Kraton Performance Polymers, Inc. (NYSE:KRA)
Q2 2016 Earnings Conference Call
July 28, 2016, 09:00 AM ET
Gene Shiels - Director of Investor Relations
Kevin Fogarty - President and Chief Executive Officer
Steve Tremblay - Executive Vice President and Chief Financial Officer
Jason Freuchtel - SunTrust
Josh Spector - UBS
John Roberts - UBS
Mike Sison - KeyBanc
Good morning and welcome to the Kraton Performance Polymers Incorporated Second Quarter 2016 Earnings Conference Call. My name is Ann and I will be your conference facilitator. At this time, all participants are in a listen-only mode. Following the Company's prepared remarks, there will be a question-and-answer period. [Operator Instructions] Today’s conference is being recorded. If you have any objections, you may disconnect at this time.
I will now turn the call over to Mr. Gene Shiels, Director of Investor Relations. You may begin.
Thank you, Ann. Good morning, everyone, and welcome to Kraton Performance Polymers' second quarter 2016 earnings call. With me on the call this morning are Kevin Fogarty, Kraton's President and Chief Executive Officer; and Steve Tremblay, Executive Vice President and Chief Financial Officer. A copy of yesterday’s news release is available in the Investor Relations section of our website as our copies of the presentation we will review this morning.
Before we review second quarter results, I’ll draw your attention to the disclaimers on forward-looking information and the use of non-GAAP measures included in our presentation this morning and in yesterday’s earnings press release.
During the call, we may make certain comments that are not statements of historical fact and thus constitute forward-looking statements. Investors are cautioned that there are risks, uncertainties and other factors that may cause Kraton’s actual performance to be significantly different from the expectations stated or implied by any forward-looking statements we make today.
Our forward-looking statements speak only as of the date they are made and we have no obligation to update such statements in the future. Our business outlook is subject to a number of risk factors. As the format of this morning's presentation does not permit a full discussion of these risk factors, please refer to our Forms 10-K, 10-Q and other regulatory filings available in the Investor Relations section of our website.
With regard to the use of non-GAAP financial measures, a reconciliation of EBITDA and adjusted EBITDA to net income or loss or operating income, our gross profit to adjusted gross profit, as well as a reconciliation of net income or loss attributable to Kraton to adjusted net income was provided in yesterday's earnings release and is included in the presentation we will review this morning. Following our prepared remarks, we'll open the line for your questions.
One final comment with regard to financial results for our chemical segment, which we acquired on January 6, 2016, I want to highlight for our listeners that all references to year to date financial results for the chemical segment are from the date of acquisition through June 30, 2016 excluding the stub period January 1 to January 5. As we disclosed in our first quarter 2016 earnings material, for this stub period, sales volume for the chemical segment was approximately 3.3 kilotons and revenue was approximately $6.9 million. For the chemical segment 2015 figures have been derived from the Arizona Chemical historic operating results and are being included for comparative purposes only.
With that said, I'll turn the call over to Kevin Fogarty. Kevin?
Thanks, Gene, and good morning, everyone. Our results for the second quarter of 2016 reflect significant volume growth in our polymer segment and sequential growth and margin stability in our chemical segment. Polymer sales volume was up 18% compared to the second quarter of 2015 with growth in all three of our product groups.
Our Cariflex product group had another strong quarter with sales volume up 30% compared to the second quarter of last year. Our specialty polymers sales volume was up 10.5% compared to the second quarter of last year. And performance products sales volume was also up 19%.
In our chemical segment, sales volume was in line with the second quarter of 2015 and was up nearly 15% on a sequential basis. Regarding this quarter’s sales volume for each of the chemical segment product groups compared to the second quarter of 2015, adhesive was down less than 2%, tires was essentially flat, roads and construction was up 14%.
In our chemical intermediates business, which is comprised of a wide variety of end market exposures including sales into coatings, mining, lubricant and oilfield markets, aggregate sales volume decreased 3% compared to the second quarter of 2015, but was up also 15% compared to the first quarter of this year.
The strong volume growth in our polymers segment led to a significant increase in the segments profitability, second quarter 2016 adjusted EBITDA of $39.2 million or 14.5% of statement revenue. On year-to-date basis, adjusted EBITDA was $91 million, up $17 million from adjusted EBITDA of $74 in the first half of 2015. On a year-to-date basis, the adjusted EBITDA margin for the polymer segment was 17.8%, a 340 basis point improvement in adjusted EBITDA margin from 14.4% in the first half of 2015. Our chemical segment second quarter of 2016 adjusted EBITDA was $53.5 million or 29% of revenue. On a year-to-date basis, adjusted EBITDA was $94 or 26% of revenue.
Now in our press release, you will notice that we have taken down the high-end of our 2016 adjusted EBITDA guidance to reflect primarily an increase in competitive market activity in both our polymer and chemical-based adhesive businesses, all attributable to C5 relative availability. To be clear, these factors are not expected to impact the entirety of our adhesive business with the majority of the impact on the more competitive product rates. Specifically, we had expected overall growth for these businesses in the back half of the year; we're now expecting relatively flat volume.
We believe the impact to our respective adhesive businesses to be a maximum of $10 million in 2016 with some of this impact having occurred in the second quarter. Based upon discussions with customers, we may already be seeing indications that C5 downward pricing trends are reaching bottom. And of course to the extent crude oil recovered above recent levels, one should logically expect a resulting impact to C5 pricing as well.
