A. Schulman's (SHLM) CEO Bernard Rzepka on Q3 2016 Results - Earnings Call Transcript

| About: A. Schulman, (SHLM)

A. Schulman, Inc. (NASDAQ:SHLM)

Q3 2016 Earnings Conference Call

June 29, 2016 10:00 AM ET

Executives

Jennifer Beeman - Vice President of Corporate Communications and Investor Relations

Bernard Rzepka - President and Chief Executive Officer

Joe Levanduski - Executive Vice President and Chief Financial Officer

Analysts

Rosemarie Morbelli - Gabelli & Company

Roger Spitz - Bank of America Merrill Lynch

Mike Harrison - Seaport Global Securities

Mike Sison - Keybanc Capital Markets

Kevin Hocevar - Northcoast Research

Dmitry Silversteyn - Longbow Research

Jason Freuchtel - SunTrust

Presentation

Operator

Good day, ladies and gentlemen, and welcome to the A. Schulman Fiscal 2016 Third Quarter Earnings Call. At this time, all participants are in a listen-only mode. Later we will conduct a question-and-answer session and instructions will follow at that time. [Operator Instructions]

I would now like to introduce your host for today’s conference, Ms. Jennifer Beeman. Ma’am, you may begin.

Jennifer Beeman

Thank you. Good morning and welcome to A. Schulman's third quarter 2016 conference call. I'm Jennifer Beeman, Vice President of Corporate Communications and Investor Relations for A. Schulman.

Joining me today is Bernard Rzepka, President and Chief Executive Officer; and Joe Levanduski, Executive Vice President and Chief Financial Officer of A. Schulman. You also have received a copy of our press release which was issued last night. Additionally, we have provided supplemental slides which we will refer to during our prepared remarks. These are available on our website and are included in the webcast of this call.

I would like to remind you that statements being made during this conference call which are not historical facts may be considered forward-looking statements. Forward-looking statements involve risks and uncertainties that could cause actual events or results to differ materially from those expressed or implied. Additional information on factors that could cause results to differ is available in the company's most recent Form 10-K and Form 10-Q.

In addition, this conference call contains time-sensitive information that reflects management's best analysis only as of the date of this live call. A. Schulman does not undertake any obligation to publicly update or revise any forward-looking statements to reflect future events, information, or circumstances that arise after the date of this call. For further information concerning these issues that could materially affect financial performance related to forward-looking statements please refer to A. Schulman's quarterly earnings releases and periodic filings with the Securities and Exchange Commission.

I would also like to remind you that for purposes of this call, we use certain non-GAAP measures. You can find a reconciliation of these non-GAAP measures to the nearest comparable GAAP result as an attachment in our third quarter earnings release which has been posted on our website.

With that, I would like to turn the call over to Bernard Rzepka.

Bernard Rzepka

Thank you all for joining us this morning as we update you on our fiscal 2016 third quarter results. As Jennifer mentioned, we have added a few supplemental slides and I will refer to them during my remarks. But first let me say that this has been a tough year for us and whilst we are making progress, we are in no way satisfied with our results. At the same time, this quarter clearly shows again significant progress in driving what really matters, profitable growth. I am pleased with this continued improvement which was a result of focus on improving product mix as well as our smart sales, savings, and safety initiatives that are now deeply entrenched within our businesses.

Even more importantly, the improved results came across our Citadel and our legacy businesses which validate our strategy to transform A. Schulman into a specialty plastics solutions company and demonstrate that we are getting traction on becoming the premier global provider of specialized plastic material solutions to market leading customers.

Turning to the slides, let's move past the legal disclaimers which you can read, and begin on slide number 4. Net sales for fiscal 2016 third quarter increased $89.5 million or 16% compared with the prior year quarter. The Citadel acquisition added $112 million or 20% to sales growth. This was slightly offset by $6 million of negative foreign currency translation. Excluding acquisitions and currency, our legacy revenues declined 3%, nearly identical to the second quarter pace. The majority of the decline in our legacy business again occurred in U.S., Canada and EMEA regions which both saw volume and price declines mainly in the Distribution and Specialty Powders commodity businesses.

Gross profit excluding certain items was $130 million for the quarter, up 25% from the third quarter of fiscal 2015. This increase was primarily due to the positive contributions from Citadel, our improved legacy mix, and favorable raw material spreads. At 10.3% this quarter marked the highest adjusted EBITDA margin than we have seen in the recent past. We delivered adjusted gross margin of 17.4% compared to 16.2 in the year-ago period. Total adjusted operating margin also gained 110 basis points to 7%. Both Citadel and legacy portfolios contributed to these improved adjusted gross and operating margins.

These profit improvements metrics across our legacy business is clear evidence that our companywide transformation has developed traction. Our margin improvements are far more widespread than that of simply integrating Citadel and enjoying an improved margin mix from the combination. I will talk more about the margin improvement initiatives such as smart sales and Manufacturing for Success program, in addition to 2016 supplemental cost reduction in a moment. Further, we fully expect these programs to add further to our bottom line results in fiscal 2017 particularly if market demand stabilizes.

Slide 5, please. Moving on to some micro factors that are affecting our regions, you will see that our EMEA region we have experienced momentum with German auto industry. However, the lackluster macroeconomic environment remains and we continue to see weakness in polyolefin pricing which has resulted in customers laying orders. I would be remiss if I didn't stop and mention the Brexit at this point, the word has certainly created turbulence in the financial market and generated a lot of speculation. Plus specifically, we have three facilities in the UK and our sales there are so far 10% of our total revenue in EMEA.

