MATERION Corp 10-Q

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations OVERVIEW We are an integrated producer of high-performance advanced engineered materials used in a variety of electrical, electronic, thermal, and structural applications. Our products are sold into numerous end markets, including semiconductor, industrial, aerospace and defense, automotive, consumer electronics, energy, and telecom and data center. Coronavirus (COVID-19) First Quarter 2022 Update In March 2020, the World Health Organization characterized a novel strain of the coronavirus, known as COVID-19, as a pandemic. The duration of the COVID-19 pandemic and the long-term impacts on the economy are uncertain and could impact the Company’s estimates. Management continues to manage global macroeconomic impacts on supply chains, inflationary costs, and temporary plant shutdowns, labor availability and costs, all of which impacted the Company during the first quarter of 2022. 22 RESULTS OF OPERATIONS First Quarter First Quarter Ended April 1, April 2, $ % (Thousands, except per share data) 2022 2021 Change Change Net sales $ 449,045 $ 354,386 $ 94,659 27 % Value-added sales 266,768 198,582 68,186 34 % Gross margin 75,291 66,796 8,495 13 % Gross margin as a % of value-added sales 28 % 34 % Selling, general, and administrative (SG&A) expense 41,662 36,776 4,886 13 % SG&A expense as a % of value-added sales 16 % 19 % Research and development (R&D) expense 7,074 6,206 868 14 % R&D expense as a % of value-added sales 3 % 3 % Restructuring (income) expense 1,076 (378) 1,454 NM Other—net 5,873 4,474 1,399 31 % Operating profit 19,606 19,718 (112) (1) % Other non-operating (income)—net (1,169) (1,276) 107 (8) % Interest expense—net 3,735 761 2,974 391 % Income before income taxes 17,040 20,233 (3,193) (16) % Income tax expense (benefit) 3,021 3,466 (445) (13) % Net income $ 14,019 $ 16,767 $ (2,748) (16) % Diluted earnings per share $ 0.68 $ 0.81 $ (0.13) (16) % NM = Not Meaningful Net sales of $449.0 million in the first quarter of 2022 increased $94.7 million from $354.4 million in the first quarter of 2021. Increased net sales in the Performance Materials and Electronic Materials segments was partially offset by net sales decrease in the Precision Optics segment. The acquisition of HCS-Electronic Materials, which was completed in the fourth quarter of 2021 accounted for $43.1 million of the net sales increase. Additionally, volume and price increases drove double digit growth in our semiconductor (16% excluding HCS-Electronic Materials), energy (25%), industrial (48%) and telecom (41%) end markets when compared to the same period last year. See Note C - Segment Reporting for additional details on the year over year changes in our net sales by segment and market. The change in precious metal and copper prices favorably impacted net sales during the first quarter of 2022 by $5.2 million . In addition, there was an increase in the volume of raw material beryllium hydroxide sales in the first quarter of 2022 of $4.1 million. Value-added sales is a non-GAAP financial measure that removes the impact of pass-through metal costs and allows for analysis without the distortion of the movement or volatility in metal prices and changes in mix due to customer-supplied material. Internally, we manage our business on this basis, and a reconciliation of net sales, the most directly comparable GAAP financial measure, to value-added sales is included herein. Value-added sales of $266.8 million in the first quarter of 2022 increased $68.2 million, or 34%, compared to the first quarter of 2021. The acquisition of HCS-Electronic Materials, which was completed in the fourth quarter of 2021, accounted for $43.1 million of the increase. The remaining value-added sales increase was driven by increased value-added sales into the industrial (36%) and semiconductor (20%) end markets as well as the increase in the volume of raw material beryllium hydroxide sales in the first quarter of 2022 of $4.1 million. Gross margin in the first quarter of 2022 was $75.3 million, which was up 13% compared to the first quarter of 2021. Gross margin expressed as a percentage of value-added sales decreased to 28% in the first quarter of 2022 from 34% in the first quarter of 2021. The decrease was primarily driven by $7.5 million of amortization of the inventory step up from the HCS-Electronic Material acquisition made in the fourth quarter of 2021, and preproduction costs associated with the set-up of the new wide area clad facility. SG&A expense was $41.7 million in the first quarter of 2022, compared to $36.8 million in the first quarter of 2021. The increase in SG&A expense for the first quarter of 2021 was primarily driven by $2.1 million of merger and acquisition costs 23 related to the acquisition of HCS-Electronic Materials, which was completed in the fourth quarter of 2021. Expressed as a percentage of value-added