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

[Interpreted] Good morning. This is Hun Shi Gyu, IR Project Leader at SK Innovation. Thank you for taking the time to join us today on this 2022 Q4 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 the 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 continued interest in the company. On this call with me today are executives from SK Innovation and its major subsidiaries who will be available to answer your questions during the Q&A. Now let me start the presentation on SK Innovation's 2022 Q4 highlights. Despite inventory losses from lower crude prices and operating losses due to weaker refining margins in the fourth quarter, for the full year, the company still posted a record level operating profit of KRW 3,998.9 billion. In particular, the Lubricants business achieved its highest annual operating profit of KRW 1,712 billion, as supply remained tight leading to high margins. SK Trading International took advantage of the volatile market situation to increase the overseas sale of high-margin products and generated bunkering trade profits by blending more lower-cost crude, resulting in full year operating profit of KRW 607.2 billion. In addition, our battery business, SK On, continued to increase sales volume with new capacity going online leading to KRW 2,875.6 billion in sales, the highest per quarter numbers to date. That is around 31% up quarter-over-quarter and a jump of 170% versus the same period last year. For 2022 in total, SK On ended with sales of KRW 7.6 trillion, an increase of 150% Y-o-Y, and we expect 2023 to be another year of significant top line growth, thanks to new capacity ramp-ups. In relation to the IRA guidance, which included details as the Advanced Manufacturing Part of Product or AMPC, announced by the U.S. Treasury on December 30, we have reviewed comprehensively the contents that have been announced to date. Once additional details are announced in the future, we will be able to provide more information such as the size of actual benefits we would enjoy in accounting treatment. But as of now, the company estimates that it will be able to enjoy a maximum around KRW 4 trillion in benefits from 2023 to 2025 in relation to the IRA AMPC. Moreover, as we expect large-scale capacity expansions in the U.S. to be completed by 2025, once full production starts in 2026 and after, we expect this amount will increase significantly. Thanks to this policy support, the company will ensure to move ahead with capacity expansion plans in the U.S. according to plan and build out its North American supply chain to further solidify its position in the market. With this as an overview to SK Innovation's Q4 highlights, let me now go into the details of our Q4 business performance. I will first start with the Q4 full company performance, including sales and operating profit. On sales, driven by weaker demand and lower crude prices due to concerns about a global economic recession and a resulting decline in refining and petrochemical product prices, sales declined KRW 3,616.7 billion Q-on-Q to KRW 19,136.7 billion. For operating profit, the weaker crude prices and refining margins, coupled with lower PX spreads for the petrochemical business and initial costs related to running new overseas capacity for the battery business, the number was down KRW 1,387.2 billion Q-o-Q to result in an operating loss of KRW 683.3 billion. On the nonoperating side, FX-related gains due to the stronger won and an increase in product derivative gains led to an improvement of KRW 335.8 billion Q-o-Q to end at a loss of KRW 64.6 billion. To break down the nonoperating loss, FX losses were KRW 187.5 billion; derivative gains KRW 44.4 billion; net interest expenses, KRW 141.9 billion; equity method losses of KRW 73.4 billion; and other expenses, KRW 81.1 billion. Next, let me walk you through the balance sheet. As of 2022 end, total assets increased KRW 17,692.3 billion Y-o-Y to KRW 67,237.2 billion because of an increase in inventory and trade receivables, coming from higher crude and refining product prices, while tangible and intangible assets from investments also increased. Liabilities during the same period increased KRW 13,977.3 billion to KRW 43,901.5 billion due to factors, including an increase in trade payables due to stronger crude prices and an increase in borrowings. The net equity ratio was 188%. In addition, net debt increased Y-o-Y on the back of facility investments for battery capacity expansions from KRW 6,101.9 billion at the end of last year to KRW 14,514.8 billion. Now let me dive into the Q4 performance of each business line. For Refining, the operating profit declined KRW 977.7 billion Q-o-Q to an operating loss of KRW 661.2 billion. Due to the fall in crude in the fourth quarter stemming from growing concerns about global economic recession, inventory-related losses including lower of cost or market LCM was KRW 624.6 billion. In 2023, we expect China reopening to lead to stronger