SK Innovation Co., Ltd. (A096770) Earnings Call Transcript & Summary

[Interpreted] Good afternoon. I am [ Wu-Han Lee ], head of the IR team at SK Innovation. Thank you for taking time to join SK Innovation's Fourth Quarter 2019 Earnings Call. Today's call is being broadcasted live on our website with Korean-English simultaneous interpretation for our overseas investors. Today's presentation has yet to be reviewed by our external auditor. So the results are subject to change based on such review. Now I will hand it over to the CFO, Mr. Myung-Young Lee, for the presentation.

[Interpreted] Good afternoon. This is Myung-Young Lee, CFO of SK Innovation. I would like to thank our shareholders and investors for your continuous interest in the company. Today, I will present our Fourth Quarter 2019 performance, after which, we will have a Q&A session. On the call with me today are executives from SK Innovation and its major subsidiaries to ensure that we would be able to address all of the questions that you may have. First, let me go over the overall Fourth Quarter performance, including sales and operating profits. First, on sales. Though crude prices increased slightly, less sales volume due to the RFCC TA and lower petrochemical product sales prices resulted in the top line decreasing KRW 499.5 billion quarter-on-quarter to KRW 11,788.5 billion. In terms of operating profit, the weak margins in refining and petrochemical products led to a decline of KRW 203.9 billion versus the third quarter to KRW 122.5 billion. On the nonoperating side, FX-related gains of KRW 6.4 billion, net interest expenses of KRW 76.3 billion, E&P asset impairment losses of KRW 288.8 billion, derivative-related losses of KRW 118.2 billion and equity method related losses of KRW 18.4 billion added up to nonoperating losses of KRW 547.5 billion. Next, let me go over the balance sheet. As of the end of 2019, driven by our increase in tangible assets from an expansion on capital expenditures, assets totaled KRW 39,511.3 billion, up by KRW 3,657.9 billion versus 2018. Total liabilities was KRW 21,316.5 billion, an addition of KRW 4,637.4 billion versus last year, because of an increase in corporate debt issuance and changes in accounting standard for lease liabilities. The Debt/Equity ratio was 30.2% points higher versus 2018 at 11 -- KRW 117.2 billion. In addition, gross debt stood at KRW 11,131 billion, up by KRW 3,117.3 billion year-on-year due to more investments in new business. Net debt grew KRW 3,042.7 billion to KRW 6,558.9 billion during the same period. Now let me move on to the market environment and fourth quarter performance of each business. Let me start with the refining market backdrop. In the fourth quarter, crude prices were strong, fueled by the U.S.-China Phase 1 trade agreement and decision by the OPEC to cut production further. In addition, in the fourth quarter, refining margins weakened on a quarter-on-quarter basis due to global refineries completing their turnaround and increased supply from regional new capacity additions. Gasoline crack rose slightly as non-regional supply-demand dynamics improved because U.S. West Coast refineries temporarily suspended production and diesel crack weakened on the back of lackluster regional, non-regional onshore demand for markets such as India and unwinding of long positions held as expectations around it IMO subsided. Amid generally slower bunker demand from less trade volume, a forecast [indiscernible] on the impact of IMO 2020. Next, I will discuss the performance of the overall refinery business. On operating profit, though refinery and products, such as diesel and FO, generally experienced weaker crack levels, higher inventory related gains driven by stronger crude prices resulted in operating profit recording KRW 111.4 billion, an increase of KRW 45.5 billion quarter-on-quarter. For your reference, fourth quarter refining inventory related gains is KRW 13.6 billion. Other key items to mention would be an increase in trading gains of KRW 40.9 billion due to RFCC TA. In terms of the outlook for 2020 refining margins, the company expects margins to improve year-over-year because of a better market backdrop for refining products as the economy is expected to improve and a stronger demand forecast for diesel driven by the full implementation of IMO 2020. However, when looking at past precedent during the SARS and MERS outbreaks and their implications, the company believes development on the current coronavirus may be a factor of consideration for the refining market. Now let me go over the petrochemical market. The fourth quarter olefin