Cabot's (CBT) CEO Sean Keohane on Q3 2016 Results - Earnings Call Transcript

| About: Cabot Corporation (CBT)

Cabot Corporation (NYSE:CBT)

Q3 2016 Earnings Conference Call

July 28, 2016 14:00 ET

Executives

Erica McLaughlin - Vice President, Investor Relations

Sean Keohane - President and Chief Executive Officer

Eduardo Cordeiro - Executive Vice President and Chief Financial Officer

Analysts

Ivan Marcuse - KeyBanc Capital Markets

Jim Sheehan - SunTrust

Kevin Hocevar - Northcoast Research

Laurence Alexander - Jefferies

Operator

Good day, ladies and gentlemen and welcome to the Cabot Corporation’s Q3 2016 Earnings Conference Call. [Operator Instructions] As a reminder, today’s conference is being recorded. I would now like to turn the call over to Ms. Erica McLaughlin, Vice President of Investor Relations. Ma’am, you may begin.

Erica McLaughlin

Thanks, Chelsey. Good afternoon. I would like to welcome you to the Cabot Corporation earnings teleconference. Last night, we released results for our third quarter of fiscal year 2016. Copies of which are posted in the Investor Relations section of our website. For those on our mailing list, you received a press release by e-mail. If you are not on our mailing list and are interested in receiving this information in the future, please contact Investor Relations. The slide deck that accompanies this call is also available in the Investor Relations portion of our website and will be available in conjunction with the replay of the call.

I remind you that our conversation today will include forward-looking statements, which are subject to risks and uncertainties, and Cabot’s actual results may differ materially from those expressed in the forward-looking statement. A list of factors that could affect Cabot’s actual results can be found in the press release we issued last night and are discussed more fully in the reports we file with the Securities and Exchange Commission, particularly in our last annual report on Form 10-K. These filings can be found in the Investor Relations portion of our website.

I will now turn the call over to Sean Keohane who will discuss the key highlights of the company’s performance. Eddie Cordeiro will review the business segment and corporate financial details. And following this, Sean will provide closing comments and open the floor to questions. Sean?

Sean Keohane

Thank you, Erica. Good afternoon, ladies and gentlemen. Before we get started, I want to share with you that Erica McLaughlin will be moving to a new leadership role in the company and this will be her last earnings call. I want to thank Erica for her leadership of Investor Relations over the last 5 years and wish her much success in her new role.

Replacing Erica will be Steve Delahunt, who is here with us today. Steve has been our Corporate Treasurer since 2010 and has a broad financial background that has prepared him well as he takes on the additional responsibilities as Vice President of Investor Relations. I welcome Steve to the new role, and Erica and Steve will ensure a smooth transition over the coming weeks.

Now, moving on to the quarter, I am pleased to see the strong improvement in operating results both on a year-over-year and a sequential basis. Key factors driving the improvement were strong volumes, along with realizing the benefit of our cost savings initiatives. We also continue to deliver exceptional results in our Performance Chemicals segment with higher volumes and margins. This is the fifth consecutive quarter of record segment EBIT. The improvement in our Specialty Fluids segment resulted from our sustained efforts to expand our business outside of the North Sea and the success this quarter validates the value proposition of this unique material even in a low oil price environment. In addition, due to our strong business results, we generated over $100 million in cash from operating activities. We used this cash to reinvest in our core businesses as well as return cash to shareholders through dividends and share repurchases. We increased the dividend by 36% during the quarter and we continue to repurchase shares, both of which are consistent with our capital allocation framework that was discussed at our Investor Day in May.

Before we dive deeper into the quarter, I would like to take a step back to remind you of our new strategy and capital allocation framework. Our strategy going forward of Advancing the Core provides us with a road map for the future. We aim to extend our leadership in performance materials by driving three key themes: first, investing for growth in our core; second, driving application innovation with our customers; and third, generating strong cash flows through efficiency and optimization.

The aim of our strategy is to generate sustained and attractive total shareholder return. We believe that our strategy will deliver solid adjusted EPS growth in the 7% to 10% range over time. Furthermore, we are committed to a balanced and disciplined capital allocation framework. As a company, Cabot generates strong and consistent cash flow. And as we move forward, we will balance the use of cash for reinvestment in our core businesses and returning cash to shareholders with about half of our discretionary free cash flow going to each. This strategy provides clarity in the direction of the company and we are confident that the balance of earnings growth and capital allocation can deliver attractive and sustained total shareholder return.

With this strategic frame as the backdrop, I would like to spend a little time discussing progress during the quarter against the three strategic themes. Growth in our core requires achieving a balance of volume growth and price management. In the third quarter, we successfully grew volumes across most segments and regions while also announcing important pricing actions. We are currently implementing price increases in Reinforcement Materials in North America, Europe and China and globally in Performance Chemicals to recover increased costs.

Also of note during the quarter is the announcement of our plan to open a new Asia technology center in Shanghai. The new facility is evidence of our commitment to developing deeper application understanding and delivering innovative formulation solutions to our customers. As China transitions to a period of more moderate growth, innovating with our customers is an essential element of our growth strategy. Our work to improve the efficiency of our operations and optimize our performance can be seen in the lower fixed cost this quarter. The reduction of $12 million of fixed cost in the third quarter as compared to the prior year has improved the competitiveness of our operations and contributed to our earnings growth. Overall, I am pleased with the progress we are making and I am confident in our ability to deliver attractive and sustained total shareholder return based on the execution of our strategy.

I will now turn it over to Eddie Cordeiro to discuss the financial results of the quarter in more detail. Eddie?

Eduardo Cordeiro

Thank you, Sean. I will discuss the segment results beginning with Reinforcement Materials. During the third quarter of 2016, EBIT for Reinforcement Materials increased by $3 million as compared to the third quarter of 2015. The increase in EBIT was principally due to lower fixed cost as a result of our restructuring cost savings initiatives, including the closure of our Merak plant in Indonesia. Lower costs were partially offset by lower volumes in Asia due to the weaker macroeconomic conditions in China and from the closure of our plant in Indonesia. As you may recall, our strategy related to the Indonesia closure was about maintaining higher margin business with the expectation that we would shed some lower margin business while also consolidating our operations to reduce costs.

Sequentially, Reinforcement Materials EBIT increased by $1 million compared to the second quarter of fiscal 2016 driven by higher volumes partially offset by a less favorable price and product mix. Sequentially, volumes increased by 6% due to higher volumes in the Americas from the full impact of the ramp up of calendar year contracts and from seasonally higher volumes in Asia. The less favorable price and product mix was primarily due to lower pricing in China as we are working to balance volume and pricing in this challenging environment. Looking ahead, we expect EBIT to improve sequentially from an improved product mix and from price increases that we are currently implementing in various regions.

Now, turning to Performance Chemicals, EBIT increased by $11 million compared to the third quarter of fiscal 2015 due to higher volumes and improved margins from a stronger product mix and lower raw material costs. Volumes increased by 3% in the Specialty Carbons and Formulations business and 9% in the Metal Oxides business largely driven by stronger sales into plastics applications for the automotive and the infrastructure sectors. Sequentially, Performance Chemicals EBIT increased by $1 million compared to the second quarter of fiscal 2016 primarily due to higher volumes. Sequentially, volumes increased by 7% in Specialty Carbons and Formulations and by 10% in Metal Oxides. The increase in volumes was partially offset by a less favorable product mix.

Looking ahead, given that we expect a normal seasonal impact in the fourth quarter, we expect results to moderate somewhat sequentially. Third quarter fiscal 2016 EBIT in Purification Solutions decreased by $3 million compared to the third quarter of fiscal 2015 due to a $9 million unfavorable impact from reducing inventory levels versus last year’s inventory build. The segment also saw growth rise in product mix compared to the prior year. These effects were partially offset by significantly higher MATS volumes and lower fixed costs from our cost savings initiatives. Sequentially, Purification Solutions EBIT increased by $2 million compared to the second quarter of fiscal 2016 driven primarily by higher volumes related to MATS demand. The increase in volumes was partially offset by an unfavorable impact from reducing inventory levels as compared to the prior quarter and a less favorable price and product mix.