As many of you know, we see 2016 as a year of execution for Kraton. During the second quarter, we continue to execute on our plan to achieve both the $65 million of transaction synergies arising from the Arizona Chemical acquisition and broader set of initiatives driving $70 million of cost reductions in our polymer segment.
With respect to the transactions energies in the second quarter of 2016, we captured an incremental $3.8 million of G&A savings and an incremental $3.1 million of operational improvements combined with a $2.9 million of synergies we delivered in the first quarter, in the first half of the year we've achieved almost $10 million of our 2016 target of $21 million to $27 million.
We remain on plan for the $70 million of cost reductions. Significant contributor of that plan is our HSBC capacity expansion in Mailiao, Taiwan. And as of now the plant is mechanically complete and is in the commissioning face. Additionally, we're very pleased to announce that we now expect that capital costs will be approximately $185 million, well below our initial estimate of more than $200 million.
Lastly, we made continued progress reducing Kraton net debt in the second quarter by nearly $50 million since March 31, 2016. We continue to expect to end the year with Kraton net debt of approximately $1.6 billion.
Now, let's turn to Slide 4 for a review of the quarterly performance in both our polymer and chemical segments. Second quarter 2016 sales volume for the polymer segment of 90 kilotons was up 13.6 kilotons or nearly 18% compared to the 76 kilotons we reported in the second quarter of 2015. Second quarter 2016 revenue for the polymer segment was $270 million, up $14 million or 5.6% compared to $256 million in the second quarter of last year. The revenue increase was driven by higher sales volumes partially offset by lower average selling prices associated with lower average raw material costs.
Cariflex revenue continued in the second – specifically Cariflex revenue in the second quarter of 2016 was $43 million and this was up $10 million or 30% compared to second quarter of 2015. Cariflex sales volume was similarly up 30% year-on-year and this was driven by higher sales into surgical glove applications. We're seeing strong growth in latex sales into glove applications and this is in part being driven by a shift from powder natural rubber latex to powder free synthetics, particularly in the U.S. resulting from new federal regulations issued earlier this year.
For the first six months of 2016, Cariflex revenue was $81 million and this was up $13 million or 19% compared to the first half of 2015. On a year-to-date basis, sales volume for Cariflex was up almost 21%, largely due to the higher sales into surgical glove applications and this volume is consistent with the longer term volume growth profile of 10% to 15% we expect for our business.
Our specialty polymers business performed well in the second quarter. Revenue for the specialty polymers business was $82 million and while this was down $2.5 million compared to the second quarter 2015. Sales volume was up 10.5% driven by higher sales into industrial lubricant additives and personal care applications. Given the increase in sales volume, a slight decrease in revenue reflects lower average selling prices associated with lower average raw material costs.
Revenue for the specialty polymers business for the first six months ended June 2016 was $167 million, and this was down $9 million, or 5% from $176 million for the first half of 2015. Sales volume for the first half of 2016 was up 5.7% compared to the first half of 2015 and this reflects higher sales into industrial and personal care application partially offset by lower sales into protective film, adhesive and coatings and lubricant additive applications. With the increase in sales volume, the year-to-date revenue decrease was attributable once again to lower average selling prices associated with lower raw material costs.
Looking now at our performance products business, second quarter 2016 revenue was $145 million, up $6.7 million or almost 5% compared to the second quarter of 2015. Second quarter sales volume was up 19% benefiting from higher sales into paving, roofing and personal care applications. While we saw strong increases in paving and roofing volumes in both North American Europe, the sales volume increase was led by Europe, which was up 39% compared to second quarter of 2015, when you may recall our European sales were limited by protection constraints associated with an extend turnaround in Bayer, France.
North American paving volume was up 31% compared to second quarter of 2015. As we discussed last quarter, we believe the current highway spending bill in conjunction with lower cost for imports such as asphalt should continue to be a positive factor for our U.S. paving markets this year. Partially offsetting the strong volume growth in paving, roofing and personal care was a decrease in sales into packaging and industrial adhesive applications. The combination of excess TOFA capacity in Asia and lower [indiscernible] pricing has resulted in a relatively competitive environment for some of the base volumes in SIS portfolio.
For the six months ended 2016, revenue for performance products was $265 million and this was down $8 million or 3% compared to $273 million for the first six months of 2015. The revenue decline is largely due to lower average selling prices as sales volume was up once again 9.8% compared to the first half of 2015. Year-to-date volume increase was driven by demand trends similar to those seen in the second quarter with higher sales into paving, roofing and personal care applications partially offset by lower sales into packaging and industrial adhesive applications.
Overall, profitability in our polymer segment continues to improve reflecting continued portfolio shift and an ongoing focus on cost. For the trailing 12-month period ended June 30, 2016, 59% of our polymer revenue was derived from differentiated product sales and this compares to 57% for the trailing 12-month period ended June 2015. The resulting adjusted EBITDA margin for the segment was 14.5% in the second quarter of 2016, up over 450 basis points from 9.8% in the second quarter of last year. And on a year-to-date basis, the adjusted EBITDA margin was almost 18%, up over 340 basis points compared to 14.4% for the first six months of 2015.
Looking now at our chemical segment on Slide 5, revenue for the second quarter of 2016 was $185 million, down $25 million or about 12% compared to the revenue of $210 million in the second quarter of 2015. Second quarter 2016 sales volume was 109 kilotons, down less than 2 kilotons from 111 kilotons in the second quarter of 2015. The revenue decrease reflects slightly lower sales volume and lower average selling prices.
