HEXCEL CORP /DE/ - Quarter Report: 2020 March (Form 10-Q)

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

For the Quarterly Period Ended March 31, 2020

or

For the transition period from                      to                    

Commission File Number 1-8472

Hexcel Corporation

(Exact name of registrant as specified in its charter)

Two Stamford Plaza

281 Tresser Boulevard

Stamford, Connecticut 06901-3238

(Address of principal executive offices and zip code)

Registrant’s telephone number, including area code: (203) 969-0666

Securities registered pursuant to Section 12(b) of the Act:

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  ☐

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  ☒    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.

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 by Rule 12b-2 of the Exchange Act).    Yes  ☐    No   ☒

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.

HEXCEL CORPORATION AND SUBSIDIARIES

INDEX

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PART I. FINANCIAL INFORMATION

ITEM 1. Condensed Consolidated Financial Statements

Hexcel Corporation and Subsidiaries

Condensed Consolidated Balance Sheets

The accompanying notes are an integral part of these condensed consolidated financial statements.

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The accompanying notes are an integral part of these condensed consolidated financial statements.

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Hexcel Corporation and Subsidiaries

Condensed Consolidated Statements of Cash Flows

The accompanying notes are an integral part of these condensed consolidated financial statements.

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Hexcel Corporation and Subsidiaries

Condensed Consolidated Statements of Stockholders’ Equity

For the Three Months Ended March 31, 2020 and 2019

The accompanying notes are an integral part of these condensed consolidated financial statements.

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HEXCEL CORPORATION AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

Note 1 — Significant Accounting Policies

In these notes, the terms “Hexcel,” “the Company,” “we,” “us,” or “our” mean Hexcel Corporation and subsidiary companies. The accompanying Condensed Consolidated Financial Statements are those of Hexcel Corporation.  Refer to Note 1 to the Consolidated Financial Statements included in the Annual Report on Form 10-K for the year ended December 31, 2019 for a discussion of our significant accounting policies.

Basis of Presentation

The accompanying Condensed Consolidated Financial Statements have been prepared from the unaudited accounting records of Hexcel pursuant to rules and regulations of the Securities and Exchange Commission (“SEC”) and in accordance with accounting principles generally accepted in the United States of America (“GAAP”) for interim financial information.  Certain information and footnote disclosures normally included in financial statements have been omitted pursuant to rules and regulations of the SEC. In the opinion of management, the Condensed Consolidated Financial Statements include all normal recurring adjustments as well as any non-recurring adjustments necessary to present fairly the statement of financial position, results of operations, cash flows and statement of stockholder’s equity for the interim periods presented.  The Condensed Consolidated Balance Sheet as of December 31, 2019 was derived from the audited 2019 Consolidated Balance Sheet.  Interim results are not necessarily indicative of results expected for any other interim period or for the full year.  These consolidated financial statements should be read in conjunction with the consolidated financial statements and notes thereto included in our 2019 Annual Report on Form 10-K.

Investments in Affiliated Companies

We have a 50% equity investment in Aerospace Composites Malaysia Sdn. Bhd. and a 25% equity investment in HexCut Services SAS.  These investments are accounted for using the equity method of accounting.      

Recent Accounting Pronouncements

In June 2016, the Financial Accounting Standards Board (“FASB”) issued Accounting Standard Update (“ASU”) No 2016-13, Financial Instruments – Credit Losses (Topic 326). The Accounting Standards Codification 326, Financial Instruments- Credit Losses (“ASC 326”) requires a financial asset measured at amortized cost basis to be presented at the net amount expected to be collected. We adopted the updated, effective January 1, 2020, applying this standard to our Accounts Receivable and Contract Assets. Our high-quality credit review practice and good customer relationships has resulted in accounts receivable write offs to be below 0.5% of our annual sales. Due to the requirements of ASC 326, we have reviewed and refined our bad debt reserve process. Management reviews the average annual charge-off rate along with an assessment of current micro and macro-economic factors to determine any required reserves. If at any time management finds that there are significant changes to any of these contributing factors, the reserve will be adjusted accordingly. In the quarter we recorded $0.2 million of reserves and there were no write-offs against receivables resulting in a reserve balance of $0.8 million at March 31, 2020.

