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

[Interpreted] Good morning. I am Wi Han Lee, IRP at SK Innovation. Thank you for taking time to join SK Innovation's Third Quarter 2020 Earnings Call. Today's presentation have reviewed by our external auditors, 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 morning. 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 third quarter 2020 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 make sure we can answer all of your questions. First, let me go over the third quarter full company performance, including sales and operating profit. To start with sales, a recovery in crude prices led to higher petroleum product prices and the sales volume refinery products and lubricants, both increased. In addition, sales volume for EV batteries also increased due to the expansion in production capacity. As a result, total sales increased KRW 1.2196 trillion quarter-over-quarter to KRW 8.4192 trillion. Turning to operating profit. Again a still sluggish refinery and petrochemical backdrop, inventory-related gains due to higher crude prices and a better lubricant performance of the business led to a quarter-on-quarter increase of KRW 410.7 billion to end with a operating loss of KRW 29 billion. On the nonoperating side, FX-relating gains of KRW 48.9 billion; equity method-related gains due to better performance from our subsidiaries, including Wuhan Petrochemical of 45 -- excuse, KRW 75.3 billion and net interest expenses of KRW 81.1 billion added up to nonoperating profit of KRW 41.2 billion. Next, let me go over the balance sheet. As of the end of the third quarter, total assets stood at KRW 39.2692 trillion a decline of KRW 256.9 billion versus the end of 2019. Tangible assets increased as capital expenditure grew, but lower oil prices versus the end of 2019 led to a decrease in inventory assets. Total liabilities was KRW 23.5138 trillion, an increase of KRW 2.1973 trillion last year as debt increase. The debt/equity ratio was 32 percentage points higher at 149%. In addition, gross debt stood at KRW 14.5341 trillion, up by KRW 3.4031 trillion versus the end of last year, and net debt grew KRW 3.65 trillion to KRW 9.6239 trillion during the same period. Next, let me go over the market environment and the third quarter performance of each different businesses. First, I'll start with the refining market and the market overview. The third quarter crude prices increased due to production cuts by the OPEC+ using oversupply around the world. The measured by effect to supply liquidity and by governments around the world to stimulate their economies also supported crude prices. Although refiners continued to cut production, the third quarter of petroleum product cap rate levels weakened quarter-over-quarter, driven by a decline in middle distillates crack levels due to lackluster demand and high stock levels. Ethylene crack continued to strengthen because of strong demand and less inventory due to the hurricanes in the U.S. However, diesel crack softened as high inventory remains an issue demand recovery was low due to pockets of resurgences of COVID-19. Aero crack was also weak since the recovery in demand from international sites is remote, while demand for local flights is still flat. In addition, the OSP for Middle East crude shifted from a discount in the second quarter to a premium level in the third quarter, resulting in weaker margins quarter-over-quarter for Asian refineries, which import a large portion of Middle East crude. Next, I would like to discuss the third quarter performance of the refinery business. Profit of the business amid a weak market backdrop created by low demand, inventory related gains increased on the back of higher crude prices, leading to operating profit increasing KRW 471.5 billion quarter-on-quarter to KRW 38.6 billion. Third quarter inventory-related gains for the refining business, including the LCM, or lower cost of market, is KRW 296.7 billion. We believe refining margins in 2021 will gradually improve because of the demand recovery as the impact from COVID-19 weakens. Now let me go over to petrochemical market. Third quarter olefin spreads continued to improve with less supply because of hurricanes in North America and regional crack facility troubles. Asia. While downstream demand remains strong, our market spreads continued to show weakness as the oversupply continued from new and restarted PX capacity in China. Next, let me talk about the third quarter performance of our business on the petrochemical side on the next page. So to discuss the operating profits, higher naphtha prices led to inventory related gains, but weak aromatics market resulted in weaker margins, while higher fuel prices increased variable costs. All in all, operating losses totaled KRW 53.4 billion, a decrease of KRW 121.6 billion quarter-over-quarter. 