For the adhesive product group, sales revenue was $63 million in the second quarter of 2016 and this was down $4.7 million or 7% compared a $68 million in the second quarter of 2015. Adhesive sales volume was down 2% compared to the year ago quarter and this was primarily due to lower sales into rigid packaging and assembly adhesive applications in Europe largely offset by increased sales across broad market applications in Asia and in the Americas.
For the first six months of 2016, adhesive revenue was $126 million, down $13.4 million or 9.6% from 2015. Sales volume was down 5.5% on a year-to-date basis, reflecting competitive dynamics relative to C5 hydrocarbon resins as previously mentioned. Once again, during the second quarter, we began to see evidence that increased availability of low cost C5 hydrocarbon tackifier resins is translating to an impact on pricing and competitive dynamics for [indiscernible].
Now despite these headwinds we were able to grow our adhesive business in Asia where we are leveraging our combined customer relationships and footprint. We manage the volume impact of these market conditions by maintaining overall unit margins through our continued focus on differentiated including development of new terpene based tackifier and other sustainable solutions valued by our core customers.
Roads and constructions revenue was $16.4 million in the second quarter of 2016, up a little over $1 million from $15 million posted in the second quarter of 2015. Sales volume was up a healthy 14.2% versus the second quarter of 2015 with growth entirely in North America. This reflects in part the positive paving fundamentals in the U.S. markets that we’ve referenced earlier for SPF products in a polymer statement.
Additionally, for the roads and construction business, we continue to see more projects for our silver road warp [ph] technology, which increases the amount of recycle asphalt that can be used in paving projects. We believe the value proposition for silver road [ph] product line is unique and we expect growth will accelerate.
Revenue for roads and construction for the six months ended June 2016 was $27 million, up from the $25.7 million posted in the first half of 2015. On a year-to-basis, sales volume was up 9.4% reflecting many of the same fundamentals that drove the second quarter 2016 results.
In our tire business, we saw somewhat slower growth than expected in the second quarter. Sales volume and revenue were essentially unchanged compared with the second quarter of 2015. Sales volume in North America is weaker than in the year ago quarter, but weakness in North America was offset by higher sales volume in Asia, which reflects new customer qualifications. Qualification cycles in this business are critical and with our new terpene offerings, we're getting to see traction for the number of customers and we expect this to be a positive development in our business for the balance of the year. Our year-to-date basis volume and revenue for tires was essentially unchanged driven by the same factors in the second quarter.
And finally, turning out to our chemical intermediates business. As you know, chemical intermediates, we have a broad exposure to end use markets, which include oilfield, coatings, mining, lubricant, and fuel additives. The primary products are tall oil fatty acid or TOFA, tall oil rosin or TOR and distilled tall oil or DTO. Given the decline in the rig count, industry TOFA sales into oilfield applications has declined significantly over the last year and given the resulting TOFA streams that have been freed up by the declining industry oilfield volume, this has an impact indirectly on TOFA pricing in the market that was already effectively not long [ph].
In addition, industry-wide TOR sales have been adversely impacted by weaker conditions in the ink market. These trends were known prior to our closing of the Arizona acquisition. And as we discussed last quarter, we have been implementing a number of initiatives, which we believe will continue to improve our overall performance in chemically intermediates. This plan includes the shift back to direct sales model and the business to regain lost share from the past. At the spike, the prevailing market conditions, we are encouraged by the progress we're making, second quarter revenue for CI or chemical intermediates was $94 million, down $21 million or 18% compared to second quarter of 2015. And sales volume was down roughly 3% compared to the second quarter of last year, volume was up almost 15% sequentially compared to the first quarter.
For the first half of 2016, revenue for chemical intermediates was $188 million, down $39 million from 2015. This revenue decrease reflects lower sales volume, which was down 3.6% compared to the first half of 2015. Since closing the Arizona Chemical acquisition, we have worked diligently to develop flexible outlets for TOFA. For example, leveraging our worldwide presence such as in India we're improving TOFA sales in what can only be described as a relatively competitive marketplace. We're applying Kraton well established price right strategy to maximize value capture. We believe we have a favorable cost position and we're working hard to reestablish the trust of our chemical customers. As we transition the CI business back to a direct sales model. We currently are seeing stabilization of prices for alternative products such as palm oil and oleic acid as well. And we remain optimistic for the outlook for the CI business in the back half of the year.
Now I’ll turn the call back to our Chief Financial Officer, Steve Tremblay for a more in-depth view of the financials. Steve?
Thank you, Kevin. Let’s move over to slide 6 and I’ll cover our second quarter and then the year-to-date results in a bit more detail. As Kevin just noted, our second results reflect strong growth in sales volume in our Polymer segment. Sales volume was up 17.9%, compared to the second quarter 2015 with nice volume growth in each of our Polymer product groups.
In our chemical segment, sales volume was down modestly, compared to the second quarter of 2015, but more importantly on a trend basis, volume was up 14.7%, compared to the first quarter of 2016. Consolidated revenue in the second quarter of 2016 was $455 million, and this compares to revenue of $256 million in the second quarter of 2015. As shown earlier in the material, our chemical segment revenue was approximately $210 million in the second quarter of 2015.
Consolidated adjusted gross profit was $135.3 million in the second quarter of 2016, $65 million of which was contributed by our Polymer segment and the remaining $70.3 million relates to our chemical segment. First, the Polymer segment. For our Polymer segment, adjusted gross profit was $65 million in Q2 2016, an increase of $11.7 million or 22%, compared to adjusted gross profit of $53 million in Q2 2015.
