Cabot Corp (CBT) Q2 2023 Earnings Call Transcript

Thank you for standing by and welcome to Cabot's Second Quarter 2023 Earnings Conference Call. At this time, all participants are in a listen-only mode. After the speaker presentation, there will be a question-and-answer session. I would now like to hand the call over to Vice President, Treasurer, and Investor Relations, Steve Delahunt. Please go ahead.

Good morning. I would like to welcome you to the Cabot Corporation earnings teleconference. With me today are Sean Keohane, CEO and President, and Erica McLaughlin, Executive Vice President and CFO. Last night we released results for our second quarter of fiscal year 2023, copies of which are posted in the investor relations section of our website. The slide deck that accompanies this call is also available in the Investor Relations portion of our website and will be available in conjunction with the replay of the call. During this conference call, we will make forward-looking statements about our expected future operational and financial performance. Each forward-looking statement is subject to risks and uncertainties that could cause actual results to differ materially from those projected in such statements. Additional information regarding these factors appears in the press release we issued last night, our 10-K for the fiscal year ended September 30, 2022, and in subsequent filings we make with the SEC, all of which are also available on the company's website. In order to provide greater transparency regarding our operating performance, we refer to certain non-GAAP financial measures that involve adjustments to GAAP results. The non-GAAP financial measures referenced on this call are reconciled to the most directly comparable GAAP financial measure in a table at the end of our earnings release issued last night and available in the Investors section of our website. I will now turn the call over to Sean, who will discuss the second quarter highlights, including progress against our sustainability strategy and an update on our battery material business. Eric will review the company and business segment results along with some corporate financial details. Following this, Sean will provide a strategic summary and closing comments and open the floor to questions. Sean?

