
6
ALERIS CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
(dollars in millions)
1. BASIS OF PRESENTATION AND RECENT ACCOUNTING PRONOUNCEMENTS
Basis of Presentation
The
accompanying unaudited Consolidated Financial Statements have been prepared in accordance with generally accepted accounting principles in the United States (“GAAP”) for interim financial information. Accordingly, they do not include all of the information and footnotes required by GAAP for complete financial statements. In the opinion of management, all adjustments (consisting of normal recurring accruals) considered necessary for a fair presentation have been included. The operating results for interim periods contained herein are not necessarily indicative of the results that may be expected for any other interim period or for the full year. The accompanying Consolidated Financial Statements include the accounts of Aleris Corporation and all of its subsidiaries (collectively, except where the context otherwise requires, referred to as “Aleris,”“we,”“us,”“our,”“Company” or similar terms). Aleris Corporation is a holding company and currently conducts its business and operations through its direct wholly owned subsidiary, Aleris International, Inc. and its consolidated subsidiaries. Aleris International, Inc. is referred to herein as “Aleris International.”
Recent Accounting Pronouncements
In June 2016, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) 2016-13, Financial Instruments - Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments (“ASU 2016-13”). ASU 2016-13 changes the impairment model for most financial instruments. Current guidance requires the recognition of credit losses based on an incurred loss impairment methodology
that reflects losses once the losses are probable. Under ASU 2016-13, we will be required to use a current expected credit loss model (CECL) that will immediately recognize an estimate of credit losses that are expected to occur over the life of the financial instruments that are in the scope of this update, including trade receivables. The CECL model uses a broader range of reasonable and supportable information in the development of credit loss estimates than our current model. This guidance becomes effective for us on January 1, 2020, including the interim periods in the year. We are currently evaluating the impact that the adoption of this ASU will have on the consolidated financial statements and related disclosures
In February 2016, the FASB issued ASU No. 2016-02, “Leases” (“ASU 2016-02”). This guidance requires lessees to put most leases on their balance
sheets but recognize expense on the income statement in a manner similar to the previous guidance. We adopted ASU 2016-02 on January 1, 2019 using a modified retrospective approach, applying the standard’s transition provisions at the beginning of the period of adoption. ASU 2016-02 provided for certain practical expedients when adopting the guidance. We elected the package of practical expedients allowing us to not reassess (i) whether any expired or existing contracts are, or contain, leases, (ii) the lease classification for any expired or existing leases or (iii) initial direct costs for any expired or existing leases.
Upon adoption, we recorded operating lease right-of-use assets of $10.8, representing the present value of future lease
payments under operating leases with terms of greater than twelve months. We also recorded corresponding operating lease liabilities of $11.5. In addition, the prior capital lease balances of $10.4, $4.0 and $6.2 previously reported in fixed assets, current maturities of long-term debt and long-term debt, respectively, were reclassified into separately classified right-of-use asset and lease obligation accounts. The adoption had no impact on reported net income or loss or retained deficit. See Note 13, “Leases” for additional information.
We
generate substantially all of our revenue from the manufacture and shipment of aluminum products to our customers. Sales, value add and other taxes we collect concurrent with revenue-producing activities are excluded from revenue. Revenue is recognized when obligations under the terms of a contract (as defined by Accounting Standards Codification (“ASC”) 606) with our customer are satisfied, which occurs at a point in time when control of the product transfers to the customer. Control may transfer to the customer at various points in the delivery process. In North America, most revenue is recognized at the point of shipment. In Europe and China, the timing of revenue recognition varies depending on individual customer arrangements, and may include point of shipment, delivery to port, final delivery to customer or another point in the delivery process.
7
ALERIS
CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
(dollars in millions)
Certain contractual arrangements, primarily with customers in our automotive and heat exchanger end-uses, allow for inventory to be held at a customer’s location or in a third-party warehouse with direct customer access. Title does not transfer to the customer on such inventory until the customer has removed the product for consumption. Under such arrangements, management has concluded that control has passed to the customer upon delivery to the customer’s location or the third-party warehouse if the customer has unrestricted access to the product and the Company has the right to invoice that customer
after a specified period of time regardless of whether or not the product has been removed by the customer for production.
The transaction price for our products includes the value of the aluminum in the product plus a conversion fee, or rolling margin, which is the price charged to the customer for conversion of the aluminum raw material to the finished product. Certain customer contracts include volume rebates applied retrospectively to quantities purchased during a specified period. The resulting variable consideration from volume rebates is estimated using the expected value method.
As all customer contracts (as defined by ASC 606) have an original expected duration of less than twelve months, we
have applied the practical expedient to the disclosure of the aggregate amount of the transaction price allocated to remaining performance obligations.
Customer payments are due shortly after completion of the performance obligation, on payment terms that are customary for the industry. As all customer payments are due in less than one year, we have not adjusted revenue for the effects of a significant financing component.
The following table discloses the disaggregated revenue from our contracts with customers by major end-use:
We
occasionally receive advance payments to secure product to be delivered in future periods. These advance payments are recorded as deferred revenue, and revenue is recognized as our performance obligations are satisfied throughout the term of the applicable contract. We may also purchase aluminum on our customer’s behalf, sell the unprocessed aluminum to our customer and then process and ship the material, charging a processing fee at the time of shipment. For these arrangements, a single performance obligation exists, and, as a result, amounts invoiced to our customers for the aluminum purchased on their behalf is recorded as deferred revenue until the aluminum is processed and shipped.
The following table details the deferred revenue for which our performance obligations have not been satisfied:
First
Lien Term Loan due 2023 ("Term Loan Facility"), net of discount and deferred issuance costs of $20.0 and $24.3 at September 30, 2019 and December 31, 2018, respectively
1,066.2
1,070.2
10.75% Senior Secured Junior Priority Notes due 2023 ("2023 Junior Priority Notes"), net of discount and deferred issuance costs of $6.2 and $7.5 at September
30, 2019 and December 31, 2018, respectively
The Exchangeable Notes mature in June of 2020, and have been included in “Current portion of long-term debt” in the Consolidated Balance Sheet as of September 30, 2019.
Restricted
cash
At September 30, 2019 and December 31, 2018, respectively, $6.8 and $7.0 of cash was restricted for payments of the Zhenjiang Term Loans, all of which was included in “Prepaid expenses and other current assets” in the Consolidated Balance Sheet.
5. COMMITMENTS AND CONTINGENCIES
Environmental Proceedings
Our operations are subject to environmental laws and regulations governing air emissions, wastewater discharges, the handling,
storage, disposal and remediation of hazardous substances and wastes and employee health and safety. These laws can impose joint and several liability for releases or threatened releases of hazardous substances upon statutorily defined parties, including us, regardless of fault or the lawfulness of the original activity or disposal. Given the changing nature of environmental legal requirements, we may be required, from time to time, to take environmental control measures at some of our facilities to meet future requirements.
We have been named as a potentially responsible party in certain proceedings initiated pursuant to the Comprehensive Environmental Response, Compensation, and Liability Act and similar state statutes and may be named a potentially responsible party in other similar proceedings in the future. It is not anticipated that the costs incurred in connection with the presently pending proceedings will, individually
or in the aggregate, have a material adverse effect on our financial position, results of operations or cash flows.
10
ALERIS CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
(dollars in millions)
We are performing operations and maintenance at two Superfund sites for matters arising out of past waste disposal activity associated with closed facilities. We are also under orders to perform environmental remediation by agencies in four states and one
non-U.S. country at seven sites.
Our reserves for environmental remediation liabilities totaled $24.5 and $25.6 at September 30, 2019 and December 31, 2018, respectively, and have been classified as “Other long-term liabilities” and “Accrued liabilities” in the Consolidated Balance Sheet. Of the environmental liabilities recorded at September 30, 2019 and December 31, 2018, $11.0
and $11.9, respectively, are subject to indemnification by third parties.
In addition to environmental liabilities, we have recorded asset retirement obligations associated with legal requirements related to the retirement of certain assets. Our total asset retirement obligations were $6.7 and $6.8 at September 30, 2019 and December 31, 2018, respectively. The amounts represent the most probable costs of remedial actions. We estimate the costs related to currently identified remedial actions will be paid out primarily over the next 10 years.
Legal
Proceedings
We are party to routine litigation and proceedings as part of the ordinary course of business and do not believe that the outcome of any existing proceedings would have a material adverse effect on our financial position, results of operations or cash flows. We have established accruals for those loss contingencies, including litigation and environmental contingencies, for which it has been determined that a loss is probable; none of such loss contingencies is material. For those loss contingencies, including litigation and environmental contingencies, which have been determined to be reasonably possible, an estimate of the possible loss or range of loss cannot be determined because the claims, amount claimed, facts or legal status are not sufficiently developed or advanced in order to make such a determination. While we cannot estimate the loss or range of loss at this time, we do not believe that the outcome of
any of these existing proceedings would be material to our financial position, results of operations or cash flows.
6. STOCKHOLDERS’ EQUITY
The following table shows changes in the number of our issued and outstanding shares of common stock:
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
(dollars in millions)
A summary of reclassifications out of accumulated other comprehensive loss for the nine months ended September 30, 2019 is provided below:
Description of reclassifications out of accumulated other comprehensive loss
Amount
reclassified
Amortization of net actuarial losses and prior service costs (recorded in “Other (income) expense, net”)
$
(3.3
)
Deferred tax benefit on pension and other postretirement liability adjustments
0.5
Losses reclassified into earnings, net of tax
$
(2.8
)
8.
SEGMENT INFORMATION
We report three operating segments based on the organizational structure that is used by our chief operating decision maker to evaluate performance, make decisions on resource allocation and for which discrete financial information is available. Our operating segments are North America, Europe and Asia Pacific.
Measurement of Segment Income or Loss and Segment Assets
The accounting policies of the reportable segments are the same as those described in the summary of significant accounting policies in the Consolidated Financial Statements for the year ended December 31, 2018. Our measure of profitability for our operating segments is referred to as segment income. Segment income
includes gross profits, segment specific realized gains and losses on derivative financial instruments, segment specific other income and expense, segment specific selling, general and administrative (“SG&A”) expense and an allocation of certain functional SG&A expenses. Segment income excludes provisions for and benefits from income taxes, restructuring items, interest, depreciation and amortization, unrealized and certain realized gains and losses on derivative financial instruments, corporate general and administrative costs, start-up costs, gains and losses on asset sales, currency exchange gains and losses on debt and certain other gains and losses. Intra-entity sales and transfers are recorded at market value. Consolidated cash, restricted cash, net capitalized debt costs, deferred tax assets and assets related to our headquarters offices are not allocated to the segments.
12
ALERIS
CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
(dollars in millions)
Reportable Segment Information
The following table shows our revenues and segment income for our reportable segments for the periods presented in our Consolidated Statements of Comprehensive Income (Loss):
The
following table reconciles total segment income to “Income (loss) before income taxes” as reported in our Consolidated Statements of Comprehensive Income (Loss):
On June 1, 2010, the Board of Directors of Aleris Corporation approved the Aleris Corporation 2010 Equity Incentive Plan (as amended from time
to time, the “2010 Equity Plan”). Stock options, restricted stock units and restricted shares have been granted under the 2010 Equity Plan to certain members of management of the Company and directors. All stock options granted have a life not to exceed ten years and generally vest over a period not to exceed four years. Shares of common stock are issued upon stock option exercises from available shares of common stock. The restricted stock units also vest over a period not to exceed four years. A portion of the stock options, as well as a portion of the restricted stock units, may vest upon a change in control event should the event occur prior to full vesting of these awards, depending on the amount of vesting that has already occurred at
the time of the event in comparison to the change in our largest stockholders’ overall level of beneficial ownership that results from the event.
During the nine months ended September 30, 2019, no stock options or restricted stock units were granted. We recorded stock-based compensation expense of $3.0 and $5.5 for the three and nine months ended September 30, 2019, respectively, and $2.1 and $2.8 for the three and nine
months ended September 30, 2018, respectively.
10. INCOME TAXES
The effective tax rates for the three and nine months ended September 30, 2019 and 2018 differed from the federal statutory rate applied to income and losses before income taxes primarily as a result of the mix of income, losses and tax rates between tax jurisdictions, valuation allowances and, for the nine months ended September 30,
2019, the results of an examination by a non-U.S. taxing jurisdiction (discussed below).
We have valuation allowances recorded to reduce certain deferred tax assets to amounts that are more likely than not to be realized. The valuation allowances relate to the potential inability to realize our deferred tax assets associated with amortization, net operating losses and interest expense carryforwards in the U.S. and net operating loss carryforwards in non-U.S. jurisdictions. We intend to maintain our valuation allowances until sufficient positive evidence exists (such as cumulative positive earnings and estimated future taxable income) to support their reversal.
As of September 30, 2019, we had $7.2 of unrecognized tax
benefits. $6.3 of the gross unrecognized tax benefits, if recognized, would affect the annual effective tax rate. We recognize interest and penalties related to uncertain tax positions within “Provision for income taxes” in the Consolidated Statements of Comprehensive Income (Loss). As of September 30, 2019, we had approximately $2.2 of accrued interest related to uncertain tax positions.
The 2009 through 2017 tax years remain open to examination. During the fourth quarter of 2013, a non-U.S. taxing jurisdiction commenced an examination of our tax returns for the tax years ended December 31, 2012, 2011,
2010 and 2009. During the third quarter of 2019, the non-U.S. taxing jurisdiction issued its final audit report which included certain significant adjustments to the Company’s transfer pricing tax position resulting in additional tax expense of $3.6 along with additional interest of $1.3. Both amounts were expensed in the nine months ended September 30, 2019. $15.7 of withholding tax associated with the audit was paid in the third quarter of 2019 and is expected to
be refunded within two to six months of the quarter end. At September 30, 2019, $18.8 has been recorded within “Prepaid expenses and other current assets” and $11.1 has been recorded within “Accrued liabilities” on the consolidated balance sheet related to this audit. Payment of the liability is expected to occur in the fourth quarter of 2019. During the third quarter of 2018, the same jurisdiction notified us regarding an examination of our tax returns for the tax years ended December 31, 2016, 2015, 2014 and 2013.