In discussions with our customers in the last few days, we do not see an immediate impact with the order pattern. However, uncertainty in this fragile environment is never good, and it is too early to tell if there will be an impact in the coming months for manufacturers. In U.S. Canada, we saw slow growth in the markets such as agriculture and oil and gas, but the primary impact on us is as we continue to see weakness in our custom services commodity business as our customers continue to take this business in-house due to possible overcapacity on their end.

In Mexico, we've capitalized on our longstanding experience and relationships with key customers and we are able to quickly leverage our core technology to service our customers. This translates to continued success in the packaging and agricultural markets in Latin America for us. As you know, in Asia Pacific, there is a well publicized slowdown in the Chinese economy and we are seeing competitive pressures there but this has not dampened our ability to find pockets of growth. For example, we see strong demand in Malaysia for compounds. In our engineered composite business, we have suffered from the weak oilfield service business and that pressure continues. On a positive note, we did see rig count improved in the recent weeks slightly and we're encouraged by the continued collaboration with our customers as they look for ways to improve efficiencies in the light of this lull.

Turning to slide number 6, polyethylene and polypropylene prices are both expected to decrease despite the continued efforts of oil manufacturers to use any option at their disposal such as closing order books, exporting, and moving up extending maintenance shutdown to reduce output. Titanium dioxide, another major raw material for us, is likely to continue to increase due to unsustainably low levels of price. Producers have been aggressive in making price increase announcements but will depend on the ability of the industry to pass price through. Other raw materials like pigments, additives, fillers are expected to remain stable for the remainder of the year. We continue to drive supply chain efficiencies which help to offset raw material price volatility.

Turning to the Lucent matter on slide number 7, as a reminder, we discovered that two Citadel plants formerly owned by Lucent passed the test results on documents provided to customers. We are happy to report that from an operational standpoint, we believe that these issues have been largely identified and addressed. This is a result of the tireless efforts and excellent work of our team who can now focus their attention on organic growth instead of resolving issues overtime. We thank our customers for the patience and support during this time. The fact that we were able to identify and address this matter as quickly as we did without to date any product recalls speaks volumes to the strength of our team and culture.

While no customers have thought to terminate their relationships with A. Schulman, we have lost some business for various reasons. At this point, we estimate roughly $20 million to $25 million in lost sales for this fiscal year. The company saw costs of $1.1 million in the quarter related to the Lucent remediation matter including $1.1 million of recurring production and material cost down from the prior quarter, $8.7 million of other costs including settlement of claims dedicated internal personnel costs and a reduction in inventory value.

On June 15, we filed a lawsuit against HGGC, the seller of Citadel. Amongst other things the suit seeks indemnification and damages for the fraudulent business practices within the Lucent subsidiary. As you recall, we had already provided a written claim notice to this effective HGGC and to the escrow agent with respect to the $31 million indemnity escrow established. During the fiscal first quarter, the company incurred $1.2 million of legal costs associated with this lawsuit.

Let's talk about our progress with the Citadel integration on slide number 8. Despite reported challenges, I firmly believe this acquisition was the right move for us. We would have missed an enormous opportunity for future growth had we not made this move. How many years would have it taken us to double the size of our U.S. business or have a meaningful participation in the macro trend? Could we have reoffered more solutions to customers without these two platforms? The Citadel acquisition provides us a great platform for growth in future years. Will it continue to fuel organic growth with higher margin product initiatives, drive synergies, and improve our combined operations to capitalize on this investment.

Having said that, let's discuss where we are with the integration thus far. Significant actions are underway to integrate our sales and marketing program and the coordination of our combined offerings at key customers. We believe that over the next five years, these top-line organic synergies could generate $50 million to $60 million of additional profitable revenue in U.S. Canada, Engineered Plastics and Engineered composites. As you can see on the slide, we have increased our cost synergy goal to $30 million in fiscal 2017. The main driver of this decrease is due to the incremental initiatives to reduce SG&A which have already been captured.

Joe, please cover the next slides.

Joe Levanduski

Thank you. Good morning, everyone. I will take a few minutes to provide more details on segment results referring to slide number 9. Turning to the individual business segments, in EMEA, reported net sales were $322.4 million for the quarter, a decline of 1.2% compared with the prior year quarter. Foreign exchange translation was actually a slight positive in the quarter. The majority of this revenue shortfall was related to lower volumes in the commodity Distribution and Specialty Powders area as customers orders fluctuated due to uncertainty over the future direction of petroleum-based commodity prices. A partial offset came from the strength in our Masterbatch solutions product family which experienced a 5.5% increase in the quarter.

EMEA's adjusted gross profit declined $1.8 million compared with the prior year quarter leading to a 15.5% gross margin down 30 basis points. While volume declines in our commodity portfolio have little impacts on gross margin, we were challenged in our Masterbatch product line has excess capacity in the region combined with higher TiO2 pressure on our gross margin.

U.S./Canada region sales rose $46 million to $183.3 million in the third quarter due to Citadel's contribution of $57.9 million of engineered plastic revenues. As a reminder, Citadel's other business segment, Engineered Composites, is reported as a stand-alone segment which I will address in a moment. Excluding the acquisition, U.S./Canada legacy sales fell 8.5%. While all product families experienced sales declines, the largest shortfall was in distribution, a 17% decline followed by the business in Masterbatch solutions and agriculture related production and engineered plastics. While we're disappointed in our revenue momentum in the region, U.S./ Canada's profitability performance tells quite a different story. The improved mix of product shipments resulted in adjusted gross margin expansion to 17.8% compared to 16.1% in the prior year period.

What's even more remarkable is that our legacy business generated a gross margin that is dramatically better than the overall segment results. That is because of the impact of Citadel's profitability. While contributing to the overall gross margin dollars, the margin associated with the Citadel Engineered Plastics business has been temporarily diminished by the cost of our Lucent resolution actions discussed earlier by Bernard. Profitability gains came from improved product spread, lower plant cost and inventory management initiatives. We've accomplished these by executing on the several smart savings initiatives including our manufacturing for success program, effective material cost management, and the result of past restructuring and cost reduction efforts.

