Innospec Inc. Q2 2008 Earnings Call Transcript

Aug.29.08 | About: Innospec Inc. (IOSP)

Innospec Inc. (NASDAQ:IOSP)

Q2 2008 Earnings Call

July 31, 2008 8:30 am ET

Executives

Kate Davison – Group Legal Advisor & Head of Investor Relations

Paul W. Jennings – President & Chief Executive Officer

Ian Cleminson – Executive Vice President & Chief Financial Officer

Analysts

Jonathan Lichter – Sidoti & Company, LLC

Jeffrey Zekauskas – J.P. Morgan

David Wilson – Smith Barney

Operator

Welcome to the Innospec earnings second quarter 2008 results conference call. (Operator Instructions) At this time I would like to turn the conference over to Kate Davison.

Kate Davison

Thanks for joining our second quarter 2008 financial results conference call. Today’s call is being recorded. As you know, last night we reported our second quarter 2008 financial results. The press release is posted on the company’s website, www.InnospecInc.com. An audio webcast of the call and the slide presentation of the results are also now available and will be archived on the website.

Before we start, I’d like to remind everybody that certain comments made during this call might be characterized as forward-looking statements under the Private Securities Litigation Reform Act of 1995. Generally speaking, any comments regarding managements’ belief, expectation, target or other predictions of the future are forward-looking statements. These statements involve a number of risks and uncertainties that could cause actual results to differ materially from the anticipated results implied by the forward-looking statements. These risks and uncertainties are detailed in Innospec’s most recent 10K report as well as other filings we have with the SEC. We refer you to the SEC’s website or our site for these or other documents.

In our discussion today, we have also included some non-GAAP financial measures. A reconciliation to the most directly comparable GAAP financial measures is contained in our earnings release and in the presentation that follows, a copy of which is available on the Innospec website. With us today from Innospec are Paul Jennings, President and Chief Executive Officer, Ian Cleminson, Executive Vice President and Chief Financial Officer and Patrick Williams, Executive Vice President and President of Fuel Specialties.

And with that, I turn this over to you, Paul.

Paul W. Jennings

Turning to slide four in the presentation, I have a few summary comments before Ian takes us through the numbers in greater detail. Despite the continued decline in our Octane Additive business we achieved positive revenue growth for the quarter with a 3% overall increase. Fuel Specialties, which is now by far our largest business, delivered another solid performance with 10% revenue growth and an improved gross margin.

However, we are obviously somewhat disappointed with our bottom line results for the quarter. Diluted earnings per share on a GAAP basis was only $0.03 compared with $0.27 for last years second quarter. The results include the write off of $0.10 per share for advisory and financing costs we had previously accrued in connection with two large potential acquisitions. Ultimately, we feel good about our decision not to pursue these deals, but that decision required that we write off these accrued expenses.

In addition, Octane Additives goodwill impairment, a small restructuring charge and foreign exchange losses, partially offset by a small real estate gain, caused a net reduction of another $0.09 in our earnings for the quarter. Ian will give us the full detail on those items in a few minutes. Fundamentally, as I said, it was another good quarter for Fuel Specialties and Octane Additives’ results were broadly in line with our expectations. Active Chemicals suffered through a very challenging quarter mainly due to increased energy and raw material costs as well as a continued shift in its sales mix to lower margin products.

However, we believe it has hit bottom in the second quarter and going forward we expect it to benefit from raising prices across all its markets and to begin to benefit from its integration with Fuel Specialties as part of a single, ongoing global Specialty Chemicals business which we announced at the end of the second quarter.

While we have adjusted our 2008 guidance ranges for both Active Chemicals and Octane Additives to reflect our second quarter results, we have not changed our expectations for Fuel Specialties and I would emphasize that overall the change in our gross profit expectation for the full year is relatively modest.

I’ll have more to say on this later but now I’d like to turn the call over to Ian Cleminson, our Chief Financial Officer.

Ian Cleminson

Turning to slide six, on a consolidated basis, revenues for the quarter increased 3% mainly due to the strong performance in our Fuel Specialties business and an acceleration in sales growth in Active Chemicals which were partly offset by a substantial revenue decline in Octane Additives. The overall gross profit percentage was 28.3%, down 5.5 percentage points from last year’s second quarter. This drop reflects significant margin declines in both Active Chemicals and our Octane Additives business. However, our gross profit percentage improved for the quarter in Fuel Specialties.

Total operating income of $6.1 million and EBITDA of $9.9 million were both down significantly from a year ago partly due to the write off of acquisition costs that Paul described which was $3.9 million pre tax, $2.5 million after tax or $0.10 per share. I’ll break other items out in greater detail in a few minutes but altogether they reduced our income by another $0.09 per share.

A year ago in the second quarter our results included similar items that had a negative impact of $0.12 per share. If you back all these items out of both years our adjusted EPS was $0.22 compared with $0.39 a year ago, the difference primarily being Active Chemicals and Octane Additives’ lower performance. Fundamentally, as Paul noted, we had another good quarter in Fuel Specialties but a very difficult quarter in Active Chemicals.

Turning to the individual business segments, starting with slide seven, in Fuel Specialties revenue growth was 10% for the quarter which is well below it’s 34% in the first quarter but still quite solid considering the macro-environment it is facing in both the U.S. and EMEA. Revenues could have been somewhat stronger if not for some raw material supply issues in certain areas. The 10% revenue growth was driven by price and product mix which accounted for seven percentage points and the favorable impact of exchange rates which accounted for another five percentage points. This was offset slightly by lower volume down two percentage points.

By region, revenues increased 7% in the Americas due primarily to a richer price and product mix. In EMEA revenues rose 18% due to strong sales of detergents and refinery products assisted by the favorable impact of exchange rates. In the Asia Pacific region revenues increased 10% mainly due to strong detergent sales. The segment’s gross margin for the quarter was 34.3%, an improvement of 0.6 percentage points from 33.7% a year ago. The increase was achieved despite significant raw material increases.

Operating income for the quarter of $15.2 million was up 6% from last year’s second quarter. The segment’s operating income growth was dampened by increased SG&A expenses partly reflecting the exchange rate differentials in EMEA and higher R&D expenses to support this expanding business. We should note that Fuel Specialties’ sales and margins were softer in June than for the full quarter reflecting raw material supply issues and cost increases which we’re effectively passing on. But it is fairly clear that year-over-year revenue and profit comparisons in this business will be more difficult in the second half than they have been for the year-to-date. Nevertheless, as Paul noted, we remain comfortable and consistent with our original full year guidance ranges for Fuel Specialties.

Moving on to slide eight, our second quarter results in Active Chemicals were clearly disappointing. While revenue growth actually accelerated to 11% from 4% in the first quarter, much of the growth was in low margin polymers. By region revenues rose 1% in the Americas where our fragrance business performed well while results in personal care were below expectations in part due to a delayed product launch by a major customer.

In EMEA sales growth was strong at 17% but most of the growth is coming from polymers and the favorable impact of exchange rates. The Asia Pacific region remains relatively small, but reported growth of 33% is due to strong fragrance and polymer sales. The segment’s gross margin of 5.3% was down sharply from 17.1% a year ago. In addition to the less favorable sales mix margins for the quarter were hurt by sharp increases in energy and raw material costs.

Average raw material costs were up 20% or more for many of our products while energy costs were up approximately 40%. Meanwhile, in many cases, we’ve been locked into contracts that prevent us from immediately passing along these costs. Overall, the segment reported an operating loss of $2.4 million compared with an operating income of $1 million a year ago. As Paul noted, we believe Active Chemicals’ performance has bottomed out in the second quarter and its results should increase sequentially in the second half of 2008 on the back of major price increases to all customers.

Turning to slide nine, Octane Additives’ results for the quarter were down significantly but were generally in line with our outlook for a longer term decline in this business. Revenues of $13.1 million were down 39% from a year ago while volumes were down 38%. Volumes remain in line with our expectations though the revenues were adversely impacted by sales mix. The gross margins for the quarter of 51.9% was down 8.8 percentage points in part reflecting a shift in the sales mix and our increased unit cost due to the significantly lower production volumes at our Ellesmere Port facility. In addition, the gross margin a year ago benefited from the company’s settlement of its disputes with Ethyl Corporation.

Moving on to slide 10, underlying corporate costs for the quarter were held at $5.7 million consistent with a year ago. We have however written off in the current second quarter $3.9 million of previously deferred costs in respect of two large potential acquisitions that we are now no longer pursuing.