In August 2018, the FASB issued Accounting Standards Update No. 2018-14 (ASU 2018-14), Compensation—Retirement Benefits—Defined Benefit Plans—General (Subtopic 715-20), which amends the current disclosure requirements regarding defined benefit pensions and other post retirement plans, and allows for the removal of certain disclosures, while adding certain new disclosure requirements. This standard is effective for fiscal years beginning after December 15, 2020 and allows for early adoption. We do not expect this new standard to have a significant impact to our disclosures.

In December 2019, the FASB issued ASU No. 2019-12, Income Taxes (Topic 740): Simplifying the Accounting for Income Taxes which amends and aims to simplify accounting disclosure requirements regarding a number of topics including: intraperiod tax allocation, accounting for deferred taxes when there are changes in consolidation of certain investments, tax basis step up in an acquisition and the application of effective rate changes during interim periods, amongst other improvements. This standard is effective for fiscal years beginning after December 15, 2020 and allows for early adoption. We are assessing the impact of this new standard on our consolidated balance sheets, statements of operations and our future disclosures. 

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Note 2 — Net Income per Common Share

Total shares underlying stock options of 0.6 million and 0.3 million, were excluded from the computation of diluted net income per share for the three months ended March 31, 2020 and 2019, respectively, as they were anti-dilutive. 

Note 3 — Inventories

Note 4 — Retirement and Other Postretirement Benefit Plans

We maintain qualified and nonqualified defined benefit retirement plans covering certain current and former U.S. and European employees, retirement savings plans covering eligible U.S. and U.K. employees and certain postretirement health care and life insurance benefit plans covering eligible U.S. retirees. We also participate in a union sponsored multi-employer pension plan covering certain U.S. employees with union affiliations.

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Defined Benefit Retirement Plans

Net Periodic Benefit Costs

Net periodic benefit costs of our defined benefit retirement plans for the three months ended March 31, 2020 and 2019 were as follows:

All costs related to our pensions are included as a component of operating income in our condensed consolidated statements of operations. For the three month periods ended March 31, 2020 and 2019, amounts unrelated to service costs were a benefit of $0.5 million and $0.8 million, respectively. 

Contributions

We generally fund our U.S. non-qualified defined benefit retirement plans when benefit payments are incurred.  We have contributed approximately $0.1 million in the first three months of 2020 to cover unfunded benefits.  We expect to contribute a total of $1.4 million in 2020 to cover unfunded benefits.  We contributed $0.2 million to our U.S. non-qualified defined benefit retirement plans during the quarter ended March 31, 2019.

We contributed $1.0 million and $1.2 million to our European defined benefit retirement plans during the three months ended March 31, 2020 and 2019, respectively.  We plan to contribute approximately $5.0 million during 2020 to our European plans.

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Postretirement Health Care and Life Insurance Benefit Plans

We recorded $0.2 million and $0.3 million of net amortization gain deferral for the three months ended March 31, 2020 and 2019, respectively. Net periodic benefit costs of our postretirement health care and life insurance benefit plans for the three months ended three months ended March 31, 2020 and 2019 were immaterial.

Amounts contributed in connection with our postretirement plans were immaterial for both the three months ended March 31, 2020 and March 31, 2019. We periodically fund our postretirement plans to pay covered expenses as they are incurred. We expect to contribute less than $0.5 million in 2020 to cover unfunded benefits.

Note 5 –– Debt

In June 2019, the Company refinanced its senior unsecured credit facility (“the Facility”), increasing borrowing capacity from $700 million to $1 billion. The Facility matures in June 2024. The current interest rate for the Facility is LIBOR + 1.0%. The interest rate ranges from LIBOR + 0.875% to a maximum of LIBOR + 1.50%, depending upon the better of the Company’s leverage ratio or the credit rating. As of March 31, 2020, total borrowings under the Facility were $693 million, which approximates fair value. The Facility agreement permits us to issue letters of credit up to an aggregate amount of $50 million. Outstanding letters of credit reduce the amount available for borrowing under the Facility. As of March 31, 2020, there were no issued letters of credit under the Facility, resulting in undrawn availability under the Facility of $307 million. The weighted average interest rate for the Facility was 2.88% for the three months ended March 31, 2020.

The Facility agreement contains financial and other covenants, including, but not limited to customary restrictions on the incurrence of debt by our subsidiaries and the granting of liens, as well as the maintenance of an interest coverage ratio and a leverage ratio. As defined in the Facility agreement, we are required to maintain a minimum interest coverage ratio of 3.50 (based on the ratio of EBITDA to interest expense) and may not exceed a maximum leverage ratio of 3.75 (based on the ratio of total debt to EBITDA) with a step up to 4.25 allowed following certain acquisitions. In addition, the Facility agreement contains other customary terms and conditions such as representations and warranties, additional covenants and events of default.