Moving to Latin America, this region was again a notable bright spot for the company, a sharp contrast from the negative headlines coming from Brazil and other nearby countries. Our Latin-American revenues were reported down 3% but including a large negative foreign currency translation of $7.3 million, revenues increased 13%, the fourth consecutive quarter of double-digit growth. Similar to the last several quarters, these gains stem from market expansion and the payoff from past operational efficiency initiatives.

Lastly, our export shipments out of our Brazil plant increased roughly 18% during the quarter, a further boost to Latin America's performance. With the benefit of a 9% volume increase and the completion of regional restructuring actions, adjusted gross profit rose to $9.1 million, up 13% excluding FX to yield an adjusted gross margin of 20.9%. In APAC, net sales were $46.9 million, down 11% from the prior year. After excluding the negative foreign exchange translation of $2.9 million, revenues declined 5.5%. I will note that some of this was planned as a result of previously contributing the rotational molded portion of APAC's specialty powdered business into a minority owned joint venture in 2016. Growth profit for APAC excluding certain items was $8.1 million leading to an adjusted gross margin of 17.2%, up 250 basis points from the prior year period primarily due to improved product spread.

Engineered Composites, our newest business segment, was launched on June 01, 2015 upon the acquisition of Citadel. EC delivered net sales of $54.5 million, down 4% from the year-ago period prior to our acquisition and exclude the foreign currency impact. Adjusted gross profit was $13.7 million or an adjusted gross margin of 25.2%. This was an increase of 200 basis points from the second quarter, what was below the adjusted year-ago level prior to our acquisition due to the weakness in oilfield services.

On the other hand, operating margin of 9.2% was well above the comparable period of 6.9% margin as our Citadel integration actions began to pay dividends. I would note here that similar integration benefits are unfolding in other portions of Citadel such as Engineered Plastics portions of U.S./Canada, but these gains are not yet falling to the bottom line because of the Lucent related costs we have incurred.

Now, turning to slide 10 and looking briefly at our balance sheet, net debt ended the quarter at $937 million, down $40 million from the prior quarter. In 12 months since the June 01, 2015 acquisition of Citadel, we have lowered our debt position by $144 million and net debt has declined by $53 million. Our adjusted net leverage on a pro forma basis was 3.96 times at quarter end compared to 4.2 times at the end of February quarter.

Working capital days decreased to 61 days compared with 71 days last quarter on an end of the quarter basis with half of this improvement coming from a reduction in days of inventory on hand. We remain focused on achieving our previously stated goal of two and a half times net leverage by the end of fiscal 2017. Capital expenditures year-to-date were $35 million compared with $33 million in the prior year period, and were primarily related to our ongoing investments to expand our manufacturing and technical capabilities.

Depreciation expense for the first nine months amounted to $37 million compared with $26 million in the prior period. The Citadel acquisition added $11 million of depreciation expense year-to-date. Amortization expense totaled $30 million in the first nine months versus $12 million in the prior period. The amortization expense associated with Citadel acquisition amounted to $19 million of the total.

Operating cash flow for first nine months was $96 million compared to $56 million in the prior period, with working capital improvements contributing to the strong cash flow and the quarter. Adjusted EBITDA year-to-date was $175 million, a 48% increase from the $118 million in the year-ago period. In the third quarter, we paid cash dividends of $0.205 or $6 million on common shares. The company also paid approximately $1.8 million in dividends on the convertible special stock in the quarter. On an adjusted basis, the third quarter tax rate was approximately 21.5% lowering our full-year expectation to 23.5% versus our previous expectation of 25%. The mix in earnings that we reported in the second quarter specifically our lowered earnings in U.S./Canada continued to impact our effective tax rate in the third quarter. Availability under our credit facility was $315.6 million at the end of the third quarter, providing significant liquidity and signaling the strength of our balance sheet.

And with that, I will turn the call back over to Bernard.

Bernard Rzepka

Thanks, Joe. And now let's turn to slide number 11. We have created a visual that depicts how we see our path to growth in the future. At the top you will see that the Citadel exposition was jump start to growth through strategic and transformational M&A. And as we stated we now expect to achieve 30 million in synergies in fiscal 2017. It is our expectations that our sales synergies will begin to materialize in fiscal 2017. Related to our composite business, we aim to expand our capabilities by adding sheet molding technologies into our existing plant in Germany.

Moving to smart sales, we see our investment centre on growing specialty sales and better serving our customers. This is done through investments in key markets such as China. At the end of April, we presented our product portfolio at Chinaplas, a signature event for China's plastics industry at every two years in Shanghai. More than 3300 exhibitors participated in the four-day show.

We took this opportunity to unveil our 30 color, color and technology trend collection and celebrated the grand opening of our new Masterbatch color plant in Changshu. Our BeColor trend collection features the next generation of color trend forecast for the specialty materials market. The 2017-2018 BeColor collection gathered forward looking trends, which are most relevant for college specialty materials. This year's collection includes a complete range of technology trends tied into our wide portfolio of specialty materials encompassing all of our expanded business portfolio.

After observing the prevalent spring and fall fashion trends A. Schulman partners with international design firm and analyzes these micro trends to enable us to provide forward-looking color recommendations to our global customers. And speaking of Chinaplas, while attending the trade show, I also had the opportunity to formerly celebrate the grand opening of our color plant in China. This new facility will produce our premium color additives for packaging, automotive, agricultural, sports and leisure, and home customers in China and other growing markets throughout the Asia Pacific.