Higher volumes compared to both respective periods were driven by demand from the MATS regulation. Mercury removal volumes were up 73% in the third quarter of fiscal 2016 compared to the third quarter of fiscal 2015. We believe that we were successful in capturing about a third of this market. The benefit from these higher volumes is being masked by the unfavorable impact from reducing inventories. If we strip out these impacts in Q3, the quarter’s EBIT would have been approximately $3 million. We anticipate an improvement in EBIT as Q4 is normally our strongest seasonal quarter in terms of volumes and inventory drawdown should decline a bit.

The third quarter of fiscal 2016 EBIT in Specialty Fluids increased by $7 million as compared to the third quarter of fiscal 2015 and $12 million as compared to the second quarter of fiscal 2016 as we saw an increased level of project activity in both the North Sea and Asia. As we look ahead to the fourth quarter, we expect to see another profitable quarter based on project activity that is underway, however, likely not at the same level that we saw in the third quarter.

I will now turn to corporate items. We ended the quarter with a cash balance of $222 million and our liquidity position remains strong at $1.2 billion. During the third quarter of fiscal 2016, cash flows from operating activities were $107 million, including an increase in net working capital of $21 million. Capital expenditures for the third quarter of fiscal 2016 were $28 million, including $21 million for sustaining and compliance capital expenditures. Additional uses of cash during the third quarter included $19 million for dividends and $8 million for share repurchases. We recorded a net tax provision of $15 million for the third quarter, which included $2 million of benefits from tax-related certain items. Excluding the impact of certain items, our year-to-date operating tax rate was 24%.

Based on the current outlook for feedstock, we also recorded a $3 million charge related to our LIFO accounting reserve principally driven by rising feedstock costs. We do not anticipate a material impact from LIFO in the fourth quarter. However, if feedstock costs move up or down from where they forecasted to end the fiscal year, this estimate could change. As we look at the full year, we expect capital expenditures to be approximately $110 million to $120 million.

And I will now turn the call back over to Sean.

Sean Keohane

Thanks, Eddie. With the third quarter operating results in line with our expectations, we are on track to deliver results in the low to midpoint of the range we communicated last quarter. Looking sequentially, while the Performance Chemicals and Specialty Fluids segments are expected to moderate, we anticipate a strengthening of results from our Reinforcement Materials and Purification Solutions segments.

In addition, we are driving our Advancing the Core strategy focused on the continuation of the strong profit growth and cash generation we saw this quarter. We are maintaining discipline around our capital allocation framework, which balances reinvesting for growth in our core businesses and returning cash to shareholders.

Thank you very much for joining us today. And I will now turn the call back over for a question-and-answer session.

Question-and-Answer Session

Operator

[Operator Instructions] And our first question comes from the line of Ivan Marcuse with KeyBanc Capital Markets. Your line is now open.

Ivan Marcuse

Great, thanks for taking my questions. The first one I have is in the reinforcement business in Asia, of the 8% decline, how much of that would be the plant that got shutdown? So, I guess of the 8%, is it half of it? And when do we start to lap that volume or sort of how to think about it in terms of the impact going forward for the next couple of quarters?

Sean Keohane

Sure. Hi, Ivan. So, specifically on the closure of the Merak plant, I would characterize that as not being a major impact here. As was commented earlier, our strategy here is to focus on the higher margin business and to gain the benefits of a more consolidated and larger scale production site in Indonesia. So, I think that’s playing out as expected. I think the bigger question I think and we need to see how things unfold is certainly as China moderates its growth rate how that plays out. And so right now, our focus is on balancing both volume and pricing in that environment. And certainly when we do this, it’s typically about how we think about the tail of the business and the lower margin end of the portfolio.

Ivan Marcuse

Okay. And then I guess moving on to the other side the world, in the Americas, you are up 6%. Was South America a drag or has that business stabilized a bit on a year-over-year basis or sequentially however you want to think about it?

Sean Keohane

Yes. So certainly, we are pleased with overall the Americas. And as we have commented before, we are seeing the expected volumes in North America, but there is no doubt that the macro situation in South America is a challenge here and continues to be a headwind. I think what will be interesting in the coming year I think is to see how this plays out with the devaluation of the currency, the currencies, but in particular in Brazil, we are hearing that some of the tire makers are adjusting their supply chains and trying to take advantage of that as an export platform. How that plays out is not very clear at this point, Ivan, but something to watch for here that could I suppose put a bit of a boost into South America over time, but again unclear. These are sort of early days as we listen to our customers.