In 2017, the Company issued $400 million in aggregate principal amount of 3.95% Senior Unsecured Notes due in 2027. The interest rate on these senior notes may be increased 0.25% each time a credit rating applicable to the notes is downgraded. Conversely, such increases would be reversed should the credit rating be subsequently upgraded. The maximum rate is 5.95%. The effective interest rate for three months ended March 31, 2020 was 3.87% inclusive of approximately a 0.25% benefit of treasury locks. Based on quoted prices the fair value of the senior unsecured notes due in 2027 was $408.3 million at March 31, 2020.

In January 2020 we used $49.9 million to repay and terminate the Euro term loan.    

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In 2015, the Company issued $300 million in aggregate principal amount of 4.7% Senior Unsecured Notes due in 2025. The interest rate on these senior notes may be increased by 0.25% each time a credit rating applicable to the notes is downgraded. Conversely, such increases would be reversed should the credit rating be subsequently upgraded. The maximum rate is 6.7%.  The effective interest rate for the three months ended March 31, 2020 was 4.83%. Based on quoted prices, the fair value of these notes was $346.0 million at March 31, 2020.

Note 6 — Derivative Financial Instruments

Interest Rate Swap and Interest Lock Agreements

In January 2020 we terminated €45 million of interest rate swaps when we repaid the European term loan recognizing a charge of $0.7 million. These interest rate swaps fixed the interest rate at a weighted average of 0.5%. These swaps were designated as cash flow hedges to floating rate bank loans, therefore, the fair value of the agreements was recorded in other assets or as a liability with a corresponding amount to other comprehensive income.

The Company had treasury lock agreements to protect against unfavorable movements in the benchmark treasury rate related to the issuance of our 3.95% Senior Unsecured Notes. These hedges were designated as cash flow hedges therefore any change in fair value was recorded as a component of other comprehensive income. As part of the issuance of these notes, we net settled the derivatives and therefore the previously deferred gains recorded in other comprehensive income will be released to interest expense over the life of the senior notes. The effect of these treasury locks reduced the effective interest rate on these notes by approximately 0.25%.  

Foreign Currency Forward Exchange Contracts

A number of our European subsidiaries are exposed to the impact of exchange rate volatility between the U.S. dollar and the subsidiaries’ functional currencies, being either the Euro or the British Pound sterling. We entered into contracts to exchange U.S. dollars for Euros and British Pound sterling through September 2022, which we account for as cash flow hedges. The aggregate notional amount of these contracts was $418.9 million and $426.9 million at March 31, 2020 and December 31, 2019, respectively.  The purpose of these contracts is to hedge a portion of the forecasted transactions of our European subsidiaries under long-term sales contracts with certain customers. These contracts are expected to provide us with a more balanced matching of future cash receipts and expenditures by currency, thereby reducing our exposure to fluctuations in currency exchange rates.  The effective portion of the hedges, losses of $17.3 million were recorded in other comprehensive income (“OCI”) for the three months ended March 31, 2020 and losses of $3.6 million for the three months ended March 31, 2019.  We classified $0.2 million of the carrying amount of these contracts as assets ($0.1 million of which was recorded in prepaid expenses and other current assets) and $24.9 million as liabilities ($7.0 million of which is recorded in non-current liabilities), on the condensed consolidated balance sheets at March 31, 2020, and $3.7 million of the carrying amount of these contracts was classified in assets ($1.3 million of which was recorded in prepaid expenses and other current assets) and $15.5 million as liabilities ($2.9 million of which is in other non-current liabilities) at December 31, 2019.  We recognized net losses of $4.4 million in gross margin during the three months ended March 31, 2020 and net losses of $1.8 million for the three months ended March 31, 2019.  

In addition, we enter into foreign exchange forward contracts which are not designated as hedges. These are used to provide an offset to transactional gains or losses arising from the re-measurement of non-functional monetary assets and liabilities such as accounts receivable. The change in the fair value of the derivatives is recorded in the statement of operations. There are no credit contingency features in these derivatives. During the quarters ended March 31, 2020 and 2019, we recognized net foreign exchange losses of $1.0 million and $0.3 million, respectively, in the condensed consolidated statements of operations. The net foreign exchange impact recognized from these hedges offset the translation exposure of these transactions. The carrying amount of the contracts for derivatives not designated as hedging instruments was $0.2 million classified in other assets at March 31, 2020, and $0.6 million classified in prepaid expenses and other current assets and less than $0.1 million of current liabilities on our consolidated balance sheets at December 31, 2019, in the condensed consolidated balance sheets.