14
ALERIS CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
(dollars in millions)
During the third quarter of 2018, a non-U.S. taxing jurisdiction notified us regarding an examination of our tax returns for the tax years ended December 31, 2016, 2015, 2014 and 2013. This examination was completed in the second quarter with no change.
During
the first quarter of 2019, a non-U.S. taxing jurisdiction notified us regarding an examination of our tax returns for the tax years ended December 31, 2017 and 2016 that is anticipated to be completed within nine months of the reporting date.
11. EMPLOYEE BENEFIT PLANS
Defined Benefit Pension Plans
The service cost component of net periodic benefit expense is included in “Operating income,” while all other components of net periodic benefit expense are included in “Other (income) expense, net” in the Consolidated Statements of Comprehensive Income (Loss). The components
of the net periodic benefit expense are as follows:
The service cost component of net postretirement benefit expense is included in “Operating income,” while all other components of net postretirement benefit expense are included in “Other (income) expense, net” in the Consolidated Statements of Comprehensive Income (Loss). The components of net postretirement benefit expense are as follows:
We use forward contracts, options and swaps, as well as contractual price escalators, to reduce the risks associated with our metal, natural gas and other supply requirements, as well as fuel costs and certain currency and interest rate exposures.
15
ALERIS CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
(dollars in millions)
Generally, we enter into master netting arrangements
with our counterparties and offset net derivative positions with the same counterparties against amounts recognized for the right to reclaim cash collateral or the obligation to return cash collateral under those arrangements in our Consolidated Balance Sheet. For classification purposes, we record the net fair value of each type of derivative position that is expected to settle in less than one year with each counterparty as a net current asset or liability and each type of long-term position as a net long-term asset or liability. As of September 30, 2019, no cash collateral was posted. As of December 31, 2018, $0.2 of cash collateral was posted. The amounts shown in the table below represent
the gross amounts of recognized assets and liabilities, the amounts offset in the Consolidated Balance Sheet and the net amounts of assets and liabilities presented therein. As of September 30, 2019 and December 31, 2018, there were no amounts subject to an enforceable master netting arrangement or similar agreement that have not been offset in the Consolidated Balance Sheet.
Net
derivatives as classified in the balance sheet
$
8.5
$
(9.6
)
$
29.4
$
(7.1
)
The
fair value of our derivative financial instruments at September 30, 2019 and December 31, 2018 are recorded in the Consolidated Balance Sheet as follows:
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
(dollars in millions)
With the exception of the interest rate derivative financial instruments (for which, realized gains are included within “Interest expense, net” in the Consolidated Statements of Operations), both realized and unrealized gains and losses on derivative financial instruments are included within “Gains on derivative financial instruments” in the Consolidated Statements of Comprehensive Income (Loss). Realized (gains) and losses on derivative financial instruments totaled the following:
The
selling prices of the majority of the orders for our products are established at the time of order entry or, for certain customers, under long-term contracts. As the related raw materials used to produce these orders can be purchased several months or years after the selling prices are fixed, margins are subject to the risk of changes in the purchase price of the raw materials used for these fixed price sales. In order to manage this transactional exposure, future, swaps or forward purchase contracts are purchased at the time the selling prices are fixed. As metal is purchased to fill these fixed price sales orders, future, swaps or forward contracts are then sold. We also maintain a significant
amount of inventory on-hand to meet anticipated and unpriced future sales. In order to preserve the value of this inventory, future or forward contracts are sold at the time inventory is purchased. As sales orders are priced, future or forward contracts are purchased. These derivatives generally settle within three months. We can also use call option contracts, which function in a manner similar to the natural gas call option contracts discussed below, and put option contracts
for managing metal price exposures. Option contracts require the payment of a premium which is recorded as a realized loss upon settlement or expiration of the option contract. Upon settlement of a put option contract, we receive cash and recognize a related gain if the closing price is less than the strike price of the put option. If the put option strike price is less than the closing price, no amount is paid and the option expires. As of September 30, 2019 we had 147.1 thousand metric tons and 301.5 thousand
metric tons of metal buy and metal sell derivative contracts, respectively. As of December 31, 2018, we had 165.0 thousand metric tons and 293.0 thousand metric tons of metal buy and metal sell derivative contracts, respectively.
Energy Hedging
To manage our price exposure for natural gas purchases, we fix the future price of a portion of our natural gas requirements by entering into financial hedge agreements. Under these agreements, payments are made or received based on the differential between the monthly closing
price on the New York Mercantile Exchange (“NYMEX”) and the contractual hedge price. We can also use a combination of call option contracts and put option contracts for managing the exposure to increasing natural gas prices while maintaining our ability to benefit from declining prices. Upon settlement of call option contracts, we receive cash and recognize a related gain if the NYMEX closing price exceeds the strike price of the call option. If the call option strike price exceeds the NYMEX closing price, no amount is received and the option expires unexercised. Upon settlement of a put option contract,
we pay cash and recognize a related loss if the NYMEX closing price is lower than the strike price of the put option. If the put option strike price is less than the NYMEX closing price, no amount is paid and the option expires unexercised. Option contracts require the payment of a premium which is recorded as a realized loss upon settlement or expiration of the option contract. Natural gas cost can also be managed through the use of cost escalators included in some of our long-term supply contracts with customers, which limits exposure to natural gas price risk. As of September 30, 2019 and December 31,
2018, we had 3.7 trillion and 4.6 trillion of British thermal unit forward buy contracts, respectively.
We use independent freight carriers to deliver our products. As part of the total freight charge, these carriers include a per mile diesel surcharge based on the Department of Energy, Energy Information Administration’s (“DOE”) Weekly Retail Automotive Diesel National Average Price. From time to time we may enter into over-the-counter DOE diesel fuel swaps with financial counterparties to mitigate the impact of the volatility of diesel fuel prices on our freight costs. Under these swap agreements, we pay a fixed price per gallon of diesel fuel determined at the time the agreements were executed and receive
a floating rate payment that is determined on a monthly basis based on the average price of the DOE Diesel Fuel Index during the
17
ALERIS CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
(dollars in millions)
applicable month. The swaps are designed to offset increases or decreases in fuel surcharges that we pay to our carriers. All swaps are financially settled. There is no possibility of physical settlement. As of September 30, 2019 and December 31,
2018, we had 2.6 million gallons and 4.3 million gallons of diesel fuel swap contracts, respectively.
Interest Rate Risk
We are exposed to variable interest rate risk on the Term Loan Facility. We entered into interest rate swaps to fix the LIBOR interest rate on $700.0 of the Term Loan Facility for the period of October 31, 2018 through June 28, 2019. As of September 30, 2019, we had no interest
rate swaps outstanding.
Currency Hedging
Our aerospace and heat exchanger businesses expose the operating results of our European and Asia Pacific operations to fluctuations in the euro and renminbi as the sales contracts are generally in U.S. dollars while the costs of production are in the local currency. In order to mitigate the risk that fluctuations in currencies may have on our business, we have entered into forward currency contracts. As of September 30, 2019 and December 31, 2018, we had euro forward
contracts covering a notional amount of €67.1 million and €77.6 million, respectively.
Credit Risk
We are exposed to losses in the event of non-performance by the counterparties to the derivative financial instruments discussed above; however, we do not anticipate any non-performance by the counterparties. The counterparties are evaluated for creditworthiness and risk assessment prior to initiating trading activities with the brokers and periodically throughout each year while actively trading.
Recurring Fair Value Measurements
Derivative contracts
are recorded at fair value using quoted market prices and significant other observable inputs. Fair value is defined by ASC 820, “Fair Value Measurements and Disclosures,” as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. The fair value hierarchy distinguishes between (1) market participant assumptions developed based on market data obtained from independent sources (observable inputs) and (2) an entity’s own assumptions about market participant assumptions developed based on the best information available in the circumstances (unobservable inputs). The fair value hierarchy consists of three broad levels, which gives the highest priority to unadjusted quoted prices in active markets for identical assets or liabilities (Level 1) and the lowest priority to unobservable inputs (Level 3). The three levels of the fair value hierarchy are described below:
Level 1—Unadjusted quoted prices in active markets that are accessible at the measurement date for identical, unrestricted assets or liabilities.
Level 2—Inputs other than quoted prices included within Level 1 that are observable for the asset or liability, either directly or indirectly, including quoted prices for similar assets or liabilities in active markets; quoted prices for identical or similar assets or liabilities in markets that are not active; inputs other than quoted prices that are observable for the asset or liability (e.g., interest rates); and inputs that are derived principally from or corroborated by observable market data by correlation or other means.
Level 3—Inputs that are both significant to the fair value measurement and unobservable.
We endeavor to use the best available
information in measuring fair value. Where appropriate, valuations are adjusted for various factors such as liquidity, bid/offer spreads, and credit considerations. Such adjustments are generally based on available market evidence and unobservable inputs. Financial assets and liabilities are classified in their entirety based on the lowest level of input that is significant to the fair value measurement. As of September 30, 2019 and December 31, 2018, all of our derivative assets and liabilities represent Level 2 fair value measurements.
18
ALERIS CORPORATION
NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
(dollars in millions)
Other Financial Instruments
The carrying amount, fair values and level in the fair value hierarchy of our other financial instruments at September 30, 2019 and December 31, 2018 are as follows:
The principal amount of the ABL Facility approximates fair value because the interest rate paid is variable and there have been no significant changes in the credit risk of Aleris International subsequent to the borrowings. The fair values of the Term Loan Facility and the 2023 Junior Priority Notes were estimated using market quotations. The fair value of Aleris International’s Exchangeable Notes was estimated using a binomial lattice pricing model based on the fair value of our common stock, a risk-free interest rate of 1.9% and 2.6% as of September 30, 2019 and December 31, 2018, respectively, and expected equity
volatility of 65% and 60% as of September 30, 2019 and December 31, 2018, respectively. Expected equity volatility was determined based on historical stock prices and implied and stated volatilities of our peer companies. The principal amount of the Zhenjiang Term Loans approximates fair value because the interest rate paid is variable, is set for periods of six months or less and there have been no significant changes in the credit risk of Aleris Zhenjiang subsequent to the inception of the Zhenjiang Term Loans.
13.
LEASES
We have leases for office space, warehousing, vehicles, mobile equipment and certain other equipment in our production facilities. Certain of these lease agreements provide rights to extend or terminate the contract which have been evaluated in estimating the lease term. Most of our lease contracts do not provide a readily determinable implicit rate. For these contracts, our estimated incremental borrowing rate is based on information available at the inception of the lease.
Leases with an initial term of twelve months or less are not recorded on the Consolidated Balance Sheet. Lease expense for these
leases is recognized on a straight-line basis over the term of the lease.
(a) Operating and finance lease right-of-use assets are included in “Other long-term assets” in the Consolidated Balance Sheet. Current
operating and finance lease obligations are included in “Accrued liabilities” in the Consolidated Balance Sheet. Long-term operating and finance lease obligations are included in “Other long-term liabilities” in the Consolidated Balance Sheet.
20
ALERIS CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
On July 26, 2018, we announced that we entered into a definitive agreement (the “Merger Agreement”) to be acquired by Novelis Inc., a subsidiary of Hindalco Industries Limited, for approximately $2,600.0, including the assumption of the Company’s outstanding indebtedness (the “Merger”). The Merger is expected to close by January 21, 2020, the outside date in the Merger Agreement, subject to customary regulatory approvals and closing conditions. There can be no assurance that the Merger will be consummated on the expected timing or at all.
15.
CONDENSED CONSOLIDATING FINANCIAL STATEMENTS
Aleris Corporation, the direct parent of Aleris International, and Aleris International’s domestic restricted subsidiaries that guarantee Aleris International’s existing obligation under the Term Loan Facility and the ABL Facility are guarantors of the indebtedness under the 2023 Junior Priority Notes (the “Guarantor Subsidiaries”). Aleris Corporation and each of the Guarantor Subsidiaries have fully and unconditionally guaranteed (subject, in the case of the Guarantor Subsidiaries, to customary release provisions
as described below), on a joint and several basis, to pay principal and interest related to the 2023 Junior Priority Notes and Aleris International and each of the Guarantor Subsidiaries are directly or indirectly 100% owned subsidiaries of Aleris Corporation. For purposes of complying with the reporting requirements of Aleris International and the Guarantor Subsidiaries, presented below are condensed consolidating financial statements of Aleris Corporation, Aleris International, the Guarantor Subsidiaries, and those other subsidiaries
of Aleris Corporation that are not guaranteeing the indebtedness under the 2023 Junior Priority Notes (the “Non-Guarantor Subsidiaries”). The condensed consolidating balance sheets are presented as of September 30, 2019 and December 31, 2018. The condensed consolidating statements of comprehensive income (loss) are presented for the three and nine months ended September 30, 2019 and 2018. The condensed consolidating statements of cash flows are presented
for the nine months ended September 30, 2019 and 2018.
The guarantee of a Guarantor Subsidiary will be automatically and unconditionally released and discharged under the indenture governing the 2023 Junior Priority Notes in the event of:
▪
any sale of the Guarantor Subsidiary or of all or substantially all of its assets;
▪
a
Guarantor Subsidiary being designated as an “unrestricted subsidiary” in accordance with the indenture governing the 2023 Junior Priority Notes;
▪
the release or discharge of a Guarantor Subsidiary from its guarantee under the Term Loan Facility, the ABL Facility or other indebtedness that resulted in the obligation of the Guarantor Subsidiary under the indenture governing the 2023 Junior Priority Notes; and
▪
the
requirements for legal defeasance or covenant defeasance or discharge of the indenture governing the 2023 Junior Priority Notes having been satisfied.