spreads were weak because of less demand, the main from concerns about an economic recession and deteriorating downstream economics due to lower cost supply coming in from the U.S. and Middle East. Propylene spreads also turned weak as downstream demand continued to decline and supply grew from new capacity additions. Aromatic spreads were influenced by slimming profitability across the value chain, driven by the decrease in polyester demand and an increase in supply as new regional PX capacity went online. Next, let me talk about the fourth quarter performance of the business on the next page. Though inventory related gains increased on the back of stronger NAFTA prices, overall, product spreads softened, leading to petrochemical operating profit posting KRW 7.3 billion, down KRW 186.3 billion quarter-over-quarter. The olefin market in 2020 is expected to continue to be soft as large-scale capacity additions are slated from the U.S. and China. The market for PX, a key aromatic product, is expected to be weak as new supply is scheduled until the end of the year. However, large-scale new capacity will also be added in PTA throughout the year, which is expected to result in a slightly better market versus the end of last year. Next, let me move on to the fourth quarter lubricants business. Lubricant operating profit was KRW 86.9 billion, less KRW 3 billion Q-o-Q because of year-end one-off expenses, even though margins improved with lower feedstock prices. To discuss the 2020 base oil market, amid concerns over a global economic slowdown and oversupply in Group II, we expect the market to gradually improve, driven by additional demand for Group III lubricants because of stronger fuel efficiency regulations in India and China, and new low viscosity specifications going into effect in North America and Europe. Next, the E&P business. The E&P business generated operating profit of KRW 41.2 billion, a decrease of KRW 7.3 billion quarter-over-quarter due to higher operating costs for Peru 88 and 56 blocks. Impairment losses of KRW 288.8 billion on North American and other exploration assets were recognized as part of fourth quarter nonoperating expenses. Next, let me move on to the batteries business. Operating losses for EV batteries totaled KRW 112.4 billion, an increase of KRW 69.7 billion versus the previous quarter, which is the result of an increase of inventory-related losses and also costs, such as sample costs and R&D. To meet customer demand, the company completed production facilities in China and Hungary at the end of last year and is currently conducting test runs, with the target to start commercial productions in the first half. In addition, in March last year, we broke ground for our second plant in Hungary, a new plant in Georgia in the U.S., which is currently in construction. Next, let me move on to the I/E Materials business. Operating profit for I/E Materials posted KRW 23.4 billion, less KRW 2 billion versus the third quarter due to a stronger Korean won, an increase in repairment costs due to turnaround. The company continues to increase production capacity for LiBS. In the fourth quarter 2019, 2 additional lines in Tongon started commercial production, taking total annual production capacity from 350 million to 530 million square meters. We also continued to make progress on the construction of our global production hubs in China and Poland. Lastly, let me discuss the company's dividend plans for the fiscal year 2019. For full year 2019 dividends, the company has taken into consideration the significant decrease in year-over-year performance and inevitably has decided on total dividends per share of KRW 3,000, a decrease of KRW 5,000 versus last year. Thus, when excluding the interim dividend paid in August, the year-end dividends would be KRW 1,400 per share. In addition, the company's board approved a share buyback during the BOD this meeting. From February 3 to May 2, the company will acquire approximately 4,628,000 shares, representing around 5% of the outstanding shares in the market. The decision to conduct a share buyback was made to protect shareholder value. In addition, the company would like to highlight its commitment to strengthening shareholder value by improving the operational efficiencies of the core business and stabilizing the new businesses as early as possible. This is the end of our presentation for today, and we would now like to start the Q&A session. Before asking your question, we would ask you to state your name and affiliation. In addition, please note that the Q&A session will be conducted with consecutive interpretation.