As expected, the Octane Additives impairment charge was down sharply at $1 million compared to $3.3 million a year ago. We incurred a restructuring charge of $1.1 million primarily for severance expenses in Active Chemicals compared with a $1.3 million restructuring charge a year ago. We also had a small gain of approximately $400,000 on the disposal of some real estate.

We incurred net foreign exchanges losses of $1 million which result to losses on foreign currency forward contracts and on translation of monetary assets in our European business primarily due to the weakness of the dollar against the Euro. In last year’s second quarter we had a $1.8 million net foreign exchange gain before taxes. In addition, we recorded another non-cash charge of $0.6 million related to our United Kingdom Pension Fund, down from $1.3 million in last year’s second quarter.

Turning to slide 11, our liquidity remains excellent with $16.4 million in cash and cash equivalents, total debt of $81 million and net debt of $64.6 million. Net debt is up $8 million from year end and almost $20 million from the end of Q1. We had a free cash outflow almost equal to the cash inflow in the first quarter reflecting our reduced net income as well as a very deliberate decision to build our inventory strategically in certain product categories. We purchased another 86,000 shares during the quarter and for the year-to-date, have now repurchased approximately 484,000 shares for a total for $9.6 million.

And now I’ll turn it back over to Paul for some concluding comments.

Paul W. Jennings

Moving on to slide 13, which shows Innospec’s ongoing operating profitability, this is one of the key metrics we have used to illustrate our success in transforming Innospec over the last three years. While this metric was down in the second quarter, reflecting the weakness in Active Chemicals. For the six months of 2008 our ongoing operating profitability was $24.8 million, up 15% from a year ago. I would remind everyone that just three years ago our operating income from Fuel Specialties and Active Chemicals, our ongoing growth businesses, did not even cover our corporate costs. We were actually losing money on this basis.

Slide 14 shows the changes we have made in some of our guidance ranges. We remain comfortable with our original revenue and gross margin ranges for Fuel Specialties. In Active Chemicals, we have actually increased our revenue guidance to a 10% to 14% increase, up from 8% to 12% previously. However, we have reduced our expectations for its gross margin to 10% to 14% from 18% to 22% previously.

In Octane Additives, we now expect a 25% to 30% revenue decline compared with our previous expectation of a 15% to 20% decline mainly reflecting our revised outlook for the timing of shipments over the balance of the year. We now expect Octane Additives’ gross margin to be between 40% and 44% compared with 43% to 47% previously. In addition, we’re now estimating the full year tax rate as approximately 34% compared with 35% previously. I would point out that when you do the math from these adjustments to our guidance ranges using the mid-point in every case, they add up to a projected reduction in our total gross profit for 2008 from that originally expected of less than 9%.

Turning to slide 15, I’d like to make a few more points before we take your questions. As we’ve already highlighted, our results for the quarter include a substantial write off of accrued costs for potential acquisitions that we are now not pursuing. The two deals in question were both large relative to Innospec’s current size and required extensive due diligence as well as costs related to potential financing that we would have needed to complete the transactions.

We feel very good about our decision not to go forward with either deal which ultimately did not make sense for our shareholders. Having said that, we remain open to considering acquisitions on an opportunistic basis but as we have said many times, any acquisition would need to compliment our existing businesses and create long term value for our shareholders.

Regarding Active Chemicals, as we have acknowledged, its performance in the quarter was substantially below our expectations and obviously unacceptable. However, we are confident that the worst is now behind it. We have some good short term opportunities to improve our pricing on several key contracts which should offset some of the margin pressure we’ve been experiencing. In addition, we believe our restructuring of Active Chemicals will begin to show benefits in the near future.

As we announced last month, we have followed up our restructuring of Active Chemicals in last year’s fourth quarter which was primarily a reorganization to three geographical regions with a further restructuring in which we are actually integrating Active Chemicals organization with Fuel Specialties to create a single streamlined organization. The new global Specialty Chemical segment unified under Patrick Williams’ leadership will have a sharp focus on meeting customer needs with innovative products and a culture built around exceptional customer service. We believe the combined business can be just as successful as the Fuel Specialties business has been over the last few years.

