Cabot Corporation (CBT) Earnings Call Transcript & Summary

David Begleiter of Deutsche Bank's U.S. Chemicals equity research team. Thank you for joining us for Deutsche Bank's Virtual Global Industrials Materials Summit. I'm very pleased to have with us today, Erica McLaughlin, Senior Vice President and CFO of Cabot Corporation. The format of today's session is a fireside chat. If you'd like to submit a question, you can do that through the web portal via a chat box on the left-hand side of the screen. So with that, we'll jump right into it. Erica, good afternoon. How are you?

Good afternoon, David. Thank you for having us today.

No, my pleasure.

Maybe first on near-term trends, Erica. How were Reinforcement volumes in May versus April? And what are you seeing in June?

Sure. So maybe I'll start with the 2 main segments. So first, with Reinforcement Materials. I'd say May volumes remained somewhat challenging, although we did see an increase from April. So volumes in May were about 19% above April volumes. But year-over-year, still about 50% below the May of last year. But we do think that April is the low point for the year. So we do see customers returning to production. And as I said, higher sequential volumes as we moved April to May. And so far, June looks like it will be another sequential increase from those May volumes. So it's improvement -- it's encouraging, I think, to see this month-over-month improvement. For our Performance Chemicals segment, we had noted on our earnings call that the volumes had been holding up pretty well in March and into early April and we would expect some weakening as we move through the quarter. And so far, if I look at April and May together, for Performance Additives were 6% below the prior year and Formulated Solutions were 9% below the prior year of the same months. So in this segment, we're seeing much smaller decline year-over-year than Reinforcement Materials. And given the diversity of the applications that we sell into with some things like as packaging, agriculture being more resilient, I'd say the volumes there are holding up relatively well.

Well, very good. That's very clear. And just going back to Reinforcement Materials, you did give a forecast for Q3 volumes to be down roughly 40%. It sounds like we're tracking that still. Is that fair that we're still tracking that down 40% type number in Q3?

Yes. I mean, the first 2 months, again, were down in the 50-ish percent April, more so than May. But June does look stronger than those 2 months so far. Where exactly will end will depend on how June turns out. But I think given where we stand at this point, I would think, probably more like a mid-40s decline probably for the quarter is what we see, again, with sequential improvement, April to May and May to June.

Sounds good. Maybe you can touch on your liquidity and balance sheet situation. You've done some work to enhance that during this downturn. So where do we stand on those metrics?

Yes. Sure. So in terms of operating cash flow, I think we had talked about on our earnings call that we thought the back half would have operating cash flow around $200 million. I'd say we're on track to deliver that. Still feel good about that number. We have really a countercyclical type of cash flow with a release of working capital as we saw the lower oil prices come through and the lower demand. And so the release of working capital helps in terms of the cash flow number. We've also taken actions in terms of reducing inventory levels and being aggressive on collections for accounts receivable. So I do feel good about that and the strength of the cash flow. This gives us the ability to fund the dividend. And so we're quite confident in our ability to do that. We understand the importance of the dividend for our investor base as they look at a cash return, and that's certainly a priority for us as we go forward and feel that we'll have ample cash flow to fund that as well as our CapEx. And so we have reduced the capital expenditure profile for the year to about $200 million, about $80 million in the back half still to spend. And so feel confident that the operating cash flow will support these. In terms of liquidity, quite good as of the end of March, over $1 billion of available liquidity. We did announce just yesterday that we did amend our committed revolver -- revolving credit facilities to increase debt to EBITDA that had been at 3.5x. We've increased it to 4.5x, really doing this at an abundance of caution. We feel good about the cash flow and the liquidity position. But as there's a lot of uncertainty in these times, we were able to amend this and give ourselves more headroom, really quite beyond what are -- any of our COVID-19-related stress test scenarios I would say. But we were able to do this for 4 quarters, so September of this year through June of next year. And there were no material changes under the agreement. So no changes in pricing on the debt, no restrictions on things like share repurchases. So I felt this was a prudent step, a good action for us to take at this point in time.

Very good. And just touching on the cash flow. You actually said you have a bit of account cyclical cash flow. You do generate a lot of cash in the back half of the year. So $200 million, while it might sound like a lot, it actually doesn't seem that big of a hurdle. Just how much working capital contribute to that $200 million of operating working capital in the back half of the year?

