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

[Interpreted] Good morning. I am [ Cheo Lee ], IR Product Leader at SK Innovation. Thank you for taking the time today to join us at this 2022 second quarter earnings call. Today's presentation has yet to be reviewed by our external auditor, so the results may be subject to change based on such review. With that, let me hand it over to CFO, Mr. Yang-Sub Kim, for the presentation.

[Interpreted] Good morning. I am Yang-Sub Kim, CFO of SK Innovation. First, let me start by thanking our shareholders and investors for your continuous interest in the company. On the call with me today are executives from SK Innovation and its major subsidiaries who will answer your questions during the Q&A. Now let me start the presentation on SK Innovation's 2022 second quarter highlights. For the company's second quarter, operating profit was KRW 2,329.2 billion. Following the record of the first quarter, we again posted the highest operating profit for a quarter. Against the market backdrop where the spread between high and low sulfur FO was widened, the company was with its #2 VRDS, which represents the largest FO desulfurization capacity in Korea, was able to achieve competitive margins. In addition, leveraging the current high volatility market, we increased our trading gains. Second is SK On second half earnings outlook. Driven by the ramp-up of new capacity, including the #1 factory in the U.S. and price adjustment discussions on increasing material prices, SK On is planning to improve its profitability and also continued top line growth in the second half with the operation of the China Yancheng #2 factory. And last is our new business initiative. SK Innovation is committed to enhancing its corporate value by establishing a differentiated green portfolio in the energy and materials sector. To this end, we are pursuing many new businesses. These are the highlights that we would like to emphasize for the second quarter. And during the later parts of the presentation, I will go into more detail on each item. Now let me discuss the second quarter business performance. I will start with the full company performance, including sales and operating profit. First, on the top line, second quarter crude and refinery product prices rose, leading to a Q-o-Q increase of KRW 3,643.8 billion to end at KRW 1,905.3 billion. On operating profit, stronger refining margins and higher oil prices led to higher inventory gains resulting in an increase of KRW 680.1 billion to KRW 2,329.2 billion. Our nonoperating losses, larger FX-related losses driven by a weaker won and an increase in interest expenses due to more borrowings led to an increase of KRW 46 billion to a nonoperating loss of KRW 319.1 billion. In detail, the nonoperating losses can be broken down into FX-related losses of KRW 145.3 billion; derivative losses, KRW 109.5 billion; net interest expenses, KRW 99.4 billion; equity method gains, KRW 39.4 billion; and other losses of KRW 4.2 billion. Next, let me go over the balance sheet. As of Q2 end, due to stronger inventory and trade receivables on the back of an increase in crude and refining product prices, and also due to an increase in tangible and intangible assets from investments, total assets increased KRW 14,892.7 billion to KRW 64,427.7 billion. Due to an increase in trade payables driven by crude prices and an increase in debt, liability versus last year-end increased KRW 12,177.3 billion to KRW 42,101.5 billion, and the debt equity ratio is 189%. In addition, net debt increased KRW 1,871 billion to KRW 10,283.9 billion as net working capital increased in line with crude prices, and facilities investments grew for battery capacity additions. Now let me drive into the second quarter performance of each business line. Refining margins have improved due to concerns about supply disruptions from the continuing war and expectations on a recovery and demand in a post-COVID environment. Against this backdrop, operating profit increased KRW 722.4 billion versus the first to KRW 2,229.1 billion. In particular, the #2 VRDS we built in 2020, which is the largest FO desulfurization capacity in Korea, has enabled the company to achieve competitive margins in a market where the high to low sulfur FO spread is the widest in history. Moreover, in the trading area, we have been able to capture high-margin power generation demand overseas and leverage the economics of blending low-cost crude in a high-volatility market to realize strong trading gains. Second quarter inventory-related gains, including LCM was KRW 766.9 billion. To discuss the outlook for refining margins in the third quarter, a structural supply shortage will continue as the work continues, and gas supply in Europe is an issue, which is expected to lead to strong refining margins. But at the same time, demand may weaken if there is an economic recession. So we expect margins to show some fluctuation for the time being. Next, let me move over to the petrochemical business. Operating profit for the petrochemical business increased KRW 44.8 billion Q-o-Q to KRW 76 billion, though there was an inventory-related impact due to weaker naphtha prices and an increase in fixed costs such as power. Our operating profit still rose Q-o-Q as spreads improved significantly driven by aromatics, including tight PX supply. Next, let me go over to outlook by product. First, for PE, we expect spreads to improve as crackers spread -- as regional crackers cut