2021, the olefin market is expected to turn weak as supply increases from new global capacity additions. PX market is expected to see spreads improve due to stronger demand as the influence from COVID-19 continues. A new capacity, PTA capacity from Shenghong and Yixing Petrochemical that will total around 9 million tons, first half of 2021 will also be another factor. Next, let me move back to the lubricants business. For the lubricant operating profit, even though margins were weaker because of higher cost and recovered, leading to an increase in sales volume in the U.S. and Europe. As a result, operating profit increased to KRW 33.2 billion quarter-over-quarter to KRW 70.6 billion. Base oil market in 2021 is expected to gradually recover as demand improves, the less impacts from COVID-19 and additional demand coming from stronger fuel efficiency regulations in Asia. Next, I will call go over the third quarter E&P business performance. So for the E&P business, our sales recovered significantly from the steep drop in the second quarter, which was driven by COVID-19. However, operating profit does -- did not as improve much due to an increase in variable costs. Operating profit was KRW 18 billion. So next, let me move on to the battery business. The operating losses of the battery business actually improved by KRW 14.9 billion quarter-over-quarter to record a loss of KRW 98.9 billion. Third quarter sales posted KRW 486 billion, an increase of KRW 147.8 billion from the previous quarter. This is mainly due to a smooth increase in sales volume from the Hungary #1 and China Changzhou factories, which were fully ramped up in [ 2019 ]. Operating losses improved quarter-over-quarter because of an increase in sales volume from overseas production sites, also a cost savings activities. In addition to Hungary and Changzhou China factories, which started commercial operations this year, we are currently building a Number 2 factory in Hungary, 2 factories in Georgia in the U.S. and another factory in China. Please refer to the appendix for more details on capacity additions by regions. In addition, if you look at the third quarter sales volume and operating profit margin for the battery business, sales volumes is increasing rapidly on the back of existing large order books and high yield rate from overseas plants, while operating losses are decreasing as planned. In total, creating a gradual improvement in our performance with the goal of a breakeven in 2022. Let me go over the I/E business. Third quarter I/E materials operating profit decreased KRW 13.8 billion quarter-over-quarter to KRW 29.9 billion. The main reasons for a decrease in LiBS sales volume, due to product schedule adjustments by clients, a stronger won and increase in other costs. The company continues to increase production capacity for LiBS. Total production capacity was increased from 360 million in 2019 end and to 870 million square meters at the end of this year. From the fourth quarter, the new factory in China is expected to start commercial productions, one line at a time. In addition, we are also on schedule with the construction of our other global production site in Poland, which will go online from the third quarter of next year. Again, for more details on the capacity addition plans by region, please refer to appendix of the presentation provided. Due to COVID-19, which has taken a hit globally, all areas are going through and experiencing significant change and navigating confusion. In addition, concerns about a second wave of COVID-19 is becoming reality. The battery-related litigation has been further extended, delaying the improvement in our business environment in Korea and abroad. In order to deal with the uncertainties in our business environment, we will continue to solidify our position in our new business such as batteries and I/E Materials, while also continuing our efforts to innovate and fundally improve our existing businesses. This would be the end of our presentationand we would now like to start the Q&A session. Before asking your questions, we would like to ask you to state your name and affiliation. And please note that the Q&A will be conducted with consecutive interpretation.