Yes. So it will be a significant amount. I mean, we have -- we've given a rule of thumb around working capital, where $1 per barrel of oil decline is roughly $5 million of cash release. So that comes through both the reduction then in inventory values, which happens usually pretty immediately and then through receivables. And so as we pass the price of the lower raw materials into our customers, you see that. And so over a 2-quarter period, you see that release. So we think it will be quite substantial. As I said, we're also working to reduce inventory levels. So certainly, as there's lower demand levels, we have the ability to take quantity of inventories down and also work quite hard on collections. And so I feel that, that will be a substantial release and will contribute to the operating cash flow in the back half.

Very good. Maybe just on the Shenzhen acquisition, if I pronounced that correctly. It's been about 2 months since you acquired this business. It's early, but how it's progressing? And what it really add to the whole energy materials entity you're trying to grade here?

Yes. So I think we're quite excited about this acquisition, Shenzhen, you did say it correctly, so that's quite good, is the second largest CNT producer in China. And so this is a CNT production for the battery market. And as you know, we have an energy materials business already where we produce carbon additives and fumed alumina for lead acid and lithium-ion batteries. And so this adds to that business, roughly doubles the size of the business. So with the acquisition, that business now roughly $50 million of revenue. And so we think it's a great opportunity for growth for us. So the EV market is projected to grow about 25% per year in China. And so then we have an existing business that participates in that and then this adds to it. We also believe that the conductive carbon additives that we have sold through our business and the CNTs together are going to be the future of the technology that's adopted in lithium-ion batteries as the blends of these additives into dispersions will create a differentiation in terms of performance of the batteries. And so with the acquisition, we're the only producer now that has both the carbon additives as well as the CNTs and we know the market quite well from having participated in it. So we feel the synergy of being an integrated player will really help us here. So we think a good business to be in provides us a good growth platform over the coming years. And we'd expect to capture market share that's similar to that of our specialty carbons business with attractive EBITDA margins similar to that business as well. And so we're quite excited about being able to complete this acquisition.

Very good. No, it's a lot of potential in that area of the world. Maybe just bringing back to the nearer term. Inventory levels in the supply chain, maybe if you can just walk through where are they right now and maybe first in Reinforcement Materials?

Sure. So I think it's a bit different if you think about different parts of the world and then different types of products. So customer and region is dependent on this, I'd say. But in terms of the tire customers, usually the OE inventory levels are quite tight. And I think in Europe and North America, that appears to be the case right now. And so what you see there is then a pretty quick pull-through of -- as the automakers start to produce again, there's not too much tire inventory in the chain right now, I think, in those regions. Asia might have a little bit more, but we'll see how that works. I think in terms of the auto market, Asia has really returned to almost up to pre-COVID levels, I think, probably more like 90% utilization is what industry analysts are projecting there. And then the replacement passenger car tire does depend on distributor inventory levels and those do vary in different parts of the world. I don't think we see any place where there's a lot of excess in the chain. But here, it's dependent on the pull-through as distributors sell-out and then the tire companies sell-in. And so our tire companies do not hold much carbon black inventory. And so as they start to produce, we should see the demand for our products turn around quite quickly. And I think we're seeing that start to prove out already with, as I said, the sequential improvement in volumes from April to May and May to June.

Very good, very good. Maybe switching to the cost side, you have a couple of different efforts underway here. Can you just update us on where they stand, whether it's the most recent efforts in response to the pandemic? Or the $45 million of cost reductions and some global business service function cost savings? Can you just update us on those various activities on the cost side?

Yes. Sure. So we did start on some cost actions, I'd say that are more structural in nature before the COVID situation hit. Some of these include the reorganization of our leadership structure, which happened in the first quarter of our fiscal year. And then also, we did move some of the service functions that were in the U.S., in our North America shared serve center to our European shared service center, which is in Riga, Latvia. And so that comes with a cost reduction, and that service center will now provide services for both our European businesses as well as our North America businesses. And so those are underway implemented largely in the first half, and we see the benefits coming through in the second half. Once the COVID-19 situation came to be, we did implement further cost reductions. I'd say a lot of these include discretionary type reductions, such as travel and entertainment and of course, lower spend on corporate projects or third-party consulting and those type of things. And so the total of all this is expected to yield $45 million of savings for the year. I'd say we're on track to deliver that. And that's quite helpful. It helps to partially offset some of the negative impacts we see from COVID-19 on the top line and then some of the costs that have come through on the growth investments that we've implemented, such as our new China plant for fumed silica.

Very, very helpful. Maybe next just on the impact of lower oil prices on Cabot. Is a structurally low oil price, a negative or a positive for Cabot?

