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Cytec Industries Inc. (NYSE:CYT)

Q2 2014 Results Earnings Conference Call

July 18, 2014, 11:00 AM ET

Executives

Jodi Allen - IR

Shane Fleming - Chairman, President & CEO

Dave Drillock - VP & CFO

Analysts

Gautam Khanna - Cowen & Company

Yair Reiner - Oppenheimer

Mike Sison - KeyBanc

Robert Koort - Goldman Sachs

David Begleiter - Deutsche Bank

Mike Harrison - First Analysis

Rob Walker - Jefferies

John Hirt - Citi

John McNulty - Credit Suisse

Will Mullin - Stifel Nicolaus

Chris Kapsch - Topeka Capital Markets

Operator

Good day, and welcome to the Cytec Industries 2014 Second Quarter Earnings Conference Call. Today's call is being recorded. For opening remarks and introductions, I would like to turn the conference over to Ms. Jodi Allen. Please go ahead.

Jodi Allen

Thank you, LeAnn, and good morning, everyone. We appreciate your participation in our conference call.

For our call today, Shane Fleming, Chairman, President and Chief Executive Officer, will provide an overview of continuing operations on an as-adjusted basis; Dave Drillock, Vice President and Chief Financial Officer, will review the financial results and special items in the quarter. Shane will then finish with some commentary on our outlook for 2014.

This call is being webcast in listen-only mode, and it will be archived in audio format on our website for three weeks. Throughout the call, we will be referencing the supporting materials, which can be downloaded from our Investor Relations website under Events and Presentations, or you may follow the slides accompanying today's webcast, which are also available through our website.

During the course of this presentation and in responses to your questions, you will hear certain forward-looking statements. Our actual results may differ materially. Please read our commentary on forward-looking statements in Slide Number two of our supporting materials or at the end of our news release or statements in our quarterly and annual SEC filings.

In addition, our discussion includes certain non-GAAP financial measurements as defined under SEC rules. We have provided reconciliation of those non-GAAP financial measures to the most directly comparable GAAP measure at the end of our press release. A copy of our press release is available on our website.

Now let me turn over the call to Shane.

Shane Fleming

Thanks, Jodi, and good morning, everyone. I appreciate you taking the time to join our second quarter earnings call.

I am extremely pleased with the results in the second quarter with topline growth of 5% versus the prior year period, excluding the divested distribution product line.

Strong sales growth in Industrial Materials segment was a major contributor to the good quarter bolstered by by sales growth in Aerospace Materials. Our operating earnings were essentially in line with the prior year quarter, mainly as a result of increased cost and changes in product mix, which I'll explain in the segment detail.

Overall we delivered 13% EPS improvement in the second quarter versus the prior year period, driven to a large degree by a lower share count.

In Aerospace Materials, sales increased by 5% to $262 million; volumes increased by 3%, driven by build rate increases in single-aisle programs as the 737 in addition to the continued ramp up of the 787.

We again saw the growth in large commercial transport, partially offset by demand declines in rotorcraft, mostly due to a lower defense spending and replacement blades and reduced demand from missile programs. Price contributed 2% of the topline growth.

Aerospace operating earnings in the quarter were $52.7 million, slightly down versus $54.6 million in the prior year quarter, but still a solid 20% operating margin. The higher volumes and price in the quarter were offset by higher raw material cost, with the largest single cost impact related to carbon fiber.

Sales growth in the large commercial transport sector is driving procurement of additional external carbon fiber. Purchased fiber is higher cost than our in-house production and pressures margins in this segment.

Overall, I am pleased with the [technical difficulty] initiatives favorably impact their profitability.

The Industrial Materials business continues to deliver strong sales growth following a great first quarter. In the second quarter, sales increased by 19% after excluding $12.2 million of sales in the second quarter 2013 from the divested distribution product line.

Volume increased by 15% driven by high demand in two key markets, the high performance automotive sector and the tooling sector.

As I mentioned last quarter, we experienced stronger than normal order patterns in the tooling sector, related to a surge in aerospace demand. We expect orders in the back half of this year to drop to a more normalized level.

Selling price contributed 1% to the growth in the quarter. Second quarter operating earnings were $9.6 million, significantly above their prior year period of $5 million with the increase driven by the strong sales volume and favorable product mix.

The In Process Separation segment performed very well against a record quarter last year with sales of $104 million, down 2% versus the second quarter 2013. The business delivered strong phosphine chemical sales in the quarter, but this was more than offset by weaker demand in alumina and order patterns from specific mining customers.

Although we had no new mine fills in the quarter, we remain on track to deliver our target fills for the year. Despite sales being below the prior year, the business delivered record earnings performance with operating earnings of $28.5 million, slightly above last year's prior record of $28.4 million.

The strong earnings performance was largely due to the increased phosphine sales, resulting in a favorable product mix. We are again in a sold-out situation in phosphine chemicals and we're eager to get the new lines running and qualified this year.

Additive Technologies sales increased 3% versus the prior year period. The increase was related to demand for specialty additives products sold into pharmaceutical and industrial surfactant markets.

Polymer Additive sales in Europe were strong as our agricultural film market showed signs of improvement, but this was offset by weak Polymer Additive sales in North America and Asia Pacific, due to a challenging economic environment in some of our key end markets.