Thank you, Steve. Good morning, ladies and gentlemen, and welcome to our call today. I am pleased with results in the second quarter and the tremendous effort of the Cabot team to execute against the challenging macroeconomic backdrop. In the second fiscal quarter, we delivered adjusted earnings per share of $1.33 in line with our expectations and up 35% sequentially. Reinforcement materials delivered a record quarter with EBIT up 21% year-over-year. The outlook for this business remains strong, driven by our leading market position, the long-term resilience of the replacement tire market, and favorable structural dynamics in this business. The Performance Chemicals segment had a challenging quarter, as we experienced lower demand in China due to significant levels of COVID outbreak, softness in key end markets, and continued inventory destocking. As expected, cash flow was strong in the quarter with operating cash flow of $162 million and free cash flow of $111 million, of which we've returned $37 million to shareholders through dividends and share repurchases. Given the strength of our underlying business fundamentals and our conviction in the long-term cash flow generation of our portfolio, yesterday we announced an 8% increase in our quarterly dividend. Cabot has a long history of growing the dividend, and it is our expectation to continue increasing the dividend over time as the earnings and cash flow of our business grow. On the strategic front, we continue to make important long-term progress in battery materials, with volumes growing 45% in the quarter despite a sharp sequential slowdown in electric vehicle sales in the March quarter. Additionally, we secured another key customer win in the quarter and now have sales to nine of the top-10 global battery manufacturers. Diving deeper into battery materials, the electrification of mobility represents a significant growth opportunity for Cabot, and we continue to invest behind this macro trend. While we believe the long-term trend of electric vehicle penetration is undeniable, market developments from quarter to quarter can be uneven; this is certainly what the electric vehicle sector experienced in the March quarter. Electric vehicle sales declined sequentially by 27% in the March quarter, driven principally by COVID impacts in China and a sharp decline in prices of key raw materials for batteries such as lithium carbonate, which drove a sharp destocking across the industry value chain. While Cabot's volumes for battery materials continued to reflect strong year-over-year growth of 45%, sequential sales volumes decreased by 11%. We expect these impacts to be short-term in nature and anticipate sequential improvement in the coming quarters in line with the Bloomberg EV forecast. So far through April, our volumes are aligned with this improving trend. The temporary loss of market momentum sequentially in the second quarter, and the projection for recovery of EV sales over the next two quarters, puts us behind where we expected to be year-to-date in sales volumes for battery materials. Additionally, we are seeing some delays in battery production scale-up of a key U.S. auto OEM. Based on these factors in our continued investment profile to support long-term growth, we now anticipate fiscal year 2023 EBITDA to be in the range of $30 million to $35 million for battery materials. We continue to believe that electrification will transform the mobility sector and are very pleased with our commercial progress to date. We've been qualified and are selling commercially to nine of the top-10 battery producers and are well positioned with key auto OEMs as they build out battery production capability. Cabot's value proposition, built on our unique product breadth, global footprint, and ability to scale capacity to meet the industry's regionalization needs, is resonating with customers. While the growth pathway may be uneven at times, we are investing to win over the long term and remain confident in our Investor Day projections of over 50% EBIT growth between 2021 and 2024. Sustainability is at the core of our purpose and our 'Creating for Tomorrow' strategy. During the quarter, we made important progress on several strategic fronts. At the recent Tire Technology Expo in Hannover, Germany, we launched our EVOLVE Sustainable Solutions Technology Platform, which is focused on advancing sustainable reinforcing carbons. Our goal for this technology platform is to develop products for our customers that offer sustainable content with reliable performance and, importantly, at industrial scale. We plan to achieve this by leveraging circular value chains and materials recovered from end-of-life tires, using renewable or bio-based materials, and enabling processes that reduce greenhouse gas emissions. As part of the EVOLVE platform, we also launched Cabot's first ISCC-PLUS Certified Solutions, which enable our tire customers to bring demonstration products to the market made from circular materials. Our market leadership, global footprint, and broad EVOLVE and E2C technology platforms position Cabot to partner and win with leading customers as the mobility sector transitions to meet society's sustainability demands. In addition, last week, we announced the launch of our new ENTERA aerogel particles portfolio. ENTERA aerogel particles are a thermal insulation additive targeted for thermal barrier solutions for electric vehicle lithium-ion batteries. We believe thermal management will be an important design feature of safe batteries, and expect a variety of application forms that serve this market. Cabot's aerogel products provide customers with formulation flexibility to develop very thin forms including blankets, pads, sheets, films, and coatings. Over time, we believe that aerogel solutions can develop into a meaningful addition to our battery materials addressable market and further position Cabot as a critical material supplier to support the global transition to vehicle electrification. Finally, our sustainability leadership continues to gain recognition from leading ESG rating services, as Cabot received a Platinum rating from EcoVadis, the highest recognition available for the third consecutive year. The Platinum rating recognizes Cabot's environmental, social, and governance efforts and places Cabot among the top 1% of companies assessed by EcoVadis. EcoVadis is one of the world's leading sustainability ratings platforms, relied upon by many of our customers to evaluate their supply chains. I'll now turn the call over to Erica to discuss the segment and financial performance. Erica?

Thanks, Sean. I will start by discussing results for the company and then review the segment results. Adjusted EPS for the second quarter of fiscal 2023 was $1.33, compared to $1.69 in the second quarter of fiscal 2022, with growth in the Reinforcement Materials segment offset by declines in the Performance Chemical segments. The quarter was impacted by higher net interest expense of $7 million year-over-year and unfavorable foreign currency exchange impacts of $7 million. Year-to-date impacts from increases in net interest expenses are $14 million, and our expectation for the fiscal year is unchanged from last quarter at approximately $20 million. Year-to-date unfavorable impacts from foreign currency exchange were $19 million, and we expect the year-over-year impacts to be somewhat minimal going forward for the second half of the year. Discretionary free cash flow in the quarter was $76 million, and we ended the quarter with $205 million of cash. Cash flow from operations was $162 million, which included a reduction in net working capital in the quarter of $59 million. The reduction was in line with what I highlighted in our expectation last quarter and looking ahead, we expect further reductions in net working capital in excess of $50 million over the two remaining quarters of the fiscal year, based on the current future expectation for oil prices. CapEx in the quarter was $51 million, and we expect full-year CapEx to be between $250 million and $300 million. The balance sheet remains strