Orion Engineered Carbons S.A. (NYSE:OEC ) Q2 2022 Earnings Conference Call August 5, 2022 8:30 AM ET

Wendy Wilson - Head of IR

Jon Tanwanteng - CJS Securities

Greetings, and welcome to the Orion Engineered Carbons Second Quarter 2022 Earnings Conference Call. At this time, all participants are in a listen-only mode. A question-and-answer session will follow the formal presentation. [Operator Instructions] As a reminder, this conference is being recorded.

It is now my pleasure to introduce your host, Wendy Wilson, Head of Investor Relations. Thank you, and over to you, ma'am.

Thank you, operator. Good morning, everyone, and welcome to Orion Engineered Carbons conference call to discuss our second quarter 2022 financial results. I'm Wendy Wilson, Head of Investor Relations.

With us today are Corning Painter, Chief Executive Officer; and Jeff Glajch, Chief Financial Officer. We issued our press release after the market closed yesterday and we also posted a slide presentation to the Investor Relations portion of our website. We will be referencing this presentation during the call.

Before we begin, I would like to remind you that some of the comments made on today's call are forward-looking statements. These statements are subject to the risks and uncertainties as described in the company's filings with the SEC and our actual results may differ from those described during the call.

In addition, all forward-looking statements are made as of today, August 6. The company is not obligated to update any forward-looking statements based on new circumstances or revised expectations. All non-GAAP financial measures discussed during this call are reconciled to the most directly comparable GAAP measures in the table attached to our press release.

I'll now turn the call over to Corning Painter.

Thank you, Wendy. Good morning, everyone, and welcome to our earnings conference call. I'm going to start with two of the slides from our Investor Day. First, on Slide 3, our strategic roadmap remains unchanged. It will continue to be our guide as we shift our capital spending from EPA compliance to financially value-added activities.

Our new conductives facility is a prime example of this strategy in action. The conductives facility will expand our production capacity by approximately 12 kilotons per year, quadrupling our capacity for acetylene-based material. Within investment in the range of $120 million to $140 million, we expect sustainable EBITDA levels of $40 million to $45 million.

Our conductive additive products are in high demand, not only for their purity, but also their performance. We view this specialty material expansion as timely, strategic and a growth accelerator. With approximately $15 million to $20 million of EBITDA generated from our conductives business in 2021, we aim to grow our earnings capacity to the $170 million range, when this project is completed. Today's high oil prices only strengthen consumer interest in EVs, further increasing demand for conductive carbons, whatever the business cycle is in 2024.

The conductives project is an addition to our greenfield project in Huaibei, China. Here, we have had zero recordable injuries and over a million construction hours in the field. We are also ahead of schedule, despite the challenges with COVID. Well done to the team. This plant will produce 65 to 70 kilotons per year of specialty and high-performance carbon black starting in 2023.

By the end of this year, we expect to have completed the debottlenecking work listed on Slide 15 and our penultimate ultimate air emissions upgrade in the United States and we should be in commissioning at Huaibei. This greatly reduces the span of our large capital project work, allowing us to focus next year on the final U.S. air emissions controls implementation, our settling facility in Texas and consider various plant upgrades.

With our value creation mindset and steady progress with our projects, we have the building blocks in place to reach our mid-cycle adjusted EBITDA capacity goal of $500 million by 2025. Despite the macroeconomic outlook, we are on track to increase discretionary cash flow significantly within the next 12 months to 24 months. As our cash flow improves, we will balance between investing in our strategic projects and returning cash to shareholders.

Frankly, I see us as well positioned today, despite a potential slowdown tomorrow. Mega trends like electrification are here and coupled with a long-term disconnect between tire and carbon black investment. Trends are working in our favor. For example, in North America alone thus far this year, we have turned down over 15 kilotons of spot volume requests. And I think the real need is somewhat larger than that.