 The change in fair value of our foreign currency forward exchange contracts under hedge designations recorded net of tax within accumulated other comprehensive income for the quarters ended March 31, 2020 and March 31, 2019 was as follows:

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Unrealized losses of $17.8 million recorded in accumulated other comprehensive loss, less taxes of $4.3 million, as of March 31, 2020, are expected to be reclassified into earnings over the next twelve months as the hedged sales are recorded.

Commodity Swap Agreements

On occasion we enter into commodity swap agreements to hedge against price fluctuations of raw materials, including propylene (the principal component of acrylonitrile).  As of March 31, 2020, we had commodity swap agreements with a notional value of $20.2 million. The swaps mature monthly through March 2022. The swaps are accounted for as a cash flow hedge of our forward raw material purchases. To ensure the swaps are highly effective, all of the critical terms of the swap matched the terms of the hedged items. The fair value of the commodity swap agreements was a liability of $8.9 million ($1.7 million of which is in other non-current liabilities) at March 31, 2020, and a liability of $5.4 million ($1.1 million of which is in other non-current liabilities) at December 31, 2019.

Note 7 — Income Taxes

The effective tax rate was 21.9% compared to 22.7% for the quarters ended March 31, 2020 and 2019, respectively. Both periods benefited from deductions associated with share-based compensation payments. Our underlying estimated effective income tax rate is expected to remain at 23% for the year.

Note 8 — Fair Value Measurements

The authoritative guidance for fair value measurements establishes a hierarchy for observable and unobservable inputs used to measure fair value, into three broad levels, which are described below:

In determining fair value, we utilize valuation techniques that maximize the use of observable inputs and minimize the use of unobservable inputs to the extent possible as well as consider counterparty credit risk in our assessment of fair value.

We have no assets or liabilities that utilize Level 1 inputs. However, we have derivative instruments classified as liabilities and assets which utilize Level 2 inputs, and one liability that utilizes Level 3 inputs.

For derivative assets and liabilities that utilize Level 2 inputs, we prepare estimates of future cash flows of our derivatives, which are discounted to a net present value. The estimated cash flows and the discount factors used in the valuation model are based on observable inputs, and incorporate non-performance risk (the credit standing of the counterparty when the derivative is in a net asset position, and the credit standing of Hexcel when the derivative is in a net liability position). The fair value of these assets and liabilities was approximately $0.4 million and $33.8 million and $4.3 million and $21.7 million, respectively, at March 31, 2020 and December 31, 2019.  In addition, the fair value of these derivative contracts, which are subject to a master netting arrangement under certain circumstances, is presented on a gross basis in the condensed consolidated balance sheets.

Below is a summary of valuation techniques for all Level 2 financial assets and liabilities:

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Counterparties to the above contracts are highly rated financial institutions, none of which experienced any significant downgrades in the quarter ended March 31, 2020 that would reduce the receivable amount owed, if any, to the Company.

Liabilities classified as Level 3 — At March 31, 2020 we have a liability for $3.2 million, which represents contingent consideration that was recognized in connection with the Company’s Oxford Performance Materials, Inc. acquisition. This amount was estimated based on certain contractual stipulations which require payments to be made to the seller in the future based upon the achievement of certain results. We used forecasted results which were discounted using an internally derived discount rate. Future amounts payable may differ from this estimate by the difference between the actual and forecasted results. There were no payments and the amount of interest related to this liability accreted was not material during the three months ended March 31, 2020.  

Note 9 — Revenue

Our revenue is primarily derived from the sale of inventory under long-term agreements with our customers. We have determined that individual purchase orders (“PO”), whose terms and conditions taken with a master agreement, create the ASC 606 contracts which are generally short-term in nature.  For those sales, which are not tied to a long-term agreement, we generate a PO that is subject to our standard terms and conditions. In instances where our customers acquire our goods related to government contracts, the contracts are typically subject to terms similar, or equal to, the Federal Acquisition Regulation Part 52.249-2.  This regulation contains a termination for convenience clause (“T for C”), which requires that the customer pay for the cost of both the finished and unfinished goods at the time of cancellation plus a reasonable profit.