21
ALERIS CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
Proceeds
from senior secured notes, net of discount
—
1,483.0
—
—
—
1,483.0
Payments
on senior notes, including premiums
—
(1,289.5
)
—
—
—
(1,289.5
)
Payments
on other long-term debt
—
—
(0.9
)
(7.7
)
—
(8.6
)
Debt
issuance costs
—
(19.5
)
—
(0.9
)
—
(20.4
)
Proceeds
from intercompany loans
—
25.4
—
—
(25.4
)
—
Repayments
on intercompany loans
—
(39.5
)
—
—
39.5
—
Proceeds
from intercompany equity contributions
—
—
13.7
10.0
(23.7
)
—
Dividends
paid
—
—
(2.0
)
(40.0
)
42.0
—
Other
(0.2
)
—
0.7
(0.7
)
—
(0.2
)
Net
cash (used) provided by financing activities
(0.2
)
79.9
11.5
(23.4
)
32.4
100.2
Effect
of exchange rate differences on cash, cash equivalents and restricted cash
—
—
—
(1.9
)
—
(1.9
)
Net
decrease in cash, cash equivalents and restricted cash
—
(36.1
)
—
(9.8
)
(0.1
)
(46.0
)
Cash,
cash equivalents and restricted cash at beginning of period
—
40.3
—
69.9
(2.2
)
108.0
Cash,
cash equivalents and restricted cash at end of period
$
—
$
4.2
$
—
$
60.1
$
(2.3
)
$
62.0
Cash
and cash equivalents
$
—
$
4.2
$
—
$
54.8
$
(2.3
)
56.7
Restricted
cash (included in “Other current assets”)
—
—
—
5.3
—
5.3
Cash,
cash equivalents and restricted cash
$
—
$
4.2
$
—
$
60.1
$
(2.3
)
$
62.0
27
Item 2.
Management’s Discussion and Analysis of Financial Condition and Results of Operations.
The following Management’s Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”) is intended to help you understand our operations as well as the industry
in which we operate. Our MD&A is designed to provide a narrative from the perspective of our management on our financial condition, results of operations, liquidity and certain other factors that may affect our future results.
Basis of Presentation
The financial information included in this quarterly report on Form 10-Q represents our consolidated financial position as of September 30, 2019 and December 31, 2018, our consolidated results of operations for the three and nine months ended September 30, 2019 and 2018
and our consolidated cash flows for the nine months ended September 30, 2019 and 2018.
Our MD&A includes the following sections:
▪
Our Business - a general description of our operations, our critical measures of financial performance, our segments, and the aluminum industry;
▪
Seasonality
and Management Outlook - a brief discussion of the material trends and uncertainties that may impact our business in the future;
▪
Results of Operations - an analysis and discussion of our consolidated and segment operating results for the three and nine months ended September 30, 2019 and 2018 presented in our unaudited consolidated financial statements;
▪
Liquidity
and Capital Resources - an analysis and discussion of our cash flows for the nine months ended September 30, 2019 and 2018, as well as a brief discussion of our current sources of capital;
▪
Non-GAAP Financial Measures - an analysis and discussion of key financial performance measures, including EBITDA, Adjusted EBITDA and commercial margin (all defined below), as well as reconciliations to the applicable generally accepted accounting principles in the United States (“GAAP”) performance measures;
▪
Critical
Accounting Policies and Estimates - a discussion of the accounting policies that require us to make estimates and judgments; and
▪
Off-Balance Sheet Transactions.
This discussion should be read in conjunction with our unaudited consolidated financial statements and notes included elsewhere in this report. The discussions of our financial condition and results of operations also include various forward-looking statements about our industry, the demand for our products and services and our projected results. These statements are based on certain assumptions that we consider reasonable. Our actual results could differ materially from those discussed in these forward-looking statements.
Factors that could cause or contribute to these differences include, but are not limited to, those discussed below, particularly under the caption “–Forward-Looking Statements.”
Potential Acquisition of Aleris Corporation
On July 26, 2018, we announced that we entered into a definitive agreement (the “Merger Agreement”) to be acquired by Novelis Inc., a subsidiary of Hindalco Industries Limited, for approximately $2,600.0 million, including the assumption of the Company’s outstanding indebtedness (the “Merger”). The Merger is expected to close by January 21, 2020, the outside date in the Merger Agreement, subject to customary regulatory
approvals and closing conditions. There can be no assurance that the Merger will be consummated on the expected timing or at all. See the Company’s Current Report on Form 8-K filed on July 27, 2018 for a more detailed discussion of the Merger Agreement and the transactions contemplated thereby, including the Merger.
Our Business
We are a global leader in the manufacture and sale of aluminum rolled products, with 13 production facilities located throughout North America, Europe and China. Our product portfolio ranges from the most technically demanding heat treated
28
plate
and sheet used in mission-critical applications to sheet produced through our low-cost continuous cast process. We possess a combination of technically advanced, flexible and low-cost manufacturing operations supported by an industry-leading research and development (“R&D”) platform. Our facilities are strategically located to serve our customers globally. Our diversified customer base includes a number of industry-leading companies in the aerospace, automotive, truck trailer and building and construction end-uses. Our technological and R&D capabilities allow us to produce the most technically demanding products, many of which require close collaboration and, in some cases, joint development with our customers.
London Metal Exchange (“LME”) aluminum prices and regional premium differentials (referred to as “Midwest Premium” in the U.S. and “Rotterdam Premium” in Europe) serve as the pricing
mechanisms for both the aluminum we purchase and the products we sell. In addition, we depend on scrap for our operations, which is typically priced in relation to prevailing LME prices, but may also be priced at a discount to LME aluminum (depending upon the quality of the material supplied). Aluminum and other metal costs represented approximately 66% of our costs of sales for the nine months ended September 30, 2019. Aluminum prices are determined by worldwide forces of supply and demand and, as a result, aluminum prices are volatile. Average LME aluminum prices per ton for the three months ended September 30, 2019 and 2018
were $1,761 and $2,056, respectively, which represents a decrease of approximately 14%. Average LME aluminum prices per ton for the nine months ended September 30, 2019 and 2018 were $1,804 and $2,158, respectively, which represents a decrease of approximately 16%. As our invoiced prices are, in most cases, established months prior to physical delivery, the impact of aluminum
price changes on our revenues may not correspond to LME and regional premium price changes for the applicable period.
Our business model strives to reduce the impact of aluminum price fluctuations on our financial results and protect and stabilize our margins, principally through pass-through pricing (market-based aluminum price plus a conversion fee) and derivative financial instruments.
As a result of using LME aluminum prices and regional premium differentials to both buy our raw materials and to sell our products, we are able to pass through aluminum price changes in the majority of our commercial transactions. Consequently, while our revenues can fluctuate significantly as aluminum prices change, we would expect the impact of these price changes on our profitability to be less significant. Approximately 93% of our sales for the year
ended December 31, 2018 were generated from aluminum pass-through arrangements. In addition to using LME prices and regional premiums to establish our invoice prices to customers, we use derivative financial instruments to further reduce the impacts of changing aluminum prices. Derivative financial instruments are entered into at the time fixed prices are established for aluminum purchases or sales, on a net basis, and allow us to fix the margin to be realized on our long-term contracts and on short-term contracts where selling prices are not established at the same time as the physical purchase price of aluminum. However, as we have elected not to account for our derivative financial instruments
as hedges for accounting purposes, changes in the fair value of our derivative financial instruments are included in our results of operations immediately. These changes in fair value (referred to as “unrealized gains and losses”) can have a significant impact on our pre-tax income in the same way LME aluminum and regional premium prices can have a significant impact on our revenues. In assessing the performance of our operating segments, we exclude these unrealized gains and losses, electing to include them only at the time of settlement to better match the period in which the underlying physical purchases and sales affect earnings.
Although our business model strives to reduce the impact of aluminum price fluctuations on our financial results, it cannot eliminate the impact completely. For example, at times the profitability of our North America segment is impacted by changes in scrap aluminum prices whose movement
may not be correlated to movements in LME prices. Furthermore, certain segments are exposed to variability in the previously mentioned regional premium differentials charged by industry participants to deliver aluminum from the smelter to the manufacturing facility. This premium differential fluctuates in relation to several conditions, including the extent of warehouse financing transactions, which limit the amount of physical metal flowing to consumers and increases the price differential as a result. In addition to impacting the price we pay for the raw materials we purchase, our customers may be reluctant to place orders with us during times of uncertainty in the pricing of the Midwest Premium or Rotterdam Premium.
For additional information on the key factors impacting our profitability, see “–Critical Measures of Our Financial Performance” and “–Our Segments,” below.
Critical
Measures of Our Financial Performance
The financial performance of our operating segments is the result of several factors, the most critical of which are as follows:
▪
volumes;
29
▪
commercial margins; and
▪
cash
conversion costs.
The financial performance of our business is determined, in part, by the volume of metric tons shipped and processed. Increased production volume will result in lower per unit costs, while higher shipped volumes will result in additional revenue and associated margins. As a significant component of our revenue is derived from aluminum prices that we generally pass through to our customers, we measure the performance of our segments based upon a percentage of commercial margin and commercial margin per ton in addition to a percentage of revenue and revenue per ton. Commercial margin removes the hedged cost of the metal we purchase and metal price lag (defined below) from our revenue. Commercial margins capture the value-added components of our business and are impacted by factors, including rolling margins (the fee we charge to convert aluminum), product yields from our manufacturing process,
the value-added mix of products sold and scrap spreads, which management are able to influence more readily than aluminum prices and, therefore, provide another basis upon which certain elements of our segments’ performance can be measured.
Although our conversion fee-based pricing model is designed to reduce the impact of changing primary aluminum prices, we remain susceptible to the impact of these changes and changes in regional premium differentials on our operating results. This exposure exists because of changes in metal prices during the period of time between the pricing of our metal purchases, the holding and processing of the metal, and the pricing of the finished product for sale to our customer. As we typically purchase metal prior to having a fixed selling price, and value our inventories under the first-in, first-out method, this lag will, generally, increase our earnings in times of rising aluminum prices and
decrease our earnings in times of declining aluminum prices.
Our exposure to changing primary aluminum prices and premium differentials, both in terms of liquidity and operating results, is greater for fixed price sales contracts and other sales contracts where aluminum price changes are not able to be passed along to our customers. In addition, our operations require that a significant amount of inventory be kept on hand to meet future production requirements. This base level of inventory is also susceptible to changing primary aluminum prices and regional premium differentials to the extent it is not committed to fixed price sales orders.
In order to reduce these exposures, we focus on reducing working
capital and offsetting future physical purchases and sales. We also use various derivative financial instruments designed to reduce the impact of changing primary aluminum prices on these net physical purchases and sales and on inventory for which a fixed sale price has not yet been determined. Our risk management practices reduce but do not eliminate our exposure to changing primary aluminum prices. In addition, exchanges have only recently begun to offer derivative financial instruments to hedge premium differentials. These markets are becoming more liquid and we are beginning to use these markets in our risk management practices. At this time, however, derivative financial instruments are not available to effectively hedge against changing scrap prices. While we have limited our exposure to unfavorable aluminum price changes, we have also limited our ability to benefit from favorable price changes. Further, our counterparties may require that we post cash collateral
if the fair value of our derivative liabilities exceed the amount of credit granted by each counterparty, thereby reducing our liquidity. At September 30, 2019, no cash collateral was posted. At December 31, 2018, $0.2 million of cash collateral was posted.
We refer to the estimated difference between the price of aluminum included in our revenues and the price of aluminum impacting our cost of sales, net of realized gains and losses from our hedging activities, as “metal price lag.” The aluminum price used in the metal price lag calculation for all segments includes the regional premium. Metal price lag will, generally, increase our earnings
and net income and loss before interest, taxes and depreciation and amortization (“EBITDA”) in times of rising aluminum prices and decrease our earnings and EBITDA in times of declining aluminum prices. We seek to reduce this impact through the use of derivative financial instruments. We exclude metal price lag from our determination of Adjusted EBITDA because it is not an indicator of the performance of our underlying operations. We also exclude the impact of metal price lag from our measurement of commercial margin to more closely align the metal prices inherent in our sales prices to those included in our cost of sales.
In addition to rolling margins and product mix, commercial margins are impacted by the differences between changes in the prices of primary and scrap aluminum, as well as the availability of scrap aluminum, particularly in our North America segment where aluminum scrap is used more frequently than
in our European and Asia Pacific operations. As we price our product using the prevailing price of primary aluminum but purchase large amounts of scrap aluminum to produce our products, we benefit when primary aluminum price increases exceed scrap price increases. Conversely, when scrap price increases exceed primary aluminum price increases, our commercial margin will be negatively impacted. The difference between the price of primary aluminum and scrap prices is referred to as the “scrap spread” and is impacted by the effectiveness of our scrap
30
purchasing activities, the supply of scrap available and movements in the terminal commodity markets, such as the price of aluminum.
Our operations are labor
intensive and also require a significant amount of energy (primarily natural gas and electricity) be consumed to melt scrap or primary aluminum and to re-heat and roll aluminum slabs into rolled products. As a result, we incur a significant amount of fixed and variable labor and overhead costs which we refer to as conversion costs. Conversion costs excluding depreciation expense, or cash conversion costs, on a per ton basis, are a critical measure of the effectiveness of our operations.
Commercial margin, EBITDA and Adjusted EBITDA are non-GAAP financial measures that have limitations as analytical tools and should be considered in addition to, and not in isolation, or as a substitute for, or as superior to, our measures of financial performance prepared in accordance with GAAP. For additional information regarding non-GAAP financial measures, see “–Non-GAAP Financial Measures.”
Our
Segments
We report three operating segments based on the organizational structure that we use to evaluate performance, make decisions on resource allocations and perform business reviews of financial results. The Company’s operating segments (each of which is considered a reportable segment) are North America, Europe and Asia Pacific.
In addition to analyzing our consolidated operating performance based upon revenues and Adjusted EBITDA, we measure the performance of our operating segments using segment income, segment Adjusted EBITDA and commercial margin. Segment income includes gross profits, segment specific realized gains and losses on derivative financial instruments, segment specific other income and expense, segment specific selling, general and administrative (“SG&A”) expenses
and an allocation of certain functional SG&A expenses. Segment income excludes provisions for and benefits from income taxes, restructuring items, interest, depreciation and amortization, unrealized and certain realized gains and losses on derivative financial instruments, corporate general and administrative costs, start-up costs, gains and losses on asset sales, currency exchange gains and losses on debt and certain other gains and losses. Intra-entity sales and transfers are recorded at market value. Consolidated cash, restricted cash, net capitalized debt costs, deferred tax assets and assets related to our headquarters offices are not allocated to the segments.