The increase in adjusted gross profit reflects the increase in sales volume and lower cost of goods sold despite some suboptimal productivity in the quarter, which more than offset less favourable sales mix, lower SAS profitability and the period-over-period effect of changes in inventory levels.
Our adjusted gross profit per ton was $723 in the second quarter of 2016, which compares favourably to the $690 per ton in the second quarter of 2015. This $723 per ton is down sequentially, compared to the first quarter of 2016 with a decrease largely a reflection of the less favourable sales mix given the higher percentage of USPC sales largely into paving and roofing in the second quarter, as well as the impact of timing associated with changes in inventory levels as we do inventory in Q2 2016 to meet strong demand.
And finally, there was some margin compression due to raw material dynamics. Wherein 2016, [indiscernible] has been increasing, albeit modestly whereas in 2015 [indiscernible]caused decrease through the first half. Polymer segment adjusted EBITDA was $39.2 million in the second quarter of 2016, and this compares to $25.1 million in the second quarter of 2015.
The 56% increase in adjusted EBITDA is attributable to the nearly $12 million increase in adjusted gross profit with the balance driven by lower selling, admin, and research costs. As a result, Q2 2016 adjusted EBITDA margin for Polymers was 14.5%, an increase of 470 basis points from 99.8% in Q2 2015.
Let's take a look at chemicals. Second quarter 2016 adjusted gross profit for chemicals was $70.3 million or $646 per ton, up from $59 million or $625 per ton in the first quarter of 2016. The $11 million or 18.5% increase was a result of the nearly 15% increased sales volume and lower costs.
Second quarter adjusted EBITDA for the chemical segment was $53.5 million, to up nearly $13 million or 31% from adjusted EBITDA of $41 million in the first quarter 2016. This increase in Q2 2016 adjusted EBITDA, compared to the first quarter of this year was a result of the significant improvement in gross profit coupled with lower SAR costs.
Second quarter 2016 adjusted EBITDA margin for the chemical segment was a robust 29%, up 590 basis points from 23% in the first quarter 2016. So on a consolidated basis, second quarter adjusted EBITDA was $92.7 million or 20.4% of revenue. Moving over now to slide 7 for a discussion of the first half, reiterating some of Kevin's early comments, Polymers sales volume in the first half of 2016 is up 9.5%, compared to the first half of 2015 and again all three of the product groups are posting volume growth year-on-year.
Polymer revenue of $513.2 million for the first half of 2016 is down modestly in the first half with a healthy sales volume growth offset by overall lower average selling prices, primarily associated with raw materials. Consolidated revenue for the first half of 2016 was $874.6 million and this includes $361 million of revenue from our chemical segment. Let's move over to the profitability metrics, adjusted gross profit for the Polymer segment was $143.9 million, up $10.7 million or 8% from $133.2 million in the first half of 2015.
This increase is driven by the increase in sales volume, lower cost of goods sold, which more than offset modestly lower unit margins, including a less favourable sales mix and the other changes in the raw material trend, which I noted earlier, as well as the timing effect of changes in inventory.
Year-to-date, adjusted gross profit for polymers was $873 per ton, which is in line with the first half of 2015. Polymer adjusted EBITDA for the first six months of this year was $91.4 million, nearly 18% of revenue and this compares to $74.4 million or 14% of revenue for the first half of 2015. The $17 million or nearly 23% growth in year-to-date adjusted EBITDA was a function of the $11 million increase in gross profit coupled with $6 million of lower selling, admin, and research costs.
In our chemical segment, adjusted gross profit was $129.6 million for the first half of 2016 or $636 per ton, and adjusted EBITDA was $94.4 million with an associated margin of 26.1%. It’s worth mentioning here that our chemical segment continues to generate margins above 20%. As a result of the foregoing consolidated year-to-date adjusted EBITDA, it was $185.8 million with a consolidated margin of 21.2%.
As we turn to slide 8, I’ll cover earnings per share. Looking at the second quarter of 2016, earnings per share is $0.24 per diluted share. To arrive at adjusted EPS, we add back transaction and acquisition related costs, which aggregated $0.20 per share. In addition, in the quarter we impaired assets associated with our next product line of approximately $8.6 million, which was partially offset by a one-time non-cash gain associated with the dissolution of a joint venture we had in Brazil. These two items net to approximately $5.2 million or $0.11 per share.
Finally, the negative spread between FIFO and current cost in the quarter was $3.4 million or the equivalent of $0.07 per share. So this gets us to a second quarter 2016 adjusted EPS of $0.63 per diluted share, compared to $0.02 per share in the comparable period last year.
Looking now on a year-to-date basis, the items in Q2 coupled with eliminating the gain on the sale of the compounding business in the first quarter, refinancing and related charges in the first quarter, and some purchase accounting adjustments in the first quarter in the release of our VA takes us from a GAAP EPS of $3.07 to a non-GAAP EPS of $1.44, which on a comparable basis is up 185%, compared to the first half of 2015.
Looking at slide 9, a little bit of a deeper dive into the initiatives, which are driving the $70 million in cost reductions that we expect to achieve by 2018. Overall, we remain on course to achieve that $70 million target. In fact during the second quarter of 2016, we recognised an incremental $3.1 million of cost reductions, primarily associated with the cost benefit of The Belpre boiler project, which came online in the second half of 2015.