Ivan Marcuse

Okay, thanks. And then in purification, how much of, I guess, available – I don’t how to say it, but of the customers that are going to take your material with the industry, is it fully ramped up now or is it still half industries as now utilizing the mercury removal and then we will see another big step up in 2017 or how much more to go and sort of – or is this sort of a run-rate, like if you look at $3 million a quarter, is that sort of how to think about this business going forward as with inventory?

Sean Keohane

Yes, I certainly can imagine, Ivan, with all of the moving parts here challenging to sort of get a sense for this sort of run-rate and let me try to help a little bit here. I think as we look at this business volumes in the mercury removal market have increased significantly, north of 70% year-over-year. And at this point, we are seeing full compliance, the rule was in and we are seeing full compliance. Now, offsetting the stronger volume profile was an unfavorable impact from inventory reduction. You will remember these were strategic decisions to build inventory rather than build capital to serve the rising demand. So, this was about $9 million compared to the prior year. So, if I look through that and exclude the impact from inventory in the quarter and try to normalize for seasonal variations, I think the run-rate for the business is probably in the $4 million to $5 million range per quarter at this stage with some quarters being a bit stronger and some being a bit weaker based on seasonality.

Ivan Marcuse

Okay. And then the inventory, when does that end? Does that start to tail off or is this like the $8 million next quarter, then $6 million a quarter after that or does it just stop at one point and when is that?

Sean Keohane

Yes. So, we built inventory in 2014 and ‘15 again, a strategic decision to defer – to avoid capital investments. And so as we stated last quarter, we expect the full year impact to be around $30 million this year. And so this means we will continue to drawdown inventory in Q4 albeit at a little slower rate. And as we head into next year, there will be further continued draw-down of inventory.

Ivan Marcuse

To the same level on a year-over-year basis?

Sean Keohane

No, no, it will moderate. It will shrink as we head into 2017.

Ivan Marcuse

Great. Thanks for taking my questions.

Operator

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

Jim Sheehan

Hi, Sean. You mentioned some price increases that you are implementing, could you talk about how those pricing actions are being received? And when you typically raise prices, about what proportion is realized?

Sean Keohane

Sure. Hi, Jim. How are you? So, we have announced a number of price increases and so maybe I will comment first on Reinforcement Materials. So, we have announced price increases in North America and the EMEA region as well as in China. Now you will recall from knowing the business and from Investor Day, we have different percentages of business under contract and open for spot. So, let me just try to quickly recap a little bit. In Europe where we have around 15% of our volumes that are not under contract, they’ve been going pretty well, thus far. And we certainly are intending to carry this forward as we head into contract negotiations. We are also working to address some feedstock challenges in Europe in terms of fixing some indices that we base our pricing on to better reflect our actual feedstock costs. So, those activities are happening there. For North America, as you know it’s a pretty small percentage of the market that is not under contract. And so we are implementing in those places but more about carrying into contract negotiations. And then China market, as you know, is an entirely spot market here. And so we are out in the market every month, balancing feedstock cost movements, volume and pricing to find that optimization. On the specialty carbon side, we have also announced price increases here and are in the process of implementing and I would say going reasonably well so far.

Jim Sheehan

Okay. And with respect to those feedstock differentials, how do they stand now? I understand that they have changed in the past and are they becoming less problematic for you at the moment?

Sean Keohane

Well, not much has changed in terms of what we have discussed in the last quarter with respect to this. Certainly, in terms of the U.S. Gulf Coast, in 2015 we saw our differentials increase throughout the year to primarily just supply demand factors. At this time, I would say the U.S. Gulf Coast differentials are in line with the historical long-term norms. If we go back over a number of years, I would say they are more back in line with those, although there can be short-term fluctuations here. For Europe, we continue to face some feedstock challenges as I mentioned and I would describe these as a little more structural in nature, where our index that we use no longer approximates our feedstock. And so for this, we are working to change those formulas for parts of the business we can address now and for our calendar 2017 contracts. So overall, I would say a bit of a mixed story, some moderation on the differentials and a few areas that we’re working to try to address. But I think it’s important to just pull back and recognize that we buy a mix of feedstocks here around the world, and we have a strategy in this business to try to take advantage of the feedstock arbitrages whenever they are available. And sometimes those are favorable. Sometimes those are not, so, but it is a strategic part of the business and one that we’re intensely focused on.

