Cabot Corporation (CBT) Earnings Call Transcript & Summary

Good afternoon and welcome to the Cabot Presentation at the Credit Suisse 35th Annual Specialties & Basics Conference. I'm Matt Skowronski, part of the chemicals team here at CS. And we are happy today to introduce Erica McLaughlin, CFO of Cabot. Erica's been with Cabot since 2022 and has served as CFO since 2018. She's also served as VP of Business Operations for Reinforcement Materials, which included raw material purchasing as well as supply chain, planning and optimization. Prior to Cabot, Erica held accounting positions at KPMG and currently serves on the Board of Directors of Azenta. Cabot is a global leading manufacturer of rubber and specialty grade carbon black as well as specialty silicas in plastic masterbatches. Erica, I'll let you take it away with the presentation.

Okay. Thank you and good afternoon. Thank you for joining us today. I'll start with the presentation today that I will make some forward-looking statements and also use non-GAAP adjustments and financial measures. More information on these can be found on our website. To start the presentation, I'll give a brief snapshot of the company for those of you that are a bit newer to the Cabot story. We're a company with a very rich heritage, dating back to our founding in 1882 and heritage is one of leadership, innovation and global expansion. Our businesses hold the #1 or #2 positions in their respective markets and our footprint of sales and assets is truly global, with approximately 75% of our sales generated outside the United States. Our end market exposures are diverse, with the largest being the very resilient replacement tire market. In addition, we produced a wide range of valuable products that are critical to many automotive applications, infrastructure in industrial sectors and a broad range of consumer applications. Across this portfolio of products and applications, the quality of returns is strong with EBITDA margins of close to 20% and the return on invested capital substantially above our weighted average cost of capital. And additionally, with our strong balance sheet and cash flow power, we have maintained a continuous and growing dividend since 1968 which is the year the company went public. If we move to the next slide, this demonstrates our improving financial performance over the past few years. We grew adjusted earnings per share 12% and adjusted EBIT by 10% compounded annually. Capital stewardship has been at the core of every decision we make and our strong ROIC performance reflects this commitment. Execution and capital discipline have yielded strong returns with an adjusted return on invested capital of 18% in fiscal 2021. With our focus portfolio and proven track record, we announced our updated strategy Creating for Tomorrow at our December 2021 Investor Day. In Creating for Tomorrow, we evolved our strategy and our leveraging our strengths to lead in performance and sustainability today and into the future. And we'll deliver this on the strategy by focusing on 3 pillars: driving advantage growth; delivering innovative chemistry and relentlessly pursuing continuous improvement in everything we do. Moving to the 3 pillars of growth, innovate and optimize, it all starts with growth. We're seeking advantage growth that means we are building on our unique advantages and from positions of strength. We'll continue to extend our strong global reach and invest organically and in differentiated capacity and do tuck-in acquisitions. Innovation remains at the center of the strategy and our efforts will be to further focus on how we can develop innovative products and processes that support our customers and enable a better and more sustainable future. And finally, optimize. The work of our manufacturing plant is essential to our strategy. This is where innovation comes to life and this is where the brand promise to our customers is built. We'll continue our impressive journey of world-class manufacturing performance and work we'll evolve to deepen our focus on capital efficiency. It'll also be important that we renew our ways of working and bring the power of digital tools to differentiate us. By pursuing our strategy, creating for tomorrow, we will grow, transform and reshape the valuation potential of the company. Cabot's businesses are connected to key macro trends of changing mobility landscape and increasing focus on sustainability and how we're becoming a more connective world. Our product portfolio connects to these important macro trends in diverse ways and the potential for innovation and growth is compelling. We're particularly excited about our emerging growth vectors in Battery Materials, Inkjet for digital packaging applications and our E2C product line to improve tire performance. In addition, Cabot is also committed to ESG transparency reporting and disclosures. Third party disclosure standards such as GRI, SASB and TCFD provide a standard measure the effectiveness and completeness of disclosures. In 2020, we completed the TCFD scenario analysis for climate risks and opportunities and you can find the summary of this on our website. We are especially proud of the recognition that we've received along the way. In 2020, the European Rubber Journal rated our E2C products as one of the Top 10 Elastomers in ESG benefits and Newsweek and Investor Business Daily are 2 additional examples of our recognition. The takeaway here is that we're committed to leading in ESG, and we're continuing to do that going forward. At the top of the list is the platinum rating we recently received from EcoVadis, the highest recognition available for the second consecutive year. A platinum rating recognizes our sustainability efforts and places Cabot in the top 1% of companies in the manufacturing of basic chemicals. This prestigious recognition underscores Cabot's commitment to transparency and provides customers with a better understanding of our performance. If I now move