Operating earnings were $10.4 million in the quarter, down from $12.2 million in the prior year period, due mostly to higher raw material cost and some competitive price pressures in the low value products.

For Cytec overall, in the first half of the year we delivered 5% topline growth, excluding the divested distribution product line and 13% net earnings growth versus the first half of 2013.

Now let me turn the call over to Dave, who will review additional financial results in the quarter and then I'll take you through our outlook for the remainder of this year.

Dave Drillock

Thank you, Shane, and good morning, everyone.

Special items for the quarter were immaterial and represent adjustment plus and minus to prior accruals. So let me start the review of our financial statements.

As Shane covered the revenues already, I'll move directly to the gross profit analysis. As a reminder, all amounts I discuss will exclude special items unless specifically mentioned otherwise.

Our gross profit dollars were up slightly, while our gross margin percentage of 34.2% is about half a percentage point lower than our prior year period. The increases in the Industrial Materials and In Process Separation segments, both related a favorable mix were slightly offset by declines in the aerospace segment, due to their higher cost purchase carbon fiber Shane just discussed and in Additive Technologies, due to lower production levels and lower selling prices.

On an overall basis, higher selling prices added about $6 million to gross profit, more than offsetting increased raw material cost of about $5 million. The increased selling volumes added about $10 million in gross profit, which was only partially offset by higher production cost of about $8 million.

Our total operating expenses are up almost $4 million from the prior year period and up less than 0.5% of sales. About three quarters of the dollar increase is in administrative expenses due to the completion of certain transition services we're providing the divested Coatings Resins Business and the remainder in mostly increased expenses for our single ERP initiative.

Corporate and unallocated for the quarter is up about $4 million from the prior year period. About $3 million is related to greater and net pension income in 2013 and 2014, due to changes in discount rate year-on-year. The remainder of about $1 million is increased cost on the aforementioned single ERP project.

As for the remainder of 2014 corporate and unallocated expense, we expect we expect the spending for our single ERP initiative to ramp up slightly. We are in the development and test phase of this project and it is going well to-date on both schedule and cost. Our full year guidance for corporate and unallocated is approximately $25 million.

Interest expense net is down $1.8 million in the second quarter, mostly due to higher capitalized interest in our major capital projects. Last quarter I mentioned, we're updating our analysis of capitalized interest as it relates to our large capital projects in which we took a conservative stance.

We've completed that review and as a result we are lowering our full year guidance for net interest expense from approximately $25 million to $70 million for the year.

The overall underlying annual tax rate for the quarter was 31% versus the underlying annual tax rate in the second quarter of 2013 of 30.7%. There are always many puts and takes in the effective tax rate, but right now we expect a full year rate to be 31% plus or minus a percent.

Don't forget to add back to our forecast for a full year a tax benefit of $5.4 million or $0.15 per diluted share related to the reversal of certain tax reserves, due to the settlement of tax audits and the expiration of the statute of limitations in several jurisdictions that was recorded in the first quarter. This is included in our overall EPS forecast for the full year.

Our cash provided by operations for the second quarter was $43 million and year-to-date is $105 million, which compares to a use of cash of $20 million and $6 million respectively for the 2013 periods. Increased earnings and the impact of reduced pension contributions to our low funded plans account for the improvement.

We continue to make good progress sustaining and improving our working capital levels. Our net working capital days at the end of the second quarter were up 5 to 81 days compared to the end of first quarter of 2014. At quarter end, inventory days of 82 were up 2, compared with the end of the first quarter.

Accounts payable days were down 3 to 49 and accounts receivable days of 48 were flat versus the end of the first quarter. Working capital days are a key cash flow metric for us. We'll continually monitor our levels to ensure we're staying within our targeted range.

While I provided you the quarter end days, to have more transparency on our cash flows, internally we also look at days on an average basis for the quarter and year-to-date. This helps us account for seasonality or unusual short term trends and lets us focus on how sustainable our working capital efforts are throughout the year.

On this basis, our average days for 2013 were 86 and our average days for the first six months of 2014 were 79, good progress by our supply chain manufacturing teams.

Our capital spending for the second quarter was $57 million, down from $72 million in the prior year period. Almost all of this is related to our manufacturing capacity investments in the Aerospace Materials and In Process Separation segments.

We have essentially completed the construction of our carbon fiber and phosphine manufacturing plants and are beginning the qualification phases. So while the spending is down year-on-year as expected, we're still incurring cash spending for the final bills and any holdbacks as the plans pass through qualification.

We expect capital spending to trend down in the third quarter and more significantly in the fourth quarter. Our full year guidance for 2014 capital spending remains in the range of $180 million to $200 million.

I am sure you’ve seen our announcement of the doubling of our dividend and the two for one stock split. As I noted moments ago, our operating cash flows are increasing as expected and you can see the impact of improved earnings and full funded pensions.

With our capital beginning to trend down, we felt it's time to take a significant step forwards towards our aspirational dividend target of 2%, which we communicated at our Investor Day in November of last year.

Our uses of cash remain the same and I'll them here. Capital to maintain our businesses, expansion capital to meet our growth projections, bolt on acquisitions, continue to improve our already strong balance sheet via debt reduction, reward shareholders with a meaningful dividend from sustainable operating cash flows and share repurchase from excess free cash flow.