Segment Adjusted EBITDA eliminates from segment income the impact of metal price lag. Commercial margin represents revenues less the hedged cost of metal, or the raw material costs included in our cost of sales, net of the impact of our hedging activities and
the effects of metal price lag. Segment Adjusted EBITDA and commercial margin are non-GAAP financial measures that have limitations as analytical tools and should be considered in addition to, and not in isolation, or as a substitute for, or as superior to, our measures of financial performance prepared in accordance with GAAP. Management uses segment Adjusted EBITDA in managing and assessing the performance of our business segments and overall business and believes that segment Adjusted EBITDA provides investors and other users of our financial information with additional useful information regarding the ongoing performance of the underlying business activities of our segments, as well as comparisons between our current results and results in prior periods. Management also uses commercial margin as a performance metric and believes that it provides useful information regarding the performance of our segments because it measures the estimated price at which we sell our
aluminum products above the hedged cost of the metal and the effects of metal price lag, thereby reflecting the value-added components of our commercial activities independent of aluminum prices which we cannot control.
For additional information regarding non-GAAP financial measures, see “–Non-GAAP Financial Measures.”
North America
Our North America segment consists of nine manufacturing facilities located throughout the United States that produce rolled aluminum and coated products for the building and construction, automotive, truck trailer, consumer durables, other general industrial and distribution end-uses. Substantially all of our North America segment’s products are manufactured to specific customer requirements, using continuous cast and direct-chill technologies that provide us with significant flexibility to produce
a wide range of products. Specifically, those products are integrated into, among other applications, building products, automobiles, truck trailers, gutters, appliances and recreational vehicles.
We are continuing to implement our previously announced project to add autobody sheet (“ABS”) capabilities at our aluminum rolling mill in Lewisport, Kentucky (the “North America ABS Project”). We have invested approximately $425.0 million to build a new wide cold mill, two continuous annealing lines with pre-treatment (each, a “CALP”) and an automotive innovation center. We have also invested in upgrades to other key equipment at this facility, including upgrading our ingot scalper and pre-heating furnaces and widening the hot mill, to capture additional opportunities. The Lewisport facility has been
31
shipping
ABS and wide non-ABS to customers using the re-engineered hot mill, the new wide cold mill and the first of the two CALPs since the fourth quarter of 2017. We have completed the construction and installation and are obtaining qualifications on the facility’s second CALP, which has begun commercial production on select grades. We believe the investments position us to meet significant growth in demand for ABS in North America as the automotive industry pursues broader aluminum use for the production of lighter, more fuel-efficient vehicles.
In connection with the North America ABS Project, the segment has incurred costs associated with start-up activities, including the design and development of new products and processes, commissioning equipment upgrades, qualification of products, the manufacture of commissioning and qualification products, and the development of sales and marketing efforts necessary to enter this new end-use.
These start-up costs were historically excluded from segment Adjusted EBITDA and segment income. The North America ABS Project substantially exited the start-up phase for the first CALP during the third quarter of 2018 and for the second CALP during the third quarter of 2019. The majority of the costs previously classified as start-up costs were included in segment Adjusted EBITDA and segment income.
Key operating and financial information for the segment is presented below:
(dollars in millions, except per ton measures, volume in thousands of tons)
Metric tons of finished product shipped
134.0
138.7
403.7
398.5
Revenues
$
496.6
$
532.4
$
1,527.3
$
1,471.9
Hedged
cost of metal
(259.7
)
(316.3
)
(837.0
)
(871.4
)
Unfavorable (favorable)
metal price lag
0.5
(10.7
)
(4.3
)
(35.1
)
Commercial margin
$
237.4
$
205.4
$
686.0
$
565.4
Commercial
margin per metric ton shipped
$
1,771.8
$
1,480.8
$
1,699.2
$
1,419.0
Segment
income
$
77.3
$
52.4
$
208.8
$
165.5
Unfavorable
(favorable) metal price lag
0.5
(10.7
)
(4.3
)
(35.1
)
Segment Adjusted
EBITDA (1)
$
77.8
$
41.6
$
204.6
$
130.4
Segment
Adjusted EBITDA per metric ton shipped
$
580.9
$
300.0
$
506.7
$
327.3
Start-up
costs
$
0.9
$
7.5
$
7.0
$
41.8
(1)
Amounts
may not foot as they represent the calculated totals based on actual amounts and not the rounded amounts presented in this table.
Europe
Our Europe segment consists of two world-class aluminum rolling mills, one in Germany and the other in Belgium, and an aluminum cast house in Germany. The segment produces aerospace plate and sheet, ABS, clad brazing sheet (clad aluminum material used for, among other applications, vehicle radiators and HVAC systems), heat-treated plate for engineered product applications and industrial coil and sheet. Substantially all of our Europe segment’s products are manufactured to specific customer requirements using direct-chill ingot cast technologies that allow us to use and offer a variety of alloys and products for a number of technically demanding end-uses.
32
Key
operating and financial information for the segment is presented below:
(dollars in millions, except per ton measures, volume in thousands of tons)
Metric
tons of finished product shipped
77.3
80.8
245.6
253.5
Revenues
$
319.1
$
348.8
$
1,003.7
$
1,084.7
Hedged
cost of metal
(166.9
)
(204.9
)
(537.7
)
(630.4
)
(Favorable) unfavorable metal
price lag
(2.0
)
7.1
(4.4
)
(2.9
)
Commercial margin
$
150.2
$
151.0
$
461.6
$
451.4
Commercial
margin per metric ton shipped
$
1,942.5
$
1,868.1
$
1,879.3
$
1,780.8
Segment
income
$
37.6
$
30.4
$
107.3
$
101.0
(Favorable)
unfavorable metal price lag
(2.0
)
7.1
(4.4
)
(2.9
)
Segment Adjusted EBITDA
(1)
$
35.6
$
37.5
$
102.9
$
98.1
Segment
Adjusted EBITDA per metric ton shipped
$
459.8
$
464.0
$
418.9
$
386.8
(1)
Amounts
may not foot as they represent the calculated totals based on actual amounts and not the rounded amounts presented in this table.
Asia Pacific
Our Asia Pacific segment consists of the Zhenjiang rolling mill that produces technically demanding and value-added plate products for aerospace, semiconductor equipment, general engineering, distribution and other end-uses worldwide. Substantially all of our Asia Pacific segment’s products are manufactured to specific customer requirements using direct-chill ingot cast technologies that allow us to use and offer a variety of alloys and products principally for aerospace and also for a number of other technically demanding end-uses.
Key operating and financial information for the segment is presented below:
(dollars in millions, except per ton measures, volume in thousands of tons)
Metric tons of finished product shipped
8.9
6.9
25.9
21.9
Revenues
$
48.3
$
35.5
$
135.3
$
109.4
Hedged
cost of metal
(24.5
)
(18.6
)
(69.8
)
(59.3
)
Favorable metal price lag
(0.8
)
(0.7
)
(1.1
)
(1.2
)
Commercial
margin
$
23.0
$
16.2
$
64.4
$
48.9
Commercial
margin per metric ton shipped
$
2,574.2
$
2,342.7
$
2,489.3
$
2,237.0
Segment
income
$
11.6
$
7.0
$
29.3
$
16.1
Favorable
metal price lag
(0.8
)
(0.7
)
(1.1
)
(1.2
)
Segment Adjusted EBITDA (1)
$
10.8
$
6.3
$
28.2
$
14.8
Segment
Adjusted EBITDA per metric ton shipped
$
1,206.6
$
912.6
$
1,091.1
$
678.3
(1)
Amounts may not foot as they represent the calculated totals based on actual amounts and not the rounded amounts presented in this table.
The Aluminum Industry
Aluminum is a widely-used, attractive industrial material. Compared to several alternative metals such as steel and copper, aluminum is lightweight, has a high strength-to-weight ratio and is resistant to corrosion. Aluminum can be recycled repeatedly without any material decline in performance or quality. The recycling of aluminum delivers energy and capital
33
investment savings relative to both the cost
of producing primary aluminum and many other competing materials. The penetration of aluminum into a wide variety of applications continues to grow. We believe several factors support fundamental long-term growth in aluminum consumption in the end-uses we serve.
The global aluminum industry consists of primary aluminum producers with bauxite mining, alumina refining and aluminum smelting capabilities; aluminum semi-fabricated products manufacturers, including aluminum casters, recyclers, extruders and flat rolled products producers; and integrated companies that are present across multiple stages of the aluminum production chain. The industry is cyclical and is affected by global economic conditions, industry competition and product development.
Primary aluminum prices are determined by worldwide forces of supply and demand and, as a result, are volatile. This volatility has a significant
impact on the profitability of primary aluminum producers whose selling prices are typically based upon prevailing LME prices while their costs to manufacture are not highly correlated to LME prices. We participate in select segments of the aluminum fabricated products industry, focusing on aluminum rolled products. We do not smelt aluminum, nor do we participate in other upstream activities, including mining bauxite or refining alumina. Since the majority of our products are sold on a market-based aluminum price plus conversion fee basis, we are less exposed to aluminum price volatility.
Seasonality and Management Outlook
Demand for certain end-uses we serve, particularly building and construction, is seasonal. This typically results in higher operating income in our second and third quarters, followed by our first and fourth quarters.
We
estimate that segment income and Adjusted EBITDA for the fourth quarter of 2019 will be higher than the fourth quarter of 2018 and sequentially lower due to normal seasonality. Factors influencing anticipated performance against the prior year period include:
▪
global aerospace volumes are expected to benefit from strong demand and fundamentals;
▪
North
America automotive sales expected to continue to increase based on committed volumes but could see temporary softness due to labor disruptions in the automotive supply chain;
▪
continued softness is expected for European automotive, heat-exchanger and regional end-uses; and
▪
favorable year-over-year rolling margins are expected in North America.
We expect 2019 capital spending of approximately $120.0
million, including $73.6 million spent through the third quarter of 2019.
Revenues for the three months ended September 30, 2019 decreased $54.5 million when compared to the prior year period. The lower average price of aluminum
included in the invoiced price of products sold decreased revenues approximately $75.0 million and a stronger average U.S. dollar unfavorably impacted the translation of our Europe-based revenues, decreasing revenues approximately $12.0 million. These decreases were partially offset by a favorable mix of products sold. While total volumes decreased 4%, the combination of volume and mix changes increased revenues approximately $18.0 million. Our global automotive volumes increased approximately 19%, as increasing shipments of autobody sheet from our Lewisport facility more than offset regional demand softness in Europe. Our global aerospace volumes increased approximately 39%, benefiting from strong
European demand and growth in Asia Pacific. In addition, improved rolling margins increased revenues approximately $18.0 million.
34
The following table presents the estimated impact of key factors that resulted in the 6% decrease in our consolidated third quarter revenues from 2018 to 2019:
North
America
Europe
Asia Pacific
Consolidated
$
%
$
%
$
%
$
%
(dollars
in millions)
LME / aluminum pass-through
$
(52.0
)
(10
)%
$
(21.0
)
(6
)%
$
(2.0
)
(6
)%
$
(75.0
)
(8
)%
Commercial
price
18.0
3
—
—
—
—
18.0
2
Volume
/ mix
(2.0
)
—
5.0
1
15.0
42
18.0
2
Currency
—
—
(12.0
)
(3
)
—
—
(12.0
)
(1
)
Other
0.2
—
(1.7
)
—
(0.2
)
(1
)
(1.7
)
—
Total
$
(35.8
)
(7
)%
$
(29.7
)
(9
)%
$
12.8
36
%
$
(52.7
)
(6
)%
Intra-entity
revenues
(1.8
)
—
Total
$
(54.5
)
(6
)%
Gross
profit for the three months ended September 30, 2019 was $112.8 million compared to $65.7 million for the three months ended September 30, 2018. Improved rolling margins and favorable metal spreads increased gross profit approximately $25.0 million, a favorable mix of products sold increased gross profit approximately $17.0 million and start-up expenses decreased $6.7 million as the North America ABS Project substantially exited the start-up phase for the second CALP during the third quarter of 2019 (the majority of costs classified as start-up expenses
in the prior year period continue to be incurred, however, they now impact volume and productivity).
In addition, metal price lag had an estimated $2.2 million favorable impact on gross profit for the three months ended September 30, 2019 when compared to the three months ended September 30, 2018. The favorable impact from metal price lag excludes the realized gains and losses on metal derivative financial instruments, which are classified separately on the Consolidated Statements of Comprehensive Income (Loss). The following table presents the estimated impact of metal price lag on our Consolidated Statements of Comprehensive
Income (Loss) for the three months ended September 30, 2019 and 2018:
Location in consolidated statements of comprehensive income (loss)
(dollars in millions)
Gross profit
Unfavorable metal price lag
$
(10.7
)
$
(12.9
)
$
2.2
Gains
on derivative financial instruments
Realized gains on metal derivatives
13.0
17.2
(4.2
)
Favorable metal price lag net of realized derivative gains/losses
$
2.3
$
4.3
$
(2.0
)
These increases were partially offset by inflation that more than offset favorable productivity, decreasing gross profit approximately $4.0 million.
Selling, general and administrative (“SG&A”) expenses were $50.2 million for the three months ended September 30, 2019 compared to $53.2 million for the three months ended September 30, 2018. The $3.0 million decrease resulted primarily from decreased professional fees and business development expenses related to the Merger.
During the three months
ended September 30, 2019 and 2018, we recorded realized gains on derivative financial instruments of $11.0 million and $16.7 million, respectively, and unrealized losses of $4.6 million and $10.4 million, respectively. Generally, our realized gains or losses represent the cash paid or received upon settlement of our derivative financial instruments. Unrealized gains or losses reflect the change in the fair value of derivative financial instruments from the later of the end of the prior period or our entering into the derivative instrument as well as the reversal of previously recorded unrealized
gains or losses for derivatives that settled during the period.
