Kraton Performance Polymers' CEO Discusses Results - Earnings Call Transcript

Aug. 1.12 | About: Kraton Performance (KRA)

Kraton Performance Polymers, Inc. (NYSE:KRA)

Q2 2012 Earnings Call

August 1, 2012 9:00 a.m. ET

Executives

Gene Shiels - Director of Investor Relations

Kevin Fogarty - President and Chief Executive Officer

Steve Tremblay - Vice President and Chief Financial Officer

Analysts

Edward Yang – Oppenheimer

John McNulty – Credit Suisse

Brian Maguire – Goldman Sachs

Kevin McCarthy - Bank of America/Merrill Lynch

Gregg Goodnight – UBS

Christopher Butler – Sidoti & Company

Mike Sison – Keybanc

Jay Brosnahan from WestPark Capital

Operator

Good morning and welcome to Kraton Performance Polymers, Inc. Second Quarter Ended June 30, 2012 Earnings Conference Call. My name is Sherry and I will be your conference facilitator. (Operator instructions)

I will now turn the call over to Mr. Gene Shiels, Director of Investor Relations.

Gene Shields

Thank you, Sherry. Good morning, everyone, and welcome to Kraton Performance Polymers' Second Quarter 2012 earnings call. With me on the call this morning are Kevin Fogarty, our President and Chief Executive Officer, and Steve Tremblay, our Vice President and Chief Financial Officer.

Before we review results for the second quarter 2012, I want to focus your attention to the disclaimers on forward-looking information and the use of non-GAAP measures, included in our presentation this and in yesterday's earnings press release.

During our call this morning, 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 expectations stated or implied by any comments that we make today.

Our business outlook is subject to a number of risk factors. As the format of this morning's presentation does permit a full discussion of these factors, please refer to our Forms 10-K, 10-Q and other regulatory filings that are 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 was provided in yesterday's earnings release and is included in the appendix to the material we will review this morning.

Following our prepared remarks we'll open the line for your questions. With that, I'll turn the call over to Kevin Fogarty.

Kevin Fogarty

Thank you, Gene. Following record sales volume and revenue in the first quarter of 2012, we were challenged in the second by a number of headwinds. Within our paving and roofing venues we experienced a slow start to the North American paving season, which was due, in part, to the continued funding challenges for paving projects.

We also experienced wet weather in Europe which constrained roofing activity. In addition to volatility and (inaudible) prices that we saw in the first quarter continue throughout the second quarter and this had an adverse effect on customer-buying patterns. Compounding these factors, we observed a general weakening of demand across a number of markets in which we operate. Given these headwinds, our sales volume in the second quarter of 2012 was 77 kilotons. this was down 5 kilotons or about 6% compared to the 82 kilotons we reported in the second quarter of 2011.

However, taking in account our strong sales volume in the first quarter of this year, our sales volume in the first half of 2012 is still up 2% compared to the first half of 2011. Second quarter sales volume at 77 kilotons was lower than our expectation at the time of our first quarter earnings call in May.

As the constraints on our paving and roofing sales volume and the impact of declining raw material prices on customer demand developed throughout May and June.

With respect to raw material volatility, following the steep run-up in North American beaded iron prices from January through April of this year. We saw the price decline in May and then drop sharply in June and July. This volatility had an adverse effect on demand as many customers acted to minimize purchases in the declining raw material environment in anticipation of lower product prices in the future.

Second quarter 2012 revenue of $376 million is down $10 million or 3% compared to the second quarter 2011 due to changes in currency in which more than offset the net effect of improved pricing on lower sales volume.

A significant portion of the volume declined relative to the second quarter 2012 was seen in lesser differentiated grades of our portfolio with the majority of year-on-year volume decrease concentrated in our USBC product grades.

Second quarter of net income of $12.4 million or $0.38 per diluted share and this compares to $47 million or $1.44 per diluted share in the second quarter of 2011. Second quarter net income includes charges of $2.6 million after tax or about $0.08 per share associated with restructuring and a severe storm that resulted in shutdown of our Belpre plant.

Following the unplanned shutdown of the plant and an outage that lasted a number of days, we incurred costs related to start-up. Given our inventory position, however, the (inaudible) did not result in any significant disruption in customer fulfillment.

I would add that in evaluating our second quarter 2012 net income and earnings per share relative to the second quarter of 2011 is important to note that our second quarter results included a FIFO benefit of $14 million, which is significantly less than the $50 million FIFO benefit we recognized in the second quarter of 2011.

Adjusted EBITDA for the second quarter, 2012, was $45 million, including the $14 million FIFO benefit. This compares to adjusted EBITDA of $74 million in the year ago quarter in which we recognized a $50 million FIFO benefit. Net cash provided by operating activities was $12.7 million in the second quarter. For the first six months of 2012, net cash provided by operating activities was $69 million, a $55 million increase compared to the fist six months of 2011. A notable achievement given the fact that we have historically consumed working capital in periods of rising raw material costs.

For the training 12-month period ending June, working capital excluding cash was 27% of TTM revenue.

During the second quarter we were pleased to announce the first commercial application for our NEXAR polymer technology. In early June, Columbia Sportswear, a leader in the performance apparel industry, launched a line of apparel and products with its latest cooling technology, which uses NEXAR to achieve the unique performance attributes of what we believe has the potential to be a step-up technology in the performance of apparel industry.

We believe that our NEXAR polymers have characteristics that make them well suited for other applications in areas such as water filtration and management and in enhanced energy recovery in HVAC application. For those of you who are attending our Investor Day tomorrow in New York. You will have the opportunity to see in person many of the exciting applications for our next (inaudible) technology.

As for our Asian HSBC capacity expansion, we continue to work on numerous fronts including continuing to negotiate documentation and operative agreements that will govern plan operation and the joint venture activities between Kraton and Formosa.

Last week on July 25, we received notification that conditional approval had been granted for the environmental permit needed for the plant operation. We are working with our partner, Formosa, and applicable regulatory authorities to ascertain the specifics of the conditions to which the approval is subject. Given that this is very recent development, it is not known whether the conditions or the timeframe for satisfying these conditions might further impact the project's timing. We will keep all of you informed as we move forward.

Turning now to Slide 5, I'll now highlight second quarter results for our for end uses, starting with the Advanced Materials. For 12-month period ending June 30, 2012, Advanced Materials accounted for 26% of Kraton's total sales revenue.

Second quarter revenue was $102 million and this was down $5 million or 5% compared to the second quarter of 2011, of which $4 million was the effect from currency changes. Sales volume for medical and personal care applications increased year-on-year, but were more than offset by lower sales volumes into other applications.

The growth in sales volumes in the medical applications, included expanded volumes of innovation grades, which provide alternatives in medical packaging resulting in PVC substitutions.

For 12 months ended June 20, 2012 our Adhesive, Seals and Coatings end use contributed 36% of total sales revenue. Revenue for the second quarter 2012 was $135 million, up $8 million for approximately 6% compared to the second quarter of 2011 of higher sales volume and higher pricing than the year ago quarter, despite a currency impact of $9 million in the quarter.

Increased sales volume was lead by higher hydrogenated sales into lubricant additives, oil gel and industrial applications, partially offset by lower unhydrogenated sales volume into pressure sensitive adhesives, (inaudible) adhesives and reactive SBS for printing plates.

Turning to our Paving and Roofing end use, as of June 30, 2012, Paving and Roofing contributed 30% of trailing 12-month revenue. Second quarter 2012 revenue was $109 million, down $19 million or 15% compared to the second quarter 2011 of which $10 million was the effect from currency change.

Sales volume in Asia-Pacific and South America increased compared to the year ago quarter, however, these increases were more than offset by lower sales volume in North America, which was due to the funding challenges I mentioned earlier and by lower sales volume in the European markets driven largely by project delays resulting from wet weather which impacted roofing volumes, as to a lesser extent, paving volumes.

In early July, President Obama signed the $105 billion transportation Bill. While the Bill runs through December 2014, funding is frozen at 2004 levels. On the margin this should be positive for paving and infrastructure projects, as without a Bill we most likely would see stronger contraction in infrastructure spending. A key issue is that the $0.18 per gallon fuel tax has been constant since 1992, while costs of asphalt and other inputs to road construction have risen. Compounding this is the fact that U.S. gasoline demand peaked in 2007 and the trend toward improved fuel economy in new vehicles is driving tax revenue lower.

The issue still needs to be addressed in order to provide long-term sustainable funding for infrastructure spending. Given this environment, we believe that our highly modified asphalt innovation grades provide a viable alternative and opportunity for DOTs to achieve longer road life and better road performance in an otherwise budget constrained fiscal in this market environment.

Wrapping up my end use review is our Cariflex end use which accounted for 7% of trailing 12-month revenue. The Cariflex end use delivered solid results in the second quarter with revenue up $7 million or 28% compared to the second quarter of 2011 and up 32% compared to the first quarter of 2012 in which revenue was essentially flat year-on-year on higher sales volume due to sales mix.

The second quarter revenue increased was lead by a higher sales volume in medical applications. We continue to have a very favorable outlook for future growth of Cariflex and we continue to expand sales into new markets.

Once again as a reminder, tomorrow during our Investor Day sessions we will discuss growth strategy for each of our four end use markets.

Turning now to Slide 6 I'll provide a few comments on our innovation metrics and activities. Our vitality index is the percentage of our total revenue coming from innovation grades, which are products introduced within the last five years. For the trailing 12-month period ended June 30, our vitality index was 13%, down from the 14% we reported last quarter for TTM period ending March 31.

Innovation revenue for the TTM period was essentially flat year-on-year despite the fact that we continue to have innovation volumes roll out of the metric. In fact, the decline in the vitality index is a function of higher base revenue and scheduled rollouts of innovations that have passed the five-year mark. I'll remind listeners that although these volumes passed the five-year mark and rolled out of our vitality index calculation, they still provide a market differentiation advantage and, thus, premium margins relative to the base portfolio.

So, the index does not completely reflect our progress and we continue to upgrade the overall portfolio. In fact, if we include the innovation volumes that rolled into the base volumes during the TTM period, our vitality index would have stood at 17%.

For the 12-month period ending June 30 we had strong growth in some of our key innovation projects. Revenue for comfort bedding applications was up 195%, for electronic coatings up 136%, revenue for adhesive innovations was up 62%, revenue for polychloroprene rubber replacement was up 41%, revenue for reactive SBS printing plates was up 25% and revenue for wire and cable was up 15%.

With that view of the business, I'll now turn the call over to our Chief Financial Officer, Steve Tremblay to give you a more detailed financial overview. Steve?

Steve Tremblay

Thank you, Kevin, and good morning, everyone. Sales volume in the second quarter 2012 was 77 kilotons, down 5 kilotons from the 82 kT we reported in the second quarter 2011. The 6% year-on-year volume decline resulted largely from lower volume in the Paving and Roofing end use and to a lesser extent lower volumes in the Advanced Materials end use.