We expect to start generating excess free cash flow in the second half of the year, which based on our latest capital spending forecast should continue to be evident as the quarters progress. In alignment with that, we'll provide an update to our capital allocation strategy at the 2014 year end conference call.

Before I end my prepared remarks, you are all aware that beginning of this year, we announced my intention to retire by this yearend. We recently announced the hiring of my replacement Daniel Darazsdi, who is starting August 4th and I am confident you'll enjoy working with him.

I will assist for 90-day transition beginning November 1st, move on to a new and exciting phase in my life with my wife Susan, but that makes this my last earnings conference call and I want to take this moment to thank you, our investors and the analysts who cover us via questions, feedback and insights. It was always appreciated.

I've known many of you for quite some time and I hope you appreciate our efforts and transparency in our reporting and our willingness to meet with you to understand Cytec and our great story.

A lot has happened over the last 20 years at Cytec, particularly the last six years. I've been fortunate to work with the supportive Board of Directors, motivating and challenging CEO and Darryl Fry, David Lilley and Shane Fleming and Jim Cronin, Cytec's first CFO as well as our super team of dedicated people in finance and for that matter all of Cytec; all the best and thanks very much. Cytec is well positioned for its next 20 years.

So with that, let me turn the call over to Shane who will provide an update and review on the remainder of 2014.

Shane Fleming

Thanks, Dave. And let me just take a minute to publicly congratulate you on your successful career and to thank you for the leadership that you provided and the many contributions you've made to the success of Cytec. I would also like to wish you and Susan, all the best in your upcoming retirement.

I'll now share some comments on our outlook and our updated guidance for 2014. Based on our first half sales in Aerospace Materials of $506 million and a review of the second half demand remaining strong, we expect full year sales to be stronger than originally forecast. This is related to the strength of the commercial aerospace sector, driven primarily by a large commercial transport.

Our operating earnings will improve in the second half versus the first half results, due to productivity improvements, which are now starting to provide meaningful benefit, yet as large commercial transport selling volumes continue to increase, we are dependent on sourcing additional external carbon fiber, which will remain a cost headwind until we have our new line fully qualified.

Our revised full year 2014 forecast for the Aerospace Materials business in sales in the range between $990 and $1,010 million versus our prior guidance of $970 to $990 million and operating earnings to be in the range between $185 million and $195 million versus $183 million to $195 million.

Although we're forecasting an increase in both the top and bottom line for the year, the earnings impact from the fire in the first quarter in our carbon fiber lines has reduced our full result.

I also have some exciting customer news to share. Having just returned from the Farnborough air show this week, at the show we signed a long term supply agreement with AeroComposit to supply primary structure materials for the wing of the single-aisle MC21 aircraft.

We've been working on this opportunity for some time now and I am very pleased with Cytec's composite materials have been selected for this important program.

In the Industrial Materials business, we continue to see sequential demand improvement coming from our core markets, demand for structural composites for Aerospace tooling increased sharply in the first half and as I mentioned last quarter, we continue to anticipate their orders in this market will drop off over the balance of the year.

Yet due to the strong first half sales and favorable product mix in this segment, we're raising full year 2014 sales guidance to a range between $320 million and $340 million and operating earnings to a range between $28 million and $32 million.

Before I leave this segment, I want to comment on the recent announcement about our strategic collaboration with Dralon, a German based leading manufacturer of acrylic fibers.

And as most of you already know, we were actively pursuing the development of carbon fiber based composites for the emerging serial automotive market. Large scale adoption will necessitate the need for our robust supply chain, including industrial grade or large-tow carbon fibers that provide the right mix of cost and performance for these applications.

We're currently exploring the auction of converting one of Dralon's existing acrylic fiber facilities to carbon fiber. At this time, we envision the operation to be a standalone entity. We're also exploring the structure of the venture and the potential to add additional partners.

We are early in this initial assessment. At this time, we do not expect a direct investment to exceed $100 million. As we expect this operation to be a standalone entity we anticipate it would be independently seeking financing additional investors and public incentives.

Moving on to the In Process Separation segment, we expect demand in copper mining to remain strong and as warehouse LME inventory levels have reached their lowest levels in six years.

In addition, we believe that Freeport and Indonesian Government have reached an agreement to support resumption of higher production levels at this large scale operation. However, we've yet to hear a confirmation on timing or operating rate from our customer.

Reduced production at this site has been a significant sales headwind for us in the first half of the year. We have confirmed some of our projected new mine wins in the second half of this year, so we remain confident in our new mines sales estimate. One headwind that still remains in this segment is softening alumina demand as more producers are reducing production rates further impacting our sales.

We've seen strong sales growth with phosphine chemical products in the first half of this year, although some of this was inventory build by customers to build safety stock in advance of our planned production outage as you start up and tie in the new manufacturing line in the second half of the year.

Factoring in all of these issues, we're lowering our sales estimate to a range between $410 million and $430 million versus our prior estimate of $420 million to $445 million.

We're tightening and slightly raising operating earnings to a range between $91 million and $95 million versus our prior estimate of $88 million to $97 million as a result of the strong first half earnings, which came in large part from the favorable mix impact of the strong phosphine sales.

In Additive Technologies, market conditions remain challenging across most of the globe, but we're forecasting slightly improved second half sales versus the first half, mainly attributable to improved demand in certain polymer additive markets.