[Foreign Language] Now Q&A session will begin. [Operator Instructions] The first question will be provided by Young-chan Baek from KB Securities.

[Interpreted] I would like to submit 2 questions. My first question relates to your VIDS. I understand that you have started commercial operation of the new process. So compared to year 2019, could you give us the breakdown between the HSFO and LSFO for 2020? That is the mix of -- in terms of the ratio, in terms of the sales of these 2 products. My second question relates to your petrochemical business. If you were to turn to Page 9 of the slide, it says that inventory valuation related gains is KRW 18.4 billion plus. But if you look at lubricant and refinery, inventory related figures are all in the negative realm. I understand that this is due to the change in the product price. Could you provide some more elaboration as to what the meaning of the positive valuation gain on inventory is?

[Interpreted] I'm from SK Energy. I would like to respond to your question. I'm the Head of Corporate Planning Office. As you know, in terms of the VRDS plant, from year 2020 onwards, we will be able to generate profit in the realm of KRW 200 billion to KRW 300 billion. As you know, the -- currently, construction is underway, and it's almost complete. The progress rate is around 99.9%. If you look at the production volume of LSFO, as of the current figure, we're currently producing about 30,000 barrel per day. But once the VIDS plant is complete, we will be able to see that increase to 70,000 barrel per day.

[Interpreted] I am [indiscernible]. I'm the Head of Finance office at SK Innovation. I will respond to your second question. If you look at our valuation gain on the inventories for the chemical business, if you look at Q4, some of the related product prices have gone down. However, on the other side, on the feedstock side, the naphtha price have actually increased quite significantly. So if you were to compare the naphtha price against Q3 as opposed to Q4, the price had actually gone up by $70 per ton. So basically, that is the underlying reason that explains the valuation related to the inventory.

[Interpreted] The following question will be presented by [indiscernible] from Hyundai Motor Company Investment Securities.

[Interpreted] My question relates to your Battery business and I/E Material business. For your Battery business, on a per annum basis, you've been reporting around KRW 300 billion in loss. I would like to understand whether, in 2020, you will be able to downsize the amount of this loss you are getting from your Battery business. And also, it will be helpful if you could also give us the guidance for your sales number for 2020 this year, and at the same time, also share with us your figure of year 2019. And the way I understand it is the Chinese government has recently made an announcement that they will not be actually eliminating the subsidies that they have been placing on EV vehicles. And I know that some of the vehicles that we provide our parts to are on that subsidy list. What implication will this recent announcement by the Chinese government will have on your Battery business? My second question relates to your -- in I/E Materials. Despite the fact that you've started mass production in the fourth quarter, I understand that your operating profit had slightly dipped. Can you also provide some color on what your margin is? And also for this year, especially once the added capacity comes under ramp up phase, what impact would that have on your operating profit? And it will be helpful if you could also give us your operating profit guidance as well.

[Interpreted] Yes. I'm from the Battery business, and my name is [ Kim Young Ju ]. I'd like to first respond to your question about our guidance on our sales and profit for 2020. So come the first half of year 2020, we will be starting our commercial running of the first plant in Hungary and the Changzhou plant in China. So together, with our domestic plant at [indiscernible], we will have a production -- global production base. We will be able to secure 3 production bases, based on which, we will start to produce our product. So the [indiscernible] plant, as was the case back in 2019, will run fully, and also the Hungary plant and China plant will run in accordance with the schedule that we have agreed with the OEM makers, and it will start mass production from the first half of year 2020. So all in all, for the entire year of 2020, we are looking at sales guidance of around KRW 2 trillion. In terms of the profit for 2020, because we are still spending expenditures relating to the investment for the construction and addition of capacity, there could be a case where we would see a slight increase in terms of the annual operating loss. Now let me talk about the implication that Chinese subsidy policy would have on our business. Now China has its objective to eliminate the subsidies that it would provide to EV starting year 2021. So at this point, they are considering use of the exemption of the purchase tax or strengthening of the double credit system or basically providing tax-related benefits. So they are considering different avenues. Hence, our company is very closely monitoring the change in the policy stance taken by the Chinese government in line with the market changes. And in order to respond to possible policy-related changes, we are very much focused on strengthening our partnership with the local players, and also solidify and bolster the battery-related ecosystem in the local market and are judging our efforts very closely cooperate with the government organizations and the industry association.

[Interpreted] It's [indiscernible]. I will respond to your question from SK IT. Your question relates to the fact that why do we not see any increase in the sales volume or the sales figure even if we started mass production in the fourth quarter. The reason is because the new lines came under operation and production in the month of November. But the existing lines, they went under turnaround, scheduled turnaround that is. So the total amount of sales volume, therefore, stayed flat. And once these new lines are normalized in year 2020, we expect there to be an upside to our top line revenue above and beyond the market demand. Thank you.

[Interpreted] The following question will be presented by Anna Park from Macquarie.

