Kraton Corporation
Q1 2018 Earnings Call Transcript

Published: 28 Apr 2018

[Operator:]

Good morning, and welcome to the Kraton Corporation First Quarter 2018 Earnings Conference Call. My name is Jay, and I’ll be conference facilitator. [Operator Instructions] Today’s conference is being recorded. If you have any objections, please disconnect at this time. I’ll now turn the call over to Mr. Gene Shiels, Director of Investor Relations. You may now begin.

[Gene Shiels:]

Thanks, Jay. Good morning, everyone, and welcome to the Kraton Corporation First Quarter 2018 Earnings Call. With me on the call this morning are Kevin Fogarty, Kraton’s President and Chief Executive Officer; and Steve Tremblay, Kraton’s Executive Vice President and Chief Financial Officer. A copy of the news release covering our first quarter results as well as the related presentation material are available in the Investor Relations section of our website. Before we review the results for the first quarter of 2018, I want to draw your attention to the disclaimers on forward-looking information and the use of non-GAAP measures included in our presentation this morning and in yesterday’s earnings press release. Our business outlook is subject to a number of risk factors. As the format of this morning’s presentation does not permit a full discussion of these risk factors, please refer to our forms 10-K, 10-Q and other regulatory filings available in the Investor Relations section of our website. With regard to the use of non-GAAP financial measures, a reconciliation of each used non-GAAP financial measure to its most comparable GAAP financial measure was provided in yesterday’s earnings release and is included in the presentation this morning. I do want to highlight for our listeners, as noted in yesterday’s release, that effective January 1, 2018, results for the roads and construction product line under our Chemical segment have been consolidated into our Adhesive and Performance Chemicals product lines. Results for the first quarter of 2017 have been restated to conform to the new reporting structure. Following our prepared remarks, we’ll open the line for your questions. I’ll now turn the call over to Kevin Fogarty. Kevin?

[Kevin Fogarty:]

Thanks, Gene, and good morning, everyone. Business fundamentals remain positive in the first quarter of 2018, and as a result, our first quarter results were in line with our overall expectations. As noted in our press release, we delivered consolidated adjusted EBITDA $88.6 million and this was up 35% compared to the first quarter of 2017. Improved financial results reflected turn -- a return to healthy Polymer segment unit margins compared to the first quarter of 2017, during which margins were adversely impacted by significant increase in raw material cost as well as improved pricing and margins in our Chemical segment particularly for our tall oil fatty acid family of products. First quarter 2018 adjusted EBITDA for our Polymer segment was $45 million, up nearly 40% compared to the first quarter of 2017. Segment sales volume benefited from a 5.6% increase in Specialty Polymers sales volume and modestly higher Cariflex sales volume, which was partially offset by lower sales of USBC grades in our Performance Products product line. In our fourth quarter of 2017 earnings call in late February, we indicated that we are working to address processing challenges that certain customers were having with the direct connect material produced in our Paulinia facility site. I’m pleased to report that we believe the technical issues have now been resolved and that customers are effectively processing the direct connect material. Consequently, we’ve been able to ramp up our production volumes in Paulinia, and we are now at approximately 90% of our planned production capacity. We continue to expect the direct connect state-of-the-art technology will enable efficient capacity expansions for our Cariflex business moving forward. We’ve also recently completed our USBC expansion in Berre, France, which was part of the overall $70 million of cost improvement initiatives for our Polymer segment that we announced back in June of 2015. We now look forward to leveraging the improved cost base and economics that we expect the expansion will provide. Overall market conditions in our paving and roofing markets remain relatively robust, as we move from an excellent summer season in South America, where our HiMA technology offerings enjoyed a 50% growth in sales volume as compared to the first quarter of last year, and through the traditional summer seasons of both North America and Europe. Thus, the timing of our Berre’s expansion and its successful startup is well timed to take advantage of the paving season. Turning to our Chemical segment. First quarter 2018 adjusted EBITDA was $44 million, up 31% compared to the first quarter of 2017 with an associated margin of 20.6%. This increase in adjusted EBITDA compared to the year-ago quarter was driven by margin improvement, primarily for TOFA-related products and other upgraded products in our Performance Chemicals business line. Looking ahead, after two years of delivering impressive cost reductions associated with both acquisition synergy initiatives and operational improvements, we expect 2018 to be a year of margin recovery versus the cycle lows that we experienced in 2017. Debt reduction, as you know, remains a high priority for Kraton. The nature of our business is such that first quarter is typically not a quarter of strong cash generation, and the modest seasonal increase in our outstanding debt was not unexpected. Our debt reduction objectives for the year remain intact, and we continue to anticipate exiting the year below four turns of leverage on a net debt basis. Given our focus on debt reduction, we continue to pursue opportunities to improve our overall capital structure and to optimize the carrying cost of our debt. Accordingly, during the first quarter, we refinanced our term loan. In doing so, we reduced the annualized cash interest cost by approximately $6 million, and we increased our financial flexibility by extending the maturity date by approximately three years, while increasing the euro tranche under the facility by €150 million. So with that review of the quarter, I’ll now turn the call over to Steve Tremblay, our Chief Financial Officer, who’ll provide a more in-depth financial review of our first quarter results. Steve?