We're revising our sales estimate to be in the range between $280 million and $290 million, versus $285 million to $295 million and operating earnings to be in a range between $39 million and $41 million, down slightly from their prior range between $40 million and $42 million.

Dave provided a guidance for corporate and allocated interest expense and taxes with a revised business segment guidance and overall improved second half operating earnings, coupled with lower interest expense, our full year diluted EPS guidance range has been adjusted upward to a range of $5.85 to $6.15 versus our prior estimate between $5.60 and $6.

Again, I'm extremely pleased with the results from our transform portfolio as we position the company to deliver sustained topline and earnings growth. We are committed to executed our growth strategy and create significant future value for our shareholders.

Now let me turn the call over to our moderator LeAnn, so we can respond to your questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from the line of Gautam Khanna from Cowen & Co. Your line is open.

Gautam Khanna - Cowen & Company

Yes. Good morning and congratulations Dave.

Dave Drillock

Thank you.

Gautam Khanna - Cowen & Company

Just had a quick question on the higher aerospace volume, if you could comment since we've been at relatively mature production rates, why you may have seen a resurgence in orders and does that imply there was destocking in prior periods. Any color you could give us how broad-based the order pick up was among the suppliers you sell to?

Shane Fleming

Yes Gautam, this is Shane, I wouldn’t characterize it necessarily as a surge, but I think what we did see was demand a little bit above our forecast and I think you’ve really hit the nail on the head. Most of this was particularly in the single isle area.

Our Tier one customers had produced parts for Boeing and Airbus, just getting their inventories balanced. So the actual production rates for the single-aisles are pretty well leveled out for some time and this was just a matter of getting the inventory levels right for the current production rate.

Then on the 787, I think we actually did see some demand come from the increased ramp up on the A7 build rate. So it was a combination of restocking or getting the right stock levels in place for single-aisles and a little bit more demand increase on that A7.

Gautam Khanna - Cowen & Company

Okay. And so when you look at your forward order book, it's not like a declines or steps down at any point. This is more of a sustained level. You are pretty confident with that.

Shane Fleming

Yes exactly. That's our view is that the rate we saw, say in the second quarter should hold through the second half.

Gautam Khanna - Cowen & Company

Okay. And just lastly, on the IPS business where you do not have the mine start, if you could just comment on what specifically -- what specifically the phosphine orders, are those going to step down, how unusual -- I think you quantify the impact of the goodness if you will of the cost in the quarter.

Shane Fleming

Yes, I guess it's probably going to be a kind of a wash if you will, because we've got more new win business coming in the second half, where we're going to have lower phosphine sales and that's obviously reflected in our guidance, but we expect that large fill order that we had hoped will come in Q2, now defined in Q3 and we've got several other new mine wins coming.

But as we have to take our phosphine plant down in Q2 and maybe early Q3 for the startup and tie-ins, we're going to lose a little sales volume on the phosphine side second half versus first half, but I think it's going to wash out.

Gautam Khanna - Cowen & Company

Okay. But how much -- how additive was it -- the second quarter results in terms of EBIT? The inventory restock on the phosphine sales.

Shane Fleming

Gautam, I can't give you an exact number and may be Jodi can do the math for you, but it moved the needle for us that margins are still high in the phosphine business. We did have quite a strong second quarter and did have a beneficial impact.

Gautam Khanna - Cowen & Company

All right. Thanks a lot guys. I'll turn it to others.

Shane Fleming

Thank you.

Operator

Your next question comes from the line of Yair Reiner from Oppenheimer. Your line is open.

Yair Reiner - Oppenheimer

I'll add my congratulations Dave, best of luck.

Dave Drillock

Yes, thank you.

Yair Reiner - Oppenheimer

So to follow-up on the aero side, margins were really good above 20% despite having to source a lot of the fiber externally, can you maybe give us a sense of how much of a headwind that was and if excluding the headwind from fiber, we should think about 20% margins in aero as a new kind of base?

Shane Fleming

Yes, I am not going to be able to exactly quantify that impact, it's significant. It's the least fraction of a percentage point. So again it shows up. It makes a difference, but we were still enjoying the leverage of the increased volume on our earnings. So we were getting margin expansions just not as much as we might get if we didn’t have the headwind from the increased fiber cost.

We are projecting 20% earnings for the second half of this year driven to some degree by the productivity improvements that we're expecting. It's probably a little bit early to give guidance for the 15% number and ongoing run rate.

I would probably go back to what I've said in the past about this business. We were still targeting about half a point margin expansion year-on-year. I think we had forecasted something like low 19% this year, so maybe something approaching 20% next year, but we still got some work to do to have a more detailed forward look.

Yair Reiner - Oppenheimer

Great and then in terms of some of the newer aerospace programs, the ones that are said to ramp over the next call it six to 18 months, the engines for the new -- any sense of how the outlook for those programs and the early indications for orders are looking?

Shane Fleming

I think pretty much as we have forecast. None of those programs are going to be huge revenue contributors in 2015. I think the number starts to get bigger as we get into 2016, but we do expect some modest increases as these programs work through fly testing and we start to see some initial production, but for 2015, in the case of the new programs, I think it's going to be relatively modest.

I think for the JSF we forecast again modest growth probably something in the neighborhood of 10% off a pretty low base.

Yair Reiner - Oppenheimer

Great. Thank you. I'll back in queue.

Shane Fleming

Thanks Yair.