back on production. In addition, PP spreads may face some downward pressure due to new capacity in China, but weaker feasibility will lead to less supply, which is expected to let the spreads gradually recover in the second half. For PX, spreads are expected to remain flat due to less gasoline demand in the second half and new capacity emerging in the region. Next, let me go over the lubricants business. Here sales volume decreased slightly versus the previous quarter, but higher crude drove lubricant prices and inventory-related gains higher, resulting in operating profit to rise KRW 43.6 billion to KRW 255.2 billion. Looking at the second half, BO spreads are expected to gradually stabilize as costs fall due to lower crude prices, and ASP weakens as supply shortages ease. However, if an unexpected recession were to happen, it is possible that prices will fall a bit more seriously due to weaker demand. Now let me go over to the E&P business. E&P operating profit in the second quarter declined KRW 32 billion Q-o-Q to KRW 166.2 billion, are due to a decrease in sales volume and an increase in certain SG&A items. On the following slide, I will now discuss the battery business. In the second quarter, battery sales increased KRW 28.1 billion because of new factory and an increase in sales prices, even though sales volume decreased on the back of semiconductor chip shortages. Operating losses increased slightly to KRW 326.6 billion due to less sales volume and higher utility costs in Europe. Across the third quarter and the second half as a whole, we expect to grow both the top line and -- in our margins and profitability driven by new capacity ramp-ups like the #1 factory. And by the end of the year, in addition to the U.S. #1 factory, the new capacity of the ongoing #2 and ramp up in the China Yancheng factory will bring our capacity to 77 gigawatt hours, which is double that of last year. The Hungary #2 factory is currently in the initial stabilization phases. We have applied the know-how of other main factories and provided full support from HQ resulting in a quick normalization. So in the second half, we expect productivity to be at stable levels equal to that of the other sites. Please refer to the appendix for more details on our capacity expansion plans by region. And next, let me move over to the I/E Materials business. For the consolidated loss of the I/E Materials business, though we did see a slight increase in sales volume, operating costs such as utilities, increased, leading to a Q-o-Q increase of KRW 9.9 billion to KRW 13 billion. For the third quarter, we expect profitability to improve with gradual increases in separator demand. And next, let me discuss our new business initiatives. SK Innovation is committed to enhancing our corporate value by creating a differentiated green business portfolio in the energy and materials space. In light of the long-term mega trends, we are exploring business and portfolio options in the net-zero and circular economy-related sectors. Zero carbon clean energy, hydrogen and ammonia-related businesses areas, CCUS and recycling are areas that we are interested in building our portfolio out in, from an energy and environment solution angle. For new business initiatives in progress, please refer to the presentation material. And finally, we will now -- let me walk you through our ESG management strategy and carbon reduction targets. As our business becomes more global with more business areas, the employees, shareholders, business partners, customers and other stakeholders of the company are also growing. In order to continue to gain the confidence and support of these many different stakeholders, and to strengthen our firm value, ESG management is not an option, but a must. To create a framework for our ESG management initiatives, we have established a GROWTH strategy: G stands for green innovation; R, road to net-zero; O, outstanding SAG management; W, winning the trust; T, together with society; and H, stands for happiness for all. This GROWTH strategy divides our ESG management initiative into 6 key areas in which we have identified 16 key corporate projects. For each project, we have established a midterm target for 2025 and annual milestones that need to be achieved to reach the midterm target. In addition, using the online data platform that we have developed, we are not only going to transparently disclose our ESG platform to the outside, but also enhance the BOD-led management to check the progress of the growth strategy and to ensure consistent implementation of our ESG management. For your information, more detailed information on our ESG growth strategy will be available in the ESG report to be issued. SK Innovation has established a net-zero target that covers all of Scope 1, 2 and 3, and we track the progress each year to ensure we move forward. In the energy chemical area, the target is to achieve a 50% reduction by 2030 in Scope 1 and 2, and to achieve net-zero before 2050. In 2022, the target is to cut emissions in energy chemicals by 1.12 million tons in comparison to 2019 levels. Based on our recent reduction simulations, we expect to reach a reduction of 1.42 million tons, satisfying this year's target. The company is planning to actively share the details of our net-zero efforts in a net-zero special report to be issued in August. So we look forward to your interest and support. Thank you. This is the end of our presentation, and we will now start the Q&A session.