So I mean, I think in terms of working capital, I talked earlier, it is a positive. So the cash release as I said, every dollar per barrel in feedstock equates to about $5 million of the benefit on the cash side. So that is quite a clear benefit for us as the lower oil flows through usually over a 2-quarter period. In terms of the businesses, I'd say, for Reinforcement Materials, there's a few effects that the lower feedstock prices have. The first is when feedstock prices are lower, there is, we have what we call energy centers. And so this is where we use the tail gas from our production process to make electricity either for our own sites or to sell to the grid or to produce steam for neighboring companies. And usually, the sale of those are related to an energy price. And so as there's lower energy prices, the revenue generated from that is lower. So we do see that impact. I'd say the second is also the benefit from some of our yield projects. We always work to improve the yield of the feedstock to the carbon black and some of those projects become a bit less valuable, there's an impact on that. The third effect, which we did talk about on the earnings call, which is really a temporary impact that can happen, is when we see a combination of a large decline in oil prices, which we saw in the March -- back end of March, and then coupled with a decline in our demand. And so as you think about this, you end up with a mismatch in terms of the inventory flow through and the revenue. So in this time frame, we had made purchases in February of our raw materials, expect to sell them out in the April time frame. But what happened is those sales will now happen in May or June. And so the pricing changes and the pricing changes as oil has dropped. And so we end up with this temporary mismatch. So that is something that will impact us in this quarter but wouldn't continue on forward. The impact from the energy center revenue as well as yields will impact us going forward, but as energy prices increase, then those become a benefit as well. It's a little bit different, I'd say, for a Performance Chemicals segment. So in that segment where our specialty carbons business is, the impact of lower oil really depends on the -- for how much price we can hold as the lower raw material costs flow through our inventory. I'd say, historically, we've had success in holding price and much of the spot business that we have. Many of those applications are differentiated type applications, and we would be successful there. The magnitude of this does vary based on the specific situation in terms of how much oil has moved, competitive behavior, inventory levels, things like that. But that's often the impact in that business where we have less of a formulaic pass-through.

Very good. Maybe switching back to the segments, maybe first in Reinforcement Materials. In terms of your tire auto customers as they restart operations, what's level of -- what's the level of activity today in June versus where it was in May, perhaps?

Yes. So it is -- it does vary, I'd say, across the world, depending where you are. I think if we look at some industry reports that talk about auto manufacturing, if you look at somewhere like China, largely back to pre-COVID levels. So probably around 90% or so of pre-COVID level in June. If you look at places like Europe and North America, it's a bit behind China, I think just starting into the recovery. And I think Europe is expected in June to be maybe about 60% of pre-COVID levels, and North America more like 70% pre-COVID levels. On the tire side, I'd say the data from industry sources have a similar type return in Europe, 60% to 70% in Europe for tire manufacturing. I'd say North America, there's a wider range. It's a bit of a dependent on what type of capacity the tire company has or the customer is doing. And so in some cases, it might be 70%, in other cases it might be up to 90%. As we do see the demand for the commercial truck and bus tires has held up quite well, actually, as miles driven in that type of application have not declined like what we saw in the passenger car type applications. And then if we look at Asia, while the domestic market, I'd say, is quite good and has returned back probably like the auto numbers close to pre-COVID levels, there are a good amount of tires that are exported out of China into regions like Europe and North America. And so that is still experiencing the impact from Europe and North America just getting back into production and more normalized levels. So I think Asia's tire customers are probably in the 65% to 75% type utilization in June. And so I think what we feel good about is the direction here, the direction that from April to May and May to June, we're seeing improvement. And so we feel good about that trajectory and then the outlook for what that could mean for the fourth quarter, assuming that work continues to -- people continue to get back into more normal activities.

Got it. And I know you had lowered your operating rates to a lot of lower demand. Where are your operating rates today in June versus May? And what do you think they could be in July in Reinforcement Materials?

Yes. So we -- I mean we have reduced them to align with the lower demand. And in some cases, maybe a little bit more than that to bring the inventory levels down. So as we looked at April and May in Reinforcement Materials, we were somewhere around 50% of a lower sales volume. We would have utilizations to match that or a bit lower in some cases. And so we will ramp that up and are ramping those back up in June and into July as the demand comes back. As I said, and certainly, in Reinforcement Materials, the -- we're direct to the tire customers in terms of the sales. And so as the tire -- our customers and the tire businesses are getting back to running their plants and producing tires, it's a quick flow through for us. And so we would expect our utilizations to increase as our -- demand for our products increases.

Very good. Maybe switching to Performance Chemicals. It seems silica margins have been challenged due to some competitive pricing pressure in China and Europe. What's behind this pricing pressure? And how long do you think it will last?

