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

Good morning. I am [ Yu Hun Shi ], a project leader at SK Innovation. Thank you for taking time to join us today on this 2023 Q1 earnings call. Today's presentation has yet to be reviewed by our external auditor so the results are subject to change based on such review. With that, let me invite Mr. Kim Yang-Sub, our CFO, to make the presentation.

Good morning. I am Kim Yang-Sub, CFO of SK Innovation. At the outset, I'd like to thank our shareholders and investors for your continued interest in the company. On the call with me today are executives from SK Innovation and its major subsidiaries to entertain your questions during the Q&A. Now let me walk you through the company's Q1 results in detail. I will start with SK Innovations key business results in Q1 2023, including sales and operating profit. China's reopening and subsequent visible demand recovery pushed up sales by KRW 6.2 billion quarter-on-quarter to KRW 19,142.9 billion. Operating profit jumped to KRW 1.139 trillion Q-on-Q to record a surplus of KRW 375 billion, buoyed by increased refining margin and Petrochem PX spread. Meanwhile, nonoperating profit declined KRW 154.2 billion Q-on-Q to post a loss of KRW 218.7 billion due to FX-related losses following higher FX rates and reduced product derivatives gains. To elaborate, FX-related losses recorded KRW 110.9 billion, product derivatives gains of KRW 18.9 billion, net interest expenses, KRW 177 billion, equity method gains of KRW 68.4 billion and other expenses of KRW 18.1 billion. Next, let me go over the balance sheet. As of the end of Q1 2023, total assets recorded KRW 71,921.6 billion, up KRW 4.7 trillion versus the end of 2022 as tangible and intangible assets increased following overseas facility investments. Liabilities recorded KRW 47,409.3 billion, up KRW 3,432.7 billion versus the end of last year due to increased borrowings for expanded investments. The debt-to-equity ratio posted 193%. Meanwhile, net debt stood at KRW 15,551 billion, up KRW 1,036.2 billion versus the end of 2022 due to CapEx for battery capacity expansion. Next, let me dive into the Q1 performance of each business. First is Refining business. Refining margins improved thanks to OSP decline and inventory-related losses also narrowed, thanks to a slowdown in thumping crude prices, while overseas sales racked in a modest profit. As a result, OP rose KRW 936 billion Q-on-Q to record KRW 274.8 billion. Q2 Refining margin outlook appears positive with China's reopening and the arrival of the summer driving season, spurring bullish demand for refinery product. Next, let me move on to the Petrochem business. Increased margins from aromatic market upturn inventory-related gains and fixed cost decline pushed up OP by KRW 197.3 billion to KRW 108.9 billion. Next is Q2 market outlook for key products. For PE and PP, despite new and added capacities of some products entering the market, China's reopening and subsequent strong domestic consumption is expected to prop up the spreads. For PX, increased output from new PX capacity additions will be offset by new PTA capacities coming online during the same period. While polyester chain demand rebound bolstered by China's reopening is expected to sustain the spread uptick. Next, I will brief on Lubricants Q1 performance. Despite increased of sales and improved costs backed by retreating oil prices, our sales prices adjustments due to [indiscernible] sales competition and average FX rate decline, quarter-on-quarter rate on Lubricants OP to record KRW 259.2 billion, down KRW 9.2 billion Q-o-Q. The rising oil prices could exert upward pressure on costs due to lubricant market is projected to maintain a sound spread as base of supply will remain tight over China's reopening and impending driving season. Next is E&P business performance in Q1. Although sales were up and SG&A was down, E&P operating profit dipped KRW 3.1 billion Q-on-Q to record KRW 113.5 billion due to higher COGS. Next, let me move on to the Battery business. Battery sales climbed KRW 429.7 billion Q-o-Q to post record high quarterly sales of KRW 3.3 trillion as plants that came online in 2022 ramped up their production. Although operating loss in [ costs ] as costs increased due to incentive payments and R&D costs, OP margin improved, thanks to bullish sales and higher plant yields. In Q2, both the top line and bottom line are expected to improve with the ramp-up of new plants overseas. Also, additional, P&L improvement is projected as US AMPC will be reflected in the accounting book post Q2. Please refer to the appendix for more detailed capacity expansion plans by region. Next, let's take a look at SKIET's Q1 performance. SKIET's operating losses decreased Q-on-Q to record KRW 4 billion as one-off costs faded, output increase and costs declined. We expect sales volume to rise gradually in Q2, but by higher demands from key accounts. Next, let me discuss the company's net zero strategy. The company has set a 2023 carbon reduction target that is in line with the 2050 Net Zero pathway. In order to achieve net zero prior to 2050, the company aims to cut emissions by 12% this year versus the baseline year, which will leave us of the remaining emissions of 10.91 million tons. Since drafting the 2021 net zero road map, the company has leveraged a wide range of options to cut emissions, including enhancing process efficiencies, switching to green fuel, optimizing facilities and transitioning to renewables. As a result, the company was able to continuously overachieve its reduction targets. Likewise, the company will explore diverse options in 2023 to meet the annual reduction target. Please note that SK Innovation's net zero targets and results will be disclosed transparently in detail to all stakeholders via our ESG report to be issued in the first half of this year. This is the end of our presentation.