On a side note, in our reporting format, we only announced our plan to combine Fuel Specialties and Active Chemicals last month and determined that this quarter was not a good time to change our segment reporting format given the very different cross currents in the two businesses. Going forward however, as their cost structures are increasingly integrated, it’ll no longer be possible for us to provide the segment information we have reported historically and the line of business information will be combined into a single segment reported on a regional basis.

While our performance in Active Chemicals this quarter represents a short term setback, I think we all need to remind ourselves how far Innospec has come over the last three years. In fact, we won two awards in the United Kingdom during the second quarter from the United Kingdom Chemical Industries Association: one for reputation and the other recognizing Innospec as Company of the Year.

In giving the Reputation Award to Innospec, the awards panel noted that while we were substantially restructuring our product portfolio, Innospec developed a proactive strategy for engaging with all its stakeholders which has transformed a poor reputation into one of the most enviable in the industry. In naming Innospec Company of the Year, the awards panel noted that strong leadership, a commitment to employees in the community, together with innovative new product development has seen Innospec grow into one of the best companies in the United Kingdom as voted for by its employees. We also noted that Innospec now has one of the best safety records in the United Kingdom, having received the Royal Society for the Prevention of Accidents Gold Medal Award this year. So it’s worth bearing in mind how much progress Innospec has made over the last few years.

Finally, I wanted to mention that we do not have any new news for you regarding the investigations related to the U.N.’s Oil-for-Food program by the SEC and the Department of Justice. You will also be aware that the United Kingdom’s Serious Fraud Office has commenced an investigation into the company’s involvement in the Oil-for-Food program. This investigation is largely following the course of the SEC and the OJ investigation. As you have probably noted, we did not take any additional charges this quarter for the related expenses. We continue to cooperate fully with the investigations. We don’t have a view yet as to how much longer the investigations will take or what the ultimate results will be. When we do we will communicate that promptly. But in the meantime there is nothing more to say beyond the disclosures we’ve already made in our 10K and our 10Qs.

And now we would like take any questions you may have.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Jonathan Lichter – Sidoti & Company, LLC.

Jonathan Lichter – Sidoti & Company, LLC

What percentage of Active Chemicals’ contracts can you get pricing on?

Paul W. Jennings

As we’ve said in the call there were a number of contracts within certain aspects of the business that we’ve been tied into but ultimately what we are looking to do with the Active Chemicals is look for significant price increases across the whole of our business and that’s something that we’re working on with immediate effect and we will be looking to push through over the coming months.

Jonathan Lichter – Sidoti & Company, LLC

Are you actually prepared to walk away from some business if you can’t get pricing?

Paul W. Jennings

I think we’d have to look at each individual piece of business on that, Jonathan, in terms of the actual margin and contribution it makes but if we felt that it was detrimental to Innospec then yes we’d do that.

Jonathan Lichter – Sidoti & Company, LLC

Did you have, or how early did you have visibility into these rising costs? How early in the quarter?

Ian Cleminson

What we’ve seen in the last quarter in Active Chemicals is price increases for some of our base raw materials of anything from 20% to 35%. In addition, we’ve seen energy costs increase and go over 40%. When you actually track that through the quarter we’ve seen a real spike in June. We have seen increases in April and May but particularly June was a very, very high month of increases for us so the visibility that we had wasn’t quite as open as we would have liked.

Jonathan Lichter – Sidoti & Company, LLC

On Fuel Specialties I think you mentioned that the second half would be more difficult. Are you having any pushback in terms of getting pricing there?

Ian Cleminson

I think in Fuel Specialties we’ve consistently said that the full year expectations were within the range and we haven’t changed that despite some push on that based on the excellent first half of the year. In some areas there is some increasing competition in certain product ranges which is making it more difficult for us to put prices through. But overall, I think that business is doing an exceptional job of being able to handle that and with a few exceptions we believe that that is something that we can continue to do.

Operator

Your next question comes from Jeffrey Zekauskas – J.P. Morgan.

Jeffrey Zekauskas – J.P. Morgan

In terms of the raw material disruptions you had in Fuel Specialties, how much did that hurt your volumes in the quarter and is that fixed?