to one of the most exciting opportunities Cabot has, it's for growth in our Battery Materials business. I've been working at Cabot for 20 years, and this is the most exciting opportunity I have seen to date. Over the past several years, we have been systematically building out our product portfolio, technical expertise, customer support and the global footprint required to be a leading lithium-ion battery producer. Battery technology is complex and rapidly changing as manufacturers look to improve safety and battery range while reducing cost and shortening charging time. Conductive carbon additives are one of the critical ingredients to address these evolving market needs and will be required regardless of whether the battery roadmap evolves from current chemistry to dry process or solid state. Cabot is the only conductive carbon additive player that has the broad product portfolio of conductive carbons, carbon nanotubes and carbon nanostructures, each of which offers different levels of conductivity and formulation flexibility for battery manufacturers. We have invested heavily in this business over many years, and we're seeing great success today. We believe the market will grow at roughly 30% between 2020 and 2030, and we have given an outlook that Cabot's business will grow at a 50%-plus CAGR over the coming 3 years. We disclosed the sales and EBITDA of this in 2021 with sales of $80 million and an EBITDA of $16 million for this business. And our outlook for 2022 is EBITDA of $30 million to $35 million. We're incredibly excited about this opportunity and believe that we have the roadmap to win. If I spend a few minutes on recent results and the highlights of these results, we're very pleased with the year-to-date results so far in fiscal 2022 and in Q3. In our June quarter, we delivered a record adjusted EPS of $1.73, which is 28% higher than the same quarter a year ago. This record level of performance reflects the resilience of our business and the end markets and our flawless execution as we continue to grow our high-growth vectors. As a result, our team was able to navigate dynamic market conditions and impacts from foreign currency headwinds and higher interest rates to deliver this performance. Results across our businesses were very strong, with consecutive quarterly record performance in Reinforcement Materials, where EBIT was up 33% year-over-year and in Performance Chemicals where we delivered 17% year-over-year EBIT growth. Year-to-date results in Battery Materials have continued to exceed market growth rates. In the third quarter, volumes grew 60% year-over-year, while EBITDA grew 70%. And finally, central to our purpose and strategy is our commitment to sustainability, as I just talked about, and we published our 2021 Sustainability Report during the quarter, which is available on our website. And aligned with our purpose and strategy, we set long-term targets that we discussed on our December Investor Day. Our outlook continues to be for a supportive market environment and strong momentum with key macro trends. We expect very strong volume growth in our Performance Chemicals segment, ranging from 9% to 11% over the period as we increased capacity to meet the growing demands, particularly in our Battery Materials business. And in Reinforcement Materials, we expect a resilient replacement market to drive steady volume growth underpinned by supportive market environment. And overall, we expect adjusted earnings per share to grow at a compound annual growth rate of 8% to 12% and generate over $1 billion in discretionary free cash flow. This slide brings together everything we're trying to do and illustrates why Cabot offers a differentiated investment opportunity. Over the past 6 years, we've divested the noncore businesses and invested in our operating platform to extend our leadership in Reinforcement Materials, specialty carbons, fumed silica and specialty compounds. Additionally, we've made sustained investments in new vectors of growth to build from positions of strength and where we have a right to win. As we sit here today, we've grown the profitability of the core to new and durable level of earnings. And additionally, the investments in our targeted high-growth vectors of Battery Materials, Inkjet for digital packaging and E2C for next-generation tires are beginning to contribute. We expect them to reach materiality in ways over the coming years, beginning with Battery Materials. As we look forward, we expect the core to continue to grow in size and value and expect the new high-growth vectors to become material value contributors. In fact, the underlying growth rates and margin in these high-growth vectors, it's reasonable to believe in the coming years, they should be a larger part of the company valuation than the core businesses. The core businesses have a deep moat around them, underpinning strong cash flow generation that will fund the growth plans that we have and enable continued returns in excess of cost of capital for our shareholders. The combination of the strong cash flow generation and breakout value from the high-growth vectors are a compelling case for investment. So in conclusion, we have a very compelling story to tell you. Our Reinforcement Materials business is structurally stronger and expected to be less cyclical over the coming years. Our Performance Chemicals portfolio benefits from an attractive industry structure and is poised for growth by new products and underpinned by compelling macro trends. We have nurtured a set of growth vectors that are inflecting, particularly Battery Materials, and we're investing behind this transformational trend to win. We expect strong discretionary free cash flow generation to fund compelling growth investments and return capital to shareholders. And finally, we're a leader in ESG and recognized by our customers and stakeholders for excellence in this area. Thank you for joining me today. I'll now turn it back over for questions.