Operator

Your next question comes from the line of Mike Sison. Your line is open.

Mike Sison – KeyBanc

Hey guys. And Dave, it's been great working with you for over the years and congratulation to you as well.

Dave Drillock

Yes, thank you, Mike.

Mike Sison – KeyBanc

Shane, can you tell us a little bit about congrats on the M21 as well, can you maybe just give us how did you win it? What did you use in terms of your technology and what was your advantage there and are there opportunities to win more parts on that plane?

Shane Fleming

Yes, I think to answer the last part of your question first, I think there are some awards still to come. That's -- the biggest award is the wing, that's the biggest piece of primary structure on the plane, so we got the one we were really after, but I think there will be some more smaller volume to come.

You hit the nail on the head there. We won it with our technology. We win in with what we thought was the best product form, the best manufacturing process to allow manufacture of this new wing, spend a lot of time and effort providing technical support, engineering application support to show the customer how to make the wing using this materials and I think was the overall value proposition in the quarter, the product, our ability to demonstrate the effective use of these materials and the amount of automation that comes with the process we're using, which lowers their overall cycle time and production cost. So with the combination of all those things that guide us the win.

Mike Sison – KeyBanc

Will you be using your own carbon fiber on that platform and was the win just the composite and then can you give us maybe -- I know it's obviously early, so not going to hit your numbers any time soon, but what is sort of the longer term potential for that win?

Shane Fleming

Yes, I can't monetize the win for you. At this point in time we're not given clearance to give you that. I think the projected build rates for this plane are roughly 50 actually get out a few years, those are the public numbers. This was not one with our fiber, this was actually one with the third party fiber that we're supplying the composite material.

Mike Sison – KeyBanc

Great. And then one quick question, you suggested that or Dave suggested that you'll have additional free cash flow in the second half of the year, can you maybe remind us what are you looking for in terms of bolt-on acquisitions?

Are you going to try to stand the aerospace side for that and then at some point toward the end of the year, it looks like your leverage will be, you have a lot of liquidity, would you consider being more aggressive on a stock buyback potentially if the cash sort of piles up.

Shane Fleming

Yes, let me go to the first question, sorry Mike, I lost, I was going to answer the first part of your question and I lost it.

Mike Sison – KeyBanc

Bolt-on acquisitions what you are looking for.

Shane Fleming

Oh, thank you, thank you. Yes, you had asked about aero space if that's the target, I would say that's probably not likely. I think more likely what you'll see is looking for opportunities there is in the industrial materials area and they can be pretty small, something more like what you saw us announce with the C-CON equity position.

We're trying to work to find ways to facilitate the adoption of our materials, these carbon fiber reinforced materials, in seal auto. And one of the big obstacles right now is the cycle time to make these parts, so looking at different ways to automate the production of parts is something that we're focused on.

We're doing a lot of that work in-house. We've got some good application engineering capability that came with the Umeco acquisition, but where there is other technologies out there that we could license or acquire again something like C-CON or taken an equity position will be the type of approach you would see us make.

And then on to the second part of your question, yes, we haven’t generated a lot of free cash flow over the last couple of quarters as we've had pretty high capital spend and as Dave said earlier, we expect that capital to trend down over the second half of the year.

As that happens and we do start to put cash on the balance sheet, we would look at the potential of announcing another buyback and we'll come back at our full year earnings announcement in January of 2015 with a new position on capital allocation strategy.

Mike Sison – KeyBanc

Great. Thank you very much.

Operator

Your next question comes from the line of Robert Koort from Goldman Sachs. Your line is open.

Robert Koort - Goldman Sachs

Thanks very much and Dave same from me, I mean 20 years you’ve been a great professional very helpful, really appreciate it. So best of luck on our retirement.

Dave Drillock

Thank you, Bob.

Robert Koort - Goldman Sachs

Shane, I was wondering you mentioned you're going to have to externally source the MC21 fiber, are there plans on the horizon maybe to build your own plant and then secondly you mentioned getting qualified on your other fiber line. In terms of that type of fiber how much backward integrated or vertically integrated will you be on fiber?

Shane Fleming

Let me get to your second question first. We are -- on just the specific grade of fiber that we will be producing on this new GP3 line, which is also most of the fiber that we produce today and our existing lines will be pretty self sufficient. I don't know it will be 100% of the way there, but by the time the programs that are using this material are fully ramped up, we should be pretty well in balance, so I don't think that we're going to end up purchasing a lot of that grade of fiber in the years going forward.

In terms of additional investment in carbon fiber, that is something that we're looking at and what we've talked about in the past is that investment could range from something like a joint venture, an equity position in another fiber producer facilities all the way up to us designing and building a plant.

We would like to use capital as efficiently as possible. So we're going to review all those options, something like what we announced with Dralon and the industrial fiber side is certainly something we would consider as well.

So we do see the need over time to invest in fiber to get a fully integrated position on these new fiber type of products and how we do that is yet to be determined, but we are going to try and do it in the most capital efficient manner.

Robert Koort - Goldman Sachs

And what's the philosophy on share purchase? I mean your stocks has been one of the best performers at least in the chemical side of things this year, and certainly some of the forecast you laid out at your Investor Day suggest pretty good times ahead. So does it make sense to lever up now ahead of that run or wait until you accumulate the cash on the balance sheet, but may be pay a higher price for your buyback.

Shane Fleming

Yes, those are the opposing forces that you’ve got to consider, but we do feel like we need some more cash on our balance sheet before we take that decision, unlike to be able to buy at a lower price, but as we continue to drive growth it works against us.

Robert Koort - Goldman Sachs

And in other sense I hope you're not being able to buy at a lower price.

Shane Fleming

I understand.

Operator

Your next question comes from the line of David Begleiter from Deutsche Bank. Your line is open.

David Begleiter - Deutsche Bank

Thank you and David, thank you very much. It's been a pleasure working with you and all the best to you. Shane, as Industrial Materials finds its legs, I want to go back before the long term future of the portfolio, again do you think at all long term about the materials business being separated from the chemicals portion of the business on a longer term basis?

Shane Fleming

I would be lying to say we don't think about it. Right now we don't think that's the right decision for the company. I think there are some advantages in having businesses that are on different cycles. Having a business in IPS, it doesn’t require a lot of capital. We got the exception in this phosphine plant, but outside of that IPS and AT business are big cash generators and we recognize that the materials business is going to require more capital going forward.

So it's not in our current thinking. It's something that we look at annually when we look at our long term planning, but at this point in time, our intent is to keep the business together in the portfolio that we have.

David Begleiter - Deutsche Bank

Very good. And tell me about the Air Show, any further update or thoughts on the 777X wings going forward?

Shane Fleming

No, we didn’t -- while we met with Boeing at the Air Show, it wasn’t party to any specific updates there. We don't have a communicated deadline for making the decision. We can kind of back into the timing just based on their targeted entry into service and the first flight date. So we still think it's probably going to be sometime around end of this year.

David Begleiter - Deutsche Bank

And lastly, Shane just on the Aerospace Materials, in terms of a big ramp up in earnings power, is it still 2016 beyond until you see returns of solid or higher double-digit earnings growth in this segment?

Shane Fleming

Yes, likely. As we've said several times over the last months, we don't expect to see revenues start to really ramp up until 2016 because of these new programs really won't start to impact us until then.

So we'll continue to get margin expansion and some sales growth, that's going to allow us to leverage that to higher operating earnings and better margins, but the strong 10% to 15% sort of operating earnings growth that we are seeing from 10% to 14% is probably another year or so away.

David Begleiter - Deutsche Bank

Thank you, very much.

Operator

Your next question comes from the line of Mike Harrison from First Analysis. Your line is open.

Mike Harrison - First Analysis

Hi. Good morning.

Shane Fleming

Good morning, Mike.

Mike Harrison - First Analysis

Let me start off with a question for Dave, since he seems to be a getting on scot-free here. On the capitalized interest expense, when should we see that start to tail off and see the expense actually start to hit the P&L and can you remind us of the magnitude as we're trying to model that into 2015? Is it something like $6.5 million $7 million a quarter that's reasonable?

Dave Drillock

Yes, I would say that it's going to start to pill off and you'll start to see it a little bit in the fourth quarter of this year and then mostly into next year and I would say that that impact on next year will increase interest expense from this year's level by $6 million $7 million.

Mike Harrison - First Analysis

For the full year or $6 million to $7 million.

Dave Drillock

For the full year.

Mike Harrison - First Analysis

Okay. Got it. And then Shane, on the Additives business, you referred to some competitive price pressure in some of the lower value added areas. I know over time you’ve tried to exit those areas is that what's going to happen, what's going to have to happen here or how are you going to handle the pricing pressure going forward?

Shane Fleming

Yes, this is a little bit of a different situation. This is really one product line that's used as a stabilizer in the production acrylic acid and methacrylic acid, MMA. We are one small handful of global producers and the market tends to be pretty well in balance. Occasionally we'll see somebody make a little bit of an effort to grab some share and then we need to keep our plans full. So we have to respond with price.

So I kind of look at this as more of an isolated issue around one product line. The product line does contribute decent earnings to the business. As long as that continues, I think it will stay part of the portfolio, but unfortunately, we did see this quarter's pricing pressure that forced us to drop price to hold volumes.

Mike Harrison - First Analysis

All right. And then in terms of the Industrial segment, you saw strength in the tooling market in Q1. You saw it again here in Q2. Is it really just that we are at kind of the peak of a cycle in there, or are you selling into some newer customers? Maybe just some more detail on what's going on?

Shane Fleming

No, it's really around new tools that's required to support OEM producers. So as the OEMs ramp up, rates -- build rates, they need to order more sets of tools to produce at the higher rate, so we saw several sets of tools come through in the first and second quarters of this year to support a ramp up of a particular program and now that that's done, we'll kind of go back to the more normal order pattern that we've seen in the past.

Mike Harrison - First Analysis

And in terms of the margin, the guidance in the second half suggests that it's probably more 8% to 9% versus the 10% or 11% we saw in the first half. Is that tooling mix, or is it the volume impact, or kind of both?

Shane Fleming

It's probably more volume than mix. I mean the tooling business is not that business. It doesn’t bring the average down and contribution margin, but I think the bigger impact on first half versus second half margins is the lower revenue.

Mike Harrison - First Analysis

All right. Thanks very much.

Shane Fleming

Thank you, Mike.

Operator

Your next question comes from the line of Rob Walker from Jefferies. Your line is open.