sales, SG&A expense was 16% and 19% in the first quarter of 2022 and 2021, respectively. R&D expense consists primarily of direct personnel costs for pre-production evaluation and testing of new products, prototypes, and applications. R&D spend was 3% of value-added sales in both the first quarter of 2022 and 2021. Restructuring (income) expense consists primarily of cost reduction actions taken in order to reduce our fixed cost structure. In the first quarter of 2022, we recorded a combined total of $1.1 million of restructuring charges in our Precision Optics, Electronic Materials and Other segments. During the first quarter of 2021, we substantially completed the closure of our Large Area Coatings business and recorded $0.4 million of income related to lower than expected facility closure costs that were recorded in 2020. Other-net was $5.9 million of expense in the first quarter of 2022, or a $1.4 million increase from the first quarter of 2021, primarily driven $2.0 million of increased intangible asset amortization expense, related to the acquisition of HCS-Electronic Materials, and a $0.9 million increase in metal consignment fees. These increases were partially offset by a favorable variance of $1.6 million due to foreign exchange gains in 2022 compared to losses in 2021. Refer to Note E to the Consolidated Financial Statements for details of the major components within Other-net. Other non-operating (income) expense-net includes components of pension and post-retirement expense other than service costs. Refer to Note J to the Consolidated Financial Statements for details of the components. Interest expense-net was $3.7 million and $0.8 million in the first quarter of 2022 and 2021, respectively. The increase in interest expense is primarily due to increased borrowings under our revolving credit facility and interest owed on our new term loan, the proceeds of which were used to fund the purchase price for the acquisition of HCS-Electronic Materials. Income tax expense for the first quarter of 2022 was expense of $3.0 million, compared to $3.5 million in the first quarter of 2021. The effective tax rate for the first quarter of 2022 and 2021 was 17.7% and 17.1%, respectively. The effective tax rate for the first quarter of 2022 was lower than the statutory tax rate primarily due to the impact of percentage depletion and research and development credits. See Note F to the Consolidated Financial Statements for additional discussion. 24 Value-Added Sales - Reconciliation of Non-GAAP Financial Measure A reconciliation of net sales to value-added sales, a non-GAAP financial measure, for each reportable segment and for the total Company for the first quarter of 2022 and 2021 is as follows: First Quarter Ended April 1, April 2, (Thousands) 2022 2021 Net sales Performance Materials 149,630 114,143 Electronic Materials 270,836 204,644 Precision Optics 28,579 35,599 Other — — Total $ 449,045 $ 354,386 Less: pass-through metal costs Performance Materials $ 20,512 $ 13,311 Electronic Materials 160,960 141,695 Precision Optics 49 34 Other 756 764 Total $ 182,277 $ 155,804 Value-added sales Performance Materials $ 129,118 $ 100,832 Electronic Materials 109,876 62,949 Precision Optics 28,530 35,565 Other (756) (764) Total $ 266,768 $ 198,582 Internally, management reviews net sales on a value-added basis. Value-added sales is a non-GAAP financial measure that deducts the value of the pass-through metal costs from net sales. Value-added sales allow management to assess the impact of differences in net sales between periods, segments, or markets, and analyze the resulting margins and profitability without the distortion of movements in pass-through metal costs. The dollar amount of gross margin and operating profit is not affected by the value-added sales calculation. We sell other metals and materials that are not considered direct pass-throughs, and these costs are not deducted from net sales when calculating value-added sales. Non-GAAP financial measures, such as value-added sales, have inherent limitations and should not be considered in isolation, or as a substitute for analyses of results as reported under GAAP. The cost of gold, silver, platinum, palladium, copper, ruthenium, iridium, rhodium, rhenium, and osmium can be quite volatile. Our pricing policy is to directly pass the cost of these metals on to the customer in order to mitigate the impact of metal price volatility on our results from operations. Trends and comparisons of net sales are affected by movements in the market prices of these metals, but changes in net sales due to metal price movements may not have a proportionate impact on our profitability. Our net sales are also affected by changes in the use of customer-supplied metal. When we manufacture a precious metal product, the customer may purchase metal from us or may elect to provide its own metal, in which case we process the metal on a toll basis and the metal value does not flow through net sales or cost of sales. In either case, we generally earn our margin based upon our fabrication efforts. The relationship of this margin to net sales can change depending upon whether or not the product was made from our metal or the customer’s metal. The use of value-added sales removes the potential distortion in the comparison of net sales caused by changes in the level of customer-supplied metal. By presenting information on net sales and value-added sales, it is our intention to allow users of our financial statements to review our net sales with and without the impact of the pass-through metals. 