As a result on a year-to-date basis, we recognised an incremental $6.8 million, which in addition to the $19.4 million we captured in 2015 puts us at a life to date cost reductions of $26 million towards our $70 million goal. As a result of where we see the first half shipping up we continue to make expect to recognise in 2016 cost reduction benefits of $25 million to $28 million.
Update on some key projects include the mechanical completion of our HSBC project in Mailiao as Kevin mentioned. This was completed in the second quarter of 2016. In addition, design work for the USBC expansion in Bayer has progressed and is expected to be completed this quarter with the expected mechanical completion at Bayer, France by Q4 2017.
As we mentioned last quarter, the boiler project in Belpre is beating the initial cost savings of $10 million, primarily due to the favourability in electricity cogeneration. In addition to that we have a number of ongoing and identified smaller projects that are contributing to the cost reductions. And in terms of our complexity reduction efforts, which includes the conversion to a direct couple production methodology for Cariflex, the asset design is underway and we continue to expect mechanical completion by the fourth quarter of 2017 all in-line with our earlier expectations.
Let's move to slide 10, since our HSBC expansion in Mailiao, Taiwan is nearly completion, I want to bring an up-to-date on the project. The pictures on slide 10 are our recent view of the plant. During the second quarter, we achieved mechanical completion and we are now undergoing the planned commissioning steps. Consistent with our expectations, we anticipate that we will introduce hydrocarbons into the plant in the fourth quarter of this year and we expect to producing commercial samples in the fourth quarter and ramping up production at the plant in the first part of 2017.
I’m also pleased to say that we now expect the plant construction cost to be approximately $185 million, which is well below our initial cost estimate, which was an excess of $200 million. On slide 11, an update on the status of the transaction synergies. During the second quarter, we continue to execute on our plan and we realised $3.8 million of incremental G&A reductions and $3.1 million of operational cost improvements for a total Q2 2016 synergy capture of $6.9 million.
Taking into account the $2.9 million realised in the first quarter, year-to-date we achieved nearly $10 million of our 2016 target of $12 million to $16 million. As a result of all the activities underway, we remain confident in our ability to deliver the $65 million of synergies by 2018.
Moving to slide 12, a few comments on cash flow and capital structure. During the second quarter, we generated net cash flow from operating activities of $67 million and Kraton Capex excluding the Capex of the joint venture was around $22 million in the quarter. As a result Kraton net debt at quarter end was $1.65 billion, a $48 million reduction from to $1.7 billion at March 31, 2016, and a reduction of $77 million since we acquired Arizona Chemical in January. We still expect to end the year with our targeted net debt of $1.6 billion.
On slide 13, I want to provide an update on specific guidance items and modelling assumptions for the balance of this year. I will note items of significance that have changed since our first quarter earnings call. With regard to market conditions, while we continue to see positive momentum in the majority of our businesses, as Kevin pointed out in his remarks, we have called out some factors that we believe will impact our ability to achieve the high end of our adjusted EBITDA guidance.
Accordingly, we have revised our 2016 adjusted EBITDA guidance to a range of $370 million to $380 million. We will certainly continue to work to mitigate these competitive pressures as we illustrated in the second quarter of this year. I am now expecting the full year effective tax rate to be in the 10% to 15% range.
We also expect given the timing of our capital expenditure plan to be, our capital spending will be in the $85 million to $95 million range and of course this excludes the remaining Capex at our KFPC joint venture, which is fully funded by financing at the JV level. And given trends in the raw material and input prices, I wanted to update you on the spread between FIFO and ECRC for the next quarter, the third quarter that is, we expect the spread between FIFO and ECRC to be less than $5 million.
And I want to reiterate again that we have not changed our view on synergy realisation for the year or on the incremental benefits we expect to realise under our cost reset initiatives.
With that, I’d like to turn the call back to Kevin for his closing comments.
Thanks Steve. Now as stated we are pleased with the progress we have made in the second quarter. Our polymer segment continues to exhibit good growth and solid demand trends. It was yet another strong quarter for Cariflex aided by an ongoing market shift from powdered natural rubber latex to powder free synthetics. Our Specialty Polymer business has had a solid growth in the quarter with good demand in many of the markets we serve and performance products also had good quarter driven by strong paving and roofing demand.
We delivered good growth in adjusted EBITDA and EBITDA margin compared to the second quarter of last year. It is also worth mentioning that during the second quarter of 2016 raw material costs were marginally higher than in the first quarter, in-part driven by some plant outages.
However with many of these outages now being behind us, we now expect our downward trend in raw material pricing for the back half of the year and this is typically a net positive from margins in our Polymer segment. As mentioned, our HSBC project in Mailiao, Taiwan is now mechanically complete and we are pleased that the project capital cost is now expected to be approximately $185 million, well below our initial cost estimates that were in excess of $200 million. This remarkable achievement is a testament for the hard work of our project team and a reflection of the tremendous capabilities of our partner Formosa.
I think on the chemical segment now for roughly 7 months, I can say that there have been no significant surprises to the downside and our original investment thesis is solid. Arizona chemical is a high quality business with great people and long-standing customer relationships that fit well with Kraton's legacy Polymer business that we believe will continue to offer opportunities for accelerated growth.
The commercial and technical teams from our Polymer and chemical segments working together have already identified a list of joint development projects that we feel confident will deliver on revenue synergy potential and inherent in the transformation combination. To date, we’re pleased with the progress we have made on the integration front. The integration process for all major functions is essentially complete.