We recognize revenue over time for those agreements that have T for C, and where the products being produced have no alternative use.  As our production cycle is typically six months or less, it is expected that goods related to the revenue recognized over time will be shipped and billed within the next twelve months. Less than half of our agreements contain provisions which would require revenue to be recognized over time.

We disaggregate our revenue based on market for analytical purposes. The following table details our revenue by market for the three months ended March 31, 2020 and 2019:

Revenue recognized over time gives rise to contract assets, which represent revenue recognized but unbilled.  Contract assets are included in our Condensed Consolidated Balance Sheets as a component of current assets. The activity related to contract assets for the three months ended March 31, 2020 is as follows:

Accounts receivable, net includes amounts billed to customers where the right to payment is unconditional.  

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Note 10 — Segment Information

The financial results for our operating segments are prepared using a management approach, which is consistent with the basis and manner in which we internally segregate financial information for the purpose of assisting in making internal operating decisions. We evaluate the performance of our operating segments based on operating income, and generally account for intersegment sales based on arm’s length prices.  Corporate and certain other expenses are not allocated to the operating segments, except to the extent that the expense can be directly attributable to the business segment.

Financial information for our operating segments for the quarter and three months ended March 31, 2020 and 2019 were as follows:

At March 31, 2020, the balance of goodwill and intangible assets was $188.3 million and $88.3 million, respectively. During the first quarter of 2020 the Company determined that the economic uncertainty caused by the novel strain of coronavirus (“COVID-19”) pandemic was a trigger for an impairment review of goodwill. As a result of management’s review, we determined that it was not more likely than not that there was impairment.

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Note 11 — Accumulated Other Comprehensive Loss

Comprehensive income represents net income and other gains and losses affecting stockholders’ equity that are not reflected in the Condensed Consolidated Statements of Operations. The components of accumulated other comprehensive loss as of March 31, 2020 and December 31, 2019 were as follows:

The amounts of net gains reclassified to earnings from the unrecognized net defined benefit and postretirement plan costs component of accumulated other comprehensive loss for the three months ended March 31, 2020, were $0.2 million less taxes of $0.1 million. The amounts reclassified to earnings from the change in fair value of the derivatives component of accumulated other comprehensive loss for the three months ended March 31, 2020 were net losses of $4.4 million less taxes of $1.1 million, for those related to foreign currency forward exchange contracts and $1.3 million less taxes of $0.3 million, related to commodity swaps. We also recorded net losses of $0.4 million less taxes of $0.1 million related to interest rate swaps. 

Note 12 — Commitments and Contingencies

We are involved in litigation, investigations and claims arising out of the normal conduct of our business, including those relating to commercial transactions, environmental, employment and health and safety matters. While it is impossible to predict the ultimate resolution of litigation, investigations and claims asserted against us, we believe, based upon our examination of currently available information, our experience to date, and advice from legal counsel, that, after taking into account our existing insurance coverage and amounts already provided for, the currently pending legal proceedings against us will not have a material adverse impact on our consolidated results of operations, financial position or cash flows.

Environmental Matters

We have been named as a potentially responsible party (“PRP”) with respect to the below hazardous waste disposal sites that we do not own or possess, which are included on, or proposed to be included on, the Superfund National Priority List of the U.S. Environmental Protection Agency (“EPA”) or on equivalent lists of various state governments. Because the Federal Comprehensive Environmental Response, Compensation and Liability Act (“CERCLA” or “Superfund”) allows for joint and several liability in certain circumstances, we could be responsible for all remediation costs at such sites, even if we are one of many PRPs. We believe, based on the amount and nature of our waste, and the number of other financially viable PRPs, that our liability in connection with such environmental matters will not be material.

Lower Passaic River Study Area

Hexcel together with approximately 48 other PRPs that comprise the Lower Passaic Cooperating Parties Group (the “CPG”), are subject to a May 2007 Administrative Order on Consent (“AOC”) with the EPA requiring the CPG to perform a Remedial Investigation/Feasibility Study of environmental conditions of a 17-mile stretch of the Passaic River in New Jersey (the “Lower Passaic River”). We were included in the CPG based on our operations at our former manufacturing site in Lodi, New Jersey.        