Yes. So we have -- I think we've been talking about this for a couple of quarters. So this is not all COVID-19 related. But the demand environment has been softer, I'd say, particularly in Europe and China. And it was really driven by key end markets like automotive and construction, more residential type construction weakened. And so in calendar '19, we do estimate that the market for fumed silica contracted versus '18. And so that weaker demand resulted in more competitive intensity overall and was quite acute, I'd say, in Europe and China, given the overall negative demand profile in those regions. At the same time, there was supply that came on stream, mainly in China. And so I think it's near-term pricing pressure. And so we've talked about that for a couple of quarters. And so while these factors present near-term challenge, I think we still believe the fundamentals of the business is attractive. And so FMO has historically been one of our businesses with very strong profitability and EBITDA margins. And we have seen demand really growing steadily above GDP. And so this is related to silicones and the growth there. And so -- and we do -- this business in terms of how it works for us is feedstock access and strategic integration is an important factor there, and we'll determine growth because you need access to the feedstock to make the fumed silica. And so we're well positioned with our strategic silicon fence line partners like Dow Silicones, ChemChina and HYC. And so we have seen that the industry historically has been well balanced between the feedstock supply and the silica demand and then it also limits new entrant risk. So I think we still feel quite positive about the business. We have to work through this near-term pricing competitiveness, but feel we will return back to the profitability and EBITDA margins we've seen here over time.

Very good. Maybe switching to raw materials and margins. How should we think about the spread between pricing raws in these businesses in the back half of the year? And how should that drive incremental margins in both Reinforcement Materials and Performance Chemicals in the back half of the year really more on that not Q3, but really Q4 and calendar -- thinking more about calendar year?

Yes. So I think in Q3, we did talk about the margin pressure in Reinforcement Materials. And so it was, as I talked about earlier, in terms of the factors of the lower oil price impacting us and the mismatch really of -- as oil declined and the demand event fell right after that. And so we had quantified that as about $15 million to $20 million in Q3. About half of that is related to the mismatch, which I would not expect to repeat. So going into the fourth quarter, about half of that impact will go away. If oil prices continue to rise, then the impact also from energy centers and yield would improve for us, but that will be dependent really on the underlying energy prices, I think. In terms of the Performance Chemicals segment, we have not seen that type of -- any type of impact like that, that we called out for Reinforcement. And here, the way the pricing works, as I talked about, is more of a spot business. There's a higher majority of the sales on spot. And so it depends on really how much pricing we can hold. And historically, we've been successful in that. And -- but it is dependent on competitive behavior and the market overall. And so we'll have to see what the impact of that would be. But in Performance Chemicals, I think, on the margin side, it's -- the impact is really more on the fumed silica business and the pricing pressure there. Otherwise, I think the margins are holding up nicely in the other businesses in specialty carbons and compounds at this point in time.

Very good. A couple of cash flow questions, Erica. At least CapEx, you have cut the kind of back this year. But longer term, how should we think about CapEx resuming in '21, '22? Do we get back to some growth activity? Or is it still more of a lower level towards maintenance-type levels?

Yes. So this year, we have reduced it to about $200 million. There is about $100 million to $125 million of that, that is really, what we call, sustaining and compliance capital. So sustaining more maintenance-type capital and the compliance, which is largely driven by EPA-related compliance capital that we have to spend in the U.S. So there is still some growth in there. The projects that we had started this year include the conversion of our specialty carbons site in China from a rubber black site to especially carbon site. So things like that are still in the number here. As we look ahead, I think the level that we spend will be informed by what we see in terms of a recovery and EBITDA generation. We will have the continuing compliance capital in the U.S. that continues for us in '21 and '22. So that will be something that we will have to fund and then the amount of growth capital we will see. If you remember, David, our capital allocation framework that we talk about is we think about a discretionary free cash flow and trying to return half of that discretionary free cash flow to investors with the dividend and share repurchases and have to fund for growth. So growth is still important for us to think about. It includes things like the acquisition we just did to fund growth and then some of these other capital projects. It's just the pace of these will be quite dependent, I think, on the recovery.

Understood. I was looking at your -- my model again. And these are my numbers. Over the last 20 years, Cabot's EPS has been up in 10 years and down in 10 years. So for me, it comes down to, how do you go about changing this profile becoming more stable earnings generated going forward?