25 Segment Results The Company consists of four reportable segments: Performance Materials (previously Performance Alloys and Composites), Electronic Materials (previously Advanced Materials), Precision Optics, and Other. The Other reportable segment includes unallocated corporate costs. The Company changed two segment names during the first quarter of 2022. The Company believes these names better represent the markets served and the advanced, next generation product solutions provided to our customers. Beginning in the first quarter of 2022, the main operating income metric used by management to measure the financial performance of each segment was earnings before interest, taxes, depreciation, depletion and amortization (EBITDA). Although EBITDA is a non-GAAP measure, it allows for better comparability of results across periods in comparison to other companies as recent acquisitions have resulted in an increased amount of purchase accounting amortization expense. The primary measurement used by management to measure the financial performance of each segment prior to the first quarter of 2022 was Operating Profit. Segment results have been revised for all periods presented to be consistent with new measure of segment performance. Refer to Note C - Segment Reporting in the Notes to the Consolidated Financial Statements for the reconciliation of EBITDA by segment to consolidated net income. Performance Materials First Quarter First Quarter Ended April 1, April 2, $ % (Thousands) 2022 2021 Change Change Net sales $ 149,630 $ 114,143 $ 35,487 31 % Value-added sales 129,118 100,832 28,286 28 % EBITDA 24,792 16,792 8,000 48 % Net sales from the Performance Materials segment of $149.6 million in the first quarter of 2022 increased 31% compared to net sales of $114.1 million in the first quarter of 2021. The increase in sales was due to higher volume in industrial and aerospace markets and an increase of $4.1 million due to sales volume increases of raw material beryllium hydroxide. In addition, sales attributable to the HCS-Electronic Materials acquisition increased sales in this segment by $6.5 million. These impacts were slightly offset by a sale to a defense customer in 2021 that did not repeat in 2022 and a slight decrease in automotive market sales as a result of the global chip shortage impacting the timing of demand. Value-added sales of $129.1 million in the first quarter of 2022 were 28% higher than value-added sales of $100.8 million in the first quarter of 2021. The increase in value-added sales was due to the same factors driving the increase in net sales. EBITDA for the Performance Materials segment was $24.8 million in the first quarter of 2022 compared to $16.8 million in the first quarter of 2021. The increase in EBITDA was primarily due to the same factors driving the increase in net sales partially offset by acquisition costs of $2.7 million, primarily related to purchase accounting inventory step up charges. Electronic Materials First Quarter First Quarter Ended April 1, April 2, $ % (Thousands) 2022 2021 Change Change Net sales $ 270,836 $ 204,644 66,192 32 % Value-added sales 109,876 62,949 46,927 75 % EBITDA 12,148 10,930 1,218 11 % Net sales from the Electronic Materials segment of $270.8 million in the first quarter of 2022 were 32% higher than net sales of $204.6 million in the first quarter of 2021. The increase in net sales was primarily due to $36.6 million in net sales from the HCS-Electronic Materials acquisition and higher sales volumes in the semiconductor, energy and industrial markets, as well as the sales impact of higher pass-through metal prices of $2.1 million. Value-added sales of $109.9 million in the first quarter of 2022 increased 75% compared to value-added sales of $62.9 million in the first quarter of 2021. The increase was primarily driven by $36.6 million in value-added sales from the HCS-Electronic Materials acquisition as well as higher organic sales volumes into the semiconductor, energy and industrial markets. 