Net interest expense increased $1.6 million primarily from increased average borrowings on the ABL Facility.
Our effective tax rates were 16.6% and (26.1)% for the three months ended September 30, 2019 and 2018, respectively. The effective tax rates for the three months ended September 30, 2019 and 2018 differed
from the federal statutory rate applied to income and losses before income taxes primarily as a result of the mix of income, losses and tax rates between tax jurisdictions and valuation allowances.
35
The following table presents key financial and operating data on a consolidated basis for the three months ended September 30, 2019 and 2018:
North America revenues for the three months ended September 30, 2019 decreased $35.8 million compared to the three months ended September 30, 2018. This decrease was primarily due to the following:
▪
lower aluminum prices included in the invoiced price of products sold decreased revenues approximately $52.0 million; and
▪
a
3% decrease in volumes, partially offset by an improved mix of products sold, decreased revenues approximately $2.0 million. Automotive volumes were up significantly as shipments of autobody sheet from our Lewisport facility continue to increase and truck trailer volumes increased 7% on favorable demand. These increases were more than offset by a 39% decrease in distribution volumes, which were replaced by automotive volumes in Lewisport, and a 5% decrease in building and construction volumes as we continue to see choppiness in the housing market.
These decreases were partially offset by improved rolling margins that increased revenues approximately $18.0 million.
Europe
Revenues
Europe revenues for the three months ended September 30, 2019 decreased $29.7 million compared to the three months ended September 30, 2018. This decrease was primarily due to the following:
▪
lower aluminum prices included in the invoiced price of products sold decreased revenues approximately $21.0 million; and
▪
a
stronger average U.S. dollar unfavorably impacted the translation of revenues approximately $12.0 million.
These decreases were partially offset by an improved mix of products sold that more than offset a 4% decrease in volumes, increasing revenue approximately $5.0 million. The favorable product mix resulted primarily from a 27% increase in aerospace volumes. This increase was offset by 14%, 7% and 13% decreases in automotive, heat exchanger and regional end-use volumes, respectively, where we have seen weakness in demand.
Asia Pacific Revenues
Asia
Pacific revenues for the three months ended September 30, 2019 increased $12.8 million compared to the three months ended September 30, 2018. An improved mix of products sold and a 29% increase in volumes increased revenues approximately $15.0 million. The improved mix of products sold resulted from a 76% increase in aerospace shipments. This increase was offset by lower aluminum prices included in the invoiced price of products sold that decreased revenues approximately $2.0 million.
37
Segment
Income and Gross Profit
For the three months ended September 30, 2019 and 2018, segment income and our reconciliation of segment income to gross profit are presented below:
Items
excluded from segment income and included in gross profit:
Depreciation and amortization
(33.4
)
(32.0
)
(1.4
)
4
Start-up
costs
—
(6.7
)
6.7
(100
)
Items included in segment income and excluded from gross profit:
Segment
selling, general and administrative expenses
31.6
31.7
(0.1
)
—
Realized gains on
derivative financial instruments
(11.0
)
(16.8
)
5.8
*
Other
(1.0
)
(0.3
)
(0.7
)
233
Gross
profit
$
112.8
$
65.7
$
47.1
72
%
*
Result is not meaningful
North America Segment Income
North America segment income for the three months ended September 30, 2019 increased $24.9 million compared to the three months ended September 30, 2018. This increase was primarily due to the following:
▪
improved rolling margins, favorable metal spreads and scrap availability that increased segment income approximately $25.0 million;
▪
an improved mix of products sold and a favorable year-over-year change in manufacturing cost absorption more than offset a 3% decrease in volumes, increasing segment income approximately $10.0 million; and
▪
favorable productivity more than offset cost inflation, increasing segment income approximately $1.0 million.
These
increases were partially offset by an unfavorable change in metal price lag compared to the prior year period, which decreased segment income approximately $11.3 million.
Europe Segment Income
Europe segment income for the three months ended September 30, 2019 increased $7.2 million compared to the three months ended September 30, 2018. The increase was primarily due to the following:
▪
a
favorable change in metal price lag compared to the prior year period increased segment income approximately $9.1 million;
▪
the net impact of currency changes increased segment income approximately $2.0 million; and
▪
an improved mix of products sold increased segment income approximately $1.0 million.
These
increases were partially offset by cost inflation, primarily from wages, and unfavorable productivity resulting from decreased automotive and heat exchanger production, that decreased segment income approximately $5.0 million.
Asia Pacific Segment Income
Asia Pacific segment income for the three months ended September 30, 2019 increased $4.6 million compared to the three months ended September 30, 2018 from increased volumes and an improved mix of products sold, resulting from a 76% increase in aerospace shipments.
Revenues for the nine months ended September 30, 2019 increased $6.3 million when compared to the prior year period. A favorable mix of products sold increased revenues approximately $144.0 million. Our global automotive volumes increased approximately 52%, as increasing shipments of autobody sheet from our Lewisport facility
more than offset softness in automotive demand in Europe. Our global aerospace volumes increased approximately 35%, benefiting from improved demand patterns and growth in Asia Pacific. In addition, improved rolling margins increased revenues approximately $57.0 million. These increases were partially offset by the lower average price of aluminum included in the invoiced price of products sold that decreased revenues approximately $152.0 million and a stronger average U.S. dollar that unfavorably impacted the translation of our Europe and Asia Pacific-based revenues, decreasing revenues approximately $49.0 million.
The following table presents the estimated impact of key factors that resulted in the change in our consolidated revenues from the
first nine months of 2018 to the first nine months of 2019:
North
America
Europe
Asia Pacific
Consolidated
$
%
$
%
$
%
$
%
(dollars
in millions)
LME / aluminum pass-through
$
(91.0
)
(6
)%
$
(58.0
)
(5
)%
$
(3.0
)
(3
)%
$
(152.0
)
(6
)%
Commercial
price
57.0
4
—
—
—
—
57.0
2
Volume
/ mix
90.0
6
24.0
2
30.0
27
144.0
5
Currency
—
—
(48.0
)
(4
)
(1.0
)
(1
)
(49.0
)
(2
)
Other
(0.6
)
—
1.0
—
(0.1
)
—
0.3
—
Total
$
55.4
4
%
$
(81.0
)
(7
)%
$
25.9
24
%
$
0.3
—
%
Intra-entity
revenues
6.0
—
Total
$
6.3
—
%
Gross
profit for the nine months ended September 30, 2019 was $301.4 million compared to $229.6 million for the nine months ended September 30, 2018. Gross profit was favorably impacted by improved rolling margins and favorable metal spreads that increased gross profit approximately $92.0 million, a favorable mix of products sold that increased gross profit approximately $34.0 million and a $28.4 million decrease in start-up expenses as the North America ABS Project
substantially exited the start-up phase for the first CALP during the third quarter of 2018 and the second CALP during the third quarter of 2019 (the majority of costs previously classified as start-up expenses in the prior year period continue to be incurred, however, they now impact volume and productivity).
These increases were partially offset by metal price lag, which had an estimated $60.5 million unfavorable impact on gross profit for the nine months ended September 30, 2019 compared to the nine months ended September 30, 2018. The unfavorable impact from metal price lag excludes the realized
gains and losses on metal derivative financial instruments, which are classified separately on the Consolidated Statements of Comprehensive Income (Loss). The following table presents the estimated impact of metal price lag on our Consolidated Statements of Comprehensive Income (Loss) for the nine months ended September 30, 2019 and 2018:
Location in consolidated statements
of comprehensive income (loss)
(dollars in millions)
Gross profit
(Unfavorable) favorable metal price lag
$
(36.4
)
$
24.1
$
(60.5
)
Gains
on derivative financial instruments
Realized gains on metal derivatives
46.1
15.2
30.9
Favorable metal price lag net of realized derivative gains/losses
$
9.7
$
39.3
$
(29.6
)
In
addition, inflation and unfavorable productivity combined to decrease gross profit approximately $25.0 million. The unfavorable productivity resulted primarily from the ramp-up of automotive production and the higher cost structure of the Lewisport facility, as costs considered start-up expense in the prior year period are now considered within segment operating results, and the lower production requirements in Europe from weaker automotive demand.
39
SG&A expenses were $155.9 million for the nine months ended September 30, 2019
as compared to $153.7 million for the nine months ended September 30, 2018. The $2.2 million increase resulted primarily from increased professional fees and business development expenses related to the Merger.
During the nine months ended September 30, 2019 and 2018, we recorded realized gains on derivative financial instruments of $41.7 million and $15.9 million, respectively,
and unrealized losses (gains) of $23.5 million and $(3.1) million, respectively.
Net interest expense increased $12.9 million primarily from increased debt as a result of the debt refinancing transaction completed late in the second quarter of 2018.
We recorded debt extinguishment costs of $48.9 million during the second quarter of 2018 related to the debt refinancing transaction.
The unfavorable change of $11.8 million in other expense (income) primarily relates to the $12.2 million gain recorded in the second quarter of 2018 related to the settlement received in connection with Real Industry, Inc.’s bankruptcy
reorganization. In connection with the 2015 sale of our former recycling and specification alloys business, we received shares of Real Industry Inc.’s Series B non-participating preferred stock, which were held in escrow to secure certain indemnification obligations under the sale agreement. In 2017, Real Industry, Inc. filed for Chapter 11 bankruptcy protection, at which time, we recorded an impairment charge reducing the carrying value of the receivables related to the preferred shares held in escrow to zero. In the second quarter of 2018, the bankruptcy reorganization was finalized, and we received shares of the reorganized company’s common stock with an estimated fair value of $11.1 million (which shares were distributed to our stockholders through a dividend of such common stock). The receipt of these shares of common stock, as well as additional net cash considerations, resulted in the gain of $12.2 million.
Our effective
tax rates were 59.7% and (27.5)% for the nine months ended September 30, 2019 and 2018, respectively. The effective tax rate for the nine months ended September 30, 2019 and 2018 differed from the federal statutory rate applied to income and losses before income taxes primarily as a result of the mix of income, losses and tax rates between tax jurisdictions, valuation allowances and, for the nine
months ended September 30, 2019, the results of an examination by a non-U.S. taxing jurisdiction.
40
The following table presents key financial and operating data on a consolidated basis for the nine months ended September 30, 2019 and 2018:
North America revenues for the nine months ended September 30, 2019 increased $55.4 million compared to the nine months ended September 30, 2018. This increase was primarily due to the following:
▪
an improved mix of products sold and a 1% increase in volumes increased revenues approximately $90.0
million. Automotive volumes were up significantly as shipments of autobody sheet from our Lewisport facility continue to increase and truck trailer volumes increased 17% on favorable demand. These increases were partially offset by a 37% decrease in distribution volumes, which were replaced by automotive volumes in Lewisport, and an 7% decrease in building and construction volumes as we continue to see choppiness in the housing market; and
▪
improved rolling margins increased revenues approximately $57.0 million.
These
increases were partially offset by lower aluminum prices included in the invoiced price of products sold that decreased revenues approximately $91.0 million.
Europe Revenues
Europe revenues for the nine months ended September 30, 2019 decreased $81.0 million compared to the nine months ended September 30, 2018. This decrease was primarily due to the following:
▪
lower
aluminum prices included in the invoiced price of products sold decreased revenues approximately $58.0 million; and
▪
a stronger average U.S. dollar unfavorably impacted the translation of euro-based revenues approximately $48.0 million.
These decreases were partially offset by an improved mix of products sold that more than offset lower volumes. The combination of volume and mix increased revenues approximately $24.0 million. The favorable product mix resulted primarily from a 22% increase in aerospace
volumes, as well as an improved mix of aerospace products sold. The increase in aerospace volumes was more than offset by 11% and 9% decreases in heat exchanger and automotive volumes, respectively, where we have seen weakness in demand.
Asia Pacific Revenues
Asia Pacific revenues for the nine months ended September 30, 2019 increased $25.9 million compared to the nine months ended September 30, 2018. This increase was due to a 18%
increase in volumes and an improved mix of products sold,
42
resulting from a 73% increase in aerospace shipments, that increased revenues approximately $30.0 million. This increase was partially offset by the following:
▪
lower aluminum prices included in the invoiced price of products sold decreased revenues approximately $3.0 million; and
▪
a
stronger average U.S. dollar unfavorably impacted the translation of revenues approximately $1.0 million.
Segment Income and Gross Profit
For the nine months ended September 30, 2019 and 2018, segment income and our reconciliation of segment income to gross profit are presented below:
Items
excluded from segment income and included in gross profit:
Depreciation
(98.1
)
(95.1
)
(3.0
)
3
Start-up
costs
(5.1
)
(33.4
)
28.3
(85
)
Items included in segment income and excluded from gross
profit:
Segment selling, general and administrative expenses
99.8
91.7
8.1
9
Realized
gains on derivative financial instruments
(41.8
)
(16.0
)
(25.8
)
161
Other
1.1
(0.2
)
1.3
(650
)
Gross
profit
$
301.4
$
229.6
$
71.8
31
%
North
America Segment Income
North America segment income for the nine months ended September 30, 2019 increased $43.3 million compared to the nine months ended September 30, 2018. This increase was primarily due to the following:
▪
improved rolling margins, favorable metal spreads and scrap availability that increased segment income approximately $91.0 million;
and
▪
an improved mix of products sold and slightly higher volumes increased segment income approximately $2.0 million.
These increases were partially offset by the following:
▪
an unfavorable change in metal price lag compared to the prior year period decreased segment income approximately $30.8 million. 2018 metal lag was favorably
impacted by a substantially higher Midwest Premium; and
▪
cost inflation, primarily from wages, and unfavorable productivity combined to decrease segment income approximately $17.0 million. The unfavorable productivity included the absorption of certain costs that were classified as start-up expenses in the prior year period, which more than offset productivity in our continuous cast operations.