[Operator Instructions] [Interpreted] The first question will be provided by Jae Sung Yoon from Hana Financial Investment.

[Interpreted] For the presentation, I will like to pose 3 question. The first question, could you share with us what your CapEx plan is going forward, including your battery business and a breakdown will also be appreciated? Second question. If you look at your net debt level, it has reached around KRW 10 trillion, and your free cash flow is also quite negative. I would like to understand what your plans are in managing your financial position going forward. Third question, I understand that you have plans to list your separator business and you're also contemplating selling your lubricant business. Could you provide us with some update?

[Interpreted] Yes. This is the CFO responding to your first question about our Capex. For this year, we're expecting on per annum basis about KRW mid-4 trillion in CapEx. And this will comprise mostly of battery and LiBS business, which will account for slightly above 60%, and which will be dedicated to investments into capacity additions. In terms of our projections of CapEx for next year, because we're currently in the process of developing our business plan, we won't be able to share with you any specific figures. Having said that, we expect that our plan will actually include CapEx that would be significantly lower than the KRW mid-4 trillion that we have spent this year. In terms of the second question, on our financial position, our net debt level has risen to around KRW mid-9 trillion, and that is mainly driven by our investments into battery and I/E business all of these activities had been so far debt financed. So it was quite inevitable that we had some impact on our financial structure. But going forward, yes, we are considering sales of our noncore assets and also equity holdings in our subsidiaries and possible IPO of our SKI technologies. So we will focus on financing for investment, even if we don't see a significant rise in the OCF level. We would think of going through and also reviewing potential reduction in our noncore assets as well as restructuring of the company. So that could be the means for us to actually finance for our investment, and also make sure that we are able to manage and defend our financial position as much as possible. Responding to your third question on the Head of Finance SKI office, in terms of the update of the I/E, IPO schedule and the possible sale of SK Lubricant. For SKIT, the I/E business arm, we are targeting to list and go IPO first half of next year. So at this point in time, we are going through preparation stages, including selection of the arranger. Now the details are currently being ironed out. So before any finalization of the details, it will be difficult to communicate at this point. But once that gets confirmed and finalized, we will come back to the market with information. Regarding the sales of the existing businesses, including SK Lubricants and our other businesses, we are looking at various different options that could help us further enhance the enterprise value of the existing businesses. So unless we make a final decision as to the future direction. Once again, it will be difficult for us to share with you the specifics. But once that decision is made, we will definitely come back to the market.

[Interpreted] The next question will be presented by Min-seok Won HI Investment & Securities.

[Interpreted] I would also like to submit 3 questions. First, can you provide us with an update as to what the current legal procedures are -- the state at the current legal process that you're currently engaged with LG Chemical? And secondly, have you made any changes to your battery business guidance? If so, could you share with us those changes? And recently, there's been certain changes in the market backdrop and usually, the winter time is the off-season. Can you share with us what your market outlook is for Q4 and for next year across all of your business areas?

[Interpreted] Yes. I am Yoon Ye-seon from the battery business. Responding to your first question, I would like to ask that you please understand that at this point in time, it will be difficult for us to share with you any specifics because what we say could actually impact the whole legal procedure. Having said that, the final decision date had been pushed back and postponed. ITC originally was to render its final decision on October 26, and that was pushed back to December 10. The initial decision date was actually the October 5. It was pushed back to the 26. And actually, this is the second time of that postponement. Now we do not know as to the specific reasons behind the decision to actually delay the final decision date, ITC originally moving that date from the 5th of October to 21 and adding another 45 days for the decision, final decision day. In light of those postponements, we believe that the committee is really considering this issue quite deeply and also wants to have ample times before it reaches the ruling. Because of the delay of the schedule, yes, the entire -- the lawsuit process has been extended. However, SK Innovation will engage in this process with its full diligence. And we are also open to any possibilities for discussions or negotiations in order to make sure that we could minimize uncertainties that may arise from such delay. Responding to your second question, for this year, regarding any changes to the revenue target guidance. During the first and second quarter earnings release, we shared with you our adjusted guidance, which is 10% lower compared to the initial KRW 2 trillion guidance that we shared with you at the beginning of the year, which was inevitable due to the volume adjustments that we've seen from the OEMs on the backdrop of the COVID-19 pandemic. Now that adjusted target that we previously communicated, we believe that we will be able to attain that adjusted guidance. In terms of the P&L objective for 2020, we believe that we will be able to achieve the original guidance that we community with you at the beginning of the year. Though the improvement of the yield rate and optimization of the cost structure, we believe that we will be able to further support our profitability, and also through early stabilization of our overseas production site we will do our utmost to make sure that we attain that P&L objective. I will also move on and share with you our guidance, P&L guidance for 2021 and '22. In the first part of this year, we started commercial operations as well as added gradually additional lines at our Hungary plant. And also, we have a Changzhou JV plant in China. And basically, in year 2020 -- as of October 2020, all of the lines are currently fully ramped up and making a smooth production. Thanks to the expansion of the capacity from these 2 site as well as increase in the supply volume towards the OEMs, we expect that 2021 topline revenue is going to be twofold that of this year, achieving KRW mid-3 trillion. And also, currently, in light of the global sites that is currently under production -- excuse me, under construction in the United States and in Europe, once these lines come under commercial production and once we start to provide our volume based on the programs, the order book that we have at this point, we believe that current year 2020, we will be able to achieve KRW mid-5 trillion in terms of revenue. And our objective, once again, is to attain BEP at that point in time. In the fourth quarter with the extended COVID-19 impact, which had really curved down on the demand, the recovery of the refinery margin has also been delayed. For the recovery margin for our company, gas, oil and jet crack really make big impact. And because of the high level of supply coming out of the European market as well as high level of inventory and low demand, we expect that the refinery margin will continue to display weakness. In terms of different petroleum product for naptha, we expect that due to low level of utilization and better market backdrop leading to better margins, we think naptha trend is going to display more robustness as we go into the future. In terms of gasoline, with the recovery of the import volumes from Indonesia and Vietnam, we are also expecting a moderate recovery for gasoline as well. And on the back of economic cycle improvement, we are -- for the fuel oil cracks, we are also expecting a slight improvement. Now in the first half of 2021, we think that the prolonged impact from COVID-19 pandemic will continue. So there will be some difficulties and drag against the improvement of the overall market environment. But as we enter into the second half of the year, we think that the situation will start to calmand we can expect global economic recovery. And hence, we think that the crack trajectory could start to show more positive trends.