In Paving and Roofing the volume decline was in North American paving applications and roofing applications in Europe. In the Advanced Materials end use the volume declined was largely due to lower sales volume in less differentiated applications. In Adhesive, Seals and Coatings end use volume expanded the second quarter 2012, compared to the second quarter of 2011 largely in lubricant additive and oil gel applications. Finally, as Kevin mentioned, the Cariflex end use posted volume gains in the second quarter due to increased sales into medical applications.

Relative to the sequential decline in sales volume from 90 kilotons in the first quarter to 77 kilotons in the second quarter, the primary driver was 8 kT of lower Paving and Roofing sales volume and to a much lesser extent lower sales volume in Adhesive, Seals and Coatings and in Advanced Materials. And, again, sequentially, sales volume for our Cariflex product increased in the second quarter compared to the first quarter.

Through the first half of 2012, the volume cadence has been atypical with the first quarter volume exceeding the second quarter volume. Normally, the second quarter volume is greater that those seasonally lower first quarter sales volume. Specifically, we experienced advanced purchases in Paving and Roofing in the first quarter of 2012, which resulted in less robust second quarter sales volume in this end use and generally, the significant drop in BD pricing in May and June that Kevin mentioned resulted in customers holding back orders until they saw BD (inaudible) bottoming out.

So, if we look at the first half of 2012, sales volume of 167 kilotons is up 2% compared to the 164 kilotons of sales volume in the first half of 2011. Sales volumes were up in three of our four end uses. Advanced Material sales volume was down year-over-year primarily due to lower sales in a less differentiated applications.

Second quarter 2012 revenue of $376 million was down $10 million or 3% compared to the second quarter of 2011 due to changes in currency, which more than offset the net effect of improved pricing on lower sales volume. Sequentially, the decline in sales volume more than offset higher average selling prices resulting in a decline in sales revenue of 8%.

Second quarter 2012 gross profit was $73 million reflecting a gross margin of nearly 20%. This compares to $108 million of gross profit with a gross margin of 28% in the second quarter of 2011. Excluding the effects of FIFO versus current replacement costs in both of these quarters, gross profit would have been essentially flat with selling price increases more than offsetting higher raw material costs and the effects of lower volume.

Sequentially, gross profit was down $3 million or 4% which includes a favorable spread between estimated current replacement costs and FIFO of $11 million. Absent this favorable impact, the sequential decline in gross profit reflects the aforementioned decline in sales volume, which amount to $16 million in higher cost of goods sold at a gain $21 million, both of which were nearly offset by the positive impact of our implemented price increases, which improved gross profit by $31 million compared to the first quarter of 2012.

Adjusted EBITDA was $45 million in the second quarter 2012, $74 million in the second quarter 2011 and $43 million in the first quarter 2012. Let's shift to the next slide for a description of the drivers. The amount of volatility captured on this slide as ECRC versus FIFO resulted in a $36 million decline in adjusted EBITDA from Q2 2011 to Q2 2012. This accounts for more than 100% of the decline in EBITDA on a year-on-year basis. Absent this, adjusted EBITDA would have been up $7 million. The 5 kiloton decline in volume amounted to $6 million reduction in adjusted EBITDA. However, average pricing was up $36 million, which more than offset the $22 million of cost of goods sold, mainly raw material costs, indicating an expansion in current cost margins.

Sequentially, adjusted EBITDA was up $2 on higher average selling prices and favorable FIFO versus current replacement cost spread, which more than offset the increase in cost of goods sold. Again, primary increases in raw materials and the decline in volume.

As a result, on a year-to-date basis, adjusted EBITDA of $88 million includes a $17 million positive spread in FIFO versus estimated current replacement costs much less than the $71 million positive spread, which is included in the $130 million first half 2011 adjusted EBITDA. Let's take a look at the impact of raw material volatility. The unprecedented volatility in raw material costs is reflected in this quarterly difference between FIFO and estimated recurrent placement costs.

Since Q1 2011, we have experienced rapid and significant movement in raw material costs in the most significant period of rising costs the spread was nearly $50 million positive in the second quarter 2011 and the most significant period of falling costs

the spread was $37 million negative in the fourth quarter of last year.

Our current estimate calls for a negative spread in Q3 2012 of approximately $40 million. Assuming the current expectation of a flat (inaudible) curve for the remainder of 2012, the Q4 spread between current placement costs and FIFO is currently not expected to be material.

That said, we continue to focus on expanding current cost margins. In the adjusted EBITDA analysis we noted that average sales prices increased $31 million, sequentially, which exceeded the increase in current costs.

As a result gross profit at estimated current replacement costs increased to $820 per ton in the second quarter of 2012, excluding $3.8 million of restructuring and storm-related charges, which reduced gross profit by $48 per ton in the second quarter.

We had targeted a larger expansion in margin per ton coming off the first quarter of 2012. Average selling prices increased by more than $300 per ton, sequentially, but average raw material costs increased in the second quarter, even though they declined late in the quarter and into the first part of the third quarter.

Margins, in fact, expanded across each of the end uses. In Adhesive, Seals and Coatings, however, the increase was modest due to competitive pressure resulting from supply and demand dynamics exacerbated by high spot isoprene costs.

In addition, with the overall decline in volume from Q1 to Q2 and with our fixed spending generally in line with Q1, gross profit per ton was negatively impacted by unfavorable fixed cost operating leverage, which, sequentially, pressured gross profit per ton. Looking forward and based on the relatively flat raw material curve, we currently expect further margin expansion in the third quarter of this year.

Looking at operating expenses, research and development expenses increased $1 million compared to the second quarter of 2011 due to the previous disclosed increase in employee-related costs commensurate with our continued investments in R&D expertise, which we completed in 2011.