Regarding synergies, through June we have captured almost $10 million of 2016 goal, which remains at $21 million to $27 million. We are on target to deliver the balance of the $65 million we have committed to by 2018. I’m also pleased that our customers are going to embrace the acquisition, acknowledging both the rational and the potential for value creation that it presents.
In terms of business performance, results for the chemical segment demonstrated a nice sequential improvement. From the start, we identified the chemical intermediaries business as a primary area of opportunity. While we still have a lot of work ahead of us, through June I believe we have made an impact on the CI business by focusing on developing new market outlets, in part leveraging our worldwide footprint and particularly our presence in Asia.
And as I have mentioned previously we are taking a more analytical approach to our overall chemical business doing a much better job of managing refinery balances in light of market opportunities. In addition to Kraton’s specific actions to improve the business we also see prices for alternatives such as palm oil and oleic acid stabilising and this is a positive metric for our chemical business.
So, we are intently focused on managing and delivering the things that we do control and positioning the Polymer and Chemical segments respectively for future growth. The positive momentum within Kraton continues and we remain intently focused on delivering on the various initiatives that we expect will create substantial value for our customers and our shareholders.
With those comments, I’d like to turn the call back to the operator and we will be happy to take some questions.
Thank you. We will now start a question-and-answer session of today's conference. [Operator Instructions] Our first question is coming from Jason Freuchtel of SunTrust. Your line is open.
Hi, good morning gentlemen.
Good morning Jason.
I enjoyed the cumulative free cash flow bridge that you provided in the past, but didn't see it in the presentation, has your outlook changed in achieving the $500 million in cumulative free cash flow by 2018?
Not at all Jason.
Okay great. I mean, I guess it sounds like a lot of your - the cost synergies and savings is on point, so I wouldn't expect that to change. But did you indicate that the revised guidance for 2016 was primarily due to the increased competitive competitiveness of the C5 hydrocarbon tackifier resins or was it was part of it also driven by increased competition in the USPC business as well?
We said it was both, but if I were to wait it, it is more driven to the effective C5 hydrocarbon tackifiers and what that causes in terms of relative price pressure in the rosin [indiscernible] of our pine chemical business.
Okay could that potentially impact the business in 2017 as well or are you proactively finding ways to potentially mitigate the impact of that business?
I mean, I wouldn't even think about describing it as an impact that we see for 2017. It’s the current market fund fundamental associated with some new capacity, particularly in Asia for the C5 tackifiers, but as I've always said in these businesses the market tends to fix itself and that's why I indicated that some of the availability of those new streams of C5 tackifiers are potentially looking at the margin points and realizing it might not be the best place to be and we are already having conversations with customers that are starting to recognize that as potential as well. So, I think it’s fairly short term and it’s clear to us that the value proposition of Kraton's offerings through its pine chemical business right now is still very real in the eyes of the customer both from a sustainable standpoint, as well as the fundamental underlying performance. So, this is a little bit of noise in our adhesive business, I get that and we’re doing a great job working through it, but there’s just all kinds of, that’s the beauty of this combination, the diversification of overall sales mix allows us to really potentially backstop some of the downside in one particular – some part of a business with a lot of the upsides we're seeing elsewhere.
Okay great. And you had several quarters strong quarters in Cariflex recently, which sounds like it was in part due to the new federal regulation for powder free synthetic rubber gloves is this growth rate sustainable through the rest of the year or how many additional quarters could you benefit from this regulation and also have you given up any margin within that high margin segment to achieve the attractive growth.
No we're not giving up any margin . The value proposition is sound Jason. I think it’s almost like when we talk about the business we always say that you don't convert when it comes to surgical gloves, you don't convert to surgeon, you convert to hospital chain. So, it is step increase in demand growth that's kind of the nature of the business. This is kind of one of those examples only on a much more universal impact because of the regulation change and it kind of hit us a little bit by surprise, I admit, we didn't have that built into our plan, so what I would say to you is stick with our counsel and guidance with respect to the 10% to 15%, low double-digit growth rates. That’s how we plan our business, but in the meantime obviously this is just another example of the great value of this product offering to the customer and to the marketplace and with Kraton being the leading supplier in this space we are solving those supply issues and in this case if it is a regulatory driver that creates that supply – or that demand will certainly be ready to satisfy it.
Okay great. I believe your 29% EBITDA margins in the chemical segment are recent high for your particular segment and potentially the entire industry, is the sequential expansion in the margin driven by the synergies you’ve achieved so far or did you experience any incremental benefit from your favorable contract with international paper?
No, there’s nothing with respect to the later. This is all just an example furthermore of the value selling or as we call it as you know in Kraton the price rate selling, but certainly as we've always said, our team at Arizona have done a tremendous job positioning the value added products with the right customers in the right markets to really continue to expand the margin potential of the business and we just saw it clearly in the second quarter results, so we are very pleased with that, but as you heard in my comments, we just see tremendous opportunities to continue to expand the business.
Okay great, thank you.
Thank you. Our next question is coming from Josh Spector of UBS. Your line is open.
Hi guys thanks for taking my call. Quick question on Polymer volumes, so I think when I look in the past typically your were up around 10% sequentially in what's may be our normal year, you are up about 20% this quarter, I was wondering what was driving that, was it all related with additional highway spending or was there any pre-buying as customers might see some pricing going up and any demand pull forward, can you help me think about that.