[Interpreted] There are 2 questions that I would like to ask you. First is about your shareholder return policy, in terms of the overall dividend payout ratio and also in terms of share buybacks that you are planning to conduct. If we look at the total impact of that in terms of the total return to shareholders, could you provide a guidance about what that level would be in terms of what stance you have? That's the first question. And the second question I would like to ask you is about your Battery business and the ongoing litigations that you have with one of your competitors. I do know that this may not be an easy question to address. But as much as possible, I would appreciate if you could talk about what the current situation is for the litigation? What type of plans do you have? How do you plan to deal with the overall litigation? And any insight that you could share or any views that you could share would be appreciated.

[Interpreted] So maybe I can address the first question about our overall stance for shareholder return. The stance that the company has taken to date on this issue is that rather than having a fixed dividend payout ratio that we wanted to abide by, we wanted to be able to create a overall track record in which we would be able to gradually increase the overall dividends that we would pay to our shareholders. So as a result of that, up until last year, we had maintained a dividend -- total dividend amount of KRW 8,000 per share. In addition, in terms of the decision that we have taken to do a share buyback and that recent decision, rather than this being a measure of shareholder return, if you look at the current share price levels during the past 12 months, in actuality, it has dropped significantly by around 40%. This is due to the various news that has been coming out related to the ongoing litigations. And also, we do believe that this has created a situation in which there is a lot of uncertainty to our shareholders. So in light of defending and maintaining -- ensuring that the overall company value is protected, we do believe that measures needed to be taken to absorb some of the outstanding shares that have been issued to defend our position. In addition, about your question about the ongoing litigation, I do understand that there is various news reports out about the litigation in itself. However, as you have mentioned, this is still a ongoing litigation and an ongoing process. Until the end of this overall process, we do have a lot of time that has been left. Nothing has been determined yet. And as a result of that, unfortunately, from the company's side, there is not anything that we would be able to officially share with you as of now. So please understand our position.

[Interpreted] The following question will be presented by Jung-Il Oh from Shinyoung Securities.

[Interpreted] So I would like to ask one question. I understand that starting November, we've seen some uptick in the sale of the low sulfur fuel oil, LSFO. I would like to understand when you think will be the timing for you to see a rebound in your refining margin driven by the IMO impact. And also, will this take the form of the increase in the prices of the LSFO? Or do you think that as the RSCC plant has suspended their operation, and what happens is that the actual gasoline and PP production is going to go down whilst the LSFO production actually goes up? So would this be more desirable from your perspective?

[Interpreted] I'm from SK Energy. I am [indiscernible]. I will respond to your question. Basically, the impact that we get from the IMO, the whole IMO related specification is an increase in the gas oil crack. But for the time being, in the short run, due to the coronavirus factor, the demand is going to -- we expect it's going to go down. So from a short-term perspective, I think there will be a downward pressure. Now however, with the decline in the amount of demand, I believe that the Chinese plant operators will start to cut their run rate. And also, if the Chinese government does a successful job of preventing the further spread of the whole coronavirus pandemic, we believe that the uncertainties will be removed. And if so, from the first quarter, we believe that the IMO impact on the diesel crack upside will start to play into -- to start to -- will start to display itself. And we believe that the run cuts that we see from the RSCC plant is actually a temporary response to a market that is quite weak. However, we also have to consider the fact that the winter season is usually the offseason. So it is a temporary phenomenon. And also, from the first quarter, with the turnaround for the U.S. FCCs, once they complete, then the supplies will come online. And in light of the fact that the high season, the driving season is coming in the second quarter, we think that the impact of an LSFO -- additional production of LSFO will be capped or limited as it is a temporary impact. Thank you.

[Interpreted] The following question will be presented by Jae Sung Yoon from Hana Financial Investment.

[Interpreted]. There are 2 questions that I would like to ask you. First, for the sale of the Peru assets that you have had. When would that deal close? In addition to that, when would the overall operations of Peru be eliminated from the company's operations -- from the company's results or performance? The second question that I have is about your 2020 CapEx. I do believe that you continuously have intentions to invest. So what is the CapEx for your refining business and also Battery business? In addition to that, I do think that the overall net debt levels of the company continued to rise. And if you look at your Battery business, this is an area in which you will continue to need to invest. So as a result of that, how does the company see its net debt going forward? And how is it going to be managed?