In March 2016, the EPA issued a Record of Decision (“ROD”) setting forth the EPA’s selected remedy for the lower eight miles of the Lower Passaic River at an expected cost ranging from $0.97 billion to $2.07 billion. This estimate does not include any costs related to a future remedy for the upper nine miles of the Lower Passaic River. In August 2017, the EPA appointed an independent third party allocation expert to make recommendations on the relative liability of approximately 120 identified non-government PRP’s.  The allocation is expected to be completed by the end of 2020.

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In October 2016, pursuant to a settlement agreement with the EPA, Occidental Chemical Corporation (“OCC”), one of the PRPs, commenced performance of the remedial design required by the ROD, reserving its right of cost contribution from all other PRPs. In June 2018, OCC filed suit against approximately 120 parties, including Hexcel, in the U.S. District Court of the District of New Jersey seeking cost recovery and contribution under CERCLA related to the Lower Passaic River. In July 2019, the court granted in part and denied in part the defendants’ motion to dismiss.  Discovery for the remaining claims is ongoing. We do not know whether this litigation will impact the EPA’s allocation process or the ultimate outcome of the matter.

The accrual was approximately $2.0 million as of March 31, 2020 and December 31, 2019. Given the uncertainty associated with the many elements of the Superfund process for the Lower Passaic River, the amounts accrued may not be indicative of the amounts for which we will ultimately be responsible.

Omega Chemical Corporation Superfund Site, Whittier, California

We are a PRP at a former chemical waste site in Whittier, California. The PRPs at Omega have established The Omega Chemical Site PRP Organized Group, (the “OPOG”), and are currently investigating and remediating soil and groundwater at the site pursuant to a Consent Decree with the EPA. OPOG has attributed to Hexcel either 1.2% or 2.18% of the waste tonnage (dependent on the specific location within the Omega Chemical Site) sent to the site.  In addition to the Omega site specifically, the EPA is investigating the scope of regional groundwater contamination in the vicinity of the Omega site and issued a ROD. The OPOG members have been served notice by the EPA as PRPs who will be required to be involved in the remediation of the regional groundwater contamination in that vicinity as well.  As a member of OPOG, Hexcel will incur costs associated with the investigation and remediation of the Omega site and the regional groundwater remedy, although our ultimate liability, if any, in connection with this matter cannot be determined at this time. The total accrued liability relating to potential liability for both the Omega site and regional groundwater remedies was $0.3 million at March 31, 2020 and at December 31, 2019.

Summary of Environmental Reserves

Our estimate of liability as a PRP and our remaining costs associated with our responsibility to remediate the Lower Passaic River and other sites are accrued in the Condensed Consolidated Balance Sheets. As of March 31, 2020 and December 31, 2019, our aggregate environmental related accruals were $2.7 million and $2.5 million, respectively, of which $0.8 million and $0.6 million, respectively, was included in current other accrued liabilities with the remainder included in other non-current liabilities.  As related to certain environmental matters the accrual was estimated at the low end of a range of possible outcomes since no amount within the range is a better estimate than any other amount.  If we had accrued, for those sites where we are able to estimate our liability, at the high end of the range of possible outcomes, our accrual would have been $16 million higher at March 31, 2020 and December 31, 2019.

These accruals can change significantly from period to period due to such factors as additional information on the nature or extent of contamination, the methods of remediation required, changes in the apportionment of costs among responsible parties and other actions by governmental agencies or private parties, or the impact, if any, of being named in a new matter.

Product Warranty

We provide standard assurance-type warranties for our products, which cannot be purchased separately and do not meet the criteria to be considered a performance obligation. Warranty expense for the quarter ended March 31, 2020, and accrued warranty cost, included in “other accrued liabilities” in the condensed consolidated balance sheets at March 31, 2020 and December 31, 2019, were as follows:

Note 13 — Other Operating Expense

In 2020, other operating expense consisted of $14.7 million of costs primarily related to the terminated merger agreement with Woodward, Inc.

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Note 14 — Subsequent Events

Response to COVID-19

As part of the Company’s response to the impact of the COVID-19 pandemic on its business, the Company is taking the following cost reduction measures: temporary salary reductions and unpaid furloughs for most salaried employees, including reducing the base salary of our Chairman, Chief Executive Officer and President by 50% and our other executive officers by 30%, reducing retainer fees for our non-employee directors by 50%, and suspending the Company’s 401(k) match, employee stock purchase plan, dividend payments and stock repurchases until further notice.  Also, in furtherance of its objectives to reduce costs, the Company is targeting a 30% reduction in labor costs to be implemented on a rolling basis beginning in the second quarter of 2020.  The Company is still developing this plan, and therefore, it cannot reasonably estimate restructuring costs relating to termination benefits at this time.  The Company continues to analyze its cost structure and may implement additional cost reduction measures as may be necessary due to the on-going economic challenges resulting from the COVID-19 pandemic.