Now it’s completely based on and what we’re referring to, I assume is, our performance products business. So, we're talking about unhydrogenated portfolio and it wasn't a pre-buying fundamental at all. I mean it’s just as I said going into the quarter we want to get ahead of ourselves, but we cannot equivocally say right now that and this is a summer paving season, particularly in North America that we've not seen for quite some time in terms of the positive fundamentals and it’s driven by a couple of I think just real factors. One is obviously there is money to the spending bill, which we've talked about and then secondly with the low price points associated with the overall base of proved input cost and what that does to asphalt pricing that just mean - in otherwise affixed budgets there are to be more linear miles and with more linear mines being paved are resurfaced that means more business to our polymer segment.
Okay, all right that helps. And then I mean you are basically saying that all the growth for the quarter was primarily in that segment or that drove this segment as a whole, is that right?
To be clear, when we talk about our Polymer segment, we have three parts, three businesses and each one of them demonstrated a pretty robust volume growth in the quarter, but you are asking about specifically lends within our performance products segment, which is the USBC portfolio excluding of course Cariflex.
Okay and I guess, I mean similarly on the chemicals segment, it looks like it was abnormally sequentially, is that kind of the right way to look at it for how things flows through Q1 to Q2 and then going from Q2 to Q3, are volumes generally more flat in that segment or would you expect to see, do you see you have any reason to see additional growth sequentially?
I don't think I would tell you to think about the sequential growth outlook business for the business. We haven’t owned it long enough for me to really be confident enough in talking about sequential growth Q1 to Q2, I would say that in the Q1 results certainly we didn't get up great start to the calendar year in January and then all of the things I talked about in my comments around what we were doing specifically in the chemical intermediaries business to really capture back some of the share loss because of commercial strategies that prior management had and the tremendous work the team is doing and looking at new market outlets and places like for example Asia through Kraton's footprint in India, has started to pay off. And that’s just a great signal for the business and of course we're going to keep doing more of that.
Okay thanks. And just one last one really quick, just on the margin expansion that you were talking about before, how much of that is pricing coming down and you guys maintaining similar dollar margins on the lower pricing environment and how much of that is actually margin expansion if you were able to [indiscernible], I guess I'm thinking as prices start to go up would you expect to be able to hold the margins or would you have to basically, you keep the same dollar margins so on a percent margin basis they go down as pricing goes up?
We run all these businesses clearly on a dollar margin basis, I think that’s fair to say. From the standpoint of, in examples where we have raw material cost increases, yes we will certainly pass that through reflective of our price rate consistent strategy and of course the value of the inherent product itself in whatever particular use we are dealing with in the marketplace. So I think you should think about the business in that dollar margin way. But all that being said, I’m not smart enough here to tell you what I think is going to happen to crude oil later this year or next year, but we have a very robust pricing process internally and our customers understand it externally and we would consistently apply that pricing strategy in periods of raw material escalation should that occur.
Okay, thanks for that.
Thank you. Our next question is coming from John Roberts of UBS. Your line is open. John Roberts, your line is open for your question please.
Yeah, sorry about that. Thanks for taking us back to back. Quick question, Steve. Do the Cariflex activities in Brazil have a significant cost advantage from currency or is that a dollar linked business?
No, it is not – are you asking about the expansion, John? The accountable cost?
Capital and then production once you are underway.
No, you shouldn't think of it as being currency exposed anymore than it is frankly today. And as you know, in our business globally, currency whether it's transaction or translation is relatively benign number sort of $4 million impact in the year-to-date results. So we don’t have any significant concerns in where we are acquiring the assets to build that plant outside of Brazil, we've request for hedging in place to avoid currency risk.
And then I apologize for jumping on the call late, but did you give any specific examples in chemical intermediates at the new flexible outlooks?
Well, what I said is – I talked about it in the context of regions, I'm not going to talk about it in the context of certainly specific markets and customers because we want to keep that obviously proprietary. But with respect to regions, clearly, Asia and predominantly India has played a key role. And what's really good about it is clearly we've got you know tremendous market knowledge and insights through our existing employee base, but here we are able to take full advantage of Kraton – legacy Kraton if you will footprint in these regions and relationships that our people on the ground had to work together with colleagues across the new combined business to generate these outlets. And to me that's one of those things that you can't put a value on going into it, but we knew it was there, so that cross selling opportunity has been already demonstrated.
Well, maybe I could maybe try to give you an example and you can confirm or not, but I – my mind kind of goes to things like fuel related historical uses, but now you're maybe moving into a solvent type use for something that might have been sold as a fuel value before, is it that kind of thing?
I'd say it's more in terms of traditional outlets that perhaps the market – the business had served in quite some. We’ve gone back and revisited some of those accounts.
Okay, all right. I will take it up offline. Thank you.
Thank you. Our next question is coming from Mike Sison of KeyBanc. Your line is open.
Hey, guys. Nice quarter.
In terms of your commentary on the adhesive side, is the pressure just coming from the C5 folks or the time chemical guys acting fairly rationally?
From a competitive standpoint?