demand while factors limiting supply, such as the EU sanctions on Russian refinery products and the OPEC+ production cuts will together result in solid refining margins. Next, the Petrochemical business. Operating profit decreased KRW 196.7 billion Q-o-Q to a loss of KRW 88.4 billion because of weaker margins as aromatic spreads fell. The impact of LCM and an increase in fixed costs also had a factor. In addition, let me talk about the outlook for our core products. For PE and PP, we expect that though there will be additional supply coming from new capacity in the region. The reopening of China should improve demand, which we believe will also contribute to gradually improving spreads. In the case of PX, a large-scale PX facility is expected to go online in the region during the first half, but at the same time, new PTA capacity expansions of a similar level and stronger demand from China is overall expected to result in moderately improving spread levels. Next, let me move on to the performance of the Lubricants business. Despite an improvement in margins from lower cost levels, the operating profits for the Lubricants business decreased KRW 67.6 billion Q-on-Q to KRW 268.4 billion due to a decrease in sales volume as it was a seasonally low season and inventory-related losses, including LCM. In 2023, we expect the Lubricants to show solid spreads because of tight base oil supply as UCL production volume decreases due to sanctions against Russia and gas to oil demand. Next, let me go over the E&P business. Q4 E&P operating profit weakened KRW 43.9 billion Q-on-Q to KRW 116.6 billion due to lower crude and gas prices even though sales volume had increased. Now let me discuss the Battery Business. The Q4 sales for the Battery business increased as sales volume continued to grow with new capacity going online. The top line increased by KRW 681.4 billion Q-o-Q to achieve a record high quarterly number of KRW 2,875.6 billion. On the operating profit level, the increase in new overseas capacity resulted in fixed cost increasing in advance, thus the level of losses increased Q-on-Q, leading to operating losses of KRW 256.6 billion. In 2023, with new overseas capacity ramp-ups, we expect top line growth to remain strong. In addition, based on the negotiation power provided by a growing EV market and an increasing demand for batteries, we will continue to improve the profitability of the business. For the details about the capacity expansion plans by region, please refer to the appendix. Next, let me talk about the I/E Materials business. In Q4, strong sales of key customers improved the consolidated operating profit of the I/E Materials business by KRW 22.1 billion Q-o-Q resulting in operating losses of KRW 4.9 billion. We expect 2023 will be another year of sales growth and more cost competitiveness, which is expected to result in a gradual improvement in profitability. Next, let me discuss the company's Net Zero Strategy. In 2022, SK Innovations emissions recorded approximately 10.7 million tons, representing a reduction of 14% from the Scope 1 and 2 emission levels for the Energy and Petrochemicals business in 2019. This performance is in line with the company's pathway to achieve its midterm targets of 25% reduction in 2025 and 50% reduction in 2030 under its Net Zero road map. To cut emissions, the company is actively utilizing a wide range of options, including improving process efficiency, transitioning towards ecofriendly fuel, optimizing operating facilities and introducing renewable energy. In addition, as we mentioned during the Q3 earnings call, SK Innovation is aiming to achieve net zero in Scope 1 and 2 before 2050. Thus, we will continue to implement the Net Zero road map established in 2022 to ensure we can continue to reduce our emission levels going forward. For your reference, the company's net zero activities and performance will be disclosed transparently in detail to all stakeholders through our ESG report to be issued in August. On the next page, let me discuss 2022 dividends. To honor the commitment we made to shareholders on our midterm dividends for the shareholder returns related to the 2022 financial performance, the company has decided to pay year-end dividends that represent a dividend payout ratio of 30%. In light of the highly uncertain business environment and large-scale CapEx plan for 2023, the company has decided on dividends in kind that use treasury shares. The final decisions on dividends will take place during the general shareholders' meeting. In addition, no decision has been made about a possible SK On IPO. However, in the event that we do review a listing, we are planning to actively explore measures to protect the interest of SK Innovation shareholders. In addition to reinvesting into the company for its own growth, special dividends and other measures to enhance mid- to long-term shareholder value are under review to ensure we match the trust of our shareholders who have shown unwavering support for the company.