[Interpreted] The next question will be presented by Hyunryul Cho from Samsung Securities.

[Interpreted] I would like to ask you 2 questions. First is about your refinery business. If you look at the CDU utilization, currently, it's at around 72%. So as a result of that, if we look at the fourth quarter and going into first half of next year, what will you think -- or how do you forecast the current utilization to be in terms of the level that you want to maintain going forward? In addition to that, if you look at Shell or the other refineries that are existing around the world, there is a lot of talk about decreasing capacity or decreasing the amount of facilities that they have. So as a result of that, do you actually see refinery scrap as something that is upcoming with regards to the use that you hear from the market? The second question that I would like to ask you is about SK IET. If you look at the performance, it has not been as good as the previous quarter, and I do believe the reason that you have cited is due to a decrease in volume. However, if you look at the third quarter, I do believe that overall, like electric vehicle particularly demand was very robust. So why has the top line declined? In addition, if we go into the fourth quarter of this year and also into next year, at the headline level, how much performance should we expect?

[Interpreted] So maybe I can address your question. This is Dong-yeol Lee from SK Energy. And with regard to the overall market that we see with regards to, for example, the Ulsan complex that we have, it is true that the market backdrop has been very sluggish. And as a result of that in terms of utilization of the capacity that we have, we are trying to be very conservative. And as a result, we have cut back the production at our CDUs. As a result of that, in the third quarter, as you have mentioned, we have been running at a throughput at around 72%. And in the fourth quarter, the plans as of now are to run at a lower level than that. And to talk about our plans for next year, going into the first half, again, we do want to take an overall very conservative stance. And as a result of that, for the current refineries that we have, we are looking at a slight change in the basic stance or the fundamental stance towards capacity, which was that in the past, the general assumption that was used is that all of the refineries would be running at full capacity. However, now we are actually moving towards a lower base level, which we would use as the base case. And according to the market situation, we would flexibly make the option of increasing when we see the market supporting that. And in addition to go to the second part of your question, which was talking about capacity reductions that are taking globally -- placed globally. It is true that due to COVID-19 situation, a lot of new and capacity expansion projects have been delayed to 2021. So as a result, if we look at the restructuring that has been taking place or is planned to take place, it represents around 0.8 million b/ds, whereas the new capacity to be added and expected in 2021 would represent around 1 million. So as a result, next year, the net capacity addition in total is expected to amount to around 0.2 million barrels per day.