Let's take a deeper look at the supply-demand balance and the implications for a recession, with another slide from Investor Day. Slide 4 in today's deck. The key point is, I don't see the Global Rubber Carbon Black supply dynamics on this slide changing dramatically, especially as most of the volume goes into tires and tires wear out. We do see a weakness in China and for lowers and specialty applications like masterbatch, but that is in our guidance and part of the reason why our specialty gross profit per ton is so high. We believe, we are entering this period of uncertainty from a position of strength.

First, there are few regions where supply and demand are imbalanced today and the projections for the next few years does not change that trajectory. Since our Investor Day, one competitor has announced a 40 kiloton expansion in Europe and there is a rumor that a plant that was going to close in the U.S. is seeking allowances to keep operating. Neither of these events changes the big picture. As a result of years of sub-par returns and under investment, the supply and demand imbalance is quite favorable now.

Second, unfortunately, there are few signs of peace in Ukraine, and it is unclear what the business relationships will be after the fighting stops. The curve on this slide for Europe excludes Russian production. And in fact, we are aware today, a good portion of that production is still being imported to Europe. However, we can ask for how long will this last and customers seem to see this as a high risk and an undesirable supply chain.

Third, a recession may not further depress production at OEM automotive manufacturers beyond the chip shortage. LCM forecast for 2022 North American SAAR to be more than 15% -- excuse me, more than 15% below 2019 levels, and the Western European car sales forecast remains more than 32% below 2019 levels. In addition, I would remind you that 60% of our tire business is replacement tire, and this market likely remains strong for both truck and passenger cars. This is further strengthened by the used car market, which is very strong.

More used cars on the road means more replacement tires are needed. So we believe we are in a good position going into this period of economic uncertainty. Yes, we are affected by inflationary costs, supply chain issues, oil price fluctuations and the threat of natural gas disruptions. However, we are well positioned and are taking action, not only to protect that position, but to grow our business and achieve our long-term goals.

Having touched on the recession, let's address an elephant in the room, natural gas supply in Europe. First, some context. We use natural gas in Europe and the Americas as the fuel for the combustion zone of many of our reactors. In other locations, such as Asia and Africa, we use other fuels. We use the heat from every one of those reactors in Europe to generate electricity and/or supply heating to the local community. Because of this, we have been put into the priority group for preferential treatment by our German gas supplier. However, keep in mind, this situation is very dynamic. And the final say is, with the Central German Government.

I want to be clear, despite that potential prioritization, we are working to reduce our gas usage. We expect to meet the European Commission's recent request for a voluntary 15% reduction across the EU. Among other things, we are working to convert European reactors to alternative fuels. Some of these reactors are easier to convert than others and some specialty customers may need to go through a qualification process.

But I think we all see this as the right thing to do. I don't want to convey that we have limited or no exposure to natural gas curtailment. Of course, we do. However, we are preparing for it and are making progress. If we had to curtail natural gas by 20%, we believe the EBITDA impact would be $0 million to $1 million per month. If it's 40%, that impact could be $3 million to $5 million per month. However, we are working to minimize that.

Another element of strength going forward is that the 2023 Rubber contracting season is well underway, and most customers want to secure more volume and wrap up the negotiations well ahead of normal practice. In fact, we've already verbally concluded several multi-year negotiations. We expect that pricing negotiations will be more favorable than in the past.

For our part, we are not looking for a one-year pop or extracting brands. We are looking for partners who are prepared to make a mutual commitment and a fair price that supports investment in the resilience that this industry needs. As I mentioned earlier, the fundamentals are robust and I believe they will be for years to come.

So onto our quarter results on Slide 5. Thanks to the operating team for delivering another tremendous quarter, and a record first half results, despite multiple challenges, while at the same time executing several key initiatives. Second quarter adjusted EBITDA was $83.4 million, up 5.8% year-over-year, our second consecutive record for the company as well as for our specialty business.