Sale and general administrative expenses in Q2 2012 were down nearly $2 million compared to the second quarter 2011 primarily to lower IT costs.

Interest expense in the second quarter 2012 was $7.8 million, up approximately $1.9 million compared to the second quarter 2011 reflecting the increase from the issuance of $100 million of unsecured notes in the first quarter of this year.

Our effective tax rate in the second quarter of 2012 was approximately 21%. This rate continues to be less than the statutory rate primarily due to the mix of pre-tax income earned in foreign jurisdictions. The 8 point increase in rate compared to our 13% estimate was a function of the geographic split in pre-tax earnings and amounted to approximately $1.2 million of higher income tax expense in the quarter.

Second quarter and first half 2011, net income was $12.4 million and $28.8 million, respectively, representing earnings per share of $0.38 and $0.89, respectively, compared to $47 million or $1.44 per share and $68.9 million or $2.12 per share in the comparable 2011 periods. Certain items, including changes in the valuation allowances associated with net operating losses, which are a component of the overall tax rate, diluted earnings per share by $0.07 in Q2 2012 and $0.05 for the six months ended June 30, 2012.

On a comparable basis, these certain items had an accretive effect of $0.17 in Q2 2011 and a dilutive effect of $0.04 through June 30, 2012. These items are detailed in our press release.

Since December 31, 2011, we have improved our cash position by $139 million with cash from operations totaling $69 million, CapEx at $25 million and net financing activities, including the bond offering in Q1 of $95 million. Working capital, excluding cash as a percentage of TTM revenue was 27% at June 30, 2012, which was unchanged from the end of the first quarter and in line with our internal expectations.

Net debt at quarter end was $262 million representing 33% of capitalization.

Moving forward to some of our selected 2012 estimates, I'll remind everybody that each of these selected 2012 estimates is based upon our view at this time and subject to revisions should circumstances change as the year progresses, though we undertake no duty to update.

The only notable change from the first quarter is an increase in the full year effective tax rate from the 13% to 16%, again, reflecting an updated estimate where we see the geographic split of our pre-tax earnings.

I'd like to now turn the call back to Kevin Fogarty for some closing comments. Kevin?

Kevin Fogarty

Okay. Great, Steve. Reflecting upon our second quarter, clearly we were challenged by a number of factors that impacted our results. Any of these factors such as the ongoing funding constraints and weather impacts and our Paving and Roofing monomer, volatility and (inaudible) prices or the worldwide economic environment are beyond our control.

Our focus is always on maximizing our performance giving the prevailing environment. The volatility we've seen in monomer prices this year in on par with the significant volatility we saw in 2011. However, it has been compressed into a six-month timeframe. Clearly, a difficult environment in which to operate. Nevertheless, we have continued to implement our price right strategy to maintain our unit margins and we have worked diligently to manage our inventory levels to mitigate working capital impact of rising raw material costs.

While it is always a difficult proposition to predict trends and raw material prices based on current demand trends we believe that pricing for (inaudible) will remain relatively stable through the remainder of the third quarter.

In such an environment, we would expect to see sales volume trends more in line with underlying demand without the destruction caused by customers minimizing purchases and declining raw material price environments.

As you know we are working to accelerate commercialization of our many innovation projects and we are pleased that in the second quarter we were able to acknowledge the first commercial application of NEXAR. Perhaps, I should say the first of many applications for NEXAR we hope to announce.

Tomorrow we will be hosting our first Investor Day here in New York. For those of you who are unable to attend in person, we hope you can join us via the webcast as we will be discussing in more detail many of our innovation platforms, as well as our plans to continue to transform Kraton's portfolio over the next few years.

With that we're happy to turn the line over to the operator to take some questions.

Question-and-Answer Session

Operator

Thank you. We will now begin the question and answer session. (Operator instructions) Our first question comes from Edward Yang from Oppenheimer.

Edward Yang - Oppenheimer

Hi, Kevin. How much of the, sorry, hold on one second. Hey, Kevin, can you hear me?

Kevin Fogarty

Hear you fine, Ed.

Edward Yang - Oppenheimer

Okay. How much of the volume decline in the quarter was BD related versus the other items?

Kevin Fogarty

When you say BD related I assume you're referring just the . . .

Edward Yang - Oppenheimer

The monomer's volatility.

Kevin Fogarty

Monomer volatility, yeah. I mean, Ed, that is not a perfect answer that I can give just because we are seeing trends associated with clearly customers being very reserved in their purchasing thinking that with the raw material environment means future declining prices. And then we had the other headwinds that I spoke of around weather and then the slow start to paving season in the U.S.

So, I'd say on balance we are very sensitive to raw materials and assume that that is particularly because of the way in which the year has unfolded with a strong first quarter and then the weaker second quarter and I think that's got a lot to do with it.

Edward Yang - Oppenheimer

Well, is there anything to read into the relative outperformance, well, putting aside Paving and Roofing for a second and the weather impacts there, the relative outperformance of adhesives volumes relative to advanced materials, it's my understanding that the adhesives products in general have a lower BD content. So the fact that segment outperformed, does that kind of give you a look in terms of the relative importance of the (inaudible) volatility in the quarter?

Kevin Fogarty

Well, a lot of the over performance that you spoke of, and I'm pleased you called that out because we as well is in our hydrogenated side of the adhesives portfolio and that does contain (inaudible), but it does also reflect the fact that these products that we're selling into things like oil lubricants, as well as oil gel applications, these are very highly advantage products that Kraton offers.

Edward Yang – Oppenheimer

OK. And second question, so much of what you’ve done at Kraton and the success there have been related to your pricing strategy, but is time to kind of rethink your pricing model or tweak it somewhat more? You know, it looks like August, butadiene has rolled over, so some stability at least in the short term. But I would think long term butadiene volatility is here to stay given the lack of supply buffer in that industry and in the monomers industry in general.

So assuming that you are going to be in a longer term period of butadiene volatility, does it make sense to give customers that 30-day, you know, what is essentially a price lock after butadiene prices change? I mean, it seems to give them a lot of incentive to buy and destock fairly aggressively, which is apparent in your quarterly volumes. I mean, this quarter volumes were down 6%; last quarter they were up 10%. You know quarter before that it was down 8%; then you had another quarter where it was up 12%. It just seems like the customer buying patterns are heavily influenced by your pricing strategy there.

Kevin Fogarty

Yeah, I think it’s fair to say that the customers don’t think in terms of the calendar quarter, but our results obviously are dictated by the calendar quarter. The customers think in terms of the trends they are seeing. So, yes, Ed, I won’t go as far as to say that we are altering our pricing policy, but we are certainly thinking through it, thinking about more real-time pricing, clearly, that would try to take away some of this volume volatility associated with what we assume will be continued raw material volatility, simply because we have no reason to believe it’s not going to be.

Edward Yang – Oppenheimer

Okay. Thank you.

Operator

Our next question comes from John McNulty of Credit Suisse.

John McNulty – Credit Suisse

Good morning, just a couple of quick questions. First, with regard to the destocking, have you seen any signs in July so far of a restocking phase, or are we just kind of at the bottom and we’re bouncing along that for a while.

Kevin Fogarty

Good morning, John. As you know, we are not going to talk about specific volumes in the current period, but I think it’s fair to say that the customers are as attuned as anyone is in terms of the raw material trends. This is all about purchasing confidence. So in other words, if they’ve got inventory to manage in their system, which many of them do, then in periods of raw material decline there is a real hesitancy to place that order unless they are absolutely sure that that’s going to be consumed in their business in the current period.

So right now, I mean, I think the confidence has returned, in terms of just normal day-to-day business. We feel that in our business model today, but, you know, it really ties to the question that was just asked by the previous person in Ed, which is the behavior of the customers, what can we do in our pricing practices such that they don’t have to make these kind of volatile decisions around their own purchasing practices. Is there anything we can do to kind of smoothen that out?

John McNulty – Credit Suisse

Okay. Sure. And then on the competitive front, it sounds like you lost some business in what you I guess had listed as left-differentiated platforms. So I assume that means that you’ve got competitors out there competing on price against you. Is that a fair read? Am I connecting the dots right on that?

Kevin Fogarty

Yeah, I think clearly less differentiated. I want to make that very clear, and in our advance materials end use, we do have some unhydrogenated sales. And from time-to-time that’s an area where we see some competitive activity.

John McNulty – Credit Suisse

And what percent of your business would you say kind of fits into that category of left differentiated, not necessarily this quarter where it got computed away a little bit, but just broadly? I assume it’s not a huge piece of your business given the vitality index and some of the other specialty platforms that you’ve got, but roughly how big is that?

Kevin Fogarty

It’s a great question and that is one topic we intend to address tomorrow is to share more detail around the current portfolio, but more importantly where we expect to take the portfolio from here.

John McNulty – Credit Suisse

Okay. Fair enough. And then just one last question on the raw material front. Clearly, butadiene has come down a lot, and that’s I guess at least a benefit for now, but the volatility has been pretty extreme. There are some companies out there discussing putting in on-purpose butadiene facilities, and I guess I’m wondering what your interest, if any, might be in either participating in those from a capital side or at least locking in long-term arrangements to maybe smooth out some of the volatility that you face in the raw material front?

Kevin Fogarty

Yeah, I mean, two things I’d say there. One is indeed there are a couple projects that we are aware of. And I think that what that will do in all likelihood–because the pricing mechanism will be different. It won’t be so much supply/demand driven as it will be kind of related to some LPG-type market adder. And that, in your own words, should take away some of the current supply/demand volatility we are seeing.

So we will be as supportive as we can be in trying to see those projects become reality, but caution there is recognize relative to butadiene as a whole and the scale and size of these projects, we would be a fairly small volume factor. Nevertheless, we will do what we can to promote them because we think that’s a good direction for the overall butadiene supply.

John McNulty – Credit Suisse

Great. Thanks for the color.

Kevin Fogarty

But, if I could, John, I’d also like to add that as we think about our portfolio, clearly, the focus for us is developing products like NEXAR and certainly more Cariflex where butadiene is less and less relevant, and even in our highly differentiated HSBC portfolio, it’s going to drive the growth to fill up the plant in Asia, we just want to make BD, even if the volatility does stay in place, less and less relevant over time.

John McNulty – Credit Suisse

Sure, makes sense. Thanks a lot.

Operator

Our next question comes from Brian Maguire of Goldman Sachs.

Brian Maguire – Goldman Sachs Group, Inc.

Good morning.

Kevin Fogarty

Good morning, Brian.

Brian Maguire – Goldman Sachs

I was wondering if you lost any sales in the quarter do the lack of inventory availability? And kind of a related question, in the first half of 2012, have you experienced any problems sourcing butadiene in the market?

Kevin Fogarty

The answer to both those questions is no.

Brian Maguire – Goldman Sachs

Okay, great. And just looking out to the third quarter, now you mentioned the decline in the monomer prices that we saw and quite a sharp decline from where we were back in April to around $0.90 a pound today. The last time we had a sharp decline in monomer prices was third and fourth quarter of last year. You saw some sequential decline in average price per ton, around $265. Are you expecting something in that area for the third quarter of this year, with kind of a similar, maybe a little bit more muted decline in monomer prices? But if you had to kind of ballpark it, are you looking for an average price per ton decline in that area?

Stephen Tremblay

Brian, we’re going to steer away from any forward-looking pricing discussion here. I’ll just reiterate that the guidance that we have given is the effect of that decline, not on selling prices, but on the spread in FIFO versus ECRC of $40 million. But anything in addition to that, we are going to, again, steer away from.

Brian Maguire – Goldman Sachs

Okay, great. And then, do you have any insight into what your customer inventory levels are now? I know you mentioned some pre-buying in the first quarter, and then maybe some deferral of purchases, but you know, just anecdotally from what your salespeople are saying do you think that the inventory levels are quite a bit lower than average? And then kind of a related question, how do you kind of access your own inventory levels? Are you carrying as much inventory as you were a year ago, or have you kind of tightened that up a bit?

Kevin Fogarty

Well, the second part of the question is our inventories, and you know, we’re running our inventory, in general, today–and when I mean today I mean 2012–at levels, not in terms of monetary value–of course that’s driven by the price of the underlying feed stock going into it–but in terms of just pure volume as in days of inventory at levels as low as we’ve ever been in Kraton. And it’s been a stated purpose to get there. And we continue to find and try to find ways to continue to drive that inventory level down, and at the same time, we definitely want to preserve our service offering, which our customers expect as part of the total value offering of Kraton.

With respect to how the customers’ inventories are, again, never perfect information, but our sense is that customer, yeah, given the fact that we’re so concerned about trends in June and July of the declining raw materials, and therefore, trying to manage their purchasing. With a more stable environment and after having probably taken some inventory decisions in their own right, our sense is inventories are down (inaudible).

Brian Maguire – Goldman Sachs

Okay. Thanks very much.

Operator

Our next question comes from Kevin McCarthy of Bank of America/Merrill Lynch.

Kevin McCarthy – Bank of America/Merrill Lynch

Yes, good morning. Kevin, if I look at your volumes for the first half, you know plus 2% I would say actually stacks up quite well against most of the globally diverse chemical companies that have reported so far. Yet, operating margins for the first half may be down 700 bps or so. I understand a lot of that is inventory accounting-related, as you pointed out, but I guess my question relates to costs to the extent it looks like you’ve got some fiscal pressure in North American paving, and possibly some challenges in European roofing. Are there levers you can pull in terms of incremental restructuring to help on the fixed cost side in coming quarters?

Kevin Fogarty

Well, we’ve gone through over Kraton’s history, especially over the last five years a couple of pretty significant restructurings. If you look at the costs that we’ve added back since those restructurings, most of those costs were directed towards market development activities in order to advance and accelerate our overall portfolio shift efforts here at Kraton. We’ll talk, of course, more about that tomorrow.

But, I hear you, and undoubtedly, we need to be thinking about something we can do creatively that would take any fixed costs we could find in terms of inefficiency and increased productivity. We need to make sure that we’re taking action. And that’s kind of a perpetual activity that our Lean Six Sigma Black Belt teams always are working towards.

I like to think of it as more in terms of productivity enhancements, so, you know, can we combine some effort of making our plant more efficient in a certain production line with a fixed cost take-up, but at the same time, also looking at the total cost picture associated with variable costs as well. Because as you know, there are always opportunities to do that, it’s just a question of priorities and overall returns relative to the other projects we have. So, it’s a perpetual activity here at Kraton, but I won’t suggest right now that we’ve got anything that we can call out that would change the model and the look for Kraton for 2013.

Kevin McCarthy – Bank of America/Merrill Lynch

Okay. And then, I just wanted to follow up on the discussion related to pricing and your contemplation of real-time pricing. As you look at your volume trends regionally, does it differ significantly among the regions? In other words, would you see greater volatility in a market like Asia relative to the U.S. and Europe, and if so, might real-time pricing make more sense for that market? Any color on that would be helpful.

Kevin Fogarty

I’m trying to make sure I’m answering your question correctly. You’re asking whether we’d see real-time pricing more applicable in any region, or are you asking where do we see the most volatility? Maybe it’s the same question.

Kevin McCarthy – Bank of America/Merrill Lynch

Well, yeah, I guess both. So, to the extent that customers come in and out of the market tactically related to their view of butadiene, for example, as you observe your historical volume trends is that phenomenon more pronounced in Asia? It seems to me to be broadly more pronounced in the chemical industry in Asia. So, I’m wondering if you see that as well, and if so, would a real-time pricing strategy be perhaps more feasible for that market, in your view?

Kevin Fogarty

Well, I think real-time would be helpful in addressing some of the questions around the lag in our business, as an example. And it might prompt customers who are thinking about waiting for “next month” to go ahead and buy this month. But, if you look at Asia specifically, most of our business is done order per order. So Asian mentality in terms of buying practices is more driven by just an overall macro view of the market and where that market is headed one or two months ahead of time, but I do think that in the case of making pricing more real time to hopefully incentivize customers to think more real time in terms of their purchasing is directly applicable in Europe.

Kevin McCarthy – Bank of America/Merrill Lynch

Okay. Thanks very much.

Operator

Our next question comes from Gregg Goodnight from UBS.

Gregg Goodnight – UBS

Good morning, gentlemen.

Kevin Fogarty

Hi, Gregg.

Stephen Tremblay

Hi, Gregg.

Gregg Goodnight – UBS

I’m looking at your volume trends and obviously, there was destocking/restocking effect in first and second quarter, and you mentioned that your expectations for butadiene pricing to be flat. You don’t expect a lot of restocking; maybe will recoup a little volume with the weather, but on a year-over-year basis in the third quarter I would think that your year-over-comparisons would start to flatten out at this point on volumes. Would you agree with that?