Merger Termination

On January 12, 2020, we announced that we had entered into an agreement and plan of merger (the “Merger Agreement”) with Woodward, Inc. (“Woodward”), which provided for the combination of Hexcel and Woodward in an all stock merger of equals (the “Merger”).  In response to the impact of the COVID-19 pandemic, on April 5, 2020, Hexcel and Woodward entered into an agreement to terminate the Merger Agreement.

Rights Plan

On April 6, 2020, the Company declared a dividend of one preferred share purchase right (a “right”) for each outstanding share of the Company’s common stock and adopted a stockholder rights plan, as set forth in the rights agreement entered into as of April 6, 2020, between the Company and American Stock Transfer & Trust Company, LLC, as rights agent. The dividend was payable on April 16, 2020 to stockholders of record of the Company’s common stock on such date. In general, the rights plan works by imposing a significant penalty upon any person or group which acquires 15% or more of the outstanding common stock without the approval of the board. If the rights become exercisable, each right will allow its holder to purchase from the Company one one-hundredth of a share of Series A Junior Participating Preferred Stock for $150.00. This portion of a preferred share will give the stockholder approximately the same dividend, voting and liquidation rights as would one share of common stock. The rights will not be exercisable until ten days after the public announcement that a person or group has become an “acquiring person” (as defined in the rights agreement) by obtaining beneficial ownership of 15% or more of the outstanding common stock. Prior to exercise, the right does not give its holder any dividend, voting, or liquidation rights. The rights will expire on April 6, 2021.

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ITEM 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

Business Overview

We develop, manufacture, and market lightweight, high-performance structural materials, including carbon fibers, specialty reinforcements, prepregs and other fiber-reinforced matrix materials, honeycomb, adhesives, radio frequency / electromagnetic interference (“RF/EMI”) and microwave absorbing materials, engineered honeycomb and composite structures, for use in Commercial Aerospace, Space & Defense and Industrial markets. Our products are used in a wide variety of end applications, such as commercial and military aircraft, space launch vehicles and satellites, wind turbine blades, automotive, recreational products and other industrial applications.

We serve international markets through manufacturing facilities, sales offices and representatives located in the Americas, Asia Pacific, Europe, Russia, India and Africa. We are also a partner in a joint venture in Malaysia, which manufactures composite structures for Commercial Aerospace applications.

We have two segments, Composite Materials and Engineered Products. The Composite Materials segment is comprised of our carbon fiber, specialty reinforcements, resins, prepregs and other fiber-reinforced matrix materials, honeycomb core product lines and pultruded profiles.  The Engineered Products segment is comprised of lightweight high strength composite structures, RF/EMI and microwave absorbing materials, engineered core and specialty machined honeycomb products with added functionality.

On March 11, 2020, the World Health Organization (“WHO”) declared the COVID-19 outbreak a pandemic. The outbreak has resulted in governments around the world implementing increasingly stringent measures to help control the spread of the virus, including quarantines, “shelter in place” and “stay at home” orders, travel restrictions, business curtailments, school closures, and other measures. In addition, governments and central banks in several parts of the world have enacted fiscal and monetary stimulus measures to counteract the impacts of COVID-19.

Our company is a sole provider for many programs, including critical defense programs. Consistent with national guidelines and with state and local orders to date, we currently continue to operate across our footprint. Notwithstanding our continued operations, COVID-19 has begun to have and may have further negative impacts on our operations, supply chain, transportation networks and customers all of which may compress our margins, even after the preventative and precautionary measures that we, other businesses and governments are taking. The COVID-19 outbreak is a widespread public health crisis that is adversely affecting the economies and financial markets of many countries. The resulting economic downturn has, and could for an extended period of time, adversely affect demand for our products and contribute to volatile supply and demand conditions affecting prices and volumes in the markets for our products, services and raw materials. The progression of the pandemic could also continue to negatively impact our business or results of operations through the temporary closure of our operating locations or those of our customers or suppliers.