[Interpreted] [Operator Instructions] The first question will be presented by Hyunryul Cho from Samsung Securities.

[Interpreted] I'm Hyunryul Cho from Samsung Securities. I would like to ask you 2 battery business-related questions. Your second quarter losses have widened, and you've also mentioned during the presentation, however, you expect profitability improvement in the third and the fourth quarter. I would like to understand to what extent we can expect that margin of improvement? And when can we also expect quarterly breakeven point? Second question. I understand that previously, you communicated that you will probably complete pre-IPO process and within the first half of the year, I would like to get some update as I believe there has been some delay. And can you provide some more details with regards to how this is currently ongoing?

[Interpreted] This is Sunmi Jean. I'm the Head of Battery Strategy and Planning Office. I will respond to your first question. So in the first half of the year due to the shortages of semiconductor supply in the first half for the automobiles as well as on the back of rise in the commodity prices, it's true that we've seen some increases in our losses. Now as we enter into the second half of the year, we expect the overall business and operational environment will start to turn positive compared to the first half of the year, in particular, with respect to the newly operating capacity that came online in the beginning of '22, believe that the ramp-up is going to go quite smoothly, and we will see initial stabilization. And we are also seeing a more stable trend when it comes to commodity prices. Now also, in particular, we are talking and negotiating with the OEMs with regards to adjusting the price or the ASP on the back of the rise in the commodity prices. And as a result, we expect in the second half of the year, we will be able to see improvements in profitability. So due to the reasons that I have just mentioned, we are sticking to our initial objective of meeting operating profit breakeven in the fourth quarter. So in the second half of the year, even if we are faced with some unexpected difficulties, the company will do our utmost to make sure that we improve our margin as well as our profitability as per our plans.

[Interpreted] So this is CFO, Yang-Sub Kim. I will respond to your question relating to SK On's pre-IPO update. Now regarding the pre-IPO process for SK On, it is true that there has been a bit of a delay compared to the original plan and schedule. But I can tell you that currently, the negotiation is ongoing, however, because we do not yet have a finalized timing or the size, I would not be able to, at this point in time, share with you the details. But once we arrive at the decision, we will make sure we make the appropriate disclosures and communicate with the market. mine.

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

My first question is on your battery revenue. So second quarter was only up very slightly, and I think you mentioned volumes were actually down quarter-on-quarter. Could you give us some updates on your full year revenue expectation, second half volume growth and 2023 volume growth? And in first half versus your expectations based on your order backlog, which region has been causing the underperformance? Would it be mostly Europe or some other regions as well? And then the second question is, there has been some news flow that Ford has been thinking about starting to do LFP batteries, potential partnership with CATL, et cetera. What do you think is the impact? Do you see this as a risk for your business? And do you have -- and what are your plans for LFP batteries for any application?

[Interpreted] Yes. once again, this is Sunmi Jean, the Head of Battery Strategy and Planning Office. I will respond to your first question. So in the first half of the year, due to the rise in the metal prices, although the battery price, the ASP actually went up due to a slight decline in the sales volume, our revenue, the top line revenue did slightly decline. Now this decline in sales volume from our company was not attributable to any internal causes. It was actually triggered by the semiconductor shortages that led to a lower level of production and sales on the OEM side. Now since year 2017, we've seen revenue grow double fold on a per year basis. And for year '22 as well, we're expecting our revenue to report a twofold growth. So we will be no less than KRW mid-7 trillion level in terms of the full year revenue. And regarding your question of whether any specific geography had an impact on the underperformance, I do not think that was the case. So in the second half of the year, we are going to be able to see some revenue being generated from the new programs that are going to come online. And also, we expect the semiconductor supply-related interruptions will also ease. Hence compared to the first half of the year, we expect there to be a significant or a quite large margin of revenue improvement.

[Interpreted] This is [indiscernible]. I'm the Head of Battery Business Strategy Office. I will respond to your second question. Well, as you may be well aware, the battery forms or battery types also are becoming more diversified depending on the type of the vehicles, is it entry-level volume or premium? Now regarding the partnership between Ford and CATL, we believe that this will relate to lower end of the segment for -- or the low end or the entry level for these LFP application. So this segment does not overlap with the segment that we serve as a company. So we believe that there will be a limited impact. So as mentioned during the first quarter earnings release, our objective is to complete the development of the LFP cells by the end of this year. And at this point, we are under discussions and talks with our customers and clients in regards to the development and supply of such LFP cells. And once we make -- or gain more visibility and when we start the mass production, we would be also able to share with you some more details.

[Interpreted] The next question will be presented by Jae Sung Yoon from Hana Securities.

[Interpreted] I think that if we look at the overall situation of SK Innovation right now from the refinery business that you have, you are generating significant profits, and a lot of cash from that business. So I think that from the markets perspective, one of the questions that we would have is that for these resources that you have acquired, what -- and what type of business are you going to engage in going forward? So on Page 15 of your presentation, you do have a lot of initiatives that you have laid out here. But of these initiatives, what would be the main focus area that you are looking at for the future? And in terms of your battery materials internalization, do you have any targets in terms of what type of -- and what level of internalization you want to achieve in the future?