[Interpreted] So this is [indiscernible] from E&P. Maybe I can address your first question. In terms of the overall schedule that we have for the deal between SK and the buyer of the asset, which is the operator, initially, it was that by the end of January of 2020, we would achieve the overall approval from the Peruvian government and also be able to close the deal. We did have a meeting early this week with the government, in which we did get very positive responses. So we do think that the deal closing will be coming soon. And the elimination from the performance is something that will take place immediately following the closing. So maybe I can address your second question about our 2020 CapEx. As of right now, the business plan is something that is still being finalized. So unfortunately, there are some variables that we still need to adjust as a result of that. I don't think it's the right time to share specific numbers with you. This is something that we will share next quarter after they have been finalized. However, if we look at 2019 CapEx, it was in total KRW 3.7 trillion. So if we look at the overall situation, for 2020, in actuality, as mentioned before, in Europe and in the U.S., we do have battery plants that are in construction right now. The overall equipment will have to go in and also the completion of some of that would also be taking place. So we do think it will be a concentrated period of time for which CapEx will be required. So that will be one of the uplifting factors. In addition to that, on the I/E Materials side, in Europe, also we do have some facilities that we will be starting to groundbreaking and there will also be some facilities that will be completed. So if we take Batteries and I/E Materials all together, when compared to this year or for next year, we do see that there will be more CapEx required. In addition, if we look at our refinery business and the overall petrochemical business, this is an area in which we think that, versus this year, the overall CapEx required will be less. In particular, for our refinery business, the VRDS is completed. So versus last year, that will mean that in first half, this is something that will require much less. So we do think that if we take the whole universe of things into consideration for 2020, that the CapEx should be lower than what we have for 2019. Over a more midterm horizon, if we look at the CapEx trends, we do think that 2020 will be the peak of the CapEx that we require. So after 2020, going into 2021 and 2022, the overall trend shall decline. In this process, of course, we do think that there will be some temporary deterioration in the financial position that we have. So to offset that as much as possible, the company will be looking into other alternatives that we can utilize, such as disposing some of the assets that we have.

[Interpreted] The following question will be presented by Oscar Yee from Citigroup.

First is, given your earlier comment, you mentioned that you are currently producing 30 KBD of VLFSO. Could I check when have you started doing that? Is it in January or is it in 4Q? And based on that, right, how much has your HSFO and the asphalt you changed when you increased your 30 KBD of VSFO? And also, I would like to know when your VSFO output went up from 30 to 70 KBD. Does it mean that your company will no longer be producing asphalt or the asphalt volume will become quite minimal going forward after the start-up of the RDS? So that's the first question. Second question is based on your understanding, given you already own a stake in the Wuhan Sinopa Complex, has there been any sort of production disruption so far based on your understanding? Third question is I noticed there was a pretty big increase in the minority interest in 4Q in your P&L. Any particular reason? And finally, I didn't join the early part of the call. Could you provide, once again, the detailed P&L nonoperating, like interest, FX associate and the derivatives and those things?

[Interpreted] I am [indiscernible] from SK Energy. Relating to the LSFO production, once the VRDS plant comes under full operations starting April, I believe that starting the second half of the year, around the month of July, we will be seeing production reach around 70,000 barrel per day. So the 30,000 barrels have been produced from January up until March. So 70,000 level will be reached in the second half of the year. Now on your second question, yes, quite naturally, with the operation of the VRDS, obviously, there is going to be decline in the production volume of the asphalt. Thank you.

[Interpreted] I am [indiscernible] from SK Global Chemical. For Wuhan Petrochem, its run rate in year 2019 was 100%. And at this point in time, it is running normally. And we are continuously monitoring the situation that's developing out of the coronavirus issue.

[Interpreted] Let me tell you the nonoperating profit number once again. It's KRW 547.5 billion; FX related is KRW 6.4 billion; and E&P related impairment, KRW 288.8 billion; derivative-related loss of KRW 118.2 billion; equity method loss of KRW 18.4 billion; and interest expense of KRW 76.3 billion. You asked about the minority stake. Last -- as of last year, our SK IPC, our holding was 68% and external shareholders had held RCPS of about 32%. And basically, all of those notes have been fully redeemed, and hence, we currently own 100%, and that's why the minority stake figure has increased.

[Interpreted] The Following question will be presented by Parsley Ong from JPMorgan.