The addition of this new facility strengthens our offerings to the customers in the region and is already off to a strong start. We will continue to invest in global R&D. Later this summer as previously announced, we're expected to open our newest innovation collaboration centre in Bay City, Michigan. Our innovation collaboration center will initially focus on our engineered thermostat composite, however, it will eventually feature a broader array of solutions using all our specialty products.

A core innovation team including material experts, design and strength engineers and manufacturing specialties will work directly with our customers to accelerate the time frame from concept to production. The company will provide full engineering services to facilitate this process and apply a mature neutral approach thus providing the best solution base on customer needs.

As you have seen in the results, our efforts in US/Canada have been too slow to take hold and we understand we need to jump start this business both from an operational and sales perspective. This is why I will now personal run the segment on an interim is basis. A search has been initiated for a new head of this region, but in the meantime my position as COO will allow me to take a deeper dive into all issues and make substantive changes where necessary.

Speaking of change, on a global scale we have realized our marking and IT functions to enable better execution at the business level. This includes the elimination of the Chief Marketing role, as well as the Chief Information Technology Officer. Marketing now reports directly to me, while the IT function reports to Joe Levanduski. Again, these moves were not to diminish the importance of the function, but rather to stream line our activities to ensure better focus and execution.

In both areas, we have made notable strides in terms of establishing processes and acquiring the right tools and program. Recently, we have begun to utilize salesforce.com, a powerful CRM tool in our two biggest regions, US/Canada and Europe. We are already seeing that this tool is driving transparency, and now it's time to drive accountability and better alignment in sales.

Lastly, I would like to focus on our smart savings initiative beginning with plant consolidation. As you know, as part of the Citadel synergies we identified 9 million in plant consolidations and are in the process of closing three facilities in the Evansville area. This follows some earlier consolidations we executed in France, while we will have 1 million to 2 million of savings in fiscal 2017.

Our regional manufacturing leads together with our new Chief Supply Chain Officer are planning additional consolidations in order to better align our footprint with the demand and improved competitive position. Our manufacturing for success program designed to strengthen our shop flow effectiveness [indiscernible]. Year-to-date we have achieved 4.9 million in cost out savings from this program.

As a next step, we are turning our attention to our S&OP inventory control and our teams are scoring quick wins in inventory reduction. As part of this new effort, we will enhance our global inventory management system to ensure the sustainability of our action. In the third quarter, our restructuring actions generated almost an additional 3 million in savings and will continue to benefit us in the fourth quarter and beyond.

Moving to chart number 12, speaking from a consolidated viewpoint, I will wrap up by saying that our strategies to transform into a value added solution provider are working as evidenced by the improvements in adjusted gross and operating margin. We will stay on this path as we continue to exit unprofitable business, provide excellent service to our market leading customers and target growth markets and geographies.

As Joe mentioned, I am also encouraged that we continue to pay down debts during the quarter, which signals to us that we are well on our way to deleveraging staff freeing up our cash to pursue future growth opportunities. Again, the Lucent quality method has been operationally addressed. Two days there have been no recalls and there's no evidence that there will be future recalls.

The vast majority of claims have been resolved, and there are only a handful outstanding, and we think they will be resolved in the near future. We have identified the products that need to be recertified, and we are well on the way to getting this recertified. With that, I'm pleased to report that our teams are getting back to their day job growing our business.

And lastly our synergies from Citadel are now expected to top our original guidance of 25 million and we now expect to reach 30 million in fiscal 2017. In this current volatile external environment is our focus will remain on internal initiatives, which are aimed at accelerating profitable growth and delivering added value to our customers and our shareholders.

Jennifer, we are ready for Q&A.

Jennifer Beeman

Thank you, Bernard. Tamara, we would like to open up the lines for questions.

Question-and-Answer Session

Operator

Thank you. [Operator Instructions] And our first question comes from the line of Rosemarie Morbelli with Gabelli & Company. Your line is now open.

Rosemarie Morbelli

Thank you and good morning, everyone.

Jennifer Beeman

Good morning.

Bernard Rzepka

Good morning.

Rosemarie Morbelli

Bernard, I was wondering, looking at the legacy decline, is there some voluntary elimination of product lines, and specifically in distribution and powder, and if we look at the overall decline, how much was something that you absolutely worked at versus something that the market dictated?

Bernard Rzepka

I would say, Rosemarie, it's probably half, half. In the distribution business for a long time, as you know, we really participate in that business if we can make money and the times have been challenging for distribution, particular in Europe where there is a big part of distribution. They have been, because of the price decreases and uncertainty, a hesitation to buy these products.

So that's what we've seen in third quarter. We see now that this is starting to improve. There have been some announcements and some slight price increases, which seem to get some traction. So, this is a very volatile business, and has been for the last past year, and we just participate if really we can have a profitable input for this business. So, this is something which the market dictates and not what we. In the specialty powder business as you probably remember from our past discussions, and probably half of the business is still commodity, and we choose to focus on the specialties. As you know we just recently started to concentrate on several facilities in France in powder, and we are really exiting commodity businesses and focusing down specialty, and this is very targeted in this business unit, as in some of the other business units where the clear marching orders for sales and marketing is to focus on added value products.

Joe Levanduski

And Rose may I just add, as I mentioned in my comments, the rotational molded specialty powder business in APAC was contributed to a JV, and that's the reason why on a nine-month basis you're seeing revenues in the specialty powders drop by a high percentage, about $6 million, about the same in terms of volume, roughly 72%, down year-over-year, but that was the planned action that we took.

Rosemarie Morbelli

Have we seen the full impact of the move of some of those product lines into the JV? Is there more to come? When do we anniversary this?

Joe Levanduski

No, everything has been transitioned into the JV. So you will see continued variance for the fiscal year because it did occur in fiscal 2016. So, when we do the comparison in the fourth quarter you will see similar types of declines.