Another key driver of profitable growth will be the completion of our surface treated gas black capacity expansion in 2023, which we announced during the second quarter. This is an important initiative for us, as we are the only producer of this material and we have been essentially sold out off and on for years. Customers will be happy to have more capacity available and can now design us into new formulations with confidence. This expansion is core to our strategy to further strengthen our leadership in the premium specialty market.

That concludes my opening remarks. For the remainder of today's call, Jeff and I will cover the second quarter results in greater detail and our outlook for 2022. After our prepared remarks, we will be happy to take your questions. Jeff?

Thank you, Corning, and good morning, everyone. If you could move to Slide 6, you'll see that our revenue stepped up both year-over-year and sequentially. This was driven by passing through higher feed cost stocks, realization of price increases, both on the 2022 pricing cycle and those we have passed on to our customers to cover rising energy costs. In addition, as Corning noted, we have improved mix, particularly in the specialty business. Higher gross profit per ton, which we believe is a key measure of our business is up over 8% compared with last year and up slightly compared with Q1.

Adjusted EBITDA increased year-over-year and from the first quarter, resulting in record first half results. As I discussed at the Investor Day, while we do see an increase in EBITDA dollars with increasing oil prices, it is dilutive to EBITDA margin. We are showing an adjusted EPS today, since you may recall in Q2 of 2021, we received a cash payment of $79.5 million from Evonik related to our EPA investments and that skews the year-over-year non-adjusted EPS comparison.

Moving on to Slide 7. Looking at our second quarter results, this was a great quarter for us, with revenue and gross profit, both increasing. Adjusted EBITDA an 83.4% was up 5.8%, compared to last year. Additionally, on a TTM basis, gross profit per ton continues its steadily increase over the past year, driven by mix in the specialty business.

As we discussed during the Investor Day and for the reasons Corning mentioned earlier, we have entered a period where demand likely outstrips global supply, so we believe we're in a position of strength, even as the global economy stalls. We have been working to find solutions this year to support our customers, given the tight global capacity relative to demand, and we are balancing this with achieving a fair price for our products to ensure we receive a strong return on the investments we have made in our facilities.

Moving to Slide 8, as you can see in these two waterfall charts are based 2022 base price improvements and better mix, especially in the specialty business with strong contributors to higher contribution margin, as were higher cogeneration profits and inventory revaluations. These were partly offset by FX headwinds and lower specialty volumes. Looking at EBITDA, our improved contribution margin was offset by higher fixed costs, SG&A and employment costs.

Moving to Slide 9, while specialty volumes decreased year-over-year and from the first quarter, revenue increased to $181.9 million, up 16.4% year-over-year and 2.4% sequentially, reflecting the pass-through of higher oil prices, as well as improved mix. From a gross profit per tons perspective, you can see that specialty was extremely strong in Q2, driven by a very favorable mix, including the positive impact of new products and improved pricing. That level of gross profit per ton, however, should not be assumed going forward. We would expect to move back toward our Q1 margin levels.

Slide 10 breaks out the major year-over-year drivers of adjusted EBITDA for the specialty business in greater detail. The most significant of which were improved pricing mix, cogeneration profit and inventory valuation, partly offset by lower volumes and the effects of FX translation.

Moving to Slide 11, and the Rubber business. Rubber revenue increased to $359.3 million, up 46.8% year-over-year and 17.1% sequentially, driven by feedstock-related price increases and higher based pricing from the 2022 cycle. Volume was also strong, specifically in Europe and the Americas.

Gross profit per ton was $308.8, while strong this was down slightly year-over-year and 3.9% sequentially. We continue to see a nice upward trend in our TTM gross profit per ton. This reflects the success of the 2022 pricing cycle balanced by higher operating costs, including higher variable comp, employment cost and air emission control costs -- related cost. Cogeneration sales were also strong in the quarter.