I have 2 questions. The first one is regarding your share buyback. Do you -- depending on the market situation and the company's earnings, is this something that management might consider doing on an ongoing basis? And also, is there a potential for the company to cancel the shares? Or could you give us any guidance on whether the company intends to release the treasury shares back into the market? Second question is with regards to your EV Batteries division. Earlier, you mentioned that you do expect EV Battery losses to widen in 2020. Do you see potential for your EV Battery operating loss to double to about KRW 600 billion in 2020? Or do you think that you can exercise better cost control and keep it below that? And could you remind us on your EV Battery breakeven target? I guess a comment on this is or a common feedback we get from investors is that the SK's valuation multiple for EV Batteries fails to go up because you're pretty far away from EV Battery breakeven compared to your peers and your sales exposure is quite low. So considering valuation multiples of all other EV Battery plays have gone up, is the company considering ways to potentially release value for this business, for example, a partial stake sale or a potential partial IPO.

[Interpreted] So maybe I can address your first question about the shareholder buyback. If you look at our history, we have done share buybacks in the past, and we did determine to do it this time again. And this in light of the deteriorating overall market situation. We did believe that the share price needed to be stabilized, and this was a determination that was made at the BOD level. So as of yet, there is no intention to cancel the shares. If you look at the motivation behind the share buyback that we have this time around, inevitably, because of the performance, we did need to cut the overall dividend level. However, in light of the deteriorating financial position, rather than having a measure which may lead to cash outlays for the company, we wanted to take a measure that would have an impact at the market -- on the market, but at time, also enable the company to maintain some of the assets that it held. So as a result of that, the alternative that we have selected is to conduct a share buyback. So I would not go as far to say that this is going to be a regular exercise for the company. But I can clearly say that the BOD does have the attention of exploring a share buyback in a situation in which -- in light of factors that would include the overall equity market situation and also a turnaround in the industry. So if the BOD, in a certain situation, would deem it necessary to protect the shareholder value, then this could be a valid option that may be considered in such a situation. So in -- I do believe that there may be concerns about overhang and a possible share that -- a possibility that the shares may be released to the market. However, in a -- if going forward, the company does need to dispose of the treasury stock because of its financial position, rather than selling the shares through the market, we would look at other alternatives available and other resources available, such as a block sale or a M&A type transaction. Thank you.

[Interpreted] So this is the Head of the Battery business support office. And maybe I can take your second question. For 2020 and for the losses that we foresee, as mentioned before, we do have a factory that is in construction right now. There is also other construction that will be ongoing. So all in all, we do think there will be upfront investments that will be required for this capacity addition. So as a result of that, we do think that there is a possibility that 2020 losses could be larger than 2019. However, that having been said, even in such a scenario, we don't think it will go as far as double that of what we had this year. In addition to that, right now, for the global production sites that we still have, we still are in the facility investment phase. So that is what is preventing us from reaching the breakeven point. However, with more momentum being created within the overall EV market, and in addition to that, across the U.S., Hungary and Chinese production sites, when we are able to reach around 50 gigawatt hours in terms of total production, which we believe will be around 2022, we do think that BP will be possible.

[Interpreted] And maybe I can take the second part of your -- the second question that you asked about SK, our company's Battery business and -- versus that of the competitors right now. The fact that maybe it is less contributing as of the current time to shareholder value and is undervalued, what our view is about that overall dynamic. What I can say is that if you look at our overall battery business, right now, we are focused on only EV batteries. And in addition to that, for the capacity expansions that we have had for our capacity versus that of our competitors, we have taken it in a bit more moderation. So as a result of that, if you look at the overall sale size and the overall capacity that we currently represent, it would be a bit less than that of our competitors. So as a result of that, 2, 3 years down the road from now, when we complete all of the capacity expansion plans that we currently have and that capacity really starts to contribute to the top line. In addition to that, when the overall market share that we have will grow to a larger size, we think that, that value will be something that will be recognized by the market. And in addition to that, for the overall Battery business and its contribution to SK Innovation, for that dynamic in itself, we are looking at maybe changing the structure or the possibility of doing so. So we do think a strategic approach is necessary. However, for the right timing for such a strategic approach, it would depend upon the overall backdrop of the battery market.

[Interpreted] So with this, we would like to wrap up the Q&A session for the Fourth Quarter 2019 Earnings Conference Call. Thank you very much. [Portions of this transcript that are marked [Interpreted] were spoken by an interpreter present on the live call.]