Rob Walker - Jefferies

Thank you. Your guidance for 2014 seems to imply 30% or 40% incremental margins. Is that higher than normal or sustainable?

Shane Fleming

I think 30% is sort of what we would expect yes, I mean it's a little bit dependent on the mix of businesses that generate that, but that's probably a pretty good average number to use.

Rob Walker - Jefferies

Okay. Thanks. And it looks like the Industrial Materials business is tracking ahead of your expectations at Investor Day. I guess what does the pipeline look like into 2015 for profit growth there?

Shane Fleming

Yes, it's a little bit hard for us to forecast this business relative to some of the others because it is lumpy and it's dependent on new programs that we don't have real good line of sight to. I think the one thing that I can say here is this business really gives you significant margin improvement as you grow topline.

We've got a lot of spare capacity that we can bring on without a lot of incremental cost and we got 11% operating profit quarter because we had a very strong revenue quarter.

We are working on a number of new programs. As some of those come through, there is a chance to get substantial growth and with that revenue growth will come good, solid earnings as well. So, very good potential to leverage revenue and to improve earnings here, but I don't have enough line of sight right now to give you a whole lot of guidance for 2015.

Rob Walker - Jefferies

Thank you.

Operator

Your next question comes from the line of P.J. Juvekar from Citi. Your line is open.

John Hirt – Citi

Good morning. This is John Hirt on for PJ today. I'm just wondering. On your agreement with Dralon in Germany for large-tow industrial grade fiber, can you talk about what their expertise is in large tool fiber and what differentiates their position from C-CON?

Shane Fleming

Yes, C-CON is a very different situation. C-CON is a design and engineering company that specializes in manufacturing parts for the automotive industry and what they bring us to, that collaboration is around converting our finished materials or composite materials in two parts. So step down the value chain.

Dralon brings to us large manufacturing footprint for the production of acrylic precursor. So the acrylic precursor can be converted into carbon fiber or it can be converted into acrylic fiber. Today Dralon makes acrylic fiber with that material, our intent is to work with them, use some of our expertise around the back into the plant, the carbon fiber conversion piece to put together these competitive large competitive assets.

If you got the installed precursor capacity, it's a low cost capital way to produce carbon. There has been a lot of that done over the last 10 years by various companies where they secure these acrylic fiber plant and then converted them. So Dralon is bringing us a plant that is very capable of producing low cost precursor. Cytec really brings a technology around converting that precursor into carbon fiber.

John Hirt – Citi

Okay. And as you look kind of longer-term, you are establishing these partnerships in serial automotive, but at the same time we're also seeing more aluminum going into automobiles, whether it's Ford's F-150, the Toyota Camry, and some luxury cars and even sports cars.

So, in your mind, what's the addressable market for carbon fiber as it goes into the auto space, and what vehicles and components do you see carbon fiber competing most effectively?

Shane Fleming

Yes, it's a really good question and that's not still fully defined, but you are going to see light weight in new vehicles across the entire chain from the very lowest in cars relatively inexpensive cars up to the high performance sports cars.

Our focus today is moving down from the super car market down into the luxury sports car market, so the $100,000 to $200,000 selling price and in those cases the OEMs are looking to make significant weight reduction, 30% to 40% weight reductions from the existing vehicle weights even if they are currently using quite a bit of aluminum.

They're still a significant available weight reduction that comes through the conversion to carbon fiber. So when you ask about what parts? What applications? When you're talking about a 30% or 40% weight reduction, it's broad across the vehicle. Chassis, door panels, lots of parts to get that sort of reduction and there is a number of those programs ongoing where we or our competitors are collaborating with the OEMs to bring the carbon fiber materials to these applications.

And in that sort of $100,000 to $200,000 market, we think you are going to see a number of new vehicles coming to market with a lot of carbon fiber over the next five years. To go beyond that, to start getting down to the sub say $100,000 car, I think the technology has got to advance further than it is today. There is processing requirements, cycle time requirements that really have not been met when you start talking about the vehicles that are build in the hundreds of thousands per year.

So initially we're targeting the sort of high end luxury market with collaboration and partnerships with OEMs and tier one suppliers and we feel like there is pretty good line of sight to a number of those programs coming to market in the next five years. How far carbon fiber ultimately penetrates the automotive market, I think is still to be seen, but there are a lot of forecasts out there that's been a very, very large market as you get in that five to 10 year timeframe.

John Hirt – Citi

Okay. Thank you. And just lastly, if I look at your IPS guidance in the second half, it looks like you are expecting sales to increase considerably. Can you just remind us how many mine fills you have kind of embedded in that forecast?

Shane Fleming

Yes, I think its three to four. I think we projected six for the year and maybe had two in the first quarter. So it's probably four and equity one, pretty substantial one.

John Hirt – Citi

Okay. Thank you so much, Shane and congratulations Dave.

Dave Drillock

Thank you.

Shane Fleming

Thanks John.

Operator

Your next question comes from the line of John McNulty from Credit Suisse. Your line is open.

John McNulty - Credit Suisse

Thanks for taking my question and Dave, congratulations. Thanks for all your help over the years. So, a few things. Shane, with regard to the cost that you've been dealing with on the Aerospace side just because you've been having to go out and buy the fiber, you've got this new line up.