So, you know, clearly what the driver is, is the availability of C5 tackifier and as you know, you know, our price setting mechanism is effectively is pricing relative to those C5 tackifier in the marketplace, and in periods when tackifier are in significant short supply that’s highly beneficial to our business. And in periods when there is new capacity being introduced at relatively lower cost because of the underlying energy, building block value, then that's what's cause C5 tackifier therefore to come down. But I want to be very clear about something. At the end of the day, we have a – we serve a part of the market, we’ve served the part of market historically and we will serve that same market in the future. So it's not a question about whether customers decide to use our material, rosin ester or C5 tackifier, this is a just a discussion around pricing because we're preserving our position with our key accounts. And I would say that that's very consistent with any of the businesses that we run and even our legacy where when there's competitive dynamics with, again, part of our price right strategy is to make sure we position our products well to satisfy customer needs, but recognizing there's market dynamics always need to be taken into account.
Right. Despite the competitive pressures, you margins in the chemical segment were – continue to be pretty impressive. When you think about, on a full-year basis, given seasonality, where do you think you'll end up for chemical segment?
Well, I'm not going to answer that question per se, but it's pretty clear to us that this business historically and currently and certainly as we look at the outlook for the balance of the year that, other than what I called out in terms of some of this adhesive pressure, there's ample opportunity for us to continue to improve the business both on a volume basis and, obviously, attacking more attractive market outlets in the process. So, this is a business that can and will generate 20-plus-percent EBITDA margins and that's why we were attracted to it in the first place and that's why we're certainly attracted to the growth it’s going to demonstrate for the combined company in the future.
Great. And then when you think about the guidance for the year, it looks like polymers and chemicals contributed about the similar amount in terms of EBITDA, close to 50/50 in the first half. Do you see that kind of the similar split in the second half and for the full year each of the businesses contribute about the same?
Yeah, I think so. What was fascinating about the quarters, in the first quarter, obviously, polymers was stronger than chemicals and in the second quarter, chemicals was stronger than polymers, which again speaks to the uniqueness now of this combined company portfolio. But as we look into the future, I wouldn't distinguish the two. There might be some quarterly differences as we just had, but overall the trend line and the run rate should be comparable, especially in the immediate term.
Thank you. Our next question is coming from [indiscernible] of Citi. Your line is open.
Hi, good morning.
On the revision to full year EBITDA guidance, is it more sort of on the – which segments is more impacted in terms of the headwinds, is it more on the polymer segment, is it more on the chemical segment, if can you just give us qualitatively?
Right. And as I just said a few minutes ago, I think a similar type question was asked maybe a little bit differently. It’s adhesives in general, but if were to weight it, I would weight it more to the pine side than the polymer site.
And has that – that headwind fed through in the current quarter or is that expected to be more on the second half of the year?
So again we characterize it as no more than or up to $10 million for the year, of which, some of it we've already seen in second quarter.
Okay. And then on the polymer side, do you have excess capacity increases as well as low cost isoprene, which one of those is the major driver for the headwind, is it more the raw material cost or is it more of the – like on the supply side?
On the polymer side, what – is it raw material or is it supply side?
I'd say probably, in the case of pricing pressure that we're seeing, it's going to be more on the supply side.
Has there been additional capacity additions in the first half of this year?
It’s not significant, but there's been a couple. And if you're starting out new capacity, what’s the first thing you are going to do, you are going to look for who the market leader in the space and go attack what is the lowest value added part of their product offering, and that’s why I said that it’s not in the differentiated part of our sales mix, it's really in the – what we refer to as the more highly competitive part of our sales mix. And we face this from time to time and we will face it again. But nevertheless it's really a fundamental in the immediate term because of that availability of new supply. This is not a structural change by any sense at all.
Okay. And just lastly, on – with regard to 2018 targets, you have previously stated debt reduction of $500 million and targeted net debt to EBITDA of about 3 times, is that still the case?
Yeah, those plans are unchanged.
Great, thank you.
Thank you. Our last question on queue is coming from Jason Freuchtel of SunTrust. Your line is open.
Hi, guys. Thanks. Just had a quick follow-up on the synergies and cost savings. It looks like you've already achieved [indiscernible] of your cost savings target for the year and if – maybe 40% of your synergy expectation for the year, is there any incremental cost savings that you could experience in 2016 or were all those coming – they were expected coming from the boiler plant that you’ve already realized? And for the cost synergies, is there any upside – is there potential upside to your target range for 2016?
Yeah, Jason, I will hit the first one first on your observation on the cost reset initiative of the $70 million in the legacy polymer business. We do expect the back half of the year on a year-over-year basis, the benefits to decline somewhat because that’s where the project did come online in the second half of last year. But it – that's not to say that the team can’t come up with some quick hits between now and the end of the year. On the synergy side, your observation is a good one there as well. Is there upside to the $12 million to $15 million, I'd say yes, there is upside. And collectively, the three areas of cost, which is the $70 million plus reset initiative in polymers, the $25 million of G&A, which spans both segments, and then the production optimization focused on driving costs out of fine chemical segment. Quite easily the third and fourth quarter could mirror in total what we generated in the second quarter, which was approximately $10 million.
Well. Okay, great. Thanks, guys.
Thank you. And that was our last question. I will now turn the call over back to Mr. Gene Shiels for closing remarks.
Thank you, Ann. Well, I just want to thank all of our participants this morning for their interest in Kraton and their thoughtful questions. Remind everyone that there is a replay of this conference call can be accessed over the internet on our website kraton.com by selecting the Investor Relations link at the top of the page and then navigating to Events. There will also be a telephonic replay of the call available for two weeks and to access that telephonic replay dial 800-945-7832. That concludes our remarks this morning. Thank you.
This concludes the Kraton Performance Polymers, Incorporated Second Quarter 2016 Earnings Conference Call. You may now disconnect. Thank you.
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