Rosemarie Morbelli

Okay. And could you give us a little more detail on how Citadel performed if you exclude the Lucent?

Joe Levanduski

Well, the Lucent cost on a recurring basis that should decline from the second quarter, I think second quarter amount was about $1.5 million of recurring costs, and the third quarter is $1.1 million. So it was actually a lower delta. The one-time costs are excluded from our non-GAAP performance metrics, so that's out there, but the real impact is really the distraction. And as Bernard mentioned, we're seeing that diminish as the team is now focused in their attention going forward on organic growth initiatives.

Rosemarie Morbelli

So when we look at Lucent, you are talking about losing approximately 20 million to 25 million of revenues from the areas with issues. How much is left of Lucent that didn't have any issues, or was it all an issue? In other words, was Lucent - how big was it prior to the loss of 20 million to 25 million of revenue?

Bernard Rzepka

Rosemarie, we published this number, it was 70 million of the entire portion of Citadel. Engineered plastics business, which has been in Evansville, and 80% of this business has been impacted by the Lucent quality matter. So we're expecting of this business 20 million to 25 million that what we see now has disappeared of the business and I call it like, to the team now like we have reached the low point now, and now that we can focus on the resources into getting more business, not only with the Lucent grade, but the entire Engineered Plastics in the U.S. and Canada was engaged in remediating this issue. And now this team can go back to the day-to-day work and really hunt for more business, and that will be across the entire great line of Engineered Plastics in US/Canada.

Rosemarie Morbelli

Do you think that you can recover that 20 million to 25 million in 2017?

Bernard Rzepka

We will be able to recover some of it. I don't believe that we'll recover everything.

Rosemarie Morbelli

And so the rest of Citadel year-over-year, if you exclude Lucent, can you give us a better feel for how they did?

Bernard Rzepka

Joe, do you have that?

Joe Levanduski

I think from, let me see if I could give the - could you repeat the question, Rosemarie? I want to make sure I answer the question appropriately.

Rosemarie Morbelli

Sure. Wondering if you exclude Lucent and you look at the balance of Citadel, can you give us a little more detail on how they performed year-over-year?

Joe Levanduski

Yes, from - obviously the impact on the Lucent costs that are impacting us on a year-to-date basis was about $3.8 million so that obviously impacted us, the loss of revenue that Bernard is talking about. In terms of the increase in the US/Canada business, or overall - the crease in total operating income before the contribution from the Citadel acquisition, the Citadel acquisition contributed about 7.3 million. So, I think overall it's contributing to the dollars on operating margins, but obviously not to the extent that we had anticipated.

Rosemarie Morbelli

Okay. Thanks.

Operator

Thank you. And our next question comes from the line of Roger Spitz with Bank of America Merrill Lynch. Your line is now open. Roger, if you could check your mute button please.

Roger Spitz

Yes. Thank you, good morning. Any update to the 2016 adjusted EBITDA guidance of 2.45 to 2.50 from last earnings call, which would imply I guess $69 million to $74 million the last fiscal quarter, if I've done my sums correctly?

Bernard Rzepka

Yes. We have not updated that guidance. We have stayed with our commitment on our earnings basis. I think we will continue to drive towards the original guidance on the EBITDA margin.

Roger Spitz

Okay. In engineering composites, is there any seasonality to that? I'm just trying to look at the EBIT from the last fiscal quarter to this past fiscal quarter. I’m just trying to think about the last Q4.

Bernard Rzepka

I think if there's some seasonality the products are tied to agricultural markets and other building and construction, electrical, electronics. So there is some seasonality that is somewhat similar in nature to our business, our legacy business.

Joe Levanduski

It's very similar to our legacy business.

Roger Spitz

Okay. And for CapEx guidance, for the fiscal year, is that still in the 55 million?

Bernard Rzepka

Yes. We did about 35 million for the first nine months. We continued to look at additional capacity I was pointing at. I think our second line in India is expected to be received in, in the fall. So, we continue, it will probably be in the $55 million range.

Roger Spitz

Thank you very much.

Bernard Rzepka

You’re welcome.

Jennifer Beeman

Thank you.

Operator

Thank you. And our next question comes from the line of Mike Harrison with Seaport Global Securities. Your line is now open.

Mike Harrison

Hi good morning.

Jennifer Beeman

Good morning Mike.

Bernard Rzepka

Good morning.

Mike Harrison

Bernard, the EMEA Masterbatch business showed the best volume that we've seen in quite awhile there, are we seeing some benefit from the additional capacity that you're building there, and can you maybe talk about whether a mid single-digit growth rate is the right way to think about fiscal 2017 for the EMEA Masterbatch business?

Bernard Rzepka

What you see in the business is not really that we see a lot of businesses yet from additional capacity that we added lines. Our Turkish expansion is scheduled for the next year. So, you don't see that. What you see is improvement in the manufacturing of success programs that we can free up some activity, and that we have a good and very aggressive sales and marketing team out there. The second part was, if we expect the single-digit growth in these markets? Yes, particularly once we have our Turkish plant up and running, I personally don't think in the current environment and what you see in the previous years in Europe that we can expect a 3%, 4%, or 5% growth in this market. We are focusing as well our Masterbatch teams in value, not only in volume, but I am pretty optimistic that our investment in Turkey would pay off, moving forward. And that what a really need to sustain this single-digit growth. I think it also emphasizes the focus of the organization on specialty and obviously the Masterbatch business is geared towards the specialty side of our business. So, I think the growth that we're seeing is in the Masterbatch solutions business in EMEA is really driven by that continued focus on moving up the food chain and the specialty platform.