Europe Segment Income
Europe segment income for the nine months ended September 30,
2019 increased $6.3 million compared to the nine months ended September 30, 2018. This increase was primarily due to the following:
▪
an improved mix of products sold more than offset the decrease in volumes, increasing segment income approximately $13.0 million;
▪
the
net impact of currency changes increased segment income approximately $3.0 million; and
43
▪
a favorable change in metal price lag compared to the prior year period decreased segment income approximately $1.5 million.
These decreases were partially offset by cost inflation, primarily from wages, and unfavorable productivity that decreased segment income approximately
$12.0 million.
Asia Pacific Segment Income
Asia Pacific segment income for the nine months ended September 30, 2019 increased $13.2 million compared to the nine months ended September 30, 2018. This increase was primarily due to the following:
▪
higher volumes and an improved mix of aerospace shipments
increased segment income approximately $12.0 million; and
▪
the net impact of currency changes increased segment income approximately $2.0 million.
Liquidity and Capital Resources
Liquidity at September 30, 2019 was $368.4 million, which consisted of $316.9 million of availability under
the ABL Facility (as defined below), $44.7 million of cash and $6.8 million of cash restricted for payments of the China Loan Facility. Both our borrowing base and ABL Facility utilization may fluctuate on a monthly basis due, in part, to changes in seasonal working capital and aluminum prices.
Based on our current and anticipated levels of operations and the condition in the industries we serve, we believe that our cash on hand, cash flows from operations and availability under the ABL Facility will enable us to meet our working capital, capital expenditures, debt service and other funding requirements for the foreseeable future. However, our ability to fund our working capital needs, debt payments and other obligations, and to comply with the covenants under our indebtedness, including borrowing base limitations under the ABL Facility
and debt incurrence restrictions in our debt agreements, depends on our future operating performance and cash flows and many factors outside of our control, including the costs of raw materials, our ability to access the capital and credit markets, the state of the overall industry and financial and economic conditions and other factors, including those described under Item 1A. – “Risk Factors” in our annual report on Form 10-K for the fiscal year ended December 31, 2018. Any future investments, acquisitions, joint ventures or other similar transactions will likely require additional capital and there can be no assurance that any such capital will be available to us on acceptable terms, if at all.
We will need to refinance all or a portion of our indebtedness on or before maturity. We cannot assure you that we will be able
to refinance any of our indebtedness on attractive terms on or before maturity or on commercially reasonable terms at all.
The following discussion provides a summary description of the significant components of our sources of liquidity and long-term debt:
Cash Flows
The following table summarizes our net cash (used) provided by operating, investing and financing activities for the nine months ended September 30, 2019 and 2018.
Cash flows used by operating activities were $26.3 million for the nine months ended September 30, 2019, which resulted from $166.9 million of cash from earnings and a $193.2 million use of cash related to an increase in net operating assets. The significant components of the change in net operating assets included an increase of $96.6 million and $22.0 million in accounts receivable and other assets, respectively and decreases of $61.5 million and $18.0 million
in accounts payable and accrued and other liabilities, respectively. These changes were partially offset by a $4.9 million decrease in inventory. The increase in accounts receivable was due primarily to increased seasonal sales volume. While our average days sales outstanding
44
(“DSO”) for the twelve months ended September 30, 2019 remained consistent with the average DSO for the year ended December 31, 2018, the revenues in the month of September 2019
were approximately $71.5 million higher than the month of December 2018, leading to the increased accounts receivable. The increase in other assets resulted primarily from an $18.6 million increase in the income tax receivable recorded during the third quarter, $15.7 million of which resulted from a withholding tax paid to a non-U.S. taxing jurisdiction that will be refunded within two to six months of the quarter end. The decrease in accounts payable is primarily due to the timing of payments. Our average days payables outstanding (“DPO”) for the twelve months ended September 30, 2019 decreased slightly from the average DPO for the year ended December 31, 2018. The decrease in accrued and other liabilities was primarily attributable
to interest payments during the period. Our average days inventory outstanding (“DIO”) for the twelve months ended September 30, 2019 increased slightly from the average DIO for the year ended December 31, 2018.
Cash flows used by operating activities were $67.4 million for the nine months ended September 30, 2018, which resulted from $86.4 million of cash from earnings and a $153.9 million use of cash related to an increase in net operating assets. The significant components of the change in net operating assets included increases of $146.0 million, $135.7 million, $76.9 million and $46.2 million in accounts receivable, inventory, accounts payable and accrued and other liabilities,
respectively. The increases in accounts receivable and accounts payable were due primarily to increased seasonal sales volume and higher aluminum prices. Our average DSO for the twelve months ended September 30, 2018 increased by two days compared with the average DSO for the year ended December 31, 2017 and revenues in the month of September 2018 were approximately $105.3 million higher than the month of December 2017, leading to an increase in accounts receivable. While our average DPO for the twelve months ended September 30, 2018 remained consistent with the average DPO for the year ended December 31, 2017, the sanctions levied against United Company Rusal Plc in 2018 shortened the payment terms on accounts payable in Europe. The increase in inventory was primarily due
to the seasonal build of inventory, an increase in aluminum prices and increased inventory in North America related to the ramp-up of automotive production, partially offset by working capital optimization efforts in Europe. Our average DIO for the twelve months ended September 30, 2018 decreased approximately five days from the average DIO for the year ended December 31, 2017. The increase in accrued and other liabilities was primarily due to deferred revenue associated with $60.0 million of capacity reservation fees received in the first half of 2018, partially offset by interest payments.
Cash Flows from Investing Activities
Cash flows used by investing activities were $74.3 million for the nine months ended
September 30, 2019, primarily related to capital expenditures.
Cash flows used by investing activities were $76.9 million for the nine months ended September 30, 2018, primarily related to capital expenditures.
Cash Flows from Financing Activities
Cash flows provided by financing activities were $38.2 million for the nine months ended September 30, 2019, which resulted from an additional $57.2 million of net borrowings under the ABL Facility, partially offset by $8.3
million of scheduled repayments of the Term Loan Facility (as defined below) and $7.0 million of scheduled repayments on the Zhenjiang Term Loans (as defined below).
Cash flows provided by financing activities were $100.2 million for the nine months ended September 30, 2018, which resulted from net cash proceeds of $1,483.0 million from the debt refinancing we completed in the second quarter of 2018. These proceeds were partially offset by the redemption of the Prior Notes (as defined below), which totaled $1,289.5 million including the prepayment premiums, net cash repayments of $64.1 million on outstanding borrowings under the ABL Facility, $20.4 million of debt issuance costs related to the debt refinancing and $5.5 million of scheduled repayments on the Zhenjiang Term Loans.
Description
of Indebtedness
On June 25, 2018, Aleris International completed a debt refinancing, pursuant to which Aleris International (i) raised $1,500.0 million in new debt financing, consisting of (A) a new senior secured first lien term loan in an aggregate principal amount of $1,100.0 million (the “Term Loan Facility”) and (B) $400.0 million aggregate principal amount of newly issued 10.75% senior secured junior priority notes due 2023 (the “2023 Junior Priority Notes”), (ii) amended its existing ABL Facility (the “ABL Amendment”), and (iii) used the net proceeds of the new debt financing to (A) redeem all of its Prior Notes, (B) repay a portion of its outstanding borrowings under the ABL Facility and (C) pay related fees and expenses.
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Term
Loan Facility
The Term Loan Facility consists of a $1,100.0 million first lien senior secured term loan facility, which will mature on February 27, 2023. Aleris International’s obligations under the Term Loan Facility are guaranteed by Aleris Corporation and Aleris International’s domestic restricted subsidiaries that guarantee Aleris International’s existing obligations under the ABL Facility and the 2023 Junior Priority Notes (the “Guarantor Subsidiaries” and, together with Aleris Corporation, the “Guarantors”).
The Term Loan Facility also includes
an uncommitted incremental facility, which, subject to certain conditions, provides for additional term loan facilities in an aggregate principal amount not to exceed the sum of (i) $75.0 million, plus (ii) an amount equal to all voluntary prepayments and loan buybacks of the Term Loan Facility and any other indebtedness that is secured on a pari passu basis with the Term Loan Facility (other than prepayments and buybacks financed with long-term indebtedness (other than revolving indebtedness)), plus (iii) an additional unlimited amount subject to a First Lien Net Leverage Ratio (as defined in the Term Loan Facility) of 3.75 to 1.00.
The Term Loan Facility is secured by (i) a first-priority lien on substantially all of Aleris International’s and the Guarantors’ assets (excluding the ABL Collateral (as defined below)), including, without
limitation, all owned and material U.S. real property, equipment, intellectual property and stock of Aleris International and the Guarantors (other than Aleris Corporation) and other subsidiaries (including 100% of the outstanding non-voting stock (if any) and 65% of the outstanding voting stock of certain “first tier” foreign subsidiaries and certain “first tier” foreign subsidiary holding companies), which assets secure the 2023 Junior Priority Notes on a second priority basis and secure the ABL Facility on a third priority basis (the “Term Loan Collateral”) and (ii) a second-priority lien on all of Aleris International’s and the Guarantors’ (other than Aleris Corporation) inventory, accounts receivable, deposit accounts and related assets (subject to certain exceptions),
which assets secure the ABL Facility on a first priority basis and secure the 2023 Junior Priority Notes on a third priority basis (the “ABL Collateral” and, together with the Term Loan Collateral, the “Collateral”), in each case excluding certain assets and subject to permitted liens.
The Term Loan Facility contains a number of covenants that, subject to certain exceptions, impose restrictions on Aleris International and certain of its subsidiaries, including, without limitation, restrictions on the ability to, among other things, incur additional debt, grant liens or security interests on assets, merge, consolidate or sell assets, make investments, loans and acquisitions, pay dividends and make restricted payments, modify terms of junior indebtedness or enter into affiliate transactions. The Term Loan Facility also contains
certain customary affirmative covenants and events of default. Aleris International was in compliance with all covenants set forth in the Term Loan Facility as of September 30, 2019.
2023 Junior Priority Notes
On June 25, 2018, Aleris International completed the issuance of $400.0 million aggregate principal amount of 2023 Junior Priority Notes and related guarantees in a private offering under Rule 144A and Regulation S of the Securities Act of 1933, as amended. The 2023 Junior Priority Notes were issued under an indenture (as amended and supplemented from time to time, the “2023 Junior Priority Notes
Indenture”), dated as of June 25, 2018, among Aleris International, the guarantors named therein and U.S. Bank National Association, as trustee and collateral agent. The 2023 Junior Priority Notes are jointly and severally, irrevocably and unconditionally guaranteed on a senior secured basis, by each of the Guarantors, as primary obligor and not merely as surety.
The 2023 Junior Priority Notes bear interest at an annual rate of 10.75%. Interest is payable semi-annually in arrears on January 15 and July 15 of each year, beginning on January 15, 2019. The 2023 Junior Priority Notes will mature on July 15, 2023.
The
2023 Junior Priority Notes are secured by (i) a second-priority lien on the Term Loan Collateral and (ii) a third-priority lien on the ABL Collateral, in each case excluding certain assets and subject to permitted liens.
Aleris International is not required to make any mandatory redemption or sinking fund payments with respect to the 2023 Junior Priority Notes, but under certain circumstances, it may be required to offer to purchase the 2023 Junior Priority Notes as described below. Aleris International may from time to time acquire 2023 Junior Priority Notes by means other than redemption, whether by tender offer, in open market purchases, through negotiated transactions or otherwise, in accordance with applicable securities laws.
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From
and after July 15, 2020, Aleris International may redeem the 2023 Junior Priority Notes, in whole or in part, at a redemption price of 104.00% of the principal amount, thereof plus accrued and unpaid interest, declining ratably to 100.00% of the principal amount thereof, plus accrued and unpaid interest, on or after July 15, 2022. Prior to July 15, 2020, Aleris International may redeem up to 40.00% of the aggregate principal amount of the 2023 Junior Priority Notes with funds in an amount equal to all or a portion of the net cash proceeds from certain equity offerings at a redemption price of 110.75%, plus accrued and unpaid interest. Aleris
International may make such redemption so long as, immediately after the occurrence of any such redemption, at least 60.00% of the aggregate principal amount of the 2023 Junior Priority Notes remains outstanding and such redemption occurs within 180 days of the closing of the applicable equity offering. Additionally, at any time prior to July 15, 2020, Aleris International may redeem the 2023 Junior Priority Notes, in whole or in part, at a redemption price equal to 100.00% of the principal amount thereof, plus the applicable premium as provided in the 2023 Junior Priority Notes Indenture and accrued and unpaid interest.
If Aleris International or any restricted subsidiary consummates one or more
asset sales generating net proceeds in excess of $35.0 million in the aggregate at any time after July 15, 2019 but on or prior to July 15, 2020, Aleris International may, at its option, redeem all or a portion of the 2023 Junior Priority Notes in an aggregate principal amount not to exceed such net proceeds at a redemption price equal to 103.00% of the principal amount thereof, in each case, plus accrued and unpaid interest.
If Aleris International experiences a “change of control” as specified in the 2023 Junior Priority Notes Indenture at any time after July 15, 2019 but on or prior to July 15,
2020, Aleris International may, at its option, redeem all, but not less than all, of the 2023 Junior Priority Notes at a redemption price equal to 103.00% of the principal amount thereof, in each case, plus accrued and unpaid interest.
In addition, if Aleris International experiences a change of control and does not elect to redeem the notes as provided above, Aleris International must offer to purchase all of the 2023 Junior Priority Notes at a price equal to 101.00% of the principal amount thereof, plus accrued and unpaid interest. If Aleris International or its restricted subsidiaries engage in certain asset sales, Aleris International will be required to use 80.00% of the consideration received
from such asset sales to permanently reduce certain debt within a specified period of time. Aleris International will be required to use a portion of the remaining proceeds of such asset sales, as well as the proceeds of certain events of loss with respect to the Collateral, as the case may be, to make an offer to purchase a principal amount of the 2023 Junior Priority Notes at a price of 100.00% of the principal amount thereof, plus accrued and unpaid interest, to the extent such proceeds are not invested or used to permanently reduce certain debt within a specified period of time.