So we have a couple of questions e-mailed in, but I wanted to see if the audience has any questions to start off with. Charlie?

A scenario where you go through a recession without having down earnings. Is that what you're sort of suggesting just trying to understand the trajectory of opportunities because the reinforced -- the core carbon black business has a lot of positive elements going right? It has a lot of moats around. Battery Materials I think has a lot of growth around it. In silica -- fumed silica, so I'm just wondering, is the company, unlike most other chemical companies projecting sort of a growth trajectory even in a recessionary world?

Yes. So the question is about the view of our growth trajectory if there's a recession, if those have not heard it. I would say that, yes, we believe the business is structurally different than it had been in the past and that you're pointing out the areas that are different. So in Reinforcement Materials, I think there is a very different supply-demand dynamic. And the migration of many of our customers from the Western world into Asia, particularly China, has slowed or stopped. And so that destabilization isn't happening anymore. And the Western regions, Europe and North America, in particular, are quite a bit tighter in the supply-demand. I'd say another factor we have today is a situation with the Russian carbon black suppliers. And so, a good amount of Carbon Black for Europe had been supplied from Russia, and we see many companies moving away from having a supply chain tied to Russia, which has further tightened the European market. And then we have these growth vectors that are not tied to cyclical trends, right? The growth in EVs is expected to continue, and I don't think that will be impacted. So as we sit here today and think of a recessionary environment, I think we do have a fundamental belief that the company's results would look different than it has historically.

Just a complementary question I'll -- is there an M&A component to your [indiscernible] and how would that M&A manifest itself?

Yes. So M&A is part of the strategy. I'd say we'd focus really in these high-growth areas is what our view is. So if there is additional capacity perhaps in Battery Materials and/or complementary materials that would help us with the growth in that area, that would be one. Another growth vector is the inkjet for digital packaging. That would be an area that's growing also 25% to 30% as there's a clinical change from using digital printing, which then uses Inkjet. And so, for us, those are the areas that we would look at. And I'd say the third would be in more sustainable products. So if we thought there was something that would enhance our sustainable offering for customers, that might be another area. So it is part of the strategy, and I think we would -- we call them tuck-in acquisitions, but we would think of them as a bolstering the high-growth areas of the company.

All right. We have a couple that were e-mailed in. Touching on what you just said. Can you kind of give us guidance or any sort of details on your capital deployment strategy over the next 2 to 3 years? What buckets do you think that would fall into?

Yes, sure. So I think for capital allocation, our number one is growth. So investing and making sure we have the capacity for the growth, especially in Battery Materials. I think we believe that there is capacity needed as EVs grow and battery demand grows and that supply chains will be moving to more regional setup. Most of the demand and most of the batteries today are made in China, which is where we've invested. But I think as we start to see that -- those regional supply chains in Europe and U.S. build out that there would be additional investment needed in capacity for growth there. And those are the areas that we're focused on first. I'd say the dividend is also an important piece of our capital allocation. So we've had a strong and growing dividend, and we will continue to look at that as an important return to shareholders and would expect that, that would increase with earnings. And then I would say share repurchases would be next on the list. So certainly, to offset dilution in our stock comp plans, but then also opportunistically as we look at cash flow being quite strong projected through the period.