Mike Harrison

All right and then kind of a similar question around the margin progression in EMEA that was the only region where you saw year-on-year decline in the margins, is that something that can show improvement in Q4 against a weak comp in the prior year, and just thinking about the timing of implementing the manufacturing for success program there, do we start to see some better margin gains or better lucky margins as we head into fiscal 2017?

Bernard Rzepka

Yes, this is what we are focused on. There is currently, I talked about raw materials. [indiscernible] I think Joe you had mentioned too, but there is of course currently some pressure in the markets because of these price increases. There's a pressure because the distribution business has been not working great the last quarter, which we see now some improvements coming in. And the part of the business, too. So that's what certainty waited a bit on the margin evolution, but the teams are very committed to further expand the margins. We are working on further programs to improve efficiencies. And one of the key driver for our Turkish plant which I was talking about is access to a big market, and when you look at the manufacturing costs in this country, they are significantly lower than in the other European countries, and that will certain improve our margin further.

Mike Harrison

Are we seeing any start-up costs related to that Turkey plant right now that are weighing on margin as well?

Bernard Rzepka

They're very small.

Mike Harrison

Okay. The last question I have for you is more of a strategic question. I know in the past we've talked about whether it makes sense to retain that distribution business. You talked during this call in your prepared comments about having some commodity business there and maybe the profitability not looking as attractive as you would like it to be. And I guess just thinking about the balance sheet still being levered around four times and assets receiving pretty attractive multiples in the M&A market right now, would you consider exploring a sale of the distribution business or any of your more commoditized product lines?

Bernard Rzepka

Strategically we are looking at all options including these which you just mentioned.

Mike Harrison

All right, thank you very much.

Bernard Rzepka

You're welcome.

Operator

Thank you. And our next question comes from the line of Mike Sison with Keybanc Capital Markets. Your line is now open.

Mike Sison

Hey guys, nice quarter.

Bernard Rzepka

Hi, Mike.

Mike Sison

One quick question on Lucent, you are closing two plants, are there any plant faster, you are running Lucent out of one plant?

Bernard Rzepka

Mike, we had eight plants after the Citadel acquisition in Evansville.

Jennifer Beeman

Not all identified at this time.

Bernard Rzepka

Yes, not all of them identified in Lucent and also after all the closures there will be no Lucent plants left any more. We have plenty of other plants there in the Evansville area, plenty of capacity to grow and develop the business.

Joe Levanduski

In fact, the plant that we're consolidating the majority of the business into is the former site that we acquired a few years ago, so it's working out very well for us.

Mike Sison

Okay, great. And then, Bernard, you are fairly adamant that Citadel was still the right strategic option for you. What's the best way for us to measure the improvement there as we head into 2017, 2018, 2019? What do you think we need to see in the business to feel good about that, that it wasn't the right move?

Bernard Rzepka

It’s certain that we need more top-line growth in the segment and this is what I'm pushing the team and personally as well being involved into this very thoughtful. We will continue the consolidation. We'll continue as well that we focus on the right products, because there has been a good interesting portfolio in the Citadel Engineered Plastics business but as well as in our portfolio, some commodity parts too which we are currently addressing. So the way to measure us is to look in the U.S./Canada business for more top-line growth and as well for more profitability.

Joe Levanduski

I think if I can add, if you go back to the original thesis behind the acquisition, we wanted the second leg, we wanted to expand into composite materials. I think that business unit, taking out all the noise of oil field services, which is obviously something that's outside of our control, but the composite material business is a very strong product that is tied to the macro trend of light weight and we have seen very encouraging things that will develop as we move forward. The second thing was balancing our geographical positioning which is done and we'll continue to do and make us more balanced between Europe and the rest of the world. And then thirdly was just building the scale and our engineered plastics business in the U.S. and giving us a lot of options and flexibility from that perspective which we're going to take advantage of.

Mike Sison

Okay. And then I don't know if you can do this, but when you think about the different product lines at Citadel maybe by end market, are you gaining some traction in transportation? Consumer I know was an end market that you were highlighting, industrial construction, health and safety. Are there areas that you can maybe help us understand, is it doing well? Are you growing that business now? Maybe some of the positives you're seeing at the Citadel, little areas here and there.

Bernard Rzepka

Mike, the issue has been with the Citadel business and Engineered Plastics is that we had to divert all the sources and our best people to address the Lucent quality matter. So, yes, we see pockets of good growth. You mentioned building construction. This is an interesting element and one reason why we bought Citadel's Engineered Plastics too because they had good businesses but with the Lucent quality matter we certainly had to step back and remediate this issue to avoid recalls and further problems with our customers in the market. So I can't tell you now about any progress at all. We made significant progress to avoid this major issues and now our teams are focusing for growth. As I said, we see growth in the automobile area here in these businesses, and in building and construction, we see growth in household businesses too but we just could not address it now. I'm pleased and that’s what I reported that the team can really go back and address that. I'm hoping in the next quarters to come back with you is a more positive news on how we are progressing in these markets with our legacy portfolio and with the new Citadel portfolio.

Mike Sison

Got it. Great. Thank you.

Bernard Rzepka

Yeah.

Jennifer Beeman

Thanks, Mike.

Operator

Thank you. And our next question comes from the line of Kevin Hocevar with Northcoast Research. Your line is now open.

Kevin Hocevar

Hey, good morning, everybody.

Jennifer Beeman

Good morning, Kevin.

Joe Levanduski

Hi, Kevin.

Kevin Hocevar

Wonder if you could talk about how Europe trended throughout the quarter and I guess here into June as well. Bernard, I know you mentioned that you talked to your people and after the Brexit vote didn't sound like it changed all that much, but wondering if you saw any kind of sluggishness as we kind of approach that vote and did it soften throughout the quarter, and into June or was it pretty consistent throughout the quarter?