The 2023 Junior Priority Notes Indenture contains covenants, subject to certain limitations and exceptions, limiting the ability of Aleris International and its restricted subsidiaries
to, among other things: incur additional debt; pay dividends or distributions on Aleris International’s capital stock or redeem, repurchase or retire Aleris International’s capital stock or subordinated debt; issue preferred stock of restricted subsidiaries; make certain investments; create liens on Aleris International’s or its Guarantor Subsidiaries’ assets to secure debt; enter into sale and leaseback transactions; create restrictions on the payment of dividends or other amounts to Aleris International from the restricted subsidiaries that are not guarantors of the 2023 Junior Priority Notes; enter into transactions with affiliates; merge or consolidate with another company; and sell assets, including
capital stock of Aleris International’s subsidiaries. The 2023 Junior Priority Notes Indenture also contains customary events of default. Aleris International was in compliance with all covenants set forth in the 2023 Junior Priority Notes Indenture as of September 30, 2019.
ABL Facility
On June 25, 2018, Aleris International entered into the ABL Amendment, which amended the credit agreement governing its existing asset-based revolving credit facility, dated as of June 15,
2015 (as amended, the “ABL Facility”), among Aleris International, the other borrowers party thereto, the lenders party thereto, JPMorgan Chase Bank, N.A., as administrative agent for the lenders (the “ABL Administrative Agent”), and J.P. Morgan Europe Limited, as the European agent for the lenders.
The terms of the ABL Amendment increased the size of the ABL Facility by $150.0 million. As amended, the ABL Facility permits multi-currency borrowings up to $750.0 million by Aleris International and its U.S. subsidiaries and up to a combined $375.0 million by Aleris Switzerland GmbH, a wholly owned Swiss subsidiary, Aleris Aluminum Duffel BVBA, a wholly owned Belgian subsidiary, Aleris Rolled Products Germany GmbH, a wholly owned German subsidiary and, upon its accession to
the credit agreement, Aleris Casthouse Germany GmbH, a wholly owned German subsidiary (but limited to $750.0 million in total). The availability of funds to the borrowers located in each jurisdiction is subject to a borrowing base for that jurisdiction and the jurisdictions in which certain subsidiaries of such borrowers are located. Both the borrowing base and the
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ABL Facility utilization may fluctuate on a monthly basis. Our borrowing base may also fluctuate due to, in part, seasonal working capital increases and increased aluminum prices. The ABL Facility provides for the issuance of up to $125.0 million of letters of credit. The credit agreement provides
that commitments under the ABL Facility may be increased at any time by an additional $300.0 million, subject to certain conditions.
As of September 30, 2019, we estimate that the borrowing base would have supported borrowings of up to $651.0 million. We had outstanding borrowings of $308.7 million under the ABL Facility as of September 30, 2019. After giving effect to outstanding borrowings and letters of credit, Aleris International had $316.9 million available for borrowing under the ABL Facility.
The ABL Facility is secured by a first-priority lien over
the ABL Collateral and is also secured by a third-priority lien (ranking junior to the lien therein in favor of the Term Loan Facility and the 2023 Junior Priority Notes) over the Term Loan Collateral, in each case excluding certain assets and subject to permitted liens.
The credit agreement governing the ABL Facility contains a number of covenants that, subject to certain exceptions, impose restrictions on Aleris International and certain of its subsidiaries, including, without limitation, restrictions on its ability to, among other things, incur additional debt, create liens, merge, consolidate or sell assets, make investments, loans and acquisitions, pay dividends and make certain payments or enter into affiliate transactions.
Although the credit agreement governing the ABL Facility generally
does not require Aleris International to comply with any financial ratio maintenance covenants, if combined availability is less than the greater of (a) 10% of the lesser of the combined borrowing base and the combined commitments and (b) $40.0 million, a minimum fixed charge coverage ratio (as defined in the credit agreement) of at least 1.0 to 1.0 will apply. The credit agreement also contains certain customary affirmative covenants and events of default. Aleris International was in compliance with all of the covenants set forth in the credit agreement as of September 30, 2019.
In addition to increasing the size of the ABL Facility, the terms of the ABL Amendment, among other things, (i) extended the maturity date of the ABL Facility from June 15, 2020 to the earliest of (x) June 25,
2023, (y) the date that is 60 days prior to the scheduled maturity date of the term loans under the Term Loan Facility (currently February 27, 2023) and (z) the date that is 60 days prior to the scheduled maturity date of the 2023 Junior Priority Notes (currently July 15, 2023), (ii) removed a previous borrowing base reserve on Belgian finished goods inventory, (iii) permitted the incurrence of the Term Loan Facility and the 2023 Notes and (iv) amended certain covenants and other provisions consistent with the corresponding terms of the Term Loan Facility and the 2023 Junior Priority Notes.
Redemption of Prior Notes
As part of the debt refinancing discussed above, Aleris International redeemed in full the aggregate principal amount of its former 77/8%
senior notes due 2020 (the “2020 Notes”) and 9½% senior secured notes due 2021 (the “2021 Notes” and, together with the 2020 Notes, the “Prior Notes”). The 2020 Notes were redeemed at a redemption price equal to 101.969% of the principal amount thereof, plus accrued and unpaid interest to June 25, 2018, and the 2021 Notes were redeemed at a redemption price equal to 104.750% of the principal amount thereof, plus accrued and unpaid interest to June 25, 2018.
Exchangeable Notes
Aleris International issued $45.0 million aggregate principal amount of 6% senior subordinated exchangeable notes (the “Exchangeable Notes”) in June 2010. The Exchangeable Notes are scheduled
to mature on June 1, 2020. The Exchangeable Notes have exchange rights at the holder’s option and are exchangeable at any time for our common stock at a rate equivalent to 60.58 shares of our common stock per $1,000 principal amount of the Exchangeable Notes (after adjustment for the payments of dividends), subject to further adjustment. The Exchangeable Notes may currently be redeemed at Aleris International’s option at specified redemption prices.
China Loan Facility
Our wholly owned subsidiary, Aleris Aluminum (Zhenjiang) Co., Ltd. (“Aleris Zhenjiang”), maintains a loan agreement comprised of non-recourse multi-currency secured term loan facilities and a revolving facility (collectively, as amended and supplemented from time to time, the “China Loan Facility”). The China Loan Facility consists
of a $27.6 million U.S. dollar term loan facility, an RMB 846.2 million (or equivalent to approximately $118.5 million as of September 30, 2019) term loan facility (collectively referred to as the “Zhenjiang Term Loans”) and an RMB 410.0 million (or equivalent to approximately
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$57.4 million as of September 30, 2019) revolving facility (referred to as
the “Zhenjiang Revolver”). The Zhenjiang Revolver has certain restrictions that have limited our ability to borrow funds on the Zhenjiang Revolver and will continue to limit our ability to borrow funds in the future.
The China Loan Facility contains certain customary covenants and events of default. The China Loan Facility requires Aleris Zhenjiang to, among other things, maintain a certain ratio of outstanding term loans to invested equity capital. In addition, Aleris Zhenjiang is restricted from, subject to certain exceptions, repaying loans or distributing dividends to stockholders, disposing of assets, providing third party guarantees, or entering into additional financing to expand the capacity of the project, among other things.
Aleris Zhenjiang was in compliance with all of the covenants set forth in the China Loan Facility as of September 30,
2019. Aleris Zhenjiang has had delays in its ability to make timely draws of amounts committed under the China Loan Facility in the past and we cannot be certain that Aleris Zhenjiang will be able to draw any amounts committed under the Zhenjiang Revolver in the future or as to the timing or cost of any such draws.
Non-GAAP Financial Measures
We report our financial results in accordance with GAAP. However, our management believes that certain non-GAAP performance measures, which we use in managing the business, may provide investors with additional meaningful comparisons between current results and results in prior periods. EBITDA, Adjusted EBITDA, segment Adjusted EBITDA and commercial margin are examples of non-GAAP financial measures that we believe provide investors and other
users of our financial information with useful information.
Management uses EBITDA, Adjusted EBITDA, segment Adjusted EBITDA and commercial margin as performance metrics and believes these measures provide additional information commonly used by holders of the 2023 Junior Priority Notes and parties to the Term Loan Facility and the ABL Facility with respect to the ongoing performance of our underlying business activities, as well as our ability to meet our future debt service, capital expenditures and working capital needs. In addition, EBITDA with certain adjustments is a component of certain covenants under the credit agreement governing the Term Loan Facility and the indenture governing the 2023 Junior Priority Notes. Adjusted EBITDA, including the impacts of metal price lag, is a component of certain financial covenants under the
credit agreement governing the ABL Facility. Management also uses commercial margin as a performance metric and believes that it provides useful information regarding the performance of our segments because it measures the price at which we sell our aluminum products above the hedged cost of the metal and the effects of metal price lag, thereby reflecting the value-added components of our commercial activities independent of aluminum prices which we cannot control.
Our EBITDA calculations represent net income and loss before interest income and expense, provision for and benefit from income taxes and depreciation and amortization. Adjusted EBITDA is defined as EBITDA excluding metal price lag, unrealized gains and losses on derivative financial instruments, restructuring charges, currency exchange gains and losses on debt, stock-based compensation expense, start-up costs, loss on extinguishment of debt and certain other gains
and losses. Segment Adjusted EBITDA represents Adjusted EBITDA on a per segment basis. EBITDA as defined in the credit agreement governing the Term Loan Facility and the indenture governing the 2023 Junior Priority Notes also limits the amount of adjustments for cost savings, operational improvement and synergies for the purpose of determining our compliance with such covenants. Adjusted EBITDA as defined under the ABL Facility also limits the amount of adjustments for restructuring charges and requires additional adjustments be made if certain annual pension funding levels are exceeded. Commercial margin represents revenues less the hedged cost of metal and the effects of metal price lag.
EBITDA, Adjusted EBITDA, segment Adjusted EBITDA and commercial margin (collectively, the “Non-GAAP Measures”), as we use them may not be comparable
to similarly titled measures used by other companies. We calculate the Non-GAAP Measures by eliminating the impact of a number of items we do not consider indicative of our ongoing operating performance and certain other items. You are encouraged to evaluate each adjustment and the reasons we consider it appropriate for supplemental analysis. However, the Non-GAAP Measures are not financial measurements recognized under GAAP, and when analyzing our operating performance, investors should use the Non-GAAP Measures in addition to, and not as an alternative for, net income and loss, operating income and loss, or any other performance measure derived in accordance with GAAP, or in addition to, and not as an alternative for, cash flow from operating activities as a measure of our liquidity. The Non-GAAP Measures have limitations as analytical tools, and they should not be considered in isolation, or as a substitute for, or superior to, our measures of financial performance
prepared in accordance with GAAP. These limitations include:
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▪
They do not reflect our cash expenditures or future requirements for capital expenditures or contractual commitments;
▪
They do not reflect changes in, or cash requirements for, working capital needs;
▪
They
do not reflect interest expense or cash requirements necessary to service interest expense or principal payments under our outstanding indebtedness;
▪
They do not reflect certain tax payments that may represent a reduction in cash available to us;
▪
Although depreciation and amortization are non-cash charges, the assets being depreciated and amortized may have to be replaced in the future, and EBITDA and Adjusted EBITDA, including segment Adjusted EBITDA, do not reflect cash requirements for such replacements;
and
▪
Other companies, including companies in our industry, may calculate these measures differently and, as the number of differences in the way companies calculate these measures increases, the degree of their usefulness as a comparative measure correspondingly decreases.
In addition, in evaluating Adjusted EBITDA, including segment Adjusted EBITDA, we may incur expenses in the future that are similar to the adjustments in the below presentation. Our presentation of Adjusted EBITDA, including segment Adjusted EBITDA, should not be construed as an inference that our future results will be unaffected by unusual or non-recurring items.
For
reconciliations of EBITDA, Adjusted EBITDA and commercial margin to their most directly comparable financial measures presented in accordance with GAAP, see the tables below. For a reconciliation of segment Adjusted EBITDA to segment income and a reconciliation of commercial margin to revenues, which are the most directly comparable financial measures presented in accordance with GAAP, for the North America, Europe and Asia Pacific segments, see the reconciliations in “–Our Segments.”
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For the three and nine months ended September 30, 2019 and 2018,
our reconciliation of Adjusted EBITDA to net income (loss) and net cash provided (used) by operating activities is presented below.
The preparation of financial statements in conformity with GAAP requires our management to make estimates and judgments that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date
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of the financial statements and the reported amounts of revenues and expenses during the reporting period. On an ongoing basis, we evaluate our estimates, including, among others, those related to the valuation of inventory, property and equipment and intangible assets, allowances related to doubtful accounts, income taxes, pensions and other postretirement benefits and environmental liabilities. Our management bases its estimates on
historical experience, actuarial valuations and other assumptions believed to be reasonable under the circumstances. Actual results could differ from those estimates.
A summary of our significant accounting policies and estimates is included in our annual report on Form 10-K filed with the Securities and Exchange Commission on March 8, 2019 for the year ended December 31, 2018. Also see Note 13, “Leases” to our unaudited consolidated financial statements included elsewhere in this quarterly report on Form 10-Q for a discussion of the Company’s updated accounting policies on leases subsequent to the adoption of ASC 842, “Leases.”
This quarterly report on Form 10-Q contains forward-looking statements that are based on current expectations, estimates, forecasts and projections about us and the industry in which we operate and beliefs and assumptions made by our management. Statements contained in this report that are not historical in nature are considered to be forward-looking statements. They include statements regarding the Merger and our expectations, hopes, beliefs, estimates, intentions or strategies regarding the future. Statements regarding future costs and prices of commodities, production volumes, industry trends, anticipated cost savings, anticipated
benefits from new products, facilities, acquisitions or divestitures, projected results of operations, achievement of production efficiencies, capacity expansions, future prices and demand for our products and estimated cash flows and sufficiency of cash flows to fund operations, capital expenditures and debt obligations, as well as statements regarding trade cases, tariffs and other future governmental actions, are forward-looking statements. The words “may,”“could,”“would,”“should,”“will,”“believe,”“expect,”“anticipate,”“plan,”“estimate,”“target,”“project,”“look forward to,”“intend” and similar expressions are intended to identify forward-looking statements.