[Interpreted] This is the end of today's presentation, and we will now start the Q&A session. The Q&A session will be conducted with consecutive interpretation. For approximately 2 weeks before this call, we received questions in advance via our homepage or website. Before taking live questions, we would like to first address some of the most frequently asked key questions. First question that we have previously received is on the company's overall CapEx guidance and the financial position. I would like to invite our CFO to respond to this question first.

[Foreign Language]

[Interpreted] I am Yang-Sub Kim, the CFO. Allow me to respond to the first question that we received in advance. First, this year's CapEx plan. This year, there will be a full-fledged investment in order to complete BO SK capacity in time. In light of such business plan, we set aside for an investment plan amounting to a total of KRW 10 trillion. And looking at more detail for the battery business, we are planning to invest a total of KRW 7 trillion to secure new capacity. On the non-battery business side, meaning recurring basis and strategic investments, we are planning around KRW 3 trillion of investments. Such investment will drive engines for growth in battery and materials business as well as already commercialized green business. Also, we will support commercialization of new businesses, including BMR and recycling of scrap plastics.

[Foreign Language]

[Interpreted] I will now talk about how we will be managing the company's financial position under the bigger CapEx spend plan versus last year. Of the KRW 10 trillion CapEx, BO SK, which amounts for a major portion -- account for major portion will be funded through partnering equity investment, more or less on a pro rata basis. We are also discussing many items at disposal to fund our CapEx spending, including government incentives from the local markets. Once such items materialize, I expect we can significantly lower the company's CapEx burden.

[Foreign Language]

[Interpreted] Also, we expect refinery business to perform quite well, backed by structural demand and supply issue, while chemical business is expected to see demand recovery from downstream products following PTA capacity additions and China's recovery, which will lead to a better PX margin. Lubricant business had a record high year in earnings and such favorable market backdrop is expected to continue. We are also looking forward to a much better performance on the battery business versus 2022. Despite good business performance in '22, steep crude price hike drove up working capital, which was a drag on operational cash flow. But this year, we expect the impact of good earnings to more or less directly feed into cash flow improvements and enhance the company's financial position.

[Foreign Language]

[Interpreted] On top of enhanced operational cash flow and KRW 500 billion of SK On's second phase pre-IPO funding, we are looking into various ways to improve financial standing, including finding an additional investor on the same terms. Once these efforts pay off, despite bigger CapEx spend versus last year, I believe we will be able to manage and keep our financial position stable.

[Foreign Language]

[Interpreted] Second question relates to the reasons behind the performance declines that we've seen in '22 for SK On towards profitability as well as '23 guidance. This question will be answered by the executive from SK On.

[Foreign Language]

[Interpreted] Hello. I am JongHyun Kim, CFO of SK On. Allow me to respond to the second question. Looking at Q4 earnings, there was an increase in ramp-up costs following new plants coming online. SK BA number 2 and SK OD number 2 posting rise and costs from ramping and delay in production yield improvement all amounted to operating loss reporting at KRW 256.6 billion, which is down by KRW 120 billion Q-on-Q. Q4 EBITDA was down KRW 108.9 billion Q-on-Q to minus KRW 99.5 billion, failing in quarterly EBITDA turnaround following Q3. But in the fourth quarter, when removing the fixed costs from the new sites, EBITDA loss had been greatly downsized.

