Kraton Performance Polymers' (KRA) Management Presents at RBC Capital Markets Global Industrials Conference (Transcript)

| About: Kraton Performance (KRA)

Kraton Performance Polymers, Inc. (NYSE:KRA)

RBC Capital Markets Global Industrials Conference Call

September 7, 2016 6:40 PM ET

Executives

Stephen Tremblay - Executive Vice President & Chief Financial Officer

Analysts

Bill Hoffmann - RBC Capital Markets

Bill Hoffmann

Good afternoon. My name is Bill Hoffmann. I cover the chemical sector for RBC Capital Markets. Today, we have Steve Tremblay, CFO, for Kraton Polymers; and Gene Shiels, IR Director for Kraton Polymers, and welcome, guys. Thanks for coming out again, and thank you for your attendance.

Stephen Tremblay

Thank you, Bill.

Bill Hoffmann

I’m going to have your intro into the business a little bit, because obviously you guys made a big transitionary acquisition in the last year or so. But I also want to start off with maybe something more interesting to the market is, how your stock is done, up over 100% year-to-date, pretty fantastic performance, I’ll just throw that out there. But once you start with the deal, the Arizona merger, kind of where you’re in process, and maybe explain to people just sort of how the business fit?

Stephen Tremblay

Okay. All right. Yes, great. Thanks, again, Bill.

Bill Hoffmann

Yeah.

Stephen Tremblay

Prior to the acquisition of Arizona in January this year, our product set was specialized polymers that go into a number of applications generally formulated compound with other materials, for example, polypropylene from the more standard grades of raw material go into things like asphalt modification, adhesive applications, anything from posted notes to adhesive applications used in residential construction.

On the higher-end of the product set is a product that we invented some years ago, as we call, we trademarked as Cariflex. It’s isoprene rubber latex. It’s used in high-end surgical gloves and condoms and other medical applications, where the value proposition primarily was an opportunity to reduce the risk of allergic reactions to natural rubber, which at the extreme can actually cause fatalities. And we found that our material being a synthetic solve that problem, while at the same time being a form fitting material that was suitable for a surgeon. That’s in the operating theatre for, as you can probably expect many hours at a time, and we expanded that into the condom business and some other medical applications.

Prior to the acquisition of Arizona, depending on the price of raw materials a $1.2 billion or so of revenue. About a $150 million of that or so was Cariflex. $400-plus million was in our performance products, which is where we have the paving and roofing and adhesive applications.

And then in the middle of the value proposition is what we call specialty polymers, which are grades of polymers that are and things such as personal care, medical applications, and a lot of high-end electronic applications. At January 6, we closed the Arizona Chemical transaction. Purchase price was about $1.370 billion.

Arizona Chemical was a – was imbedded in International Paper up until the early 2000s, where we spun out, and it was at the time we did the deal was owned largely by American Securities. It is very, very closely aligned from an end market perspective, as the legacy polymer business, but a different business on the front-end. It began embedded in the IP business.

International Paper developed this as a way to upgrade a byproduct of craft pulp making. When you make in the pulping process, you create crude tall oil, which you – this really to uses for it. One use, it can be recycled into the pulp maker’s boilers and use as an energy source or it can be extracted refined and sold to a number of different applications, including many applications that are familiar to Kraton, especially adhesives, road marking, and a array of other solutions that include things like. metalworking fluids and field chemicals. We have a nice niche market that go into tire applications.

So, what appears to be two very, very different businesses on the front-end. One, a batch polymerization process, the legacy Kraton, and the other a classic refinery. Again, front-ends are very different, but we found that about 60% of Arizona’s revenue overlapped Kraton revenue, whether it’s similar applications in adhesives or similar customers and in many cases both, similar customers and consumer applications.

Bill Hoffmann

So from a process standpoint, we’re now call it six months or really theoretically longer in on this thing like how is it coming together? From a merger standpoint, are you starting to get some of the synergies and I’ll frame that maybe in a bigger question, because you’re one of the companies that I put in our category of what we call self-help companies, because Kraton itself had $65 million to $70 million of its own synergies.