[Steve Tremblay:]

Thank you, Kevin, and good morning. First, our Polymer segment first quarter 2018 results, where the revenue was $289 million in the first quarter of 2018 versus $271 million in the first quarter of 2017. This increase includes the benefit of a 5.6% increase in Specialty Polymers sales volumes with approximately $13 million coming from changes in foreign currency exchange rates. Polymer segment adjusted EBITDA of $44.8 million is an improvement of about 40% compared to the first quarter of 2017. The increase reflects improved unit margins across each of the three product groups, driven by the recovery from the raw material headwinds we faced in the first quarter of 2017. Indicative of the improved unit margins is an increase in adjusted gross profit per ton of 25% to $949 per ton in Q1 2018, as well as an increase in adjusted EBITDA margin to 15.5% in Q1 2018. As for the progress toward the cost reset initiatives, Q1 benefited by approximately $4 million. The completion of the USBC expansion in Berre, France marks a significant milestone as the footprint optimization initiatives are now complete. As a result of the ongoing positive momentum with respect to these initiatives first outlined in 2015, we continue to be confident that a substantial portion of the $70 million benefit will be achieved by year-end 2018. These Polymer segment initiatives and the deal-related improvements associated with the Arizona acquisition were well executed. We completed the efforts to date with no safety incidents and expect delivering the $135 million of aggregate benefit at a cost of approximately $106 million, and this is substantially lower than the original estimate of $145 million. Moving next to the Chemical segment. Revenue of $213 million was up $26 million quarter-over-quarter, resulting from higher average selling prices with approximately $12 million associated with foreign currency movements. The Chemical segment generated adjusted EBITDA of $43.9 million in the first quarter of 2017, representing growth in excess of $10 million or 31% compared to the first quarter of 2017. The significant improvement in adjusted EBITDA was driven by higher average selling prices and improved product mix, primarily for TOFA and related products and other upgraded streams within Performance Chemicals. As a result, adjusted EBITDA margin improved 270 basis points to nearly 21% in the first quarter of 2018. Moving on to Slide 7. Our consolidated results reflect first quarter revenue of $502 million compared to $458 million in the first quarter of 2017. On a constant currency basis, revenue improved 4%, driven by the volume growth in Specialty Polymers and the improved pricing in portions of our Chemical segment. Adjusted EBITDA improved $23 million or 35% to $88.6 million in the first quarter of 2018, with adjusted EBITDA margin up fully 330 basis points to 17.6%, reflecting the improved adjusted EBITDA margin in both of our segments. Adjusted EPS improved to $0.58 per share compared to a $0.15 per share loss in the first quarter of 2017. Relative to indebtedness, as Kevin mentioned, we continued to lower the cost of our long-term debt in Q1 2018 by repricing the term loan and increasing our euro base indebtedness. In fact, since we closed the Arizona acquisition, we have successfully reduced the annual cash interest obligation by $31 million or 24%. We currently anticipate refinancing the existing 10.5% notes, which will further reduce our cash interest cost. From December 2017 to the end of March 2018, there was a seasonally modest increase in net debt which was in line with our internal expectations. We now currently anticipate a reduction in net debt of $125 million to $150 million in 2018, which is an improvement from earlier expectations where we indicated the 2018 reduction in net debt would be 125 million. As of March 31, 2018, leverage was 4.1 turns compared to 4.3 turns as of year-end 2017. And with our adjusted EBITDA and net debt expectations, we expect to close 2018 with leverage inside 4 turns. Finally, before I turn the call back to Kevin, included in the appendix of the presentation are additional modeling assumptions which are largely unchanged from our February estimates. Kevin?

[Kevin Fogarty:]

Thanks, Steve. As we move into the second quarter, demand fundamentals are good, so our near-term outlook remains positive. In our Polymer segment, our focus remains on innovation and its importance in leading our growth, margin preservation and capturing the balance of our planned cost reductions. As we have noted, sales trends for HSBC product grades and our Specialty Polymers business has been favorable over the last several quarters. We’re therefore pleased that production qualifications in Mailiao have continued to progress, which will allow us to fully leverage the cost structure and operating capabilities of the joint venture state-of-the-art manufacturing assets. As I mentioned in my opening remarks, we believe we have successfully addressed technical issues our customers were experiencing in processing the product produced by our new Cariflex manufacturing process. And we are continuing to increase production capacity in Paulinia. Most importantly, we expect the direct connect process technology will allow for efficient capacity expansions in our Cariflex business moving forward. For our Performance Products business, as we are anticipating another year of strong paving demand, the timing of our recent completion -- recently completed USBC expansion in Berre, relative to the start of the paving season, should provide additional positive momentum, with the expansion itself representing a key step in delivering the incremental $15 million of cost-outs planned for the Polymer segment this year. We continue to believe the first quarter of 2017 marked a cycle low for margins in our Chemical segment. Although in the second half of 2017, we saw improvement in pricing, primarily for TOFA and related products, we continue to work toward a return to historic margin levels for the Chemical business. As you have seen in late January, we announced a global price increase for TOFA, TOR and TOR derivatives. With these price increases, we expect 2018 to be a year of ongoing margin recovery. To date, price momentum for the TOFA has been more positive and our Performance Chemicals team has done a fantastic job of positioning our business for further margin recovery. However, we continue to see further incremental improvement in TOR pricing and margins that will enable us to maintain the R&D capability and support that our Adhesive customers have come to expect. As we have maintained, I believe it is important to also note that given the current level of pricing and margins in our Chemical segment, we have yet to fully realize the full benefits of the G&A reductions and the $40 million of operational cost improvements our team has worked so hard to deliver. As margins for TOR and TOFA products continue to recover, we believe the accretive nature of our transaction synergies will be fully realized. I would also like to comment on our tire business. Thus far in 2018, it is shaping up to be another good year. First quarter margins were much improved compared to the first quarter of last year, and sales volume was up a healthy 7.3% compared to the first quarter of 2017. Given our expectations for the year, coupled with the differentiated aspect of our commercial relationships across leading global tire OEMs, we certainly look forward to the recently-announced expansions for our tread enhancement agent capacity in Niort, France, expected to be completed by the end of the third quarter. In closing, we feel that our Polymer segment and our Chemical segment are both well positioned to deliver on our expectations for the year, which include both volume growth and margin improvement. As such, we continue to target full year 2018 adjusted EBITDA of approximately $400 million. We will continue to take steps to improve our capital structure and reduce outstanding debt. And with our continued progress in debt reduction, we expect to end the year below 4 turns of leverage on a net debt basis. We look forward to updating you on our progress, of course, as the year unfolds. With those comments, we’ll now happily open the call up for questions.

[Operator:]

[Operator Instructions] Our first question is coming from the line of James Finnerty from Citi.

[Unidentified Analyst:]

This is actually Powell Ward [ph] on for James Finnerty. First, can you guys provide us any update on the Exxon facility in Singapore?

[Kevin Fogarty:]

I’m sorry, I didn’t understand the question. The voice is a little bit muffled.

[Unidentified Analyst:]

Sorry about that. The Exxon facility in Singapore, is there any update or any data points that you guys have on that?

[Kevin Fogarty:]

I mean, other than the facility is, as we’ve said previously, it’s up and running as best we know it. And it’s been in the market in terms of its impact now for at least a couple of quarters or several months, shall we say. And I think that the point we’ve tried to make in the past and I think we still see evidence of that is, while we don’t directly compete in the same space as the products that are produced from that ExxonMobil facility in the Adhesive space, we always believe there could be a downstream ripple effect of that material being positioned in the market, and therefore, other material that is being displacing perhaps coming up against in a competitive sense. But the good news is, if you think about these comments in the context of what I said just a few moments ago, that we are in a recovery mode for margins, the impact of that Exxon facility in the marketplace, I think, is already well understood.

[Unidentified Analyst:]

Okay. Great. And then just secondly, can you guys talk about how you’re approaching -- potentially refinancing the 2023 notes that you have outstanding? And any effect that might have on your long-term leverage target?

[Steve Tremblay:]

Yes. We -- as we mentioned in the prepared remarks, the 10.5% is a clearly a high priority, as we think about capital structure. We don’t -- we anticipate potentially a modest increase in leverage which would just be associated with the fees to get the deal done. But with a 10.5% coupon, each 100 basis point reduction we’d be looking at north of a $4 million per year interest saving. So again, the cost to achieve that refinancing will be paid back pretty quickly.

[Operator:]

Our next question is coming from the line of Jim Sheehan from SunTrust.

[Jim Sheehan:]

First of all, on your TOFA price increase, it seems like you’ve been getting good reception from customers on that but maybe the TOR price hasn’t started to get any traction yet, TOR price increase. Can you talk about TOR? And when you might expect to see a higher pricing there? Is that something we should expect later in the year given where oil prices are today?

[Kevin Fogarty:]

So first of all, I would never let it be said that the reaction we’re receiving from customers on our price increase is favorable, just to make clear. Customers never like to see any supplier raising prices, but they understand why, and of course, that’s driven by two primary fundamentals, the largest of which, of course, is supply demand. But there’s also the element, too, in terms of crude oil pricing going up, therefore, costs are going up a little bit. But that being said, specifically we’re talking about on the TOR side of the equation, and look, I’m not going to suggest to you that we see the same dark market dynamic in our TOR segments as we do in our TOFA segments. Clearly, there is still an element of the capacity overhang primarily in the hydrocarbon space. But we are seeing indications of -- and slowly but surely, certain degrees of improvement. And then the other thing that I think also helps in terms of the timing of our price increase is the fact that we do include now our roads and construction in the Adhesive part of our business. And that is clearly a summer season business, second and third quarter. So that helps also create some momentum behind our price increase moves, because do recall, one of the reasons that we do bring these businesses together is because the products that we sell into the fundamental Adhesive space are similar products that we sell into the road and construction space. And therefore, we have the ability, by combining efforts the way we have, to make sure that we position our products not just in the long term but also in the short term in terms of the most value contributing sales outlets.

[Jim Sheehan:]

Great. And on the Cariflex processing issue, I’m encouraged to see that you were able to resolve that so quickly. Can you just talk about why you were able to address the issue as quickly as you did?

[Kevin Fogarty:]

Well, by the time we shared the information with you in our last quarterly call, clearly we were well on our way to working towards the successful resolution of this issue. And that means that while most of the problems that the customers experienced were based on material that was produced well back in 2017, efforts began really in the late part of fourth quarter, and of course, most of first quarter to see that problem through. And so when we obviously had a conversation with investors a little shy of two months ago, we already had good momentum in terms of the improvements. But we needed some time to make sure that the customers, which is the most important thing, confirmed what we were seeing in our plant which was that stabilization, given some of the actions we were taking. And that’s kind of all played out exactly as we had projected it would. And that’s why we’re delighted to give you that news today.

[Jim Sheehan:]

And on the increase in your expectation for debt pay down in 2018, can you talk about what was the main driver for increasing that target?

[Steve Tremblay:]

Yes, couple things. Certainly, the $6 million that Kevin mentioned that we garnered from the work we did on the term loan in the first quarter was a help. As we continue to evaluate the impact of tax reform, that was a bit of a help, as well as an overall new view of where we see working capital for the year. We’ve got a bit more positive view of where working capital is going to land.

[Operator:]

Our next question is coming from the line of John Roberts from UBS.

[John Roberts:]

The Adhesives business seemed to be down materially in volume. Was that just the seasonality of the roads and construction products that are now included in that unit?

[Kevin Fogarty:]

No, because you’re comparing the same season. Although I would say that in the case of our roads and construction business, while we have very optimistic view for how the season will play out this year, it is also true to say that it’s been a pretty tough winter going into the season. So therefore the first quarter was impacted by that weather pattern. But generally speaking, I think the volume cadence that you’re describing is really just a fundamental associated with the Adhesive business itself. I mean, we’re obviously trying to balance as we always do, volumes versus pricing and margins. And so if the business, as you see it, was down just a little, it really reflects that more so than anything seasonal.

[John Roberts:]

And then Polymer EBITDA, obviously, again, was up against an easy comp a year ago. But that’s also a seasonal segment. Would you call the first quarter Polymer’s EBITDA kind of a normal seasonal quarter? And therefore it’ll be by far the lowest of the year?

[Steve Tremblay:]

It’s a -- a $45 million quarter for the first, John, is a reasonably consistent quarter. It’ll generally be lower than the second and third quarter because of seasonality, and I won’t comment on really -- on where we see the fourth quarter business. But against the -- those middle two quarters, it’ll definitely be the seasonal -- seasonally low.

[Operator:]

At this time, we do not have any questions in queue. [Operator Instructions] We have another question from the line of Christopher Kapsch from Loop Capital Markets.

[Christopher Kapsch:]

Had just a couple follow-ups. One on the boost in the free cash flow guidance. And Steve, you just cited your renewed view on the working capital development. So can you just talk about that in a little bit more detail? This is -- given that butadiene prices are up a little bit, so presumably a little bit of more of a consumption in working capital from raws. So does it tie to the view of the ramp of the Taiwan facility not needing as much working capital build? Or any more color on that would be helpful.

[Steve Tremblay:]

Yes. It really does have to do more with inventory but less about the ramp-up in the Taiwan facility. We are still expecting even in this renewed higher-end guidance for cash flow, some inventory build associated with those transitions. But as we looked at our demand outlook for the year, which as Kevin said, fundamentals look good, led us to the conclusion that we’re not going to end the year with as much inventory as we had anticipated. A good problem to have.

[Christopher Kapsch:]

Right. And then a follow-up just on this pricing dynamic. I guess, the momentum sort of on the TOR side -- I’m sorry, on the TOFA side, and you provided some color on efforts on the TOR side. But just wondering about that incremental progress that you’re seeing and optimism for the balance of ‘18, juxtaposed against this year-over-year decline in Adhesive-related volumes. Are you willing to cede sort of lower margin volumes in order to get incrementally to shift your mix towards higher-priced or higher-margin products in that portfolio? Just give any sense of your strategic thinking on that front.

[Kevin Fogarty:]

Well, the operative word is always balance. Because we obviously want to maintain a certain presence and share, especially with a combination of our longer-term multinational strategic customers, as well as regional customers that, in many cases, really do present a great opportunity for us to grow, particularly on some of the innovation grades. So that balance is absolutely vital to our business performance. But the volumes in Q1, I mean, they were down marginally. And from our perspective, the price increase for TOR, really the implementation date is kind of Q2, the beginning of Q2. And therefore, I think it’s just too soon to tell and conclude one way or the other, where these price increase discussions are going. We’re having, as you can imagine, very important discussions with all our customers about this price initiative. And I think they understand, as certainly we do that part of that is driven by just the overall increase in CTO cost associated with crude oil moving upwards. And they understand that typically becomes an impetus, if you will, for price increase movements. And so we’re just trying to understand or they’re just trying to understand how much of our price increase initiative is driven by that cost and how much is driven by overall market in terms of our recovery of margin objectives.

[Christopher Kapsch:]

Okay. Appreciate that extra color. And, if you covered this already, I’m juggling multiple calls. But normally you provide a little bit of color on the Polymer side, the sort of profit per ton metric and the progress that you’ve made there. Can you just talk about how that looked? I know there are some seasonal factors that influence that, but just how you see that over the balance of ‘18?

[Steve Tremblay:]

Sure. The first quarter, nice rebound, 25% improvement well north of $900 per ton really, as we expected, Chris. If you look longer term -- in a forward view longer term, merely by taking last year, as you know, upper $900 on full year basis and the growth this year on a TTM basis, with -- we’re north of $1,000 per ton, which, as you know, has been our long-term target. We’re going to continue to look at cost opportunities and continue to price right to improve those margins. We feel like we’re on the right track. Clearly, there’s a little more room to go in the cost-out initiative to get to $70 million. So that should be accretive. But again, first quarter, nice rebound as we expected. And that gets us over $1,000 on a trailing 12-month basis.

[Operator:]

Our next question is coming from the line of Mike Sison from KeyBanc.

[Mike Sison:]

The profitability in your Chemical segment, pretty good, and given the fact that you’re just getting some pricing here. But what do you think that can ramp up to as the year unfolds?

[Kevin Fogarty:]

Well, I think that -- again, we used the words margin recovery, Mike, and that’s certainly our objective this year. And clearly, with our price increase that we announced in the first quarter for April 1 effective start date, there’s more to come in terms of that margin expansion that we’re looking for. But just -- if I might, I’ll just remind you and other listeners that at Kraton, whether it’s our Polymer business or our Chemical business, I mean, we are as always focused on innovative-led growth. And there’s a cost to committing ourselves to innovative-led growth for the benefit of our customers and that’s, of course, the R&D that we put behind it. And so part of everything we do is associated with making sure that we’re justifying those expenses and the margins that we expect therefore, our customers they’d be comfortable with, do reflect the fact that we’re putting that emphasis on R&D for their benefit. And so as I think about the margin objectives we have this year, certainly they are objectives that would see improvement year-on-year, and very consistent, therefore, with what we have talked to customers about much in the past, is the need therefore to get a return for the investments we’re making for the benefit of their business, including not just capacity investments, but also R&D investments.

[Mike Sison:]

Right. Okay. And then did you -- when you think about the Polymer segment, typically the second quarter, third quarter is seasonally a good quarter for you guys. Do you see a volume pickup potentially in 2Q and 3Q?

[Kevin Fogarty:]

Yes. Look, we’re expecting, based on everything we’re seeing, that the summer season, particularly, for those infrastructure businesses of traditional styrenic block copolymer, bitumen modification businesses, both paving and roofing as well as the road markings business of our Chemical segment to be benefiting from what I think is going to be a pretty good summer season. And the weather has turned in Europe, I’m not sure if you follow it, weather has turned pretty quickly in Europe as a matter of fact, kind of like they didn’t have a spring, went from winter to summer. And that’s good. That’s a good start for the summer season for our business.

[Mike Sison:]

Great. And then when you think about the quarterly progression, I’m encouraged to see you maintain guidance for EBITDA for the year. So -- when you think about 2Q, 3Q should be typically the strongest and then fourth quarter comes back to maybe the low -- one of the lower quarters?

[Steve Tremblay:]

It’s the right way to think about it, Mike. Absolutely.

[Operator:]

We have another question from John Roberts from UBS.

[John Roberts:]

In the Polymers segment, the Performance Products had relatively flattish volume. I’m guessing that’s a pretty diversified portfolio. Could you maybe talk about what were the best performers and the worst performers in there?

[Kevin Fogarty:]

Yes. I’m not going to break out in terms of the "best and worst performers". But I would tell you that it’s really difficult in the performance polymers business to be thinking about the first quarter as a bellwether, if you will, for how the rest of the year is going to unfold, because it’s so, especially in the case of our paving business, very weather-dependent. And the only kind of way in which you get real incremental growth in the first quarter that you’re measuring the full year against is if it just happens to be a relatively benign winter, and that was not the case this year, I think, as you know. We did have a great start to the season in our southern hemisphere businesses, as I referenced; South American markets were very robust in terms of paving infrastructure. But we are quite optimistic that, that kind of trend will carry forward into the northern hemisphere now for the second and third quarter, particularly in the paving business, where we’ve just seen evidence in the U.S. where there is just continuing to be spend in updating much-needed infrastructure improvement.

[Operator:]

At this time, we don’t have any questions on queue. I will hand the call back to Mr. Gene Shiels for closing remarks.

[Gene Shiels:]

All right. Thank you, Jay. Well, we certainly want to thank all of our participants this morning. Appreciate the questions. I want to remind listeners that there is a replay of this call that will be available later on this morning. To access that replay, you may dial 800-839-5154. This concludes our call. Thank you.

[Operator:]

Thank you. This concludes the Kraton Corporation First Quarter 2018 Earnings Conference Call. You may now disconnect.