[Foreign Language]

[Interpreted] Looking back at year 2022, we continued on with activities to improve profit including improving productivity, adjusting the sales price or the ASP to the OEMs. But due to the negatives such as decline in sales and semiconductor supply issues versus what was forecasted and higher commodity price from global inflation, labor cost increase and rise in power cost from Russia and Ukraine war as well as increase in FX rates and the fact that we weren't able to respond on a timely basis contributed to deterioration of the profit. Aside from such external factors on slower-than-expected ramp-up of new factories in the U.S. and Hungary, operating loss amounted to close to KRW 1 trillion.

[Foreign Language]

[Interpreted] While we haven't fully realized profitability as we are in the growth phase where sales and revenue growth are both quite steep, we have identified issues on the profitability side, developed measures and are in the process of implementing those plans. This year, year '23, we plan to focus both on growth and profitability, and such measures will include improving productivity at site, discussing our ASP with OEMs and strengthening purchasing power. We believe results of such improvement activities will start to feed through as visible outcomes starting the second half of year '23.

[Foreign Language]

[Interpreted] On productivity improvement, first priority is improving yield, which affects profitability the most. We are in the midst of carrying out projects that drive up operational yield on process and equipment. We chose sites with stabilized yield as best practice sites, taking lessons learned to new sites at Hungary and the U.S., thereby improving the process and the way in which we work. For those sites where yield has already stabilized, we will continue to find and implement measures to further bring improvements and will also apply them to other sites as well.

[Foreign Language]

[Interpreted] On OEM ASP discussions, metal and material price and FX rate and factors that impact our profit is passed through to the selling price as much as possible to remove the risk of variability in profit. And for the cost increase on the back of inflation, we are actively engaging in price discussions. Already in '22, through talking with major OEMs, we improved pass-through mechanisms for metals, linked FX rate impact and recouped incremental costs, and we expect to bring added improvements in 2023.

[Foreign Language]

[Interpreted] Lastly, on purchasing power. Leveraging the bargaining power we gained from purchasing more volume on growing sales, we are seeking to lower purchasing price for materials and cathodes, et cetera, and diversify suppliers as well as carry out value engineering in order to set up a robust supply chain and gain cost competitiveness.

[Foreign Language]

[Interpreted] In 2023, we expect uncertainties to heighten. However, on increased production volume from new sites, we believe we can maintain double the rate of growth in 2023. And in terms of profit, we're putting in all our efforts as in putting all the measures into action. And in the second half of the year, we expect to see visible P&L improvement.

[Foreign Language]

[Interpreted] Based on such improvement activities for the product -- for the P&L, our objective for year 2023 is to achieve annual EBITDA plus and improve our operating profit. And we believe that after we turn around in our operating profit in 2024 on a per annum basis, we will be able to continue on with an improvement of the OP margin as well.

[Foreign Language]

[Interpreted] As we will now take the live questions, please, when you pose your questions, introduce your name and affiliation before submitting your questions.

[Foreign Language] Now Q&A session will begin. [Operator Instructions] The first question will be provided by Nikhil Bhandari from Goldman Sachs.

A couple of questions. Firstly, when you quantify the IRA benefits of maximum KRW 4 trillion in 2023 to '25, can we check how are we arriving at that number? Is that assuming $35 per kilowatt hour on all the headline capacity or on the likely production out of those capacity's times $35? So can you help confirm that? And what will be the mechanism that we are expecting for receiving this credit? Will that be like at the end of every year, you will show how much your capacity is or how much you produced? And will there be an offset of your tax bills? Or -- and if there is no tax liability, then how do you expect to receive those benefits, if you can provide whatever clarity you have on that? The second question is on the normalization of the plant deals. So it looks like if I get it correctly, we are still guiding full normalization yields to happen sometime by mid of this year. And then after that, we expect to achieve more P&L profitability improvement in the second half of the year. And more specifically, there were some concerns around the module size requirements to be met for VW. Where are we in terms of that? Is that sorted out? Or are there any concerns? Yes. So just trying to slightly better understand the path of the profitability of first half versus second half. Should we expect losses of the current intensity to continue in the first half? Or will that -- will there be an improvement every quarter by quarter?

[Foreign Language]

[Foreign Language]