Ian Cleminson

One of the things we’ve seen in Fuel Specialties this quarter is about a two percentage point drop off in our volumes. That is mainly due to some supply issues we’ve had with certain raw materials. We are on with fixing that. It’s hurt our margins and it’s hurt our ability to sell. There is no issue with demand in the medium term. I’m not going to tell you which raw material that is because that is obviously a sensitive issue we’re looking to resolve either with our current supplier or other suppliers.

Jeffrey Zekauskas – J.P. Morgan

So it’s not yet resolved, so there may be a volume penalty in the third quarter? Is that what you’re saying?

Ian Cleminson

I think in the third quarter, Jeff, we will see some margin impact and some potential volume issues. We have though some strategic stock in this area but we remain unresolved completely on this issue.

Jeffrey Zekauskas – J.P. Morgan

In the Active Chemical area, which you are going to put together with Fuel Specialties, you spoke of cost reduction efforts and restructuring efforts. How much do you expect to save and how much will that cost you?

Ian Cleminson

We booked in the second quarter a restructuring charge which principally takes care of the amount of restructuring we expect to see and that was about the $1 million. And the people related to that have already left the business but the principal reason for doing this, Jeff, was not one in terms of a cost reduction per se; it was more about leveraging the skills and the expertise and the performance that we’ve seen in our Fuel Specialties area.

They have done a great job over the last few years in terms of managing pricing, running their business on a regional basis and being extremely customer focused and that’s something that I thought was needed in greater degree within Active Chemicals. And I think the team that we’ve got within that business can handle it and we will start to see the improvements overall across Innospec.

Jeffrey Zekauskas – J.P. Morgan

I guess, lastly, in Octane Additives, your gross margin was pretty good this quarter. It was maybe 52% or so which was up about 1200 basis points from the first quarter when your sales were much higher. So what was it about this quarter that was so profitable? Is it have, does it have something to do with the mix or with your inventory costs? What’s there?

Paul W. Jennings

Jeff, you’re absolute right when you said mix. We have a number of countries which we sell to and some are more profitable than the others. This quarter was just a more profitable mix going through for us than the same quarter last year.

Jeffrey Zekauskas – J.P. Morgan

There wasn’t, as least as I understood your comments, there wasn’t much change in average pricing? Is that something that will be true for the year or that’s something that had to do with the mix in this quarter?

Paul W. Jennings

We have had some average pricing changes, Jeff, but that is more masked by the mix and we had some obvious increases year-over-year but yes the mix has played the biggest part of that.

Operator

Your next question comes from David Wilson – Smith Barney.

David Wilson – Smith Barney

Could you give me an idea of what your Avgas volumes are and what pricing is doing in that market?

Paul W. Jennings

We don’t normally state the actual Avgas volume per se in terms of actual tonnage. All I would state it’s a much greater part of what we sell in tetra ethyl lead at this stage than it used to be and as you know those volumes get reported within our Fuel Specialties business. In terms of pricing, where we can we have looked at increases year-over-year and will continue to look at that but there are a couple of areas where that’s a little bit more challenging but we are looking to try and manage the margins as much as we can.

David Wilson – Smith Barney

The inventory build you said are, is any of that in the TEL of the Avgas markets?

Ian Cleminson

Some of it is in the TEL business and we’re taking some opportunities to build some strategic inventory there, yes.

Operator

We have no further questions.

Paul W. Jennings

Thank you and thank you all for your questions. I would now like to leave you with a few final thoughts. While we are far from satisfied with our overall results for the quarter, it is important to note that our largest business, Fuel Specialties, remains on track for a strong year in 2008. We have fine tuned our guidance ranges for both Active Chemicals and Octane Additives but the adjustments add up to a relatively small change in our overall outlook for the year.

In many ways, our strategy today remains the same as it was three years ago. We want to continue running our core businesses better and we’ve clearly set the stage for that with our new, integrated global Specialty Chemicals organizational structure. We continue to believe our ongoing growth businesses in Fuel Specialties and Active Chemicals have strongly leadership positions in attractive markets which we are well positioned to leverage in the years ahead. We are steadily increasing the understanding and visibility of the company and [inaudible] improving our capital management through our share repurchases and steady growth in our cash dividend.

If you have any further questions, please give Kate, Ian, Patrick or myself a call. If we don’t hear from you in the meantime, we will look forward to sharing our third quarter results with you at that time. Thanks again for being with us on the call today.

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