[Interpreted] Yes, maybe I can address your question about ITC. This is Yoon Ye-seon. First of all, if we look at the overall separators business and the third quarter revenue, we can break down the revenue into separators for IT equipment and then for EV batteries. In the case of the EV batteries, as you have mentioned, the overall demand has been strong in the third quarter. So there were no issues there. However, if we look at the IT-related demand, in actuality, there were some changes in the sales volumes at our client level. And also, there were some adjustments made to the plant within the third quarter. So as a result, there was a temporary dip in the overall volume that we have been able to sell. However, if we go into the fourth quarter in terms of the utilization at our clients, it actually has improved and been increased. So as a result, if we look at the fourth quarter-to-date and compare that to the third quarter, in actual already, the fourth quarter is looking much better. In addition, if we talk about our expectations for next year in terms of LiBS. So market as a whole has been growing at a CAGR of around 30%. And we do believe that, that will be true for next year again. So as a result, our growth, we do to match market. And to make that happen, we are looking at detailed sales plans by customer. And also, we are doing our utmost to make sure that we can catch up and make that happen.

[Interpreted] The next question will be presented by Sang-won Han from Daishin Securities.

[Interpreted] I would like to also post 2 questions. Your chemical business has posted a loss. Can you provide us with some more color on what those -- what the situation is like for your olefin business and aromatics business for the Q3? in terms of the battery business, the form factors are undergoing quite a bit of transformation. In terms of the pouch type that you provide, what are some of the development initiatives or plans do you have? And also those efforts, what impact would they have, if any, on your performance or possibly your cost basis?

[Interpreted] Yes. I am [ Kim Young Ju ], responding to the question about the losses on our chemical business. And you've asks for the breakdown between the olefin and the aromatics business. As mentioned in my previous presentation, during the third quarter, operating profit reported negative KRW 53.4 billion compared to the previous quarters of negative KRW 121.6 billion. It's actually a reduction of about $6.8 billion -- KRW 68 billion, excuse me. Now for the olefin business, the demand held up quite well. So we saw a robust demand. So as a result, we were able to reported operating profit of KRW 49 billion. While for the PX business, there was an issue of oversupply, which therefore clamped down on our business performance, leading to minus KRW 115 billion. In terms of our battery business, you are right, we are providing a pouch power type, and we are exerting efforts to improve on the performance and improve on the cost basis. Basically, in order to increase the capacity and the mileage traveled for the batteries, we have been developing high-density energy batteries. We were the first in the world to develop a cathode with the high content of nickel. So we have been actually at the very forefront of the market. Also, we've been focusing very much on flash charging, which will really help the mileage traveled for the used. At this point, we're developing a technology that will enable a car to travel both ways from Seoul to Busan and Busan to Seoul with just a 10-minute charge-up over 2 instances. Currently, we think that this technology will be complete by the end of the year or by next year. Also, In terms of performance and cost benefits, we have been exerting continuous efforts to enhance the safety of the stability as well as reliability of our components. Especially in terms of the components we use for the batteries, one of the key components that really determine the safety aspect of battery separators. And we are the only company in the world that could actually in-source separators out of all the global providers. And hence, we believe that this is a very important aspect that could contribute to quality. And also, we have a manufacturing and production capability that actually aligns these electrodes in a most optimal way. Hence, we were able to gain high-quality reliability. Also, that is why all the vehicles that actually use our batteries have never been subject to any fire-related events out in the field. So that really attests to high level of quality that our products are offering.

[Interpreted] The next question will be presented by Young-chan Baek, KB Securities.

[Interpreted] There are 2 questions that I would like to ask you. First is, if you look at the overall market for the PX spreads, the PX spreads are currently very weak, and I do understand that at the end of the year, you do have the plan to scrap the #1 cracker. So over the mid- to long term for the petrochemical business, as a whole, what would be your plan and overall road map to grow this business? The second question that I would like to ask is about your lubricants business. As more electric vehicles are adopted, I do believe that there is the issue that -- or issue of concern by the investors that the overall lubricant base oil demand that we will see will continue to decline. So how would you address this concern that the investors have?

[Interpreted] So maybe I can address your question. This is SKGC. My name is [indiscernible] and with regard to the third quarter, if you look at the overall market backdrop behind PX, it was that there was new capacity added in China and also because of the COVID-19 situation, all in all, the demand for textiles has yet to recover. So that was the overall dynamics that we saw going into 2021. If a vaccine is success developed and we can overcome the COVID situation. I do believe that in the first half, because there is a large amount of capacity on the PTA side that is expected to be added from China that we expect overall spreads improve. So if we look at the overall road map that we have for the overall mid- to long term, the main areas that we will be focusing on is environmentally-friendly packaging and also the various products that we can produce to support lighter vehicles in general. So the technology that we have will be focused to be executed in these areas. In addition to that, we have a 3R strategy, which would represent reduce, replace and recycle. So under that overall strategy, on the recycle side, we do want to promote more and enable that take place within the market space. So we are looking to acquire the technology that would be necessary. So that for plastics, we can create a virtuous and also circular economy that would provide a more environmentally-friendly solutions.