Slide 12 breaks out the major year-over-year drivers of adjusted EBITDA for the Rubber business in greater detail. Similar to what I noted on the last slide, higher volume, base price and mix were favorable. These were offset by the strong U.S. dollar, as well as higher employment costs, maintenance costs and relative to last year, lower inventory bills. You may recall that we built inventory in Q2 last year as we plan for shutdowns in the second half of the year.

Slide 13, a quick look at our year-to-date consolidated results. Revenue was up 34.8% to $1.026 billion on flat volume and adjusted EBITDA is up $167 million from $150 million last year. Our guidance which Corning will discuss shortly projects a stronger second half, compared with last year's $180 million of EBITDA.

As we have noted a few times, we believe that we are entering this period of uncertainty from a position of strength. Despite some near-term challenges, we are well positioned and have plans in place to not only protect our position, but grow our business to achieve our long-term goals which we laid out at our Investor Day.

With that, I will turn the call back over to Corning to discuss our 2022 guidance and capital expenditures for the rest of the year.

Thanks, Jeff. Our pricing has kept up with significant inflation. Our major projects are progressing well and we've upgraded the quality of our specialty business. Beyond the conflict in Europe, we have experienced increased demand in our Rubber business and realized the benefits from our contracted pricing cycle for 2022. The 2023 pricing cycle is well underway and we are verbally close with a few customers on multi-year agreements. While some specialty markets have softened, results continue to be strong.

With that taken into consideration, we are maintaining our full year adjusted EBITDA guidance range of $310 million to $340 million, reflecting the momentum we achieved in the first half of the year, as well as the impact of current market conditions. We are also maintaining adjusted EBITDA guidance for 2022, within a range of $2 to $2.35 per share. Our guidance anticipates sustained demand, particularly for Rubber Carbon Black, despite an uncertain global economy and inflation pressures. We balance these challenges with our operating performance and confidence in the demand drivers we mentioned earlier in the call.

Turning to Slide 15. We shared this slide with you in the first quarter, but believe it is worth repeating, it lays out the shift in our capital expenditures to growth projects, and what the near-term benefit is expected to be. Note that we have approximately $50 million of U.S. air emission control spending remain.

In closing, I'd like to leave you with a few thoughts. First, for the reasons we outlined earlier on the call, we are entering a period where the supply and demand balance works in our favor, despite what might happen in the global economy. Second, the 2023 Rubber contract negotiations are ahead of the normal pace and we expect a very positive results this year.

Third, we have the majority of the projected EPA air emission control spending behind us and are entering a period of spending for growth and higher returns to shareholders. With our demonstrated earnings power, we expect to have significant discretionary cash flow in 2023.

Fourth, while European natural gas supply is a real concern, we are advancing contingency plans with an aim to at least reach the 15% gas reduction mark. With all that taken into consideration, we remain on track to achieving our mid-cycle adjusted EBITDA capacity goal of $500 million by 2025.

Thank you. Operator, please open up the lines for questions.

Thank you very much, sir. At this time, we will be conducting a question-and-answer session. [Operator Instructions] We have a first question from the line of Josh Spector with UBS. Please go ahead.

Yeah. Hi. Thanks for taking my question. And just kind of a couple ones around margin. So within Specialty, I mean, really impressive margin performance. You mentioned, do you expect that to go down sequentially? I guess, I'd be curious how much of that is, was a temporary benefit in mix versus some of the weaker markets, maybe you're not selling into there. And I mean, you're spending a lot of capacity into specialty markets, if you could capture that mix with your current asset, I guess, why wouldn't you expand less and capture that more? Is there a reason why you can't do that?

So, first of all, if we look at where we're expanding, which would be our premium areas and things like conductivity, I’d like to be clear, we can sell all the conductive additives we can make right now, that's going very well, let's say in the lithium-ion space, the premium area in that area. So I think there is no question, that remains a real positive for us. Where we see the weakness is in the lower ends of specialty areas like masterbatch.