Jim Sheehan

Great. And on mercury control, you mentioned you think you have got about a third market share of the MATS market. Is that above or below your expectations? I seem to remember that you have been targeting something more like 40% in the past.

Sean Keohane

Yes, market share here is a tough one, Jim, to nail with any great degree of accuracy here, for a whole bunch of different reasons. First of all, it’s a new market that’s coming into play here. And there are factors in terms of which products are used, where natural gas pricing is, how that impacts the overall energy, the utility fleet and what energy makeup is running which utilities. So, it’s a difficult one. As we sit here today, we estimate that we are in about that one third share position and we are working to try to balance both volume and pricing as this new market settles out.

Jim Sheehan

Thank you.

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 afternoon everybody.

Sean Keohane

Hi, Kevin.

Kevin Hocevar

I am wondering if you could comment on – Specialty Fluids obviously had a really good quarter. What’s – could you kind of comment? I know it sounds like maybe you expect a sequential slowing, but is this – did all the stars just happen to align this quarter or should we think of this as with you moving outside of the North Sea a bit more, this will be a more steady earner going forward, how should we think of this segment in the fourth quarter, but beyond too? Like what should we think of profitability here going forward?

Sean Keohane

So, we are certainly pleased with the performance in the quarter and in part, the result of our sustained efforts here to grow our revenue base outside of the North Sea. So, this has been something we have been committed to and sticking to here and beginning to see some contributions from that. So, that’s very good to see. The fundamentals of the business haven’t changed in terms of the value proposition here. And as I said earlier, I think even in a low oil environment, we are proving that. But that being said, there is a lot of volatility here in terms of the project nature of this business. And so which wells is this – is the cesium formate right fit for, what’s the timing of that completion activity and the duration of any given project? These are all variables that are difficult to predict. And they are actually quite difficult for even our customers to predict, things like duration of projects. So, it’s a tough one to give you anymore visibility into, Kevin, I think, but we are pleased to see the progress here and again feel that it’s validated the value proposition even in this somewhat unprecedented low oil environment, but there will be choppiness given the project nature for this business.

Kevin Hocevar

Okay. And then curious about there has been – cash has built up quite a bit on your balance sheet. You are up to $222 million, which it’s barely been above $100 million for any quarters for the past couple – several years, so kind of curious how you are thinking about that between share repurchases and M&A that you might have in the pipeline. I guess, how should we think of your uses of that cash going forward?

Sean Keohane

Yes, I think the best way to think about it is to come back to our messaging and framework at Investor Day, where we laid out a framework that we think is going to drive both attractive and sustained TSR and this is the combination of investing the strong cash flows that we generate, about half back into growth in ourselves, in our core, and about half of the discretionary free cash flow back to shareholders both in the form of dividends and share repurchases. And I think over time that’s the right way to be thinking about it. So, I wouldn’t get – I wouldn’t get too tied up in the short-term. This is how we are thinking about it over the longer term and over time and this is what we are driving.

Kevin Hocevar

Okay. And then in terms of a little more into the mercury activated carbon business now that MATS is fully implemented, how is utilization rates of the plants, I mean are they relatively tight at this point. And then how does it work with contracts with customers, do they – are they pretty standard, were they 1-year, multi-year, what have you and kind of like in rubber carbon black, they come due, most of them January 1 or how does all that work?

Sean Keohane

Well, I think first, in terms of a typical contract I think they are more in the sort of 2-year duration. And again because this is a relatively new market, we would like to see how that plays out over time, but that’s what we have been seeing so far. In terms of our utilization, we have further unused capacity, so there would be some operating leverage here in the business. And I think overall, the industry still has some excess capacity, so that’s been putting a bit of pressure in terms of pricing here. But again, we will have to see how this one settles out as it is a new market.