Got it. And this is more of a near-term question, but can you just talk a little bit about how the volatility in FX and higher interest rates is affecting your business?

Sure. So I think similar to many companies, they're affecting -- both are affecting us. So I'd say on interest rates, we have some higher short-term borrowings, so we do use CP, and we've seen the rates increase on those. We saw in the third quarter about a $3 million increase in our interest rate for the quarter. And then we did refinance a bond in June. So we had notes coming due. And so, we will finance them at a higher interest rate, that will add another $4 million. So I think when you look at it on an annualized basis, an increase of roughly $15 million based on where current rates are from higher interest. As we look at foreign currency, our biggest impact is the translation of earnings into U.S. dollars. So most of our business is operated in the regions with which we manufacture. So our sales and our costs are in the same currency in most cases. But the translation of that earnings into U.S. dollars is now less, given the devaluation of foreign currency. So that impact was about $8 million in our third fiscal quarter, and we would expect that to worsened here in Q4. So we'd expect there to be probably a larger impact in the fourth quarter. And then when you annualize that and impact as we move into our next fiscal year.

And can you just give us an update on business conditions regionally?

Sure. So I think as we look across and if I start with Reinforcement Materials, I think business conditions still continue to be quite strong for us. So I think the replacement tire market is holding up quite well and we have seen that. As I think many people know, the OE market and auto production is still below pre-COVID levels. And so that is still a recovering picture. But I'd say replacement tire market has been quite strong and I'd say that globally. I've been asked a lot today about China and impact of COVID lockdowns in China. Operationally, we did not have any impact to our operations. We've been able to operate through the Shanghai lockdowns and so far through any other rolling knockdowns. But there was an impact in -- for some of our customers as well as some of the shipping within China. So in our Performance Chemicals segment, in our June quarter, we did see some reduction in demand, about 10% year-on-year across that portfolio. I think as China lockdowns have become less so as compared to when Shanghai lockdown was in, in the third quarter, we see that solely improving at this point. And then the government has provided some stimulus in China as well and that's helping. I think we'll see that come out of there. In Europe, I'd say, again, Reinforcement Materials quite strong, continues to be good. There is a normal summer seasonality to Europe for us, we're seeing that in Reinforcement Materials. And then I'd say, in some of the other specialty markets, we have seen a little bit of a softness particularly specialty compounds. So here, we have a black masterbatch and compound business. And we've seen both polymer prices dropping in Europe, which I'd say the normal customer behavior is then to slow purchases and wait for that to level out before they come back in the market. We're seeing that behavior now happen as well. And then I'd say, in the U.S., so far across the board, still quite strong for all of our businesses.

Just on pricing, can you talk about the differential between rubber black and specialty black pricing? And then can you talk about the contract pricing cycle for tire blacks and what the different pricing dynamics are for specialty blacks?

Sure. So in Reinforcement Materials, we have a good amount of the business under more contractual agreements. And so [indiscernible], we have formula pass-throughs most of the business in the Western world; so in the Americas, Europe and then also, Japan. And so in this case, the formula is passed through any changes in energy prices as they move through and the intent is to hold the dollar margin quite steady. What we've seen in 2022 is an increase in contractual base pricing, which has contributed to higher EBIT levels going through. As we look at 2023, we see also very favorable dynamics right now shaping up. We've had some early -- earlier than normal, I'd say, in the schedule negotiations with customers for the calendar '23 contracts and we have closed some of those contracts as well with some of the large and multi-region customers and some for multiple year deals with escalating pricing in both years. So we feel quite good about the situation we're in right now, and we'll continue to work on the remaining contracts for '23. If we think about the specialty carbons, it's a bit different. There's less contractual business. It's more of a spot nature in terms of negotiated pricing. So we have seen the increase in many of the input costs and energy as many have, and we've been able to price appropriately as we've moved through 2022, so in many cases, pricing even ahead of the cost flow-through of those. And so I've been quite successful in that sense in terms of holding or expanding margins in that business. And our view is that as inflation continues, we'd continue to execute that strategy to make sure we're getting price coverage for any cost increase there.