26 EBITDA for the Electronic Materials segment was $12.1 million in the first quarter of 2022 compared to $10.9 million in the first quarter of 2021. The increase in EBITDA is due to increased sales volumes partially offset by restructuring charges of $0.8 million incurred during the quarter and acquisition and integration costs of $6.0 million, primarily related to purchase accounting inventory step up charges. Precision Optics First Quarter (Thousands) First Quarter Ended April 1, April 2, $ % 2022 2021 Change Change Net sales $ 28,579 $ 35,599 (7,020) (20) % Value-added sales 28,530 35,565 (7,035) (20) % EBITDA 2,191 7,471 (5,280) (71) % Net sales from the Precision Optics segment of $28.6 million in the first quarter of 2022 decreased 20% compared to net sales of $35.6 million in the first quarter of 2021. The change was primarily driven by a reduction in sales related to COVID-19 PCR testing programs, the discontinuation of a consumer electronic application, as well as a temporary government-mandated shut down of our Shanghai facility due to COVID-19 at the end of the quarter. Value-added sales of $28.5 million in the first quarter of 2022 decreased 20% compared to value-added sales of $35.6 million in the first quarter of 2021. The decrease in value-added sales was due to the same factors driving the decrease in net sales. EBITDA for the Precision Optics segment was $2.2 million in the first quarter of 2022, compared to EBITDA of $7.5 million in the first quarter of 2021. The decrease in EBITDA was driven by decreased volumes and related unabsorbed cost and restructuring charges incurred during the quarter. Other First Quarter (Thousands) First Quarter Ended April 1, April 2, $ % 2022 2021 Change Change Net sales $ — $ — — — % Value-added sales (756) (764) 8 (1) % EBITDA (5,177) (5,600) 423 (8) % The Other reportable segment in total includes unallocated corporate costs. Corporate costs were $5.2 million in the first quarter of 2022 compared to $5.6 million in the first quarter of 2021. Corporate costs accounted for 2% and 3% of Company-wide value-added sales in the first quarter of 2022 and 2021, respectively. The decrease in corporate costs in the first quarter of 2022 compared to the first quarter of 2021 is primarily related to favorable foreign currency impacts and a decrease in incentive compensation expense. 27 FINANCIAL POSITION Cash Flow A summary of cash flows provided by (used in) operating, investing, and financing activities is as follows: Three Months Ended April 1, April 2, $ (Thousands) 2022 2021 Change Net cash (used in) provided by operating activities $ (14,304) $ 15,450 $ (29,754) Net cash used in investing activities (18,966) (30,675) 11,709 Net cash provided by financing activities 39,305 8,727 30,578 Effects of exchange rate changes (260) (446) 186 Net change in cash and cash equivalents $ 5,775 $ (6,944) $ 12,719 Net cash used in operating activities totaled $14.3 million in the first three months of 2022 versus $15.5 million provided by operating activities in the prior-year period. Working capital requirements used cash of $47.4 million and $19.7 million during the first three months of 2022 and 2021, respectively. This was primarily driven by incremental cash outflow of $25.7 million used for incentive compensation payments in the first quarter of 2022 compared to the same period in the prior year. Cash flows used for inventory were $28.1 million in the first quarter of 2022, compared to $23.2 million in the prior-year period. Inventory levels have increased to support higher sales volumes as well as metal price increases and inventory build related to the ramp up of our new precision clad engineered strip operations. Net cash used in investing activities was $18.9 million in the first quarter of 2022 compared to $30.7 million in the prior-year period. The decrease in cash used in investing activities is due to decreased capital expenditures, primarily related to investments in new equipment funded by customer prepayments in 2021. See Note I to the Consolidated Financial Statements for additional discussion. Capital expenditures are made primarily for new product development, replacing and upgrading equipment, infrastructure investments, and implementing information technology initiatives. For the full year 2022, the Company expects payments for property, plant, and equipment to be approximately $75 million. Net cash provided by financing activities totaled $39.3 million in the first three months of 2022 versus $8.7 million in the prior-year period. The increase is primarily due to increased net borrowings of $49.1 million under our revolving credit facility in the first quarter of 2022, compared to an increase in borrowings of $15.0 million in the same period in the prior year. CRITICAL ACCOUNTING POLICIES The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires the inherent use of estimates and management’s judgment in establishing those estimates. For additional information regarding critical accounting policies, please refer to our 2021 Annual Report on Form 10-K. Liquidity We believe cash flow from operations plus the available borrowing capacity and our current cash balance are adequate to support operating requirements, capital expenditures, projected pension plan contributions, the current dividend program, environmental remediation projects, and strategic acquisitions for at least the next twelve months and for the foreseeable future thereafter. At April 1, 2022, cash and cash equivalents held by our foreign operations totaled $16.8 million. We do not expect restrictions on repatriation of cash held outside of the United States to have a material effect on our overall liquidity, financial condition, or results of operations for the foreseeable future. 