Stephen Tremblay

Gregg, we’re not going to give specific view on volume in the third quarter unfortunately.

Gregg Goodnight – UBS

Okay, not even a qualitative look at volumes?

Kevin Fogarty

I think, Gregg, you kind of described how you think our business has unfolded based on the numerous examples we’ve had of what happens in periods of raw materials rising and what happens in periods of raw materials declining. And I think you summarized it very well in terms of that purchasing activity on the margin, if you will, which does have an impact on our quarter-to-quarter, and certainly an impact even on both sequentially as well as looking at it from the prior period in the prior year.

So, yeah, you describe it well, and we thing that there is no reason to believe that current practice isn’t going to continue here unless we are able to do something more significant in terms of changing that behavior.

Gregg Goodnight – UBS

Okay, all right. If I could then, second question with respect to the FIFO, you know I expected a bit of a higher FIFO contribution in the second quarter, not equivalent to but more similar to the second quarter of 2011. And I note that butadiene prices were down sharply in June, and perhaps that is the biggest part of the differential between my expectation and what you guys have reported with the 14 million. My question to you is there something in the second quarter, say for instance, you guys running at pretty low inventories that it contributed to the lower year-over-year comparison on FIFO?

Stephen Tremblay

Gregg, it was more the former. The timing effect of the dramatic drop in the back half of the quarter muted the favorability that would have been rolling in from the first quarter increases in BD. Inventory really wasn’t a factor. It was essentially flat, a bit up in the second quarter versus the first quarter. That increase was mainly planned increase as the swing line in Belpre, which you probably recall can make our Supreme rubber, as well as make USBC products. And we’re now on a campaign where we’re going to be campaigning IR, so we built some USBC inventory at the end of the quarter.

Gregg Goodnight – UBS

Okay, okay. Just so I’m clear, Steve, you did provide some guidance, FIFO versus ECRC of $40 million. That’s third quarter, and then you said, fourth quarter flat?

Stephen Tremblay

Yes, it’s $40 million estimated third quarter negative spread, and if the curve remains flat you would expect, therefore, that any difference in the fourth quarter would be modest.

Gregg Goodnight – UBS

Well, that also what my model says. Let’s see if we’re right. Thank you, gentlemen.

Kevin Fogarty

Thanks, Gregg.

Stephen Tremblay

Thanks, Gregg.

Operator

Our next question comes from Christopher Butler with Sidoti.

Christopher Butler – Sidoti & Company

Hi, good morning, guys.

Stephen Tremblay

Hi, Chris.

Christopher Butler – Sidoti & Company

If we’re looking at gross margin on a current cost basis, in comparison to second quarter 2011, last year we had dramatically rising BD costs. This year we had dramatically falling BD costs. How come we didn’t see a more significant increase in current cost gross margin on a profit per ton basis year-over-year?

Stephen Tremblay

Part of it is going to be product mix in the relative quarters as well as lower volume second quarter this year compared to the second quarter of ’11. As I mentioned, in the sequential effect where we did in fact see our gross profit per ton grow, but not as strong as we had thought, a significant piece of that was the low volume and the effect on plant fixed cost absorption. A similar, but to a lesser degree, certainly impacted Q2 this year versus Q2 last year given that we had overall volume decline in the period.

Christopher Butler – Sidoti & Company

So taking the first part of that product mix, a lot of the commentary that we’ve had here for the second quarter was that the volume losses were lower margin business, so wouldn’t that, while not good for fixed cost absorption, be good for product mix and profitability?

Stephen Tremblay

Yeah, for sure, but again, there is the effect of the fixed cost absorption which we can’t minimize, as well as the effect in some of the base business, which is we talked about the pressure that we’ve seen in some of our SIS portfolio due to dramatic increases in spot isoprene, which is an anomaly in this year. So, that eye capture is part of our product mix, which is the effect of isoprene movements and their impact on SIS, and frankly, to a much smaller degree in our Cariflex product, which as you know is 100% isoprene.

Christopher Butler – Sidoti & Company

And if we’re looking at the volumes during the quarter, can we assume that they tracked with butadiene down with June being the weakest of the three months?

Stephen Tremblay

Quarter-over-quarter for us, there’s a lot of variability, and month-over-month, there’s also a lot of variability. But, you know, generally, you could see that in the back half of the quarter is where we began to see, to use your words, some of the weakness.

Christopher Butler – Sidoti & Company

And with European vacations here in front of us, any reason to expect that we’re going to see a significant uptick before, say, September.

Stephen Tremblay

No, I don’t think. The August European effect is in every third quarter, so we’re not expecting that to have any different impact on the business really. What we’re seeing in volume is what Kevin has talked about here quite a bit, which is what we saw in the effect of raw material prices and then the macro economy. But, you know, August this year, August last year, we wouldn’t see a cadencing any different necessarily.

Christopher Butler – Sidoti & Company

And has weather improved in Europe to get a bounce back from the roofing demand.

Stephen Tremblay

Weather has, in fact, improved. It remains to be seen whether that will manifest itself into a bounce back, but clearly those are more favorable conditions than what we experienced in the second quarter. (inaudible)

Christopher Butler – Sidoti & Company

(inaudible)

Stephen Tremblay

That will also have an effect on the paving business in Europe as well.

Christopher Butler – Sidoti & Company

All right. Thank you.

Stephen Tremblay

Thanks, Chris.

Operator

Our next question from Mike Sison from Keybanc.