Stephen Tremblay

Yeah.

Bill Hoffmann

It cost out some things that you are trying to do really to generate growth in your business, I don’t know, from the EBITDA standpoint. When you throw on top, Arizona, which added another $65 million of synergies. We get $135 million of synergies on top of the businesses, which is a very substantial number. So just tell us a little bit about where you are in that process?

Stephen Tremblay

Okay. Let me handle the $70 million, if I could, on the legacy business for us. We – in 2014, a couple, we got together as a team and there’ve been a fair amount of capacity ads globally in the Performance Products business, again, that’s the less differentiated grades of our polymer offering, a fair amount of capacity ads largely in Asia. And therefore, benefiting from a low-cost structure.

So we decided that we want to pursue ways to improve the cost structure of that business. And we’ve looked at a number of opportunities and one of the things that became very, very apparent to us is, with the feedstock butadiene primarily, with that dynamic, we believe structurally changing. And therefore, resulting in a European cost structure that our view is going to be significantly cheaper than North American butadiene for a some period of time.

We unlocked the strategy to determine if we could move some USBC capacity into Europe and actually benefit from that low cost structure. At the same time, we’re sorting out what to do to become more cost competitive in that piece of our market. In our high margin Cariflex business, we have been working for years to try to find a way to make that supply chain more, more efficient, for those you don’t know to make their product today, we actually convert isoprene monomer into a solid rubber in Ohio, shift that block of rubber to Brazil, transport to a plant in Brazil, and then convert it to a latex, and then ship it to a customer.

Bill Hoffmann

Right.

Stephen Tremblay

That was the only technology available, because it’s our technology. Since we formed that category, our scientists were trying to figure out a way to take out that step of creating the rubber and moving over down to Brazil, we finally figured that out. So that that offered us the opportunity to transform our Brazil side into a dedicated Cariflex side, which then allowed us to take some USBC capacity and we’re going to ultimately move that to Europe, we will benefit from structural lower BD. That coupled with a brand new plant that was starting up in Taiwan later this year and a number of other ongoing initiatives all tally up to a $70 million reduction in overall costs.

And we can debate whether the enabler was structural BD in Europe or cracking the code on Cariflex with a very, very closely related one without the other wouldn’t have given us the full package and then lay on top of that this $185 million plant that’s now nearing completion in Taiwan, all that’s going to result in $70 million of cost out by 2018, well on our way as we look at the second quarter and the balance of this year.

Bill Hoffmann

Right. And just on an LTM basis and I’ll throw out a number, LTM performer last year was like $350-ish million.

Stephen Tremblay

Yes.

Bill Hoffmann

How much of that cost out is in that number?

Stephen Tremblay

In last year’s cost out, there was $19 million in that.

Bill Hoffmann

Okay.

Stephen Tremblay

This year, we’re expecting the $19 million of legacy Kraton to grow by $25 million to $28 million.

Bill Hoffmann

Yes.

Stephen Tremblay

So an incremental $6 million to $9 million as those ramp up. And on top of that we’ve now with the Arizona acquisition, we targeted $65 million of cost synergies in that transaction, two major pools of opportunity, one is in the G&A area, very traditional duplicative C-Suite, duplicative back office, as well as some procurement savings on things like common software, common insurance costs, and the like. Those we’re targeting – this year we targeted about $12 million of the $25 million and $16 million. We’re trending more towards you $12 million to $15 million of that with an eye towards getting the full $25 million of that largely if not all in 2017.

The remaining $40 million of those synergies is a list of opportunities that we uncovered going through the plant operations of Arizona, the refineries and the upgrading facilities, everything from improving logistics, reducing storage costs, getting a better control of maintenance, improving yields, improving energy usage, some of which is going to take some CapEx about $25 million to $30 million of CapEx, some of which is going to be just improvements that we’ve demonstrated in our own polymer sites by applying Lean Six Sigma.

That we expect to lay in by, again, by 2018 fully garnering the $65 million. The $40 million targeting this year around $9 million, and then that will wrap up into 2017 and fully implement into 2018.

