Orion S.A. Common Shares

Greetings and welcome to the Orion Engineered Carbon's 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. If anyone should require operator assistance during the conference, please press star zero on your telephone keypad. 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 Carbon's 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 Gleit, 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'd 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 6th. 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 three, 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 materials. With an investment in the range of $120 to $140 million, we expect sustainable EBITDA levels of $40 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 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, in addition to our greenfield project in why they 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 coven 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 de-bottlenecking work listed on slide 15 and our penultimate air emissions upgrade in the United States, and we should be in commissioning at Y-Bay. 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 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. Megatrends 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 four 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 lower end specialty applications like master batch, 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 in balance 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's 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 subpar returns and underinvestment, The supply-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 forecasts for 2022 North American SAAR to be more than 15% below 2019 levels And the Western European car sales forecast remains more than 30% 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. 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 year 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 is 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 to $1 million per month. If it's 40%, that impact could be $3 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 have 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 rents. We are looking for partners who are prepared to make a mutual commitment at 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, on to our quarter results on slide five. 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 this 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'll be happy to take your questions.

Jeff? Thank you, Corning, and good morning, everyone. If you could move to slide six, 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 diluted 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 seven. Looking at our second quarter results, this was a great quarter for us, with revenue and gross profit both increasing. Adjusted EBITDA at 83.4% was up 5.8% compared with last year. Additionally, on a TTM basis, gross profit per ton continues to steady 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 eight. As you can see in these two waterfall charts, our 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 nine, 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 ton 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 effect of FX translation. Moving to slide 11 and the rubber business, Rubber revenue increased to $359.3 million of 46.8% year over year and 17.1% sequentially, driven by feedstock related price increases and higher base pricing from the 2022 cycle. Volume was also strong, specifically in Europe and the Americas. Gross profit per ton was $308.8 million, 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 costs, and air emission control related costs. 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 a 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 planned for shutdowns in the second half of the year. Slide 13, a quick look at our unit aid consolidated results. Revenue is up 34.8% to $1.026 billion on flat volume, and adjusted EBITDA is up to $167 million from $150 million last year. Our guidance, which Corning will discuss shortly, projects a stronger second half compared with last year's $118 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 and 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 have upgraded the quality of our specialty business. Beyond the conflict in Europe, we are experiencing increased demand in our rubber business and realize the benefits from our contracted pricing cycle for 2022. The 2023 pricing cycle is well underway, and we have verbally closed 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 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 result 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 of 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 our question and answer session. If anyone would like to ask a question, please press star 1 on your telephone keypad. A confirmation tone will indicate your line is in the question queue. You may press star 2 if you would like to remove your question from the queue. For participants using speaker equipment, it may be necessary to pick up your handset before pressing the star keys. One moment please while we poll for questions. We request you to restrict to one question and one follow-up. We have a first question from the lineup. Josh Pector 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 you expect that to go down sequentially. I guess I'd be curious how much of that was a temporary benefit in mix versus some of the weaker markets, maybe not selling into there and I mean, you're expanding a lot of capacity into specialty markets. If you could capture that mix with your current assets, 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 connectivity, 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 and the premium area in that area. So I think there's no question that remains a real positive for us. Where we see the weakness is in the lower ends of specialty, areas like Master Batch. Our customers tell us there's a lot of price competition in Master Batch right now, and just that the market's 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 be able to switch those to rubber, but we could never make that grade of a conductive material in it. There's real differences in the different reactors. We can think about, and 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. Again, if you wish to ask a question, please press star 1 on your telephone keypad. We have a next question from the line of John Tanvantang 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 culmination 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 on the range compared to three or six months ago of especially given all the moving parts with currency, inflation, your voluntary gas usage 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 a really strong December, and that could well happen in the rubber area in particular maintaining the mix and you know a high margin and 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 um maybe a week q4 the economy continues to slow down that sort of thing but um yeah i think we 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 and delay process of 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'll have to see. Most of the fuels will cost a little bit less than 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 if we have economies there, fair is fair, 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 boundings of, hey, what could be the impact at 20 or 40 percent, just so that, you know, like the risk factor, you guys have a sense of what the boundary conditions are there. Does that help, John?

It did. I get the run rate impact. I'm just trying to get a sense of more of the one-time conversion cost and, I guess, the way it's 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 liquid fuel prices per amount of contained energy are typically, in Europe, less than natural gas. So conceivably, right, there's a 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, oh, we're not going to get your tail or whatever, right? We run ourselves thinking, hey, a recession is coming, natural gas curtailment is 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 at one-time cost, but for right now, the alternative fuels, by and large, would be more cost-effective.

John, just to clarify on 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 the 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, not 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. A reminder to participants, if you wish to ask a question, please press star 1 on your telephone keypad now. We have next question from the line of Josh Spector with UBS. Just go ahead.

Okay. Thanks for letting 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 called 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 one of the headwinds we had, of course, was on the FX side. I think that's a big one. I think as we look forward... at rubber black for the rest of the year. I think the GP per ton perhaps is in range, probably in a range of 310 to 330 looking forward. We were at 315 in the first half of the year, so in the same ballpark.

Okay, thank you.

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

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

Well, I'm looking forward to the fact that steel prices and other things may come down, and that could be a benefit for us in LaPorte, 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. Oh, yes, we do, definitely. Okay, and in that case, are you exploring the idea of other capital allocation like buybacks or M&A and other things beyond organic growth?

John, thank you for that, because it would have been like an unusual call if we didn't talk about buybacks. So look, 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 a strong fiduciary duty thinking about a recession, 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 it is a possibility for us next year. Ultimately, that will be a full board decision on which way we go. But when we say that we use that free cash flow for strategic projects and for increasing shareholder value and returning cash to shareholders, Clearly, a buyback would be one of the opportunities for us to do that.

Great. Thanks, Gordon.

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, $9.5 million negative to us. So that obviously hurt the second quarter 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 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 that I think got the issues out for people. So Josh and John, 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 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.