Kevin Hocevar

Okay. And then I guess just final question. You mentioned in the press release for guidance that the third quarter was in line with expectations and then that you mentioned that you expect your prior guidance to come in at the low to midpoint, so I guess maybe implying that the fourth quarter maybe is going to be in line to maybe a little softer than you had initially expected, I guess taking away the high end of the guidance range, I guess, if I am reading that right, I guess what factors are there that might be a little bit softer than you previously would have thought?

Sean Keohane

Well, I think as we look into the fourth quarter we are definitely expecting to see some positive movement or progress versus Q3 in both reinforcement as well as Purification Solutions, but expecting some moderation in Performance Chemicals because of seasonality. So normally during this period, we see a seasonal slowdown and we are certainly expecting that. And then in Specialty Fluids, some moderation as well off a pretty high level of activity here in Q3. So I think in some ways, those – you could think about those as balancing out, balancing out a little bit.

Kevin Hocevar

Alright, thank you.

Operator

Thank you. [Operator Instructions] And our next question comes from the line of Laurence Alexander with Jefferies. Your line is now open.

Sean Keohane

It seems that there is no one there.

Operator

One moment please.

Laurence Alexander

Do you hear me, can you hear me?

Operator

And Mr. Alexander, I apologize your line is now open.

Laurence Alexander

Hello, you can hear me now?

Sean Keohane

Yes, we can.

Laurence Alexander

Sorry about that. So I think in the past you mentioned the commercial tires in China were somewhat of a headwind, I was wondering if that was still the case or if things have improved at all?

Sean Keohane

Commercial tires?

Laurence Alexander

Or just automotive in general?

Sean Keohane

Well, okay. So, I think one of the things that we have talked about in the past is the truck tire market having moderated somewhat in China and this would stand to reason as the level of industrial activity has slowed down and therefore the hauling of steel and cement and things like that has impacted the truck tire market. So that is the case. We, I think are seeing that stabilize somewhat. China has continued to inject some stimulus into the economy and some of that is going into the infrastructure space, which is I think helping to stabilize the truck tire market, but it certainly had pulled back a little bit, but I would say stabilizing is kind of what we are seeing right now.

Laurence Alexander

Okay. And then just with trends in – just worldwide transfer automotive OEM demand, maybe more for your Performance Chemicals segment or has that moderated at all, was that still going strong?

Sean Keohane

It’s been pretty strong for us. I think the outlook next year is for it to pull back a little bit. If you just look at people like IHS and others that forecast auto builds and so we certainly watch that closely. But that’s – the forecasters are seeing perhaps a little bit of a pullback next year.

Laurence Alexander

Okay. And then a final question, you said that I think you mentioned $12 million in cost or expense reductions in the quarter and I think and if my math is right that, that would translate into like around, I don’t know, $0.13 to $0.16 in potential savings and I think what you are looking for or you haven’t really quantified it, but is that – I mean, are you halfway done is that half the savings you are looking for or is there a lot more room for growth, I am just wondering where we are going from here?

Sean Keohane

So maybe I will pullback on that one for a second and just sort of recap what we have been doing on the cost side. So we had committed $50 million of cost savings from our restructuring actions and we are on track with that as we sit here today in the quarter and did realize about $12 million towards that objective, so. But on a full fiscal year basis, we are on track to achieve that $50 million.

Laurence Alexander

Alright. Thank you very much.

Operator

Thank you. And our next question is a follow-up question from the line of Ivan Marcuse with KeyBanc Capital Markets. Your line is now open.

Ivan Marcuse

Thanks. Just a quick question, in terms of investing in growth, where you – your CapEx has been about as low as it’s been in a long time, where do you envision that going in ‘17, ballpark?

Sean Keohane

Yes. So we are still working through, Ivan, our slate of projects as we go forward, but we would certainly expect that number to go up and we had given some range on that at our Investor Day. And I don’t recall specifically the number. I thought it was more in the 150 to 175 range, so you can – you think about that as a reasonable range at this point. And included in that will be a mix as we have laid out in the capital allocation framework of both sustaining and compliance as well as investment for growth.

Ivan Marcuse

Great. Thanks for taking my questions.

Operator

Thank you. And I am showing no further questions at this time. I would now like to turn the call back to Mr. Sean Keohane, President and CEO for closing remarks.

Sean Keohane

Great. Well, thank you very much for joining us today and I look forward to speaking with you again next quarter. Have a good day.

Operator

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

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