Bernard Rzepka

Thanks for the question. What we really observed was very strong beginning in Europe in our third quarter. May was pretty weak over almost all segments in the entire Europe and to do something really was the Brexit vote because May has been a holiday month in Europe. Probably when you look at [indiscernible] they had three or four bank holidays. And there have been the sluggishness as well in the raw material markets because nobody knew in which direction it will go. So that is May was very slow and Europe, but we had very strong March and April. What we see in June, it's back to normal business. We would describe it – we see a normal order income, so it’s interesting to see all this political turmoil and chaos, I would call it now, in Britain, particularly, but the manufacturing business moving ahead, and we have a normal order pattern from customers typical for June.

Kevin Hocevar

Okay. In terms of the guidance, maintaining the $2.40 to $2.45 which implies that fourth quarter is going to be the strongest quarter of the year, which is atypical. Third quarter is typically the strongest. So could you help me understand all the things that are going to – and if I'm remembering correctly, some of the synergies will kick in, so that run rate will improve, maybe some cost savings or what have you, but can you help me understand what all kind of – help me understand how the, I guess, normal seasonality will be more than offset by these additional synergies and cost savings.

Bernard Rzepka

You basically said it already. I do from the macro level, then Joe can help with you some detail, but basically we expect a solid quarter from what we see now coming from all the businesses, from all the regions, and we will have more traction on the synergies coming from this acquisition, and we will have more traction on all the additional saving activities which we have started over the last couple of months.

Joe Levanduski

Yeah, I think the only thing that was a recent development and we considered it as we looked at our guidance range, is just the exchange rate coming out in Europe because of the recent developments in the UK. As you know, it dropped from about $1.13 down to $1.10. So there may be a slight headwind that we're going to have to address but obviously when I think about $2.40 to 2.45, I think we're comfortable within that range. Obviously when we set that range we weren’t anticipating headwinds coming from the euro exchange rate. There may be a little bit of pressure that we're going to have to overcome but we're still feeling comfortable and that's why we stood with our guidance range.

Kevin Hocevar

Gotcha. Okay. And then, Bernard, you talked about recouping some of the $20 million to $25 million in loss sales from Lucent next year. You're at $3.8 million year-to-date in terms of the ongoing cost at Lucent so maybe that's a $5 million annualized type number. Do you think as divert your attention back to normal business, can you recoup some of those costs as well as some of the sales?

Bernard Rzepka

We're not really expecting that the costs will go up. The costs will go down and down over the next couple of quarters. We will have some more legal costs and maybe Joe?

Joe Levanduski

I think in terms of the recurring costs and I think that's what's affecting our non-GAAP results that we’ve been reporting, as we've said consistently it's a cost we incurred to ensure that we protected our customer's supply chain and protected our continuation of fulfilling their orders. So we will continue to manage that cost as we manage all our cost buck, and we'll do our best to try to drive that number down. I think the dropping from $1.5 million to $1.1 million, to be honest, it’s more of a focus on that cost bucket as well as the mix of products that we're providing. So it's a combination of both. As we go forward in the fourth quarter, we want to continue to manage that process, and I think as we continue to go forward, I think there will be appropriate times that we discuss the commercial side of the equation with the customers, but obviously we want to be sensitive to the timing of those discussions.

Bernard Rzepka

But the cost will not go way the next one or two quarters slow. So you’ll see some still coming up.

Kevin Hocevar

Okay. And then just a final question, quick one for Joe. This quarter looks like in the adjusted earnings you excluded the special dividend, and you instead diluted the share count. Is that how we should model it going forward? Is there any reason why you did that this quarter as opposed in to the prior quarters?

Joe Levanduski

On a non-GAAP basis, the way you have to compute the EPS is you compute both ways. You assume that the dividend is the negative to the net income number against the common shares outstanding, and then you also have to calculate it assuming that if converted methodology, where you would eliminate the dividend if you convert those shares. And you have to compute both methodologies, and whichever one is the most dilutive is how you report things. And so from a quarterly basis, just to put things on a roll, once you get above $0.80 a share in a quarter, the if converted methodology normally drives the equation. So this is something that we will to have watch from a non-GAAP standpoint. It will affect us as our earnings continue to grow. So that's our focus. But it is a complication from the accounting perspective. As an accountant in my background, it's not always common sunscald [ph], but we have to change from quarter-to-quarter depending on which one is the most dilutive methodology.

Kevin Hocevar

Gotcha. Okay, thank you very much.

Operator

Thank you. And our next question comes from the line of Dmitry Silversteyn with Longbow Research. Your line is now open.

Dmitry Silversteyn

Good morning. Thank you for squeezing me in here before the end. Couple of questions if I may. First of all in terms of your expectations for raw material pricing, specifically with respect to TiO2, we have seen TiO2 pricing go up in the second quarter sequentially but that's not unusual from a seasonal perspective. There's still plenty of capacity there. It doesn't sound like demand is flying off the shelves here. So sort of what's behind your estimation that TiO2 is going to continue to inflate beyond recurring price increase announcements by manufacturers?

Bernard Rzepka

It's a pressure because it's unsustainable for not on the time but the entire industry to have this price levels like you saw in the quarters before. So the consolidations will be more consolidations and we see some pickup in demand great but you see some pickup in demand. So that's what we believe will drive some – two or three more steps, not huge step like we've seen prior in three or four years ago, but we will see some sequential improvements in pricing. That's at least what we believe. But you're right, it depends a lot on the markets.

Dmitry Silversteyn

Okay. In terms of Europe, just switching gears a little bit, we've had volumes down there on year-over-year basis for about seven quarters in a row. Is there a headwind that's about to abate? Is there a strategy that you've been putting in place that's going to get revenues growing? Can you talk about sort of should we expect the continuation of this trend, or are we at some sort of inflection point? And as we look towards 2017, is there any reason for us to model volumes being up in Europe after two consecutive years of declining volumes?