Yes. So I mean, certainly, I think it's something that we have been trying to do here is to minimize the cyclicality here. And there are some actions we've taken over the years that have been trying to do that. Some of that relates to the divestitures we've done. So David, you'll be around long enough to remember our supermetals business, this is linked to the electronic supply chain and that, could fluctuate quite a bit year-to-year and is in your 20-year number here. And some of those years, quite profitable and others more challenged. Last year, we divested our Specialty Fluids business. This is the oil drilling fluids business and was quite project driven. So that even had quarterly type of variability in the earnings, and we divested that as well. So we are trying to have the portfolio overall be a bit more stable. I'd say second, we've implemented changes certainly in our rubber black pricing mechanisms to make our profitability per ton more stable. So this goes back a number of years where we changed our formula pricing, which used to be a quarterly change. So we changed based on the feedstock input only once a quarter, and we changed that to monthly, and that was really to match the flow-through of the raw material costs and make sure we didn't have those fluctuations quarter-to-quarter and year-to-year in earnings based on the movement of oil. I'd say more recently, we've also implemented cost adjustments to recover the MARPOL-related mismatches. So as we've talked before about feedstock differentials, over the last 2 years, we have adjusted our formulas to try to ensure that we don't have these differentials coming negatively on us and the price of the feedstocks we're buying is appropriately passed on to customers in the formula. And so I do think in terms of that, that stabilizes our performance as well. And then certainly, there's a diversity of product offerings that help us, too. I mean, I think we see it here now in our Performance Chemicals segment where there are these diversity of end markets, which do help. And so the non-auto-related applications can have less cyclicality. And so that has helped us as we've tried to penetrate things like different agriculture applications or consumer applications to help. And so we'll certainly continue to keep working, I think, other levers we can to reduce the variability year-to-year.

That's a very full answer. I appreciate that. You did mention also your contracts in Reinforcement Materials. I believe 2020 was the first big year of contract price increases. Given the weak macro, should we expect to see a decline in contract pricing for next year? Or I know it's premature, but how should we think about that given where the macro demand is right now?

Yes. Well, I think it's quite early really to be able to comment on that too much. We usually operate -- we usually negotiate those in the November, December time frame is when we would finalize those. And so I think it will -- how things turn out will be more dependent on when we're negotiating as well as the outlook for 2021. So as our customers look out and see the demand needs and the security of supply they need for next year, we'll inform that as well. But I think right now, we're a little too early to try to predict the outcome.

Understood. I had to give a shot though. You talked about -- on the portfolio of Purification Solutions, is this business still noncore to Cabot?

Yes. I don't think we've changed our stance here in terms of its strategic fit. So I think looking for strategic alternatives for that business is still remains the course. We have spent the last year, 1.5 years implementing a transformation plan to improve the profitability of the segment and more consistency in delivering the profitability. And we reorganized the organization underneath to reduce costs. We focused on certain segments of products and price increases in that to help drive price and mix in the specialty side of the business. I think that has been going well. But it doesn't change, I think, our fundamental belief that strategically wouldn't be long term part of Cabot's portfolio.

Got it. Very clear. And just lastly, we've already discussed a little bit energy materials. You also have another growth platform in Cabot elastomer composites. How should we think about the opportunities for both these businesses going forward? And any key milestones look for? How should we think about investments in these platforms going forward?

Yes. So I think we talked a little bit about the energy materials investment. The acquisition was our latest investment there. We do think this is a continued growth driver really around the penetration of lithium-ion batteries and driven by EV penetration. So I think those are the important things to consider for energy materials. I think that should be a bit of a consistent growth story for us, as year-to-year, we win business and see the growth to take on. In terms of the elastomer composite, you'll probably remember that this is our Cabot elastomer composite business technology that we called CEC, and we had licensed this to Michelin over a decade ago now under a loyalty type agreement. We have continued to develop this technology platform, and we have now recently launched a new brand called E2C, which is engineered elastomer composites product line. In addition to the new brand, we launched some products, mainly focused in the heavy mining equipment space where investments in efficiency and automation create really strong demand for high-performance rubber, products like earthmover tires and other rubber parts. And so, so far, we've been pleased by the initial adoption in this area by multiple lead customers. Our R&D team continues to invest in this technology, and we think it's -- it could really improve and change the future of our Reinforcement Materials segment. The size of this, there's over $40 million of rubber compound produced annually. So even a small penetration into the segment could be pretty transformational for Cabot. And so we're focused on performance applications where we know that the deep knowledge of carbon black with the proprietary mixing technology can produce rubber materials and properties that are substantially better than the alternatives for our customers. And so we're being quite targeted in the applications, but do feel quite good about the opportunity ahead for this technology.

Very good. With that, our time is up. Thank you for that very full and complete update, Erica, and thank you all for dialing as well. Have a great day.

Thank you, David. You too.