[Interpreted] So this is Heon Jung from SK Lubricants. And maybe I can discuss our mid- to long-term direction for the lubricants market. I think that there are 3 different areas in which we can talk about. The first is that we want to transform ourselves into an ultra-low viscosity, exclusive entity, which would mean that if we look at the growth of the battery market and the overall path and journey that is required. We have had a lot of discussions with various consumer organizations, with industry groups and also consulting companies that provide consulting to the group. And we do believe that if you look at the overall path that battery development needs to take, in the middle of that, will be a transition period during which there will be a surge in hybrid vehicles. If we look at hybrid vehicles, demands that they have, the lubricants that would be required is higher quality than the existing Group 3 lubricants. So it would be a Group 3 plus type of very ultra-low viscosity-type of product. And we do think that this transition period will take a significant time and be maintained for a significant time. So as a result of that, we do want to cater to this market. So what we're trying to do is that at Busan right now, we do have Group 2 production capacity, which we are currently converting to be able to provide a Group 3 plus very ultra-low risk custody products. And as a result of that, in the short term, we do want to become the dominant player within this market space. And the second pillar would be the lubricant that is required for EV vehicles. So this is an area of focus for us. If you look at battery-installed EV vehicles that it actually do have lubricants that are required. And this is a market that is growing at a CAGR of around 15%. We currently already enjoy a very strong presence within this market and this is a position that we are looking to expand. And the last would be to transition the overall product portfolio so that we would be able to be more environmentally friendly. So if we look at the current state of the lubricant market, it can be divided into 2 big sections: one would be the base oil or the engine oil that is used for cars and the second would be the lubricant-finished products. However, going forward, we think that there will be a shift that will be taking place within this market space to become more environmentally friendly. And accordingly, we do also want to ensure that our product portfolio supports that type of shift. So it would be to produce wind to turbine oil that would go into the various wind farms that exist. Also battery cooling oil, also spray oil for animals and also special degreases would be a few of the different varieties that we would like to add on to our product portfolio.

[Interpreted] The next question will be presented by Dong Jin Kang from Hyundai Motor Securities.

[Interpreted] I would like to ask 2 questions. From the press, we've heard that your company is very much focused on in-sourcing all of the anodes and the electrodes that are used for your batteries, could you provide some color as to what kind of assets that you have, the capacity? And if you have any intellectual property, what are those? And also any mid- to long-term plan on your cathodes, which you use for your battery production? And also, if you were to compare end of last year and also as of today, what is your order backlog in terms of your batteries? And if you can't provide us with any specific number, could you at least provide some color and direction?

[Interpreted] So this is Yoon Ye-seon from the battery business. Basically, when it comes to these cathodes, it is quite important to gain a very stable supply. And we do agree that there is a certain level of in-sourcing that is needed. With the increase in the demand for the high nickel content cathodes, basically, our company, it was the company that actually, for the first time, commercialized this very material. So we do have a technical and technological know-how the company. So basically, we do have -- we do enjoy same level of in-sourcing. In that, we are working together with an outside partner who actually produce these material for us, but we have that technical know-how in developing the high nickel content cathode. Responding to your second question, we have our existing clients like Daimler and Hyundai-Kia Motors as well as other global OEMs like Volkswagen and Ford. And we are exerting efforts to gain new orders and new programs from these different customers. As of end of October of 2020, our order backlog is around 550 gigawatt hours. And as we continuously as our efforts to strengthen our ties with the existing customer base and also efforts to actually expand on the new clients so that we could continuously build up our order book.

[Interpreted] And this ends the Q&A session. And we will close the Q3 2020 earnings presentation. Thank you very much. [Portions of this transcript that are marked [Interpreted] were spoken by an interpreter present on the live call.]