Mike Sison – Keybanc

Hey, good morning, guys.

Stephen Tremblay

Good morning, Mike.

Mike Sison – Keybanc

In terms of the hit, the $40 million FIFO, estimated current replacement cost of $40 million that you are going to take in third quarter, the last time you had that level in the fourth quarter, your gross profit per ton on a FIFO basis was 315. So any puts and takes that would suggest it could be better than that? Obviously, you had some destocking in the fourth quarter, but why wouldn’t be back at those levels in the third?

Stephen Tremblay

The fourth quarter, Mike, as you are very familiar with is a low fourth quarter for us in terms of volume. Our third quarter has historically been much higher than our fourth quarter volume, so the inverse effect of the negative absorption that we spoke about earlier, we should be able to get a bounce from higher volume in the third quarter this, relative to the fourth quarter of last.

Mike Sison – Keybanc

Okay, that’s one plus. Is there anything else that would benefit relative to what you did in the fourth?

Stephen Tremblay

We’ll keep it to that for now, Mike. As Kevin mentioned before, there are no real major cost initiatives, other than the traditional do-betters that we have, so we are not anticipating a major change in our fixed cost structure. And as you know, again, 60% of cost of goods sold is in raw materials and the 40% is a mix of fixed and variable, so the operating leverage is confined to, in the overall cost of goods sold basis, a relatively small pool of discretionary. And given that we are already into the third quarter, I wouldn’t suggest that we would expect a major shift in our cost structure.

Mike Sison – Keybanc

Got it. And then, Kevin, you’ve talked about and maybe you’ll elaborate a little bit on your Analyst Day, but $1,000 gross profit per ton on a FIFO basis is what’s reasonable for your business. You did hit it this quarter, but it’s been a struggle to hit it for a full year. Can you maybe talk about what needs to happen to do that on an annualized basis?

Kevin Fogarty

Well, I mean, all along as we’ve gone and embarked on this overall portfolio shift, which is kind of in a nutshell meaning improve the sales mix. Over time, that’s why we are continuing to feel like the targets that we have outlaid for you are within reach.

And, you know, we have to put more and more of our sales mix coming from things like NEXAR and Cariflex and especially hydrogenated styrenic block copolymers, and quite frankly, that means that the percent of our business coming from unhydrogenated paving-type applications, which brings that average down. Needless to say, means that we’ll be able to achieve those levels of sustainable profitability, and that’s exactly what we are working on here at Kraton, and that’s certainly what we’ll be sharing, as you point out, more detail on tomorrow.

Mike Sison – Keybanc

Okay. And then, last question, when you think about progress that you’ve made this year, you’ve had some in the second half of last year, some [discipline] from customers in terms of your pricing strategy. You’ve changed that a little bit this year. Do you think you are gaining some market share at all? (inaudible) any thoughts there?

Kevin Fogarty

We are certainly talking with customers, needless to say, about the need to become more real time, as I mentioned earlier, associated with volatility that got 2011 wrapped up in the first six months of 2012. So, you know, talking to customers about the need for that real time is just more in terms of how we conduct or business with them, but it doesn’t change the underlying theme of Kraton, which is ensure we are getting the appropriate level of profitability (inaudible) that we’re offering as part of the overall service offering.

And so, I think it’s important those two things not be confused. We are just trying to deal with a very volatile raw material market in more current term pricing. As far as share goes, actually, we look at share maybe a little bit differently than the market does because we are so focused on the higher end of portfolio. So we always measure share in terms of, quite frankly, what revenue we represent with respect to the overall industry, and also recognize that we are a heavier weighting to HSBC in the styrenic block copolymer industry than the industry itself because so much of the business associated with unhydrogenated SBC, Kraton doesn’t participate in, like footwear, and even like the large road infrastructure business going on in China. And tomorrow, we’ll actually share an update on our most recent view of those revenue shares.

Mike Sison – Keybanc

Okay, great. Thank you.

Operator

Our next question comes from Jay Brosnahan from WestPark Capital.

Jay Brosnahan – WestPark Capital

Yes, can you talk about what has changed from the first quarter to the second quarter? After the first quarter you gave us some guidance on volumes, so why not do the same this quarter?

Kevin Fogarty

Volume guidance is something that we have shared when we think that there is a compelling reason to do so. We commented when we gave the first quarter results that sales volume in that quarter was extraordinary. It was certainly the biggest first quarter we’ve ever had, and I was thinking about the business more in terms of the volume trends as opposed to the quarter-to-quarter results. But in the case of where we are today relative to how we look at the balance of the year, we think that there is just not a need to call out anything extraordinary as we did in the first quarter.

Jay Brosnahan – WestPark Capital

Thank you.

Operator

I have no further questions in queue. I would like to turn the call back over to Gene Shiels for closing comments.

Gene Shiels

Thank you, Sherry. Well, we’d like to thank all the participants this morning for their interest in Kraton and for their thoughtful questions. I’d like to remind everyone about our Investor Day tomorrow beginning at 8:30 Eastern, and for those of you who cannot participate in person, again, you can access the webcast through the Events tab under the Investor Relations page of our website.

A replay of this conference call will be available beginning today at approximately 11:00 a.m. Eastern, and will available through midnight on August 14th. A replay will be available over the internet, and you can access a link to that replay on our website at www.kraton.com by selecting Events under the Investor Relations tab of the website. To hear a telephonic replay, you may dial 888-282-0029, and international callers may dial 402-998-0514.

This concludes our call. You may now disconnect.

Operator

This concludes the Kraton Performance Polymers, Incorporated second quarter ended June 20th, 2012, earnings conference call. You may now disconnect.

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