[Interpreted] So this is [indiscernible] Kim, the Head of Corporate Development Office at SK Innovation, and maybe I can address your first question. So as we have mentioned in the presentation, I think that for the future, as of the current time, the overall the overall approach that we have is that for our future business portfolio, we are looking at a wide variety of options that would be available to us, and the best way going forward. So as a result of that, I do think that the areas that we are interested in would be clean energy, hydrogen and ammonia-related businesses, CCUS and also recycling. So as of the current time, we are leaving all of the options that we have opened. And I think that right now, what we're trying to do is explore and also review the possibilities that we have for us. So with regards to the ammonia side and also the waste-to-energy area, I think that what we can say is that we're in the seeding phase as of the current time. But once we have a more specific focused area that we are going to concentrate on, I do think -- and once we have more definitive plans for the future, we will make sure to share that with you. And with regards to battery materials specifically, again, I think it's coming from the same note. We are looking at a wide variety of options. Of course, within the SK Group as a whole, there are a lot of different companies that are within the group. So right now, on the battery materials area, we do have different investments and also discussions that are in place. And we do want to be able to cooperate as the group as a whole. So with regards to the internalization and also commercialization of these various opportunities, I think that as of now, we are reviewing the options that are available to us. And in the same note, once we have more definitive plans, we will make sure to share that with you.

[Interpreted] The next question will be presented by Nikhil Bhandari from Goldman Sachs.

My first question is on the balance sheet. So if I look at the gearing that has gone up this year versus end of last year, even with pretty strong profitability of the refining business. Can you talk about where do you see gearing heading into the second half of the year, assuming no transaction on the battery, private investment side? And also, if you can just talk about your CapEx in the first half this year and the updated guidance for this year and next year. And even in the newer areas, the green businesses that you're getting into, have you allocated any kind of CapEx in those green areas that you will be investing in the next 3 to 5 years. It will be helpful to understand. And the other question I have is on the battery business profitability. So you mentioned you're planning to get to breakeven still by 4Q this year from negative 25% right now. Can you make us understand a bit more about where we stand right now on the gross margin and the EBITDA margin for the battery business in the second quarter? And my last question is on the refining side, if oil prices stay at a current level, would you -- for the rest of the quarter, would you expect still any more inventory gain in third quarter? Or will there be inventory loss?

[Interpreted] This is the CFO. I will respond to your question about the gearing ratio. Over the first quarter, the crude prices have increased by around $17.3 per barrel, and even during the quarter, there's been a sustained uptrend in crude prices, which led to an increase in the working capital, really offsetting lion's portion of the pretax income. And continuous CapEx spend also had an impact on the debt-to-equity ratio as well as debt and borrowings. But coming into the second quarter, and as we move into the third quarter, we are seeing an easing of the rise in the crude oil prices, which also mitigated the impact from the working level capital increase -- working capital increase. So in the second half of the year, we would be able to see generation of OCF, and possibly a decline in the working capital or at least an easing of that increase in working capital. So I believe there is a great possibility that we will not be able to see a tick up in the gearing ratio. And also on the SK On side, if we consider that pre-IPO process, and that coming to a conclusion, I believe that ratio will not -- will actually be coming down. Responding to your second question on for this year, as we previously communicated, based on our order book, the front and back, we expect the CapEx for this year will amount to around KRW 6 trillion to KRW 6.5 trillion in light of the investment that we will need to make in batteries, materials and I/E. Now in terms of further out into the future after next year, we do not yet have the concrete figures for CapEx yet because we have yet to develop a plan for that. Once we have that in place, we will conduct to you, and share that information. I will continue to respond to your question on the inventory gains. The amount of inventory-related impact that is going to be reflected based on the time lag will amount to about KRW 170 billion. But of course, having said that, the caveat is, it will fluctuate or change depending on the crude oil price changes.

[Interpreted] Moving on to your third question on battery. Once again, this is Sunmi Jean. I'm the Head of Battery Strategy. Let me once again walk through what are the key drivers behind our expectations that there will be improvement in the margin for SK On in the second half versus the first half. End of year 2021, the U.S. Georgia plant started its operation, and beginning of year 2022, the #2 Hungary plant started its operation as well. And at this point, these 2 sites are currently ongoing, stabilization phase. And we believe that by the second half of the year, the productivities from these factories will become on par with our other existing sites. And also in the first half, there was a sudden surge in the commodity and materials prices, which led to widened volatility, and that worked as a risk factor bottom line profitability. But in order to respond to such surge in commodity prices, we've been negotiating and talking with our OEMs, and we were able to gain some good achievements from those endeavors. And also, there were some internal efforts as well for us to improve our cost effectiveness and also identify some items where we could bring about cost savings. So there's been a continuous effort improve our profitability. And these are the basis based on which we expect, the margin will start to improve as we enter into Q3 and Q4. And hence, we expect we will be able to achieve the BEP level by the fourth quarter of this year. In terms of the gross profit margin and EBITDA margin, at this point, we are receiving the outside auditors audit review, and we do not yet have the audited numbers, so please understand that we won't be able to share with you the specific numbers.