Bill Hoffmann

Right. And the overall equation from an equity return standpoint is you get 350 of EBITDA baseline, 30% plus essentially EBITDA growth, also through the window a very strong free cash position talk about your…

Stephen Tremblay

Yes.

Bill Hoffmann

Cash allocation.

Stephen Tremblay

Maybe we’ll talk about the stock price after we talk about cash. One of the absolute mandate internally to do the transaction, which is actually doubling the size of the company and taking the leverage profile from circa two in a quarter to over five times of closing was we absolutely had to be positively convince that we can delever quickly…

Bill Hoffmann

Yes.

Stephen Tremblay

Our internal target for leverage is about 2.5 times, which we expect to achieve by the end of 2018. We expect to be at around three times by the end of 2017. And as we look at this year, we’ve given some guidance, so we had net debt expectations or we’ll reduce net debt from closing to 12/31 by about half a turn. So that gave us the confidence that we can delever meaningfully in a very, very short period of time.

As we think about the value creation opportunity, if we look at June numbers, roughly between this piece of the $70 million and the piece of $65 million in the number is around $100 million to go, all controllable cost outs. We’re trading at a multiple that none of us are happy with, but we’re trading at circa seven times.

So it’s now $700 in value that we expect to garner between now and 2018 cost only. And by reducing debt by $0.5 billion, which is what our plan is. There’s effectively $1.2 billion of value creation over 30 million shares between June 30, and the end of 2018.

Bill Hoffmann

Right.

Stephen Tremblay

So if you ask what the management team is working on, we’re working on that and that assumes no growth in the base business. And we believe each of our businesses has anywhere from GDP to GDP plus growth with where GDP plus is in the Cariflex product offering and in our specialty polymers offering, again, high-end medical, high-end electronics. And some of the more niche products within the chemical business that we just acquired.

Bill Hoffmann

And so if you look at what’s called a GDP macro view, where do you – what are your biggest concerns right now? Is it the macro view to get from point A to point B, because lot of this is execution you guys can do? So…

Stephen Tremblay

Yes. It’s – I’d classify it more on the execution point of view.

Bill Hoffmann

Yes.

Stephen Tremblay

We have no intentions of not growing the business. So I think everything we just got done talking about, there should be some accretion by just – by business growth The – what gives us confidence is that, we don’t – we’re not geographically centric. We’re roughly 43% of our revenue. This is combined now through June, both company 43%-ish percent of our revenue is in North America, mid to high 30% is in Europe, and 20%-some odd is in Asia.

People off get concern of what’s going on in Asia, Asia is slowing down. Most of our Asia business is the Cariflex business that we sell into Asia, where most of the glove producers are and that gets exported globally.

The other big piece of our Asia presence is in high-end HSBC or specialty polymers, which again polymers are shipped into Asia and then distributed globally. So we’re not exposed to slowdowns in infrastructure, as an example in Asia, the very much the opposite.

And then going deep into our businesses, we have – we’re somewhat exposed to housing in residential construction in caulking and construction tapes. But it’s less than 10% of our polymer business, which now becomes less when you add on another $800 million of revenue.

We like the exposure to auto, especially as the auto industry seeks the lightweight, which fits our polymer business well. But our auto business is, again, less than 10%. So in a downturn on anyone of those sectors, we don’t really – we’re not terribly exposed on the upside, certainly there’s opportunity for us. In fact, the last economic downturn that we weathered in end of 2008, 2009, we didn’t see significant volume declines in anyone piece of our business, it was mainly driven by overall kind of overall macroeconomic GDP.

I think that downturn if there’s another one out there would be worse than the next one, because I think there’s too much inventory throughout the entire supply chain. In the supply chain our formulators are compounds, I think, they really tightened up and there’s less opportunity to see the volume decline.

Bill Hoffmann

Right. So just going back to the Asian side of the business for a moment, you’re talking about it being 20% of the total, like if you really boil it down to what’s exposed to that market, is it more like 10% or…

Stephen Tremblay

Well, way less.

Bill Hoffmann

Okay.

Stephen Tremblay

The vast majority of the Cariflex business is roughly a TTM [ph] of $150 million business. The vast majority of that is material shift to Asia…

Bill Hoffmann

Right.

Stephen Tremblay

…and converted. So, if we’re talking about the business that’s $1.8 billion, 20% of it $260 million, half of that is not exposed at all, that’s high-end surgical gloves. And we don’t participate in any of the footwear business, or any of the infrastructure in Asia just because of the cost structure.

Bill Hoffmann

Right. So let’s talk about that for a minute too, couple of years ago you did look at LC wide your merger, but there were some opportunities to actually get more into the commodity side of the business. Obviously, Arizona give you ton of opportunity anyway. But what’s happening in the commodity side of the business in China, Asia, are they getting capabilities to upgrade, given the more HSBC like what’s the dynamic one?

Stephen Tremblay

There’s certain grades in our performance products business and in our HSBC or specialty polymer business, where competitors have been doing a good job getting up the learning curve. We always assume in our base business planning that some of that attrition or so the attrition is going to take place.

Our point of view right now is that, we don’t see it accelerating. We actually think, perhaps, it may be reached its peak, if you will. Our job is to keep innovating, bringing new solutions to the market that shelter us for some of their competition. As we look at the market, there has been a lot of capacity ads, especially in performance materials, the lower end.

We think those capacity ads are going to slow in the near-term between now and 2018. And then that’s going to absorb a lot of their capacity to put in place. But we’re not participating in a lot of the markets that new capacity is targeted. And we don’t participate in the footwear business and we don’t participate in any of the infrastructure that’s going on in Asia, where a lot of that capacity is directive.

Bill Hoffmann

Okay. And maybe just digest in, [ph] one of you explain to what – how this is used in footwear, sort of what’s providing to the product, because people talk about great time polymer, they don’t really – they never quite understand it.

Stephen Tremblay

When Shell created the category back 60 odd years ago.

Bill Hoffmann

Yes.

Stephen Tremblay

Their first use of the material was in the source of juice. And right now, I think, that market is over 4,000 tons of footwear business. Our total capacity is less than that all Kraton tranches, the whole Kraton out there serving the market that we anticipate in.

Bill Hoffmann

Right.

Stephen Tremblay

Interestingly enough, as we’ve got away from that business and other producers to satisfy their market, we actually have found some opportunities for all things, our Cariflex business in high-end footwear, the ability to get a, especially in the high-end athletic shoe and have the sole the shoe be clear or isoprene rubber is so clear that it fits really nicely.

So it’s kind of an odd, it’s an eye change. We created the category, started footwear. We moved ourselves from footwear, as we went up the value chain, found new solutions then now here we’re with a high-end isoprene solution that have all things are on the – on the soles of shoes, but again, in the high-end soles of shoes.

Bill Hoffmann

Right. Okay, thanks. I think that’s always helpful. Just to once a while explain, if you will, who you are? The other part of the business some of these – some of the commodity business is paving and roofing, some of those in the locations. But you talked a minute ago about sort of value-add product and the product development. And you used to talk a lot about your vitality index and new products and how they rollout? Where are you on that scale? Are there – what – how many sort of blockbuster type products do you see out there? I mean I know you don’t want to quantify them, but just sort of they help people understand sort of share focus on the business?

Stephen Tremblay

We’re in the process right now taking some of the metrics that we traditionally used in our polymer business and through the chemical business. So my comments now are going to be on the polymer business. And again, we’re working really hard to bring the same metrics in the supply and chemical business.

We look at our portfolio the polymer business has as two broad sets, we call it standard grades, which are predominantly in our Performance Products into the business. Again, it’s the adhesive tapes it’s paving and roofing applications, and then we look at what we call the differentiated grades, which is all of our Cariflex business by definition, nobody else producers the material but us.

Bill Hoffmann

Right.

Stephen Tremblay

And a significant piece, north of 70% of our specialty polymers are in our point of view differentiated grades. And we apply, it’s a pretty hard metrics, I guess, they’re either brand new in the product set for five years, we qualify. If they’re not in the products set for five years, we look at things like patent protection, ability or lack thereof of customers to switch or the difficulty to switch grades. The margin profile for sure, weighs into our internal thinking whether specialty or not. If you on a June TTM basis 59%, jeez 59% of our revenue was what we would call in for – in – what we would call differentiated grade. So again, a combination of the margin profile, the patent protection, the ease of substitution lack thereof. And other factors go into that algebra that we apply every month, as we evaluate the portfolio.