Bernard Rzepka

No, I would not see this currently how the business look alike. We believe still there will be pressure on the commodity segment of our business like in powders or in distribution services. So I believe we will still have 1% to 2% contraction if you look at the overall businesses. But Dmitry what I said about our upcoming plant in 2017 in Turkey, that's where we see in the business where it matters, and we start with Masterbatch, but sometimes we start successful with Masterbatch like we did many years ago in China, we then built up Engineered Plastics capabilities in other products. We are really driving our manufacturing businesses in Europe and profitability and this is color business, this is specialized business, this is a engineered plastics business and in future that’s what line up as well in my comments, we have to drive harder in our Engineered Composites business in Europe because that's the second biggest market after the U.S. and Canada. So we have huge opportunities there. But the other two business segments, specialty powders and distribution we just focused on profitable pockets and now we are not participating in the commodity part of this business.

Dmitry Silversteyn

Okay. So basically you are going to continue to see declines in lower margin businesses or at least value businesses.

Bernard Rzepka

Yes.

Dmitry Silversteyn

So from a profit perspective we should still continue to see modest profit growth but more from mix than volume.

Bernard Rzepka

Yes, from the mix and our saving opportunities and the focus on new product development including what we will plan next year in the engineered composite business.

Dmitry Silversteyn

Got it. And then one final question Bernard on North America. The business was down again on – it sounds like the oilfield services portion of it. Is there a point at which this business becomes small enough where it's not going to mask the growth in the rest of the composites? And what are some of the areas that you're targeting as you gotten newer hands in this business as far as sort of first priority accessing market growth and then what are your longer term markets that you're looking to penetrate with this asset?

Bernard Rzepka

As I said, we are opening in Michigan a technology center for composites, but not only in composites, we’re really targeting the lightweight trend where our composites business have been successful. There is really certainly setbacks what you talked about in oil and gas market, but if you look at some of the agricultural equipment producers which are big customers of us too, which really suffered from the down cycle in the general agriculture industries like in Russia or in Asia or now as well in Brazil, we are doing a lot of development work together with them now for new products and new technologies. So I'm very excited about the future. But this is something which is medium and long term. This will be not hitting through in the next one or two quarters, but it's very, very clear that in automotive, in everything which is mobile, there is a huge lightweight trend and now with Engineered Composites and some of our Engineered Plastics portfolios we are really set up for this trend for the future. But short term you won't see this impact now on our numbers. Short term what really hit our business in U.S./Canada is in the Masterbatch solution part, again that we had too much commodity tolling business which were the current investments. We're addressing it. We are moving out there. We are moving more in value added product, in packaging, in agriculture film and we have certainly - some of the results are certainly impacted by the lose and quality manner which as I reported we’re happy now to get out of it and to focus more on organic growth. So I’m expecting like organic growth in the U.S./Canada and pockets of opportunities.

Dmitry Silversteyn

Got it. And then final question on foreign exchange, do you think that line item can actually turn positive for you in fiscal fourth quarter, even though European currency is a little bit stronger here in the last week or so, but overall on a year-over-year basis I still believe that for August it looks to be positive. Anything outside of the major Euro currencies that we can think about or do you do expect to see a little bit of a positive comp on a year-over-year basis?

Joe Levanduski

I think regionally obviously last week at this time it was a little different story. I would have said there would be not much of an impact to us, and actually it's kind of crossed over from a euro/dollar standpoint on a year-to-year basis. So I don't anticipate unless things continue to decline in that currency that the impact would be that significant. You noticed in my discussion in my talking points, we talked a little bit about the exchange rate in Latin America, both the peso and the real is down on a quarter-to-quarter basis in third quarter about 14%. So those currencies we have to watch as well. So there may be a little bit of negative pressure coming out of the Latin-American currency.

Dmitry Silversteyn

Okay. Thank you very much.

Jennifer Beeman

Thanks.

Joe Levanduski

Thank you.

Operator

Thank you. And our next question comes from the line of Jason Freuchtel with SunTrust. Your line is now open.

Jason Freuchtel

Hey, guys, good morning and congratulations on getting a title in Cleveland.

Bernard Rzepka

[indiscernible].

Joe Levanduski

Yes, we were waiting for that. Thank you. [indiscernible]

Jason Freuchtel

Great. First just a clarification on a previous question, aside from the customers that drove the $20 million to $25 million of lost sales at Lucent, are all of the other Lucent customers now comfortable with the actions that you've taken and ordering at regular levels?

Joe Levanduski

Yes, they are. They are very comfortable with our transparency and our teams service them and help them through their and our difficult times, absolutely.

Jason Freuchtel

Okay, great. And then I guess secondarily, how much are you expecting to spend in R&D as a percent of sales, maybe this year, next year, and should that increase as you focus on producing more specialized material?

Joe Levanduski

Yeah, I think for a year-to-year basis I think our percentage may be up slightly as we have continued to develop more technical capabilities globally. I think when we look at fiscal 2017, Bernard mentioned the technical center, the innovation center that we're doing, and the composite side of the business. We're also going to be expanding what we started this year in our APAC region to make the technology more localized from that perspective. So I do think you will see an increase in R&D, which is more deep activities in our organization next year versus historical levels.

Jason Freuchtel

Okay, great. Thanks, guys.

Joe Levanduski

Thank you.

Operator

Thank you. And I'm showing no further questions at this time. I would like to turn the conference back over to Ms. Jennifer Beeman for any closing remarks.

Jennifer Beeman

Thank you all for joining us today. That concludes our call.

Operator

Ladies and gentlemen, thank you for participating in today's conference. This does conclude today's program. You may all disconnect. Everyone have a great day.