28 A summary of key data relative to our liquidity, including outstanding debt, cash, and available borrowing capacity, as of April 1, 2022 and December 31, 2021 is as follows: April 1, December 31, (Thousands) 2022 2021 Cash and cash equivalents $ 20,237 $ 14,462 Total outstanding debt 495,172 449,747 Net debt $ (474,935) $ (435,285) Available borrowing capacity $ 127,356 $ 176,419 Net debt is a non-GAAP financial measure. We are providing this information because we believe it is more indicative of our overall financial position. It is also a measure our management uses to assess financing and other decisions. We believe that based on our typical cash flow generated from operations, we can support a higher leverage ratio in future periods. The available borrowing capacity in the table above represents the additional amounts that could be borrowed under our revolving credit facility and other secured lines existing as of the end of each period depicted. The applicable debt covenants have been taken into account when determining the available borrowing capacity, including the covenant that restricts the borrowing capacity to a multiple of the twelve-month trailing earnings before interest, income taxes, depreciation, depletion and amortization, and other adjustments. In 2021, we amended and restated the agreement governing our $375.0 million revolving credit facility (Credit Agreement) in connection with the HCS-Electronic Materials acquisition. A $300.0 million delayed draw term loan facility was added to the Credit Agreement and the maturity date of the Credit Agreement was extended from 2024 to 2026. Moreover, the Credit Agreement also provides for an uncommitted incremental facility whereby, under certain conditions, the Company may be able to borrow additional term loans in an aggregate amount not to exceed $150.0 million. The Credit Agreement provides the Company and its subsidiaries with additional capacity to enter into facilities for the consignment, borrowing, or leasing of precious metals and copper, and provides enhanced flexibility to finance acquisitions and other strategic initiatives. Borrowings under the Credit Agreement are secured by substantially all of the assets of the Company and its direct subsidiaries, with the exception of non-mining real property, precious metal, copper and certain other assets. The Credit Agreement allows the Company to borrow money at a premium over LIBOR or prime rate and at varying maturities. The premium resets quarterly according to the terms and conditions stipulated in the agreement. The Credit Agreement includes restrictive covenants relating to restrictions on additional indebtedness, acquisitions, dividends, and stock repurchases. In addition, the Credit Agreement includes covenants that limit the Company to a maximum leverage ratio and a maximum interest coverage ratio. We were in compliance with all of our debt covenants as of April 1, 2022 and December 31, 2021. Cash on hand up to $25.0 million can benefit the covenants and may benefit the borrowing capacity under the Credit Agreement. In November 2021, we completed the acquisition of HCS-Electronic Materials. The Company financed the purchase price for the HCS-Electronic Materials acquisition with a new $300.0 million five-year term loan pursuant to its delayed draw term loan facility under the Credit Agreement and $103.0 million of borrowings under its amended revolving credit facility. The interest rate for the term loan is based on LIBOR plus a tiered rate determined by the Company's quarterly leverage ratio. Portions of our business utilize off-balance sheet consignment arrangements allowing us to use bank owned metal as we manufacture product for customers. Metal is purchased from the consignee and sold to our customer at the time of product shipment. Expansion of business volumes and/or higher metal prices can put pressure on the consignment line limitations from time to time. The precious metal consignment agreements, including our largest such agreement entered into in 2019 and maturing on August 27, 2022, were amended in 2021 to be more consistent with the Credit Agreement. The available and unused capacity under the metal consignment lines totaled approximately $79.5 million as of April 1, 2022, compared to $69.8 million as of December 31, 2021. The availability is determined by Board approved levels and actual line capacity. In January 2014, our Board of Directors approved a plan to repurchase up to $50.0 million of our common stock. The timing of the share repurchases will depend on several factors, including market and business conditions, our cash flow, debt levels, and other investment opportunities. There is no minimum quantity requirement to repurchase our common stock for a given year, and the repurchases may be discontinued at any time. We did not repurchase any shares under this program in the first quarter of 2022. Since the approval of the repurchase plan, we have purchased 1,254,264 shares at a total cost of $41.7 million, or an average of $33.23 per share. 