Our customers tell us, there's a lot of -- price competition in masterbatch right now, and just that the market is weaker. So I think as we look forward, I wouldn't want to say, margins as high as the GP per ton this last quarter is what you guys should model. But I do think that we'll see, let's say, the lower end remaining more challenged as we move forward. Does that help?

Yeah. That helps. And I guess, just to follow-up on that same line of thought then. So if that's more challenged and if masterbatch has a lower margin profile, I guess, would you proactively deselect from some of those markets? And maybe slow some of your longer-term expansions to improve the mix, or is that not feasible?

Well, so like, if you think about what we're doing in La Porte for the acetylene, the reactors that make this lower grade specialty, we might go and switch this to rubber, but we could never make like that grade of a conductive material in it. There is real differences in the different reactors. So we can think about when we absolutely do, how do we want to allocate our reactor time, reactor by reactor and there's things we can do. But just to be clear, the ones that are, where we see the slowdown are pretty different from the high premium markets in terms of the nature of the material.

Okay. Thank you. I'll turn it over there. Thanks.

Thank you. [Operator Instructions] We have a next question from the line of Jon Tanwanteng with CJS Securities. Please go ahead.

Hi. Good morning. Thanks for taking my questions. And it's exciting to hear that you're signing these multi-year contracts. I think that's a combination of a lot of work you guys have been doing, so good work there. My first question is, you confirmed the range in guidance, but I was wondering if you're expecting to be higher or lower in the range compared to three months or six months ago, especially given all the moving parts with, currency inflation, your voluntary gases reduction. Just help us understand which side of that equation you're angling towards now?

I'd say, we're tracking really towards the dead center of that as we look at it. There's things that could push us up. Those would include like, a really strong December and that could well happen in the Rubber area, in particular, maintaining the mix and your high margin in specialty and just continued good execution on stream of the plants. At the lower end would be maybe an earlier adaptation of, for example, a 20% cut, maybe a weak Q4, the economy continues to slow down, that sort of thing. But yeah, I think we'd see that guidance range is solid.

Okay. Great. And then just to drill a little bit deeper into the curtailment. What are the other fuels that you're converting to? Is there a cost associated with that? And is it something that we need to think about as a ramp-up in delayed process with the qualifications that you talked about might be occurring?

Yeah. I think that, that will be manageable. I think things are tight, people will work with us on the qualifications, and there probably isn't going to be a huge change in the nature of the product that we're making, we will have to see. Most of the fuels will cost a little bit less the natural gas, you shouldn't be thinking that's going to capture a huge margin to us. We basically pass through everything to our customers. So we have economies there. We fair share (ph) right, we would pass that through as well.

So I think it's more just a view of, we've got stability, we've got plans, we can deal with this. We don't use natural gas in many parts of the world. We're on our way. Not that it's zero risk, but I think between the prioritization and the work we've got going, it's at a good place. And for that reason, we want to just give you those bounding’s of, hey, what could be the impact at 20% or 40%? Just so that, like the risk factor, you guys have a sense of what the boundary conditions are there. Does that help Jon?

It did. I get that the run rate impact. I'm just trying to get a sense of more of the one-time conversion cost and I guess, related to ramping up to speed?

Yeah. I don't think that they're necessarily going to cost more. I mean, natural gas is pretty dear right now. So I think -- the liquid fuel prices per amount of contained energy are typically in Europe less than natural gas. So conceivably, right, there is cost savings in this by doing it. So I mean, it makes sense in any case. I do not believe running your company on hope that, we're not going to get your tail or whatever, right?

We run ourselves thinking, hey, a recession is coming, natural gas curtailments running, let's be ready, let's be ready. In this particular case, those same things could well help us to be more economical in this coming winter in Europe. So I don't see the conversion, yet one-time costs. But for right now, the alternative fuels by and large, would be more cost effective.