In the first quarter of 2020, we began to see the impacts of COVID-19 on our markets and operations including significant decreases in air traffic, temporary shutdowns of our customers’ and suppliers’ facilities and decreased demand from our customers. In response, we are in the process of taking certain mitigating actions including reductions in workforce, compensation and benefits, and the suspension of dividend payments and stock repurchases.  The extent to which COVID-19 will adversely impact our business depends on future developments, which are highly uncertain and unpredictable, including new information concerning the severity of the outbreak and the effectiveness of actions globally to contain or mitigate its effects. While we expect the pandemic to continue to negatively impact our results of operations, cash flows and financial position, the current level of uncertainty over the economic and operational impacts of COVID-19 means the related financial impact to us cannot be reasonably estimated at this time.

On January 12, 2020, we announced that we had entered into an agreement and plan of merger (the “Merger Agreement”) with Woodward, Inc. (“Woodward”), which provided for the combination of Hexcel and Woodward in an all stock merger of equals (the “Merger”).  In response to the impact of the COVID-19 pandemic, on April 5, 2020, Hexcel and Woodward entered into an agreement to terminate the Merger Agreement.

Net sales for the quarter were $541.0 million, 11.3% lower (11.0% in constant currency) than the $609.9 million reported for the first quarter of 2019.  Declines in demand in the Commercial Aerospace and Industrial markets drove the decrease in sales for the quarter.

Commercial Aerospace sales of $362.9 million decreased 12.7% (12.7% in constant currency) for the quarter as compared to the first quarter of 2019.  Lower sales for the Boeing 737 MAX was the largest contributor year over year, followed by the end of the A380 program, partially offset by higher sales year over year for the Boeing 787 and 777X programs

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Sales to other commercial aerospace, which includes regional and business aircraft customers, were up 3.1% for the first quarter of 2020 as compared to 2019.

Space & Defense sales of $111.6 million increased 3.5% (4.1% in constant currency) for the quarter as compared to the first quarter of 2019. Rotorcraft, particularly the Black Hawk program, and a number of Space programs drove the increase.  

Total Industrial sales of $66.5 million for the first quarter of 2020 were down 23.2% (21.6% in constant currency) as compared to the 2019 period. Wind energy sales were down 23.2% (21.5% in constant currency) compared to the prior year period primarily due to temporary plant closures in China and Austria arising from the COVID-19 pandemic.  Both of these facilities have reopened, but are operating with some ongoing labor access constraints.

Gross margin for the first quarter of 2020 decreased to 26.0% as compared to 27.4% for the first quarter of 2019 primarily related to the volume declines described above.

Selling, general and administrative and research and technology expenses for the first quarter of 2020 were lower than the prior year period, reflecting tight cost control.

Other operating expense of $14.7 million was primarily related to professional fees incurred in connection with the Merger.

Operating cash flow for the first three months of 2020 was $8.6 million compared to $45.9 million in 2019 on lower earnings and higher working capital. Working capital increased resulting in a cash use of $94.8 million in 2020 as compared to $78.4 million in 2019. For the first three months of 2020, capital expenditures were $27.2 million as compared to $61.1 million in the first three months of 2019.  Free cash flow (defined as cash provided by operating activities less capital expenditures) for the three months ended March 31, 2020 was a use of $18.6 million versus $15.2 million in the comparable period of 2019.

Accrual basis additions to capital expenditures were $21.9 million for the first three months of 2020 and $57.5 million in 2019.

Financial Overview

Results of Operations

The Company uses non-GAAP financial measures, including sales and expenses measured in constant dollars (prior year sales and expenses measured at current year exchange rates); operating income, net income and earnings per share adjusted for items included in operating expense and non-operating expenses; and free cash flow. Management believes these non-GAAP measurements are meaningful to investors because they provide a view of Hexcel with respect to ongoing operating results and comparisons to prior periods. These adjustments represent significant charges or credits that we believe are important to an understanding of Hexcel’s overall operating results in the periods presented. Such non-GAAP measurements are not determined in accordance with generally accepted accounting principles and should not be viewed in isolation or as an alternative to or substitutes for GAAP measures of performance. Our calculation of these measures may not be comparable to similarly titled measures used by other companies, and the measures exclude financial information that some may consider important in evaluating our performance. Reconciliations to adjusted operating income, adjusted net income, adjusted diluted net income per share and free cash flow are provided below.

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Net Sales

The following table summarizes net sales to third-party customers by segment and end market for the three months ended March 31, 2020 and 2019: