Kraton Corporation
Q2 2018 Earnings Call Transcript

Published: 26 Jul 2018

[Operator:]

Good morning, and welcome to the Kraton Corporation Second Quarter 2018 Earnings Conference Call. My name is Jesse, J-E-S-S-E and I’ll be your conference facilitator. [Operator Instructions] Today’s conference is being recorded. If you have any objections, you may 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:]

Thank you, Jesse. Good morning and welcome to the Kraton Corporation Second 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 our news release covering second quarter results as well as the related presentation material we will review this morning are available in the Investor Relations section of our website. Before turning to the second quarter results, I will 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. Regarding 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 included in this morning’s presentation. Lastly a reminder that effective January 1, 2018, results for the former roads and construction product line under our Chemical segment have been consolidated into Adhesive and Performance Chemicals product lines. Results for the second quarter of 2017 have been restated to conform to the new reporting structure. As is our usual practice, 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. As we anticipated our second quarter results reflect improved margins and core profitability in both our Polymer and our Chemical segments. Margin increases along with healthy demand fundamentals and favorable mix where all significant contributors second quarter 2018 adjusted EBITDA of $105.6 million which was up $4.1 million or 4.1% compared to the $101.5 million we reported for the second quarter of 2017. The strong second quarter performance in combination with results for the first quarter of the year have driven growth in the first half of 2018 adjusted EBITDA to $194.2 million this is up $27.2 million or 16.3% compared to the first half of 2017. Second quarter 2018 results for our Polymer segment were particularly notable with adjusted EBITDA of $68.7 million up over 9% compared to the second quarter of 2017. For the Polymer segment this is the highest second quarter adjusted EBITDA posting in our history. These results were driven by increased sales of high value products in our Cariflex and Specialty Polymers businesses with Cariflex volume up nearly 7% and Specialty Polymers volume up nearly 8% compared to the second quarter of 2017. While performance products volume was down 5.8% compared to the second quarter of last year. The lower sales volume was relative to a very strong SPS volume in last year second quarter. Moreover in this year’s second quarter our margins expanded as we elected to pass in certain volume sales with a less than acceptable price in margin profile. All said the segment’s adjusted EBITDA margin was an impressive 20.3% in the second quarter despite pressure associated with increasing raw material cost in the quarter particularly from [indiscernible] as well as inflation and transportation and logistical cost. Further evidence of our ongoing commitment to price discipline consistent with our Price Right strategy. Our Chemicals segments also improved margins in the second quarter. In part reflecting the benefit of price increases announced earlier in this year. Margin expansion and improvements and core profitability were primarily driven by higher pricing for TOFA and TOFA derivatives as well as sales of other high value derivative products in both our performance chemicals business and in our Tire business. Where second quarter 208 results also benefitted from improved sales mix and price increases. Adjusted EBITDA for the Chemical segment was $36.9 million in the second quarter of 2018 and while this was down $1.7 million compared to the second quarter of last year. The decrease was due to planned maintenance cost of $4.8 million in the quarter. Even with the impact of these maintenance costs Chemical segment adjusted EBITDA for the first half of 2018 was up nearly 12% compared to the first half of 2017. Our Chemical segment results have continued to improve as we’ve moved beyond the first quarter of 2017 which we continue to believe was the trough in both pricing and margins for the segment. Overall we’re pleased with the incremental improvement and core margins we achieved in the second quarter as we continue to focus on realizing the full potential of our Chemical business. Since the acquisition of our Chemical segment, we’ve worked to also optimize our capital structure through a series of transactions to lower our overall cost of debt. A key highlight for the quarter was a successful refinancing of our 10.5% senior notes. The refinancing is expected to reach annual cash interest expense by $24 million enhancing our cash flow profile and facilitating further reduction in outstanding net debt and consolidated leverage. Those opening remarks I’ll turn the call over to our Chief Financial Officer Steve Tremblay for more details. Steve?

[Steve Tremblay:]

Thank you Kevin and good morning, everyone. On Slide 5, our Polymer segment had a very good second quarter with adjusted EBITDA $68.7 million and an associated adjusted EBITDA margin of 20.3% is exceeded the second quarter 2017 by 9.4% and 160 basis points respectively. Historically we have recovered increases in raw material cost through selling price increases and our second quarter results continue to demonstrate disability. In fact, at the bottom of the graph we illustrate this point. During the quarter selling price increases were implemented such that unit margins is evidenced by the blue line have been preserved despite is raw material headwinds. This is consistent with our historical business model and our proven price right strategy. In addition, we delivered volume growth in Specialty Polymers and Cariflex which richens the overall sales mix and therefore improves our overall segment margins. In Performance products, our Price Right strategy led to increased core unit margins albeit on lower overall sales volumes. As result of all of this, our adjusted gross profit per ton was $117 per ton in the second quarter, 2018 which exceeded the second quarter, 2017 by $105 per ton. Now turning to the Polymer segment cost reset initiative. I’m happy to report that we continue to make progress delivering another $3.5 million of benefit in Q2 and this results in $7 million of incremental savings through the first half of 2018. We also continue to expect that a significant portion of the overall $70 million cost reset benefit will be achieved by the end of 2018. Through the first half of the year, adjusted EBITDA of $113.5 million represents growth of $18.6 million or 19.6% year-to-date first half of 2017. The increase reflects higher unit margin across the portfolio and the effect of a more favorable sales mix as indicated by volume growth in both Specialty Polymers and Cariflex. Moving onto our Chemical segment on Slide 6, sales volume of 111 kilotons was up 9.1% compared to the second quarter 2017 largely driven by 16.8% volume increase in the Performance Chemicals and use which was partially offset by a modest decline in Adhesive volumes. In the second quarter turnaround cost amounting to $4.8 million had a negative effect on overall segment adjusted EBITDA but this was largely offset by the improved unit margins in both Performance Chemicals and Tires. Adjusting for these turnaround costs, second quarter adjusted EBITDA would have been $41.7 million or nearly 22% of revenue. Looking at the year-to-date performance, the 2018 results represents a significant improvement in adjusted EBITDA in the Chemicals segment. First half 2018 adjusted EBITDA was $80.8 million compared to $72.2 million through the first six months of 2017. More than offsetting the higher turnaround cost were increases in unit margins primarily for TOFA and derivative upgrade products as well as higher margins in our differentiated tire business. As Kevin mentioned, since Q1, 2017 core unit margins continue to improve in the chemical segment taken as a whole. Second quarter and first half consolidated results are reflected on Slide 7. On a consolidated basis adjusted EBITDA in the second quarter of 2018 amounted to $105.6 million or 19.6% of revenue compared to $101.5 million or 19.3% of revenue in the second quarter of 2017. First half adjusted EBITDA came in $194.2 million with an adjusted EBITDA margin of 18.7%. These represent healthy improvements against 2017’s first half of 16.3% in terms of EBITDA and 170 basis points in terms of adjusted EBITDA margin. Similarly adjusted EPS improved 7.3% in the second quarter and more than 116% in the first half of the year. I will note that our second quarter adjusted EPS of $0.88 per share included a slightly higher effective tax rate than we originally anticipated which amounted to approximately $0.12 per share or in terms of net income about $4 million. This was due to some discrete items in the mix of our overall global earnings. Having said that, on a year-to-date basis the effective tax rate used to determine adjusted EPS was in line with our continued full year guidance of 20% to 25%. Slide 8 illustrates the additional steps we completed in the second quarter to lower our cost of capital. We repaid the most expensive of the acquisition related indebtedness by taking out the 10.5% Senior Notes in favor of new tranche of 5.25% Senior Notes and using some borrowings under existing lower cost facilities. The transaction is expected to reduce cash interest expense was $24 million on an annual basis. This was a well-executed transaction and when coupled with the other initiatives we have taken since the closing of the Arizona transaction results in a reduction and cash interest expense from $135 million per year as of the closing, to $78 million per year as of June 30, 2018 pro forma for this recent transaction. This represents 32% reduction in the cost of our overall indebtedness. In addition to lowering the cost of capital, we believe the new ratio of secured and unsecured debt as well as the geographic mix of Euro of US versus non-US debt provides a flexible well balanced debt capital structure. Moving to Slide 9, consolidated net debt amounted to $1.6 billion at June 30, 2018. We provided a bridge from the consolidated net debt at December 31, 2017 to this level of indebtedness at June 30. You can see here the effect of refinancing cost of $53 million increased net debt from December 31, 2017 which was partially offset by changes in foreign exchange rates associated with the Euro and Taiwan borrowings the latter at our consolidated JV. Consistent with prior years, I will note that cash flow is generally low in the first half of the year due to seasonality and it accelerates in the second half of the year. Excluding the effects of currency on our offshore indebtedness, we continue to expect consolidated net debt to decline by $75 million to $100 million for the full year 2018. This of course includes the fees incurred from the second quarter refinancing which had the effect of increasing indebtedness by $53 million. Other than the impact of the fees, our overall cash flow expectations for 2018 is therefore unchanged from prior estimates. As a result of our EBITDA growth and continued de-levering, we expect our consolidated net debt leverage ratio to decline from 1.4 turns at June 30 to less than 4 turns at 2018. This marks a significant milestone when we compare the 5.4 turns of leverage at the time of the closing of the Arizona transaction. Finally, with respect to the refinancing, we also effectively pushed out maturities of the non-JV debt such that the first meaningful debt pay down will not be until 2025. Before I turn the call back over to Kevin. I remind you that the appendix includes modeling assumptions, this is most significant change is a lower interest rate assumption as a result of the financing. It’s a lower interest expense assumption as well as – and cash interest for the year. Kevin?

[Kevin Fogarty:]

Thanks Steve. As you just heard our consolidated results for the first half of the year reflect margin expansion and good fundamental demand across the majority of end markets we serve. Compared to the first half of 2017 adjusted EBITDA was up over 16%, we’ve improved our adjusted EBITDA margin by 170 basis points to 18.7%. In our Polymer segment, the improved mix and margin expansion in the first half of 2018 provides favorable momentum going into the second half of the year. We expect freight [ph] moves for raw materials such as Butadiene to rather benign in the second half of the year and an environment that should provide for relative margin stability. That being said, I would like to point out however last year raw material price trends and market dynamics contribute to a particularly robust third quarter with respect to paving volumes and margins that are not likely to reoccur in the third quarter of this year. nonetheless, demand fundamentals remain good across the wide range of our Polymer end used markets and while our second quarter paving volume was down relative to the very strong second quarter of 2017, first half 2018 paving volume was up 2% compared to the first half of last year. Based upon current activity the third quarter should shape up to be another solid quarter of paving demand for our Performance Polymers business. Our ongoing focus on innovation and differentiation the unique product offering of our Specialty Polymers business has continued to demonstrate solid volume trends with sales volume up 7.8% in the second quarter of 2018 following volume growth of 5.7% in the first quarter of 2018 and 6.8% in the fourth quarter of 2017. This volume growth has been driven by sales and specialty applications such as oilfield, medical packaging, personal care products, lubricant additives and cable gels. In many cases these sales are associated with unique polymers developed by Kraton to meet specific customer needs supporting key megatrends in the marketplace. The volume trends and margin profile for these differential offerings highlight the value of our innovation and application development programs. Over the past year, we’ve also further refined our research and development approach directing resources towards polymer and application development opportunities that we believe have the potential for rapid commercialization and favorable market growth. These efforts have resulted in tangible success and I believe our current pipeline of R&D projects is the best I’ve seen in several years. Looking at our Chemical segment we have continued to see incremental improvement in core margins as we move beyond the early 2017 trough. As noted earlier, our chemical segment adjusted EBITDA was down slightly in the second quarter versus the second quarter of 2017, this was due to the impact of planned maintenance cost of nearly $5 million in the quarter. As evident in the 12% increase in first half 2018 adjusted EBITDA for the segment. We have seen good demand and improved pricing for TOFA and TOFA Derivatives and derivatized products. These derivatized products many from the crude sulphate turpentine are contributing to growth and margin enhancement through our differentiated offerings such as those in our tires business. Furthermore, price increases announced earlier this year have contributed to margin improvement and the TOFA chain and demand has been favorable driven by factors such as healthy activity levels in oil field markets. Thus far in 2018, margin recovery for Tall Oil Rosin and rosin esters has been more muted. The price increase is serving largely to offset increases in raw material costs. With regard to our chemical segment innovation programs, we are very pleased with the progress we’ve made in building and innovation pipeline since we acquired the business. Many of these innovation opportunities represented by tapping into cross developmental potential for our chemical and polymer technologies. For example, through unique combination of our rosin esters and our polymer technology we’ve developed a system for road marking applications resulting in high performance durable road marking compound at lower toll system cost. We’re pursuing further opportunities to innovate in the road marking space utilizing our innovations from our Polymer segment. In Adhesive business, we continue to see growth opportunities for rosin ester formulations with improved color and reduced odor. One such example is SYLVALITE 9000 which was introduced in the market in early 2017. While SYLVALITE 9000 is increasingly being embraced by customers our innovation teams continue to working to achieve further step changes in color and odor characteristics. In addition to the price and performance benefits of these improved products, they’re based upon renewable resources which is important to Kraton and to our customers given the increased focus on and appreciation for sustainability in today’s world. We truly believe in the value creation opportunities that exist in developing and providing high performing environmentally sensitive products. I’ll note that we’ve recently published our second annual sustainability report and hopefully we’ll take a moment to read the report to learn more about our commitment to sustainability at Kraton. A few comments now about strategic execution. In the first half of 2018 we have started to leverage key projects intended to optimize the global manufacturing footprint in our Polymer segment. Specifically the new HSBC expansion in Mailiao, Taiwan. Our direct connect production process [indiscernible] Brazil for our Cariflex business and our USBC expansion in Berre, France. In the second quarter, production volumes in Mailiao continue to ramp and was net income positive through June 30, 2018. We’re nearing planned production capacity in [indiscernible] and are therefore expecting incremental contributions from the benefits of the direct connect production going forward. With the completion of these key components of our $70 million cost reduction plan for the Polymer segment and having delivered the $65 million of synergies associated with the acquisition of our Chemical segment. We’re now positioned to unlock additional value through cash flow expansion and innovation lead organic growth. And as mentioned the recent and successful refinancing of our 10.5% Notes and the associated interest savings will contribute further to our cash flow profile improvement. For the near term our focus remains on debt reduction and while our expectations for reduction and consolidated leverage in 2018 have been modestly revised due to the cost associated with the refinancing of those 10.5% Notes. We still anticipate ending 2018 with the consolidated net leverage ratio of less than 4 turns. And with the normalized cash flow expansion we expect for next year, we plan to achieve our leverage target of less than 3 turns in 2019. To close as we move into the second half of the year, our Polymer segment is coming off record second quarter and we continue to see good margin progression in our Chemical segment. Our results for the first half of 2018 were very much in line with our expectations and better than our expectations for the second half of 2018 is continuation of these favorable dynamics and good overall operating performance. With those comments we’ll be happy now to open the call up to take some questions.

[Operator:]

[Operator Instructions] first question on the line is from Jim Sheehan from SunTrust. Sir your line is now open.

[Jim Sheehan:]

Could you comment on your TOFA price increases? What are your prices up year-over-year in TOFA?

[Kevin Fogarty:]

So if we look at the price increase initiatives that were put in place at the beginning of the year, from a TOFA perspective and the TOFA related derivative products. I mean we’ve saw good success enable implementation of those price increases reflecting as you know very healthy favorable market conditions. Overall I’d say the prices are up in the 5% to 6% range relative to last year, but nevertheless we’ll continue to monitor the marketplace and see if the market continues to improve and warrants further increases.

[Jim Sheehan:]

Great and on the new product innovation. Can you give us some color on how much you expect new products to be contributing to top line growth over the next couple of years?

[Kevin Fogarty:]

So we are relentless in our focus on measuring just exactly that Jim which is how much of our revenue is derived from innovation products. And we have set targets for ourselves that at least 20% of our revenue should be able to be achieved by true innovation, when I mean true innovation. I mean that which is commercialized in the last five years. Of course this is a moving trend because you have materials that come off and go on, so it can be a little choppy year-to-year but as we measure it versus a trend line, there’s no reason why we can’t achieve that relative goal in a relatively short period of time.

[Jim Sheehan:]

Terrific and on your Slide 5 chart regarding the sensitivity to Butadiene prices, it seems like your SBC margins per ton have become fairly resilient to changes in Butadiene. How have you achieved that improved margin stability overtime?

[Kevin Fogarty:]

So resilient infers that it just happens and I can assure you Jim that’s not the case. But they have reflected the fact that we through our price right strategies are very predictable in terms of our behavior in the marketplace with respect to passing those cost increases through, that’s part of the price right strategy. We always like to say that we expect our customers to predict our [indiscernible] behavior just as quick as we do. It’s just very important to recognize that and what has been historically from time-to-time a kind of volatile Butadiene pricing market that we have to be very timely and disciplined in the way in which we pass those raw material cost through.

[Jim Sheehan:]

Thank you.

[Operator:]

Next question is from Josh Vector [ph] of UBS. Sir your line is now open.

[Unidentified Analyst:]

Just a question on Chemicals and pricing within their again, so if I look at year-on-year. I guess I expected that pricing would potentially be up given higher energy prices and given some of the volume growth on the chemical side, maybe it's mix within performance. Well I’m curios, if there’s anything else going on that we should be watching when we’re trying to model the top line there?

[Kevin Fogarty:]

There’s clearly always a mix issue and pretty much everything we do at Kraton and so that can happen from quarter-to-quarter as you look at the TOFA and TOFA derivatives and so when we measure price increases, obviously it has to be like apples-to-apples across the same grades. And I can assure you that, in the case of our TOFA and TOFA related products the price increases are going through, but from time-to-time, there’s a mix issue in the quarter and so that’s why we’re more focused on the overall margin profile than we’re just the pricing profile.

[Unidentified Analyst:]

Okay, it makes sense. What I’m trying to understand where pricing have been done. Pricing down around like 7%, TOFA I understand, C5/C9 rosins I guess, I think pricing will be up a little bit, what area is down or is it just much greater mix of the lower price product.

[Kevin Fogarty:]

I think clearly we’re not seeing any negative momentum in terms of pricing these days. We managed both in our Polymer business and in our Chemical business to use from time-to-time volume as of means to make sure that our price increases are solid and secure. And then if I think about it in the context of your specific question about, which products perhaps, we sell a variety of different markets in the TOFA and used segment and some of those markets clearly are at lower price points and therefore margin profiles than other markets. We like to grow in the higher value added markets clearly, but from time-to-time as [indiscernible] mentioned we’ll use volume to move material into some lower market, and that lower market margin segments and that can reflect in the overall, therefore weighted average profile of the business.

[Unidentified Analyst:]

Okay, great. Thank you.

[Operator:]

Next question is from the line of Christopher Kapsch from Loop Capital Markets. Sir, your line is now open.

[Unidentified Analyst:]

This is Ryan Filling [ph] for Chris. So in pine chemicals has there been any notable change of competitive behavior on behalf of your key rivals in this space since the closing of Ingevity’s acquisition of Georgia-Pacific. And separately, is the competitive dynamic benefitting [indiscernible] at all from petrochemical derived inflation for non-pine based alternatives for the markets you addressed.

[Kevin Fogarty:]

I’m not going to answer that first question because that’s well I mean I could go on and on about the competitive dynamics in all of our markets and it probably wouldn’t be appropriate for this time, but in terms of your second question. Clearly we’ve been watching very closely as crude oil continues to rise how that’s affected particularly in our Adhesive business. The alternative materials, the hydrocarbon’s that you referenced and so far, it’s apparent to us that there hasn’t been a significant step improvement in overall hydrocarbon values that we price against in the marketplace. That being said of course with the rising crude oil price in itself, we’re not seeing any erosion per se because that provides for a higher floor through which people are pricing off of, but what has been a historical fairly consistent relationship between higher crude oil prices and therefore higher [indiscernible] value still hasn’t manifested itself in the marketplace.

[Unidentified Analyst:]

Great, thank you. And my other question is that, in your Polymer segment focusing on really impressive profitability in terms of gross profit per ton, we’re curios about how much of that outperformance is from a favorable mix versus favorable variance of pricing over ECRC based raw material cost. And to the extent mix, [indiscernible] is a contributor is there a more seasonal structure or nature.

[Kevin Fogarty:]

Well compared to the two things you mentioned, there is an element, a little bit of element of both. But generally speaking, we’re not seeing dramatic changes in shift in terms of the actual product mix, where we do see shift changes in terms of the relative amount of innovation materials that we’re offering and therefore by virtually – fact that those are differentiated sales, they do carry with them a higher margin profile just naturally, that’s what you would expect and that’s exactly what happens. So that can affect mix, but in terms of the overall makeup of the marketplace, we’re pretty consistent in terms of the types of the markets we serve in particular in our Polymer business.

[Unidentified Analyst:]

All right, great. Thank you.

[Operator:]

[Operator Instructions] speakers no questions at this time. Mr. Shiels, you may proceed.

[Gene Shiels:]

Thank you Jesse. Well we want to thank all of our participants this morning for their interest in Kraton. There will be a replay of this call available later on this morning. To access that replay, you may dial 800-551-8152. With that, we’ll conclude our call. Thank you.

[Operator:]

Thank you, Mr. Shiels. This concludes the Kraton Corporation second quarter 2018 earnings conference call. You may now disconnect.