Do you think Cabot is better positioned today to handle a recession than in past downturns?

Yes, definitely. I mean I think we've talked about earlier the structural changes we've made in the business. And I think certainly, there was a large time of destabilization when we saw a lot of our customers, particularly tire customers, migrating to China, a lot of expansion in China happening and capacity added. And then when recessions hit, you had a bit of a supply-demand imbalance already in a market on top of that than volume weakness. Now we have very strong supply-demand fundamentals in these regions, less capacity being added in China for a number of reasons and feel much better about that. I'd say we've also spent a lot of time on commercial practices in terms of our formulas and making sure we're covering ourselves for more proactive monthly instead of quarterly formula changes for things like having a delivered cost adjustment within our formulas to cover any dislocations in feedstock and in places like Europe having CO2 pricing mechanisms as well. So I think we've structurally improved our commercial practices in that sense as well. And then I think many of the end markets that we're in, as we talked about Battery Materials, are not as exposed to recession risk because they are high growth and Inkjet, similarly. So I think overall, the portfolio has shifted our businesses into different areas. I think all of that helps us to be much better positioned than in the past.

And there are a few different start-ups working on projects that no carbon is a byproduct. How significant are these for the carbon black industry?

So there are -- for many that might not know, there are different projects, some around hydrogen product and then there's a carbon byproduct that comes from these. This is in the energy transition to a net 0 world. Many of the byproducts are not carbon black, they are a carbon product. And so they don't have similar characteristics to a carbon black, which has a specific engineered outcome in terms of surface area and chemistry. And so these -- we watch all of these and make sure we understand. I think some of these are not meant to go into carbon black. They may be used as a fuel source or something in another market. Others, I think, we'll look to upgrade the material and participate in the carbon black market. But I think by and large, today, we don't see any of that have the same performance ability as carbon black. And we'll continue to watch how those evolve over time.

Is there anything in the new IRA Bill that's going to drive capital spending?

So there is a couple. I think there's a tax credit related to producing Battery Material products within the U.S. And so for those products that we have produced here in the U.S., that would be the case. Also, there's been DOE funding for the battery material supply chain. So I'd say those are areas that we're looking into investigating in terms of how to achieve value for Cabot in those areas. As I said earlier, we do believe that there will be more localized supply chains built out over time. So as EVs grow in the U.S. I think carmakers and battery makers will locate here and want their supply chain in the U.S. And so for us, we do see opportunity for investment here to capture that growth.

What is Cabot's overall earnings sensitivity to oil and gas prices, including the byproduct energy that you sell using hot exhaust gas? And what's the lag you see between your input costs and pricing?

So I'll take the second one first. The input cost and pricing, we worked to limit the lag between that. So as I said, our formulaic pricing in the Reinforcement Materials side is set to change every month, and that's based on the cost flow-through of our raw material purchases and how they work through the P&L. So there should not be a lag. I think in the past, we used to have quarterly pricing. And so when oil prices and our raw material prices move dramatically, you could have that quarter delay. We've looked to eliminate that in our current mechanisms. And then, I'd say, on the areas where we have spot pricing, we have to go to market for those pricing, but we're quite adept, I'd say, in our commercial practices to make sure we understand the cost movements, we understand the impact to our results, and we're proactively changing pricing to do that. I think in many cases, even in this year, we have, in some cases, put surcharges in that link to in the instance of European energy costs that have increased so substantially. We've tried to be transparent with customers to understand the magnitude of the change and what it's driven by. In other cases, we passed through just regular base price increases that would cover a whole host of cost increases. So I think on that sense, I wouldn't expect there to be a lag in us to realize pricing to cover our costs. In terms of the exposure to energy, so we do have cogeneration facilities at many of our plants. And so this is where we take the tail gas that comes out of our process to make the carbon black and turn it into electricity or steam generation and then we sell that. So we are tied to energy prices in those local economies or with partners that we may have a steam sale arrangement with. I'd say that is quite favorable, and that's reported in our 10-Q, 10-K. You can see the byproduct sales, which have increased pretty substantially this year related to that. I would say that an area, not P&L-related, but cash flow related is the -- the cash flow is tied also because of the working capital component of the change in energy prices and that has been quite substantial for us over the past 2 years. So we have a rule of thumb about every dollar per barrel change is about $5 million of working capital. So you can see over the past 2 years as oil prices have risen, that the use of working capital has also increased. As oil stabilizes, or the forecast for the next year is backwardation, you should start to see at least a leveling out or release of working capital as those prices stabilize or decline.