29 We paid cash dividends of $2.5 million on our common stock in the first quarter of 2022. We intend to pay a quarterly dividend on an ongoing basis, subject to a determination that the dividend remains in the best interest of our shareholders. OFF-BALANCE SHEET ARRANGEMENTS AND CONTRACTUAL OBLIGATIONS We maintain the majority of the precious metals and portions of the copper we use in production on a consignment basis in order to reduce our exposure to metal price movements and to reduce our working capital investment. The notional value of off-balance sheet precious metals and copper was $485.5 million and $480.2 million as of April 1, 2022 and December 31, 2021, respectively. We were in compliance with all of the covenants contained in the consignment agreements as of April 1, 2022. For additional information on our contractual obligations, refer to our 2021 Annual Report on Form 10-K. Forward-looking Statements: Portions of the narrative set forth in this document that are not statements of historical or current facts are forward-looking statements. Our actual future performance may materially differ from that contemplated by the forward-looking statements as a result of a variety of factors. These factors include, in addition to those mentioned elsewhere herein: the ultimate impact of the COVID-19 pandemic on our business, results of operations, financial condition, and liquidity; our ability to achieve the strategic and other objectives related to the HCS-Electronic Materials (defined herein) acquisition, including any expected synergies; the global economy, including the impact of tariffs and trade agreements; the impact of any U.S. Federal Government shutdowns or sequestrations; the condition of the markets which we serve, whether defined geographically or by segment; changes in product mix and the financial condition of customers; our success in developing and introducing new products and new product ramp-up rates; our success in passing through the costs of raw materials to customers or otherwise mitigating fluctuating prices for those materials, including the impact of fluctuating prices on inventory values; our success in identifying acquisition candidates and in acquiring and integrating such businesses, including the integration of the HCS-Electronic Materials business; the impact of the results of acquisitions on our ability to fully achieve the strategic and financial objectives related to these acquisitions, including, without limitation, the HCS-Electronic Materials acquisition being accretive in the expected timeframe or at all; our success in implementing our strategic plans and the timely and successful start-up and completion of any capital projects; other financial and economic factors, including the cost and availability of raw materials (both base and precious metals), physical inventory valuations, metal consignment fees, tax rates, exchange rates, interest rates, pension costs and required cash contributions and other employee benefit costs, energy costs, regulatory compliance costs, the cost and availability of insurance, credit availability, and the impact of the Company’s stock price on the cost of incentive compensation plans; the uncertainties related to the impact of war, including the conflict between Russia and Ukraine, terrorist activities, and acts of God; changes in government regulatory requirements and the enactment of new legislation that impacts our obligations and operations; the conclusion of pending litigation matters in accordance with our expectation that there will be no material adverse effects; the disruptions in operations from, and other effects of, catastrophic and other extraordinary events including the COVID-19 pandemic; and the risk factors set forth in Part 1, Item 1A of the Company's 2021 Annual Report on Form 10-K. Item 3. Quantitative and Qualitative Disclosures about Market Risk For information regarding market risks, refer to Item 7A. Quantitative and Qualitative Disclosures About Market Risk in our 2021 Annual Report on Form 10-K. There have been no material changes in our market risks since the inclusion of this discussion in our 2021 Annual Report on Form 10-K. 30