That’s on a revenue basis, I would tell you that and it shouldn’t be a surprise, but it’s less than 50% of our volume, different – less differentiated grades normally higher volume, more differentiated grades are Cariflex, smaller volume, but high margin. So it’s less than 50% of our volume generating just less than 60% of our revenue, but generating more than 60% of our profits.

Bill Hoffmann

Right.

A - Stephen Tremblay

And that’s why we spend $30 million a year in R&D. We’re always looking for ways to either redeploy existing materials into new solutions, or create new solutions. One of the things we’re working on is a high melt flow polymer, which sets a fancy way of saying, it allows extruders to use our polymer and injection molding applications, which heretofore haven’t been available.

So we redesign some polymer, which could prove to be really beneficial. It opens up new markets for styrenic block copolymers. That’s an example, one of the bigger things that we’re working on applications and things like automotive as a prime example.

Bill Hoffmann

Right.

A - Stephen Tremblay

The automotive business – a lot of those are injection molded parts, and our styrenic block copolymers is nobody’s, styrenic block copolymers fit. We’re working hard to make them fit again to get back that light weighting solution.

Bill Hoffmann

Yes, we also have talked in the past about HiMA and the asphalt modification as a growth business, but the penetration in the U.S. is still pretty thin. Where are we on that? Is there a still opportunity to get in the U.S. market more?

A - Stephen Tremblay

Yes, one of – there are – those are – HiMA stands for highly modified asphalt. And it would – it’s a – we currently modify asphalt in our performance project. You can modify asphalt to give road like the road life with lot of materials and ground up tires to our polymers.

We created another grade of polymers, which allows you traditionally if a modifying polymer is on re-road, it is about 5% polymer in the asphalt in the aggregate of 5%. This polymer we created, you can actually load in north of 7% of the polymer and what it does, it allows the road builder to reduce the road bed by about 40%.

Bill Hoffmann

Right.

A - Stephen Tremblay

So less asphalt, less aggregate, and a longer-lived road. The – therefore, it’s more expensive, it’s more suitable for new roads, where in the U.S. most of the road work is re-roads. So we are finding solutions in places like South America, where there is a fair amount of privately-owned roads.

We are finding solutions to that throughout some of the developing countries, where again people starting out, not from a road that has been redone, but a brand new road, fair amount of nice successes although we have stalled a little bit in South America because of things that are going on in South America.

But we are still seeing nice growth in the parts of the world, and it’s proven – and it’s proving really successful. We look at places like new potentials, things like India with the amount of – just the amount of airports that are going to be constructed there.

Bill Hoffmann

Right.

A - Stephen Tremblay

The roads they have to be built to support their infrastructure. We think that’s where our opportunities we think are going to be for that. But we haven’t given up our South America, but for now what was trending real nicely is taking a little bit of a stall.

Bill Hoffmann

Right. I was explaining to people like why wouldn’t you use this in your asphalt that makes your roads less longer and there are not potholes and all the stuff. [Multiple Speakers]

A - Stephen Tremblay

If you are a concessioner that owns the road and you’re collecting tolls it really resonates.

Bill Hoffmann

Right.

A - Stephen Tremblay

Because the domain costs are dramatically low.

Bill Hoffmann

Right. Okay. Now switching back to Arizona business for a minute, one of the things that you look at in the Arizona businesses, call it, 50% of it is commodity product sold in through distribution systems. And part of your value add has been to take it to your customers when your customers back in on direct sale. You want to just sort of explain that and how this fits into this whole saves and position the business, because there’s a change.

A - Stephen Tremblay

Right. We are less focused to distributors now. Well, frankly, the Arizona business was less focused on distributors. It was a model that was embarked upon, but didn’t work out as well as what have been expected. So the amount going through distributors is less. We are continuing to want to gain some of that business back. The business that we acquired roughly $100 million or so of revenue is, a third of that is in adhesives, which is a, again, a GDP kind of business, mainly in corrugated boxes, where the adhesive needs to be pretty highly engineered, as well as things like food grade packaging, cereal boxes.