How long is the qualification time? Is it the typical -- should we assume you're going to continue to have to deal with these headwinds for the next six to nine months? Is it longer than that? So when should we see the margin lift start to come back in?

Shane Fleming

Yes, unfortunately, it's longer than that John. I think it's going to be into 2015, early 2016 before we are fully qualified, it's about an 18-month process from beginning to end. So -- I just want to make sure that we don't send the wrong message about this margin headwind either.

This is affecting certain programs and it's really affecting growth in the large commercial transport sector where they use this type of fiber. So this doesn’t mean we're going to be facing this across the Board, but where we do see growth in these large commercial transport programs, that's where we're going to see this cost penalty come in.

It's still going to be good business, still going to add a lot of incremental margin, but not as much as it would if we were able to source the fiber in-house.

John McNulty - Credit Suisse

Got it. Okay, Fair enough. And then just a question about one of your strategic collaborations, because you have a bunch of them out there. Mubadala in the UAE just actually in this last quarter delivered its first composite part to Boeing as a tier 1 player. I believe you've got a relationship with Mubadala. So maybe you can kind of flesh that out a little bit and give us some indication as to what that may mean for you longer-term.

Shane Fleming

Yes, Mubadala is actually been producing through a subsidiary company called Strata parts for aerospace for some time. Now maybe they're calling themselves tier one now where it was tier two in the past, but they make a number of parts for Boeing for their existing large commercial transport programs and we supply quite a lot of composite materials to Strata for the conversion to these parts.

And that's been a longstanding relationship as Strata to develop their business. We were brought into to help them. There was a large potential commercial opportunity for us. So we've had people in the Emirates working with them for a number of years.

The future looking collaboration there is around the possibility of co-investment to make carbon fiber composites in the Emirates to support Strata as they grow their position going forward and that's ongoing dialog right now. It depends on Strata's ability to win business in the future, but we feel very good about the partnership and we feel like it has the potential to put us in a very nice position to be a partner with somebody who I believe is going to be a major player in the aerospace industry going forward.

John McNulty - Credit Suisse

Great. Thanks very much for the color.

Shane Fleming

Thanks John.

Operator

Your next question comes from the line of Steve Levenson from Stifel. Your line is open.

Will Mullin - Stifel Nicolaus

This is actually Will Mullin on for Steve. Can you guys comment if the opportunities on the GE9X fan case will be similar to what you guys have on the LEAP?

Shane Fleming

Yeah I think potentially we have an opportunity to work GE to win a position there that is likely to be a composite fan casing. The one difference being, one of those two difference is one of the 9X is the much larger agent, so the fan case and opportunity will be more substantial, but you don't have the blade that you do on the LEAP.

So I couldn’t quantify the dollar value, but you're right in assuming that that fan case is an opportunity for the type of technology that we're providing to the LEAP engine.

Will Mullin - Stifel Nicolaus

Great, thanks. And I think all our other questions have been answered. So congratulations, Dave, and thanks again guys.

Shane Fleming

Thanks Will.

Dave Drillock

Thank you.

Operator

(Operator Instructions) Your next question comes from the line of Chris Kapsch from Topeka Capital. Your line is open.

Chris Kapsch - Topeka Capital Markets

Yes, hi Shane. Shane, I had a follow-up in the context of your intended or potential collaboration with Dralon. And what you described in repurposing those acrylic acids is essentially what sort of what Zoltek has done over the past call it two decades.

And I'm just wondering if there's anything unique about those assets, the Dralon assets that would allow for some form of differentiated industrial grade high-tow fiber or is this really just ultimately a potential play on having an integration and access to some in-house capacity.

Shane Fleming

Yes, it's a little bit difficult to answer this question Chris without getting too much into the technology and putting information out there, that I don't really have clearance to do so. Let me just characterize this that these are large volume what we think are potentially very low cost assets for the production of large-tow fiber.

You are right in that Zoltek has in the past had similar approaches to producing large two and as have others, so it has been a number of companies that have taken this approach because you can repurpose a significant investment by using those existing acrylic acid.

So we believe this will give us an opportunity to have a competitive position, but I am not going to be able to comment specifically on the technology or why I think that.

Chris Kapsch - Topeka Capital Markets

Okay. And then if you could just clarify the commentary about the capital involved. I think you said up to $100 million. I'm just wondering. Is that -- obviously your portion of ultimately capitalizing a potential venture? I am just -- is that enough to cover ultimately the conversion of these assets as well as the downward integration into the fiber production, or would it be…

Shane Fleming

No, no it's not. That $100 million that we talked about in the speech was the direct investment by Cytec in the venture. Ultimately as we would expand the footprint there and add capacity, the venture would need to get funding from some form or fashion to support the additional capital requirement.

So yes, you're talking about several hundred million dollars ultimately if you want to convert a significant asset like this to produce carbon fiber.

Chris Kapsch - Topeka Capital Markets

Okay. Thank you for the clarification.

Shane Fleming

Thanks Chris.

Operator

And we have no further questions at this time. I will turn the call back over to you Ms. Allen.

Jodi Allen

Thank you to everyone for participating in today's call and if you any follow-up questions please contact me directly at (973) 357-3283. Thank you very much and have a good weekend.

Operator

This concludes today's conference call. You may now disconnect.

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Source: Cytec Industries' (CYT) CEO Shane Fleming on Q2 2014 Results - Earnings Call Transcript
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