[Interpreted] The next question will be presented by Oscar Yee from Citi.

I've got 2 questions. One is today, there was some news saying that SK On has secured EUR 2 billion sort of funding already, I think, based on some local news. Could you confirm if that's the case? Obviously, the worry is with the delay in the pre-IPO funding. There has been some market concern about the funding gap, and how you will be able to meet that. Second question is, you comment about the utility cost increase in Europe impacting your margin? Would it be possible if you could share roughly in terms of percentage what percentage is utility costs as a percentage of product cost and its possible roughly how much of that liquidity costs have gone up versus, say, last year? And because of this higher utility costs, do you think or sort of target breakeven can still be achievable under such sort of higher fixed cost? And just finally, also on this, could you share with us, are you using a renewable or using just gas fired or just you buy from the grid with any sort of like PPA agreement?

[Interpreted] Yes. This is the CFO, Yang-Sub Kim, and maybe I can take your first question about the euro funding, and the news report that you mentioned. So for the amount in euro that you just mentioned, this is related to the funding activities that we have for the #3 plant that we are building, and planning to build in Hungary. So the nature of these funds would be ECA financing, and also green financing. And as far as I understand, within the battery industry, it is the largest ECA financing to date. So it is true that this process is underway. And I do believe that we can say that we are in the almost final, final stages of this process. And so this financing in nature is not related in any way to the pre-IPO process. And the reason for that is because initially, when we had the funding plan for the Hungary #3 factory, from the beginning, we were planning to fund some of it in equity and some of it in debt. So therefore, this amount related to the ECA financing should be regarded as a portion of the overall debt financing that we are trying to achieve related to this factory.

[Interpreted] So this is Jean Sunmi the Head of the Battery Strategy and Planning Office. And maybe I can address your second question. So from the beginning of 2020, due to the Russia-Ukraine conflict in the European area, if we look at prices for electricity and also LNG, there has been a significant increase taking place. However, going into the second quarter, if you look over -- if you look at the overall situation, the overall increased rate in itself has been moderating out. And therefore, at the Hungary factory, with regards to the overall suppliers that we have in that area for utilities and also due to the support from the HQ, we have been able to come up with a plan to counter the situation, and have been executing that accordingly. In particular, if we look at the second half of 2022, in the case of the Hungary for the suppliers that we have for electricity and LNG, we have forged a strategic alliance with these partners. So as a result, we have come up with a supply overall target price that we have, and also are pursuing long-term fixed price agreements with these parties to ensure that the overall profitability of these sites and also the uncertainties that would be related to the overall feasibility for the future can be minimized as much as possible. So -- though inflation and our overall utility price increases are something that we are seeing taking place across board, around the globe. If we look at it specifically by region, compared to Europe, we do believe that for the U.S. and also China, the overall increase in utility costs is not working as a -- it doesn't have as large an impact as we see in Europe. And in addition to that, in terms of the overall targets that we have achieved in achieving the profitability that we have want going forward and for the targets that we have shared with you, the rise in the utility and also power prices is fully reflected into those plans. So when we talk about our second half expectations, this is something that has already been included. And maybe to talk about our environmentally from the energy sourcing initiatives. In line with SK Innovation's overall ESG strategy as a whole, of course, SK On, in line with that strategy also has its own ESG initiatives. So with the target of reaching net-zero in 2035 in terms of Scope 1 and 2, we are trying to decrease the overall energy usage, try to source from fuel sources, and also leverage various more green energy sources. In particular, as a preemptive measure to achieve net-zero earlier than our target by 2030 for all of the production sites that we have, we do have a road map that we are currently establishing to adopt more environmentally friendly power sources. And for 2022 in Hungary, and for some of the U.S. factories that we have, that would be the beginning. And we are going to expand this initiative to our global sites in the future on a gradual basis.

[Interpreted] So with that, we would like to wrap up our Q&A session, and also end this conference call for the second quarter of 2022. Thanks again for your participation. [Portions of this transcript that are marked [Interpreted] were spoken by an interpreter present on the live call.]