How big could electronic grade carbon black be for Cabot?

Electronic grade carbon black for?

For EVs.

EVs. So yes, the Battery Materials business. As we said, we had $16 million of EBITDA last year, our forecast is $30 million to $35 million this year. Our projection on growth is 50%-plus as we look out. So if you extrapolate that, I think out a few years, 5 years, you're at $500 million or so of revenue. And if you go out 10 years, you might be $1 billion of revenue. So for us, we think quite substantial for the company.

Are there any additional questions?

Senior 20 years at Cabot. You joined the company shortly after Cabot Micro, spun off, bigger than Cabot Micro. And Cabot Micro was so different that it was spun off that's there. I don't know whether Battery Materials kind of might follow the same path.

Yes. So Battery Materials right now is bigger than Cabot Micro was when we spun it off. So I'd say a much better opportunity in our view. I think the value that Cabot brings to the overall Battery Materials business is quite significant because I think based on where it is today and the technology advancements and the speed of that technology change, the Cabot understanding of that and how carbon works in different formulations is pretty important and has been additive to that success of that business. I also think as we regionalize the supply chain, there's value because Cabot has the full infrastructure built out in Europe and U.S., et cetera. And when you look at some of the competitors, particularly in China, where many of the CNT competition is for us, they're Chinese companies that participate in that market. And for them to move and try to build an entire ecosystem in Europe or in U.S. to compete, I think we're ahead of them, and we'll be able to do that quicker and better. So I think right now, we look at it as we think Cabot, this is a very big opportunity for us to grow. A different decision than Cabot might grow at the time, which generated some short-term value for Cabot but was spun off and value created under a different company.

So we wait until it's bigger than the rubber black business and then you spin off rubber black and the other businesses?

Look, we're trying to maximize the value of the company overall. I think all the businesses that we're in right now have great value drivers, really strong fundamentals and can add to the value of Cabot. I think Battery Materials is a business with incredibly high growth rate and Cabot has right now been proving to win new accounts. We're in 6 of the top 8 battery companies right now. We're working with people in the space about next-generation batteries, where our materials will continue to be important to the battery, solid-state and things. So I think right now, we feel really good about where we stand as an entire Cabot and see the valuation potential quite compelling.

What would be the reason you're not in the 2 of the 8 but -- so you're in 6 of 8. Are they Chinese companies that buy from Chinese suppliers?

No I think it's just time of qualification and next generation of their materials. I think as you get qualified into these platforms, you're pretty well spec-ed in and until the next generation, then you come in. And so for us, I'd say we're working on development projects with [indiscernible]. And so our goal would be to have [indiscernible]

[indiscernible]

I think for that, which is mostly housed within our Performance Chemicals segment, there's a very diverse set of applications there. So even through the COVID period, what we see is if one application set is down, we can often shift volume into another, right? And so there is more, I'd say, of an ability to do that in that segment. And then within that segment, there's also the Battery Materials and the inkjet for digital printing opportunities, which don't have a cyclical angle. So I'd say that is more a mix of portfolio in terms of how we've strengthened the ability to weather a recession.

Well, thank you very much.

All right. Thank you all. Appreciate your interest in Cabot.