Hey, Jon. Just to clarify that the investment level is small for these changes. I think the important thing is that, we've gotten ahead of it. We're being proactive here. And that the reason we believe the impact to profitability of a 20% reduction in natural gas usage in the EU, is not by happenstance, it's because we've been proactive and we're looking at how do we make these changes now, that once they're forced upon us so perhaps. But again, the investments to do so are fairly minimal.

Got it. Thank you, guys.

Thank you. [Operator Instructions] We have next question from the line of Josh Spector with UBS. Please go ahead.

Hi, there. Thanks for let me back in. So just a follow-up on Rubber Black. Kind of similar line of thought on the margin progression. I guess, you had a higher volume sequentially. You guys are getting pricing, but EBITDA and EBITDA per ton were lower sequentially. I think, we thought that could be maybe in the mid-200s came in closer to 200. Was there anything one time you call out in the quarter? You talked about some maintenance? And I guess along with that, how are you thinking about the earnings cadence for Rubber Black through the rest of the year?

Yeah. I think there were -- I think one of the headwinds we have, of course, that was on the FX side. I think that's a big one. I think as we look forward at Rubber Black going -- for the rest of the year, I think the GP per ton perhaps is in range, maybe a -- probably in the range of 310 to 330. Looking forward, we are at 315 in the first half of the year, so in the same ballpark.

Thank you. We have next question from the line of Jon Tanwanteng with CJS Securities. Please go ahead.

Hi. Thanks for taking the follow-up. I was wondering if there was an update on your CapEx expectations for the out years, just given that steel prices are falling and if there's been any change in the expected cost there? And what does that do to your free cash flow expectations that are going forward as well?

Well, I'm forward to the fact that steel prices and other things may come down. And that could be a benefit for us and report, but we have not updated that at this point.

Okay. Great. Just remind me if you expect to be free cash flow positive next year, with the investments that you're doing?

And in that case, are you exploring the idea of other capital allocation, like buybacks or M&A and other things that are beyond organic growth?

Jon, thank you for that. Because it would have been like an unusual call if we didn't talk about buybacks. So like we as a Board, see the stock as extremely attractively priced, undervalued. And in that sense, a buyback would make a lot of sense. I think as a Board, we also just feel strong, fiduciary duty, thinking about a recession and thinking about the EPA capital spending is trending down, not quite over. And just really, in a sense of caution, have obviously not done anything in that sense this far.

But that's something that we will continue to evaluate and I think is a possibility for us next year. And ultimately, that'll be a full board decision on which way we go. But when we say that, we'd use that free cash flow for strategic projects, and for increasing shareholder value and returning cash to shareholders, clearly, the buyback could be one of the opportunities for us to do that.

Thank you. I now turn over to Wendy Wilson for the questions received via email.

Thank you, operator. We've got a question here that came in that we haven't addressed yet on the call. And that question is around year-over-year second quarter EBITDA on a constant currency basis.

Sure. Thanks, Wendy. If we had not had the impact of a stronger U.S. dollar, the impact of Q2 this year compared to Q2 last year was about $9 million, $9.5 million negative to us. So that obviously hurt the second quarter compared on a comparable basis. Another data point that I'd probably put out there is, had the FX rates stayed constant in the second quarter, compared to what our expectation was in the first quarter. It was probably a $3 million to $4 million impact on the sequential basis also.

Thanks, operator. If we don't have any more questions, I'll turn this back over to Corning.

Okay. Hey, thank you all for joining us today. We had relatively few questioners, but they were high-quality questions. And I think got the issues out for people. So Josh and Jon, thank you for that. Just a reminder to everyone that we're going to be presenting in a few upcoming conferences and traveling around the U.S. this fall. And after like basically two years of pretty much doing this virtually by Zoom, I'm really looking forward to getting out on the road and seeing some people in the flesh going forward. So we hope, we have the opportunity to see everybody on this call in the near future. Thanks very much for your interest and your investment, and have a good rest of your day. Thank you.

Thank you very much, sir. Ladies and gentlemen, this concludes today's conference. You may disconnect your lines at this time. Thank you for your participation.