Forward-looking statements should be read in conjunction with the cautionary statements and other important factors included in this document under “Management’s
Discussion and Analysis of Financial Condition and Results of Operations” which include descriptions of important factors which could cause actual results to differ materially from those contained in the forward-looking statements. Our expectations, beliefs and projections are expressed in good faith, and we believe we have a reasonable basis to make these statements through our management’s examination of historical operating trends, data contained in our records and other data available from third parties, but there can be no assurance that our management’s expectations, beliefs or projections will result or be achieved.
Forward-looking statements involve known and unknown risks and uncertainties, which could cause actual results to differ materially from those contained in or implied by any forward-looking statement. Important factors that could cause actual results to differ materially from the forward-looking statements
include, but are not limited to:
•
our ability to successfully implement our business strategy;
•
the success of past and future acquisitions or divestitures;
•
the cyclical nature of the aluminum industry, material adverse changes in the aluminum industry or our end-uses, such as global and regional supply and
demand conditions for aluminum and aluminum products, and changes in our customers’ industries;
•
increases in the cost, or limited availability, of raw materials and energy;
•
our ability to enter into effective metal, energy and other commodity derivatives or arrangements with customers to manage effectively our exposure to commodity price fluctuations and changes in the pricing of metals, especially LME-based aluminum prices;
•
our
ability to generate sufficient cash flows to fund our operations and capital expenditure requirements and to meet our debt obligations;
•
competitor pricing activity, competition of aluminum with alternative materials and the general impact of competition in the industry end-uses we serve;
•
our ability to retain the services of certain members of our management;
•
the
loss of order volumes from any of our largest customers;
•
our ability to retain customers, a substantial number of whom do not have long-term contractual arrangements with us;
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•
risks of investing in and conducting operations on a global basis, including political, social, economic, currency and regulatory factors;
•
variability
in general economic and political conditions on a global or regional basis;
•
current environmental liabilities and the cost of compliance with and liabilities under health and safety laws;
•
labor relations (i.e., disruptions, strikes or work stoppages) and labor costs;
•
our internal controls
over financial reporting and our disclosure controls and procedures may not prevent all possible errors that could occur;
•
our levels of indebtedness and debt service obligations, including changes in our credit ratings, material increases in our cost of borrowing or the failure of financial institutions to fulfill their commitments to us under committed facilities;
•
our ability to access credit or capital markets;
•
the
possibility that we may incur additional indebtedness in the future;
•
limitations on operating our business and incurring additional indebtedness as a result of covenant restrictions under our indebtedness, and our ability to pay amounts due under our outstanding indebtedness; and
•
risks related to the Merger, including the possibility that the Merger may not be consummated.
The above list is not exhaustive. Some of these factors and additional risks, uncertainties
and other factors that may cause our actual results, performance or achievements to be different from those expressed or implied in our written or oral forward-looking statements may be found in our public filings with the Securities and Exchange Commission, including the sections entitled “Risk Factors” included therein and herein.
These factors and such other risk factors are not necessarily all of the important factors that could cause our actual results to differ materially from those expressed in any of our forward-looking statements. Other unknown or unpredictable factors could also harm our results. Consequently, there can be no assurance that the actual results or developments anticipated by us will be realized or, even if substantially realized, that they will have the expected consequences to, or effects on, us. Given these uncertainties, you are cautioned not to place undue reliance on such forward-looking
statements.
The forward-looking statements included in this document are made only as of the date of this document. Except to the extent required by law, we do not undertake, and specifically decline any obligation, to update any forward-looking statements or to publicly announce the results of any revisions to any of such statements to reflect future events or developments.
Available Information
We make available on or through our website (www.aleris.com) our reports on Forms 10-K, 10-Q and 8-K, and amendments thereto, as soon as reasonably practicable after we electronically file (or furnish, as applicable)
such material with the Securities and Exchange Commission (“SEC”). The SEC maintains an internet site that contains these reports at www.sec.gov. We use our investor website (investor.aleris.com) as a channel of distribution of Company information. The information we post through this channel may be deemed material. Accordingly, investors should monitor this channel, in addition to following our press releases, SEC filings, and public conference calls and webcasts. None of the websites referenced in this quarterly report on Form 10-Q or the information contained therein is incorporated herein
by reference.
Item 3.
Quantitative and Qualitative Disclosures About Market Risk.
In the ordinary course of our business, we are exposed to earnings and cash flow volatility resulting from changes in the prices of aluminum and, to a lesser extent, hardeners, such as zinc and copper, and natural gas and other fuels, as well as changes in currency and interest rates. We use derivative instruments, such as forwards, futures, options, collars and swaps to manage the effect, both favorable and unfavorable, of such changes. For electricity and some
natural gas price exposures, fixed price commitments are also used.
Derivative contracts are used primarily to reduce uncertainty and volatility and cover underlying exposures and are held for purposes other than trading. Our commodity and derivative activities are subject to the management, direction and control of our Risk Management Committee, which is composed of our Chief Financial Officer and other officers and employees that the Chief Executive Officer designates. The Risk Management Committee reports to the Audit Committee of our Board of Directors, which has supervisory authority over all of its activities.
We are exposed to losses in the event of non-performance by the counterparties to the derivative contracts
discussed below. Although non-performance by counterparties is possible, we do not currently anticipate any nonperformance by any of these parties. Counterparties are evaluated for creditworthiness and risk assessment prior to our initiating contract activities.
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The counterparties’ creditworthiness is then monitored on an ongoing basis, and credit levels are reviewed to ensure that there is not an inappropriate concentration of credit outstanding to any particular counterparty.
Metal Hedging
Aluminum ingots, copper and zinc are internationally produced, priced and traded
commodities, with the LME being the primary exchange. As part of our efforts to preserve margins, we enter into forward, futures and options contracts. For accounting purposes, we do not consider our metal derivative instruments as hedges and, as a result, changes in the fair value of these derivatives are recorded immediately in our consolidated operating results.
The selling prices of the majority of the orders for our products are established at the time of order entry or, for certain customers, under long-term contracts. As the related raw materials used to produce these orders can be purchased several months or years after the selling prices are fixed, margins are subject to the risk of changes in the purchase price of the raw materials used
for these fixed price sales. In order to manage this transactional exposure, futures, swaps or forward purchase contracts are purchased at the time the selling prices are fixed. As metal is purchased to fill these fixed price sales orders, futures, swaps or forward contracts are then sold. We also maintain a significant amount of inventory on-hand to meet anticipated and unpriced future sales. In order to preserve the value of this inventory, futures, swaps or forward contracts are sold at the time inventory is purchased. As sales orders are priced, futures, swaps or forwards contracts are purchased. These
derivatives generally settle within three months.
We can also use call option contracts, which function in a manner similar to the natural gas call option contracts discussed below, and put option contracts for managing metal price exposures. Option contracts require the payment of a premium which is recorded as a realized loss upon settlement or expiration of the option contract. Upon settlement of a put option contract,
we receive cash and recognize a related gain if the closing price is less than the strike price of the put option. If the put option strike price is less than the closing price, no amount is paid and the option expires.
As of September 30, 2019, we had 147.1 thousand metric tons and 301.5 thousand metric tons of metal buy and metal sell derivative contracts, respectively. As of December 31, 2018, we had 165.0 thousand metric tons and 293.0 thousand metric tons of
metal buy and metal sell derivative contracts, respectively.
Energy Hedging
To manage the price exposure for natural gas purchases, we can fix the future price of a portion or all of our natural gas requirements by entering into financial hedge contracts. Additionally, from time to time, we have entered into diesel fuel swaps with financial counterparties to mitigate the impact of volatility of diesel fuel prices on our freight costs. We do not consider our natural gas or diesel fuel derivative instruments as hedges for accounting purposes and as a result, changes in the fair value of these derivatives are recorded immediately in our consolidated operating results.
Under
our natural gas derivative contracts, payments are made or received based on the differential between the monthly closing price on the New York Mercantile Exchange (“NYMEX”) and the contractual hedge price. We can also use a combination of call option contracts and put option contracts for managing the exposure to increasing natural gas prices while maintaining the benefit from declining prices. Upon settlement of call option contracts, we receive cash and recognize a related gain if the NYMEX closing price exceeds the strike price of the call option. If the call option strike price exceeds the NYMEX
closing price, no amount is received and the option expires unexercised. Upon settlement of a put option contract, we pay cash and recognize a related loss if the NYMEX closing price is lower than the strike price of the put option. If the put option strike price is less than the NYMEX closing price, no amount is paid and the option expires unexercised. Option contracts require the payment of a premium which is recorded as a realized loss upon settlement or expiration of the option contract. Natural gas cost can also be managed through the use of cost escalators included in some of our long-term supply contracts
with customers, which limits exposure to natural gas price risk. As of September 30, 2019 and December 31, 2018, we had 3.7 trillion and 4.6 trillion of British thermal unit forward buy contracts, respectively.
We use independent freight carriers to deliver our products. As part of the total freight charge, these carriers include a per mile diesel surcharge based on the Department of Energy, Energy Information Administration’s (“DOE”) Weekly Retail Automotive Diesel National Average Price. From time to time, we enter into over-the-counter DOE diesel
fuel swaps with financial counterparties to mitigate the impact of the volatility of diesel fuel prices on our freight costs. Under these swap agreements, we pay a fixed price per gallon of diesel fuel determined at the time the agreements were executed and receive a floating rate payment that is determined on a monthly basis based on the average price of the DOE Diesel Fuel Index during the applicable month. The swaps are designed to offset increases or decreases in fuel surcharges that we pay to our carriers. All
54
swaps are financially settled. There is no possibility of physical settlement. As of September 30, 2019 and December 31,
2018, we had 2.6 million and 4.3 million gallons of diesel fuel swap contracts outstanding, respectively.
Currency Hedging and Exchange Risks
The financial condition and results of operations of some of our operating entities are reported in various currencies and then translated into U.S. dollars at the applicable exchange rate for inclusion in our unaudited consolidated financial statements. As a result, appreciation of the U.S. dollar against these currencies will have a negative impact on reported revenues and operating profit, while depreciation of the U.S. dollar against these currencies will generally have a positive effect on reported revenues and operating profit.
In addition, our aerospace and heat exchanger businesses expose the operating results of our European and Asia Pacific operations to fluctuations in the euro and renminbi as sales contracts are generally in U.S. dollars while the costs of production are in local currencies. As a result, appreciation in the U.S. dollar will have a positive impact on earnings while depreciation of the U.S. dollar will have a negative impact on earnings. In order to mitigate the risk that fluctuations in currencies may have on our business we have entered into forward currency contracts. As of September 30, 2019 and December 31, 2018,
we had euro forward contracts covering a notional amount of €67.1 million and €77.6 million, respectively.
Interest Rate Risks
As of September 30, 2019, approximately 78% of our debt obligations had variable interest rates. We are subject to interest rate risk related to the Term Loan Facility, the ABL Facility and the China Loan Facility, to the extent borrowings are outstanding under these facilities. As of September 30, 2019, Aleris International had $1,086.3
million and $308.7 million of borrowings under the Term Loan Facility and the ABL Facility, respectively, and Aleris Zhenjiang had $146.1 million of borrowings under the Zhenjiang Term Loans. In the third quarter of 2018, we entered into an interest rate swap to fix the LIBOR interest rate on $700.0 million of the Term Loan Facility for the period of October 31, 2018 through June 28, 2019. At September 30, 2019, we had no interest rate swaps outstanding.
We estimate that if the market interest rates would have increased by 10%,
our interest expense for the nine months ended September 30, 2019 would have increased by approximately $2.6 million, excluding the impact of any interest rate derivative instruments.
Fair Values and Sensitivity Analysis
The following table shows the fair values of outstanding derivative contracts at September 30, 2019 and the effect on the fair value of a hypothetical adverse change in the market prices that existed at September 30, 2019:
Impact of
(in
millions)
Fair
10% Adverse
Derivative
Value
Price Change
Metal
$
7.1
$
(28.2
)
Energy
(1.0
)
(2.0
)
Currency
(7.2
)
(7.5
)
The
disclosures above do not take into account the underlying commitments or anticipated transactions. If the underlying items were included in the analysis, the gains or losses on our derivative instruments would be offset by gains and losses realized on the purchase of the physical commodities. Actual results will be determined by a number of factors outside of our control and could vary significantly from the amounts disclosed. For additional information on derivative financial instruments, see Note 12, “Derivative and Other Financial Instruments,” to our unaudited consolidated financial statements included elsewhere in this quarterly report on Form 10-Q.
Item 4.
Controls
and Procedures.
Disclosure Controls and Procedures
During the fiscal period covered by this report, the Company’s management, with the participation of the Chief Executive Officer and Chief Financial Officer, completed an evaluation of the effectiveness of the design and operation of the Company’s disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) of the Securities and Exchange Act
55
of 1934, as amended (the “Exchange Act”)).
Based upon this evaluation, the Company’s Chief Executive Officer and Chief Financial Officer have concluded that, as of the end of the fiscal period covered by this report, the disclosure controls and procedures were effective to ensure that information required to be disclosed by the Company in reports that it files or submits under the Exchange Act is recorded, processed, summarized and reported within the time periods specified by the SEC’s rules and forms and that such information is accumulated and communicated to management, including the Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosures.
Changes in Internal Control Over Financial Reporting
There
were no changes in internal control over financial reporting during the third quarter ended September 30, 2019 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.
PART II – OTHER INFORMATION
Item 1.
Legal Proceedings.
We are party from time to time to what we believe are routine litigation
and proceedings considered part of the ordinary course of our business. We believe that the outcome of such existing proceedings would not have a material adverse effect on our financial position, results of operations or cash flows.
Item 1A.
Risk Factors.
There have been no material changes to the risk factors included in the Risk Factors section in our annual report on Form 10-K for the fiscal year ended December 31, 2018.
Item 2.
Unregistered
Sales of Equity Securities and Use of Proceeds.
Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