We also see a lot of opportunity in hot melt solutions, we are getting away from silicons and the like. That business, again, I wouldn’t call it necessarily commodity, doesn’t have really commodity margins, again GDP is kind of growth.

Two other small pieces of the business that we have a nice tire business, where actually we use our material to help the tire manufacturers be able to put more silicon in the tires why is that important. It creates a really hard tire, which is great for roll resistance.

So the run flat tires may have fine chemical in it, if a cafeteria stands that that’s what gives the epigean answer, low abrasion. That’s a nice business. And then we have a tire – road and construction business, which is little different than the polymer paving business, this is road marking, it’s more of an adhesive. It’s the properties that takes the glass beads that go into road marking and paints on the black top and it adheres to the road.

So those two are pretty small businesses. What you referred to as the less differentiated businesses, what is the chemical intermediate portion of the business, which was north of 50%, that’s everything from oil field fluids, metal working fluids…

Bill Hoffmann

Fuel additives.

A - Stephen Tremblay

Fuel additives, basically the whole TOFA chain that sold into the marketplace some of which is upgraded by us into those applications, some is sold directly. The – we see a lot of opportunity in that business is a business that didn’t have sales leadership when we acquired it. We now have sales leadership on that business. We think it’s an opportunity, where our business was lost when the distributor model was teed up, an understatement of how customer intimacy even some of these more commodity grades is important that was misjudged.

We’ve got direct feedback from customers, as we’ve been around talking to customers and we’re actively looking for other opportunities to sell TOFA. But when you don’t – it’s refinery. So to satisfy an adhesive need, we buy crude tall oil and we are going to make a product that goes into adhesive and we are going to generate roughly 67% of all the stuff that has to find a home. And ultimately, if it doesn’t find a home, it’s sold as burn value for basically no margin.

So since we own the business, we have had very nice success so far in finding some new outlets for that product. So we think there’s more upside there than anything.

Bill Hoffmann

Okay, really good. And then just for the last component, I think it’s very important. The story is Kraton’s price rate strategy, Arizona had shown quite a bit of volatility over the last four years, because a lot of that competes with oil-based products over the oil and 101 EBITDA lower 48, it’s a lot different. Could you just talk about sort of what you are going to do about that volatility in more in that new business?

A - Stephen Tremblay

Yes, the pricing model that we put in place the effective 2008, the polymer business is really what took us prior to this question is, it really took us from, there is a big component. The change in mix from more HSBC and more Cariflex has been a real driver. But we took the business from all end gross profit per ton of less than $425 in 2007 to we are printing routinely mid-800s, and we’ve had some quarters where we printed over $1000 depending on mix. That was a function of change in the pricing model.

The Arizona management team embarked upon much the same and has had a lot of success. We do think, though, there is continued opportunity in chemical engineers to apply that same price rate strategy that hadn’t been applied yet. And we also think price rate is also about, it’s really price smart. And as much as we never been a business that wanted to price to the lowest product in the market, because we think we price for value. We think there’s also opportunities at times to price smart and...

Bill Hoffmann

Right. And continued for margin volatility, right?

A - Stephen Tremblay

Yes, so as we look at it, clearly applying that same discipline and now that we put a sales leader in a business didn’t have a sales leader and that person is used the price rate model. We really do think there is opportunity to capture new volumes smartly, but also recognize the value and use of that significant piece of the business, where perhaps, it really wasn’t price value, perhaps it was priced, because it was the last opportunity to sell before picking them.

Bill Hoffmann

Right, excellent. With that anybody have any questions? Otherwise, I will thank you guys for coming out and participating, we really appreciate it. Thank you. Thank you for your time.

Stephen Tremblay

Do we get invite next year?

Bill Hoffmann

Yes.

Stephen Tremblay

Perfect.

Bill Hoffmann

Absolutely.

Question-and-Answer Session

Q -

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