We will now start the Q&A session. Also, please note the Q&A session will be conducted with consecutive interpretation. Prior to today's earnings call, the company has collected questions via our website for around two weeks. So before we open up the floor today, we would like to provide answers to some of those questions first. So the first question will be about the various activities that the company is engaging upon to improve the yields of the battery business. The answer will be provided by SK On.

Yes. I am the CFO, [ kim yang-Sub ] . Maybe I can address this question. In order to improve our overall yields of -- what we're currently doing is to try to expand and spread the know-how that we have accumulated in our best practice sites by dispatching seasoned personnel to our new sites and also engaging upon various activities that will enable us to improve the overall productivity on a continuous basis. So as a result of that, if you look at most of our sites on a Q-o-Q basis, our first quarter yields have improved. If we look at the overall productivity improvements of our global sites, in particular, right now, we are putting a top priority and improving the yield that we have because this is directly related to the profitability. So as a result of that, we are in the process of redefining the key items around the overall process that we have in place, also putting in various management measures and plans and also try to standardize the overall process for process analysis that we have for each of the processes and also double check the manufacturing and quality that we have so that at the end of the day, the overall yield can improve. So based upon these activities for the overall progress that is made and the key issues that we are identifying, this is something that we are looking at very closely. And for the best lines that we have that are already stabilized, the improvements that have been made on these lights -- on these lines have been also taken over to new sites that we have. So as a result of that, for the existing sites, we are trying to maximize the overall yield and also focus on ensuring that the overall quality by each of the process stages is stabilized.

So the second question that we have would be the overall view that the company has about the IRA and also new emission rules announced by the EPA and also what the outlook would be on the North American market. This again will be answered by SK On.

So this is [ Yoo-Jin Seok ], the Head of the Battery Business Strategy Office from SK On, and maybe I can take this question. So as mentioned, the U.S. government has recently put in full force and started to put full force against the IRA. And recently from the U.S. Environment Protection Agency, they have announced new emissions-related regulations. So across the mid- to long term, we do believe that in the North American market, we do see a more positive environment being created for battery growth probabilities and possibilities and also profitability. So first, just talk about the growth potential in the North American market, we do think that there will be an acceleration of the overall transition to electric vehicles that will be taking place. And as a result of that, of course, demand for batteries also to grow very rapidly. If we currently look at the situation, our OEM companies, we do see an increasing demand coming for a local supply chain to be put in place. So to be able to meet those overall demand, if you look at the suppliers that are available, it is a limited number. So as a result of that, we do believe that there will be an increasing number of opportunities for us to win more orders in the North American market. If we look at the current situation, in addition to Ford and also Hyundai Motor vehicles or HMC and the JVs that we have with them in North America, we are currently discussing possibilities of cooperation with a wide variety of other clients. In terms of the overall profitability, tax credit of $35 per kilowatt hour per cell and also $10 per kilowatt hour per module that is defined in the IRA, we do believe will enable us to enjoy a significant improvement in the level of profitability that we are able to generate. And as a result of that, we do believe that the investments in the North American market will become more efficient. So for the company, of course, we already have a large capacity in the U.S. and Georgia, which represents around 22 gigawatt hours. And from this year, as a result of that, we immediately would be able to enjoy benefits under the AMPC credit available. In addition, from 2025, when we will have our JV's with Ford and also HMC up and running, at that time, the capacity in the U.S. will approach 180 gigawatt hours or more. And as a result of that, we do think that, that will represent again a significant level of tax credit that we would be able to enjoy. If you look at the recent announcements in the regulations by the Environment Protection Agency in actuality, it is forecasted that by 2035, the EV portion of the automobile market in the U.S. would represent 67% of new cars sold. So if you compare that to the overall outlook that -- or the overall target, that was released by the Biden administration in 2021 of having a conversion of 50% by 2030, we do think that it represents a much stronger level of EV presence. And it also reflects, we believe, the overall commitment that the U.S. government has to transition to clean vehicles. So if you look at the actual regulations and if they do go into force, we do believe that it will be an impetus to drive further demand in the North American market. And for the company across the mid- to long term, in line with the overall trends of demand that we see for EV vehicles in North America. This is, of course, something that we will continue to monitor and also try to preemptively address so that we can further solidify our already strong position within the North American market.

So with this, we would like to conclude our pre-submitted questions and now take questions live. Before you ask a question, we do ask that you will announce your affiliate and also name before you ask the question.

[Operator Instructions] The first question will be presented by Jin Ho Lee from Mirae Asset Securities.

And first, I would like to congratulate you about your strong performance in the first quarter. The question that I would like to ask you is about the AMPC under the IRA. You did not reflect this into your Q1 numbers. So is this something that you will start to reflect from the second quarter? And if so, will it come retrospectively into the first quarter? In addition to that, during the previous conference call, I do believe that you had said that you expect that the benefits under the IRA would represent around KRW 4 trillion across 2023 to 2025 in terms of the guidance numbers. If that is the situation, what do you expect the overall benefits that you would be able to enjoy for 2023 to be?

This is Kim [ Chang-Geun ] from SK On, and maybe I can take your question. If you look at these guidelines that were announced on March 30 in regards to the IRA, as you have mentioned, the details with regards to the AMPC are something that has not been included in that announcement. So as a result of that, we did not include that overall benefit in the Q1 numbers. However, going forward, once we do have more details about the guidelines with regards AMPC, we do think that we would be able to maybe reflect that from the second quarter after discussions with our accounts. In addition to that, of course, in terms of size, because we don't have the specifics about the details yet, I don't think that, that is something that we would be able to share. But if we do start to reflect it from the second quarter, then naturally, it would be applied retrospectively to the Q1 numbers also. In terms of our overall forecast for the full year, I think that at the end of the day, it would be based upon our sales volume, which we expect to be around 10 to 15 gigawatt hours.

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

So I have two questions on your Battery division. The first question is, if I look at Page 10 of your slide pack, you mentioned that sales volume improvement contributed to the quarter-on-quarter margin improvement for your Battery division, but there was also negative coming from cost increase. Could you share what were the details behind this cost increase. And I saw that you also revised your fourth quarter operating profit number from negative KRW 256.6 billion to negative KRW 338.1 billion. So what was behind that revision in your fourth quarter operating profit? And then the second question is on your Hyundai -- potential Hyundai joint venture in the U.S. I see that you haven't included that project in your PPT yet. Maybe could you share some color on the expected CapEx, capacity and chemistry type.

So this is Jean Sunmi, the Head of Battery Strategy and Planning Office at SK On and maybe I can take your first question. The first question that you asked was about the details of the cost increase that we saw in the first quarter which, of course, was in line with the overall top line growth that we saw in that quarter. At the beginning of the year, across all of the SK innovation companies, there were incentives that were provided to employees, and that was some of what we recognized as the cost increase. This was initially something that had not been planned, but was incurred. So that was one of the items that would drive that specific line. And in addition to that, there were other items that also contributed to the cost increase. There is R&D that we are executing for new product development and also there was a slight increase in our overall SG&A. And you also asked why the 4Q numbers in terms of our operating profit were adjusted? And what we can say to that point was that when we did the presentation on the Q4, of course, it was before we did finalize our full year numbers in terms of the book closing. And of course, if there are any material findings that we have thereafter, it is something that we will reflect into our numbers to update them. At that time, there was of course thereafter, the Ford fire that took place. And the overall loss amount related to that, that we would need to bear with was something that had not been determined as of that time. However, for the issues that we found with products that were manufactured in 2022, we did set aside an allowance or a provision for that. And that provision was recognized at a later time into the Q4 numbers, which led to the adjustment.

This is Kim [ Chang-Geun ] and maybe I can answer and address your second question about the details of Hyundai JV that we are currently contemplating. Right now, the expected CapEx that we are planning to build out would represent around 35 gigawatt hours, and the necessary CapEx to build that facility is expected to be about USD 5 billion in total. And the overall -- once the facilities are available, the plan as of now in terms of production chemistry or product type would be NCM batteries that would be a pouch-type battery.

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

There are three questions that I would like to ask you. The first question is about your battery yields. This is something that you have mentioned and addressed before but if you could break it down by each of your production sites, for example, for China, the U.S. and also Poland. If you could mention what your current yield levels are and in terms of your target yields for the future, if that is something that you can share, that would be appreciated. The second question that I would like to ask you is that if I remember correctly, I think that for your Battery business, the overall profitability related targets were to be at a breakeven point in terms of your EBITDA for this year. And then next year to turn into the black on the operating profit line level. Since we now have the AMPC going into force, would there be any change in your guidance in terms of the overall timing? The third question that I would like to ask is about your Refining business. It does seem to be that on the diesel side and the diesel margins, there seems to be a weakening taking place there. What is the drivers behind that? And as a result of that, do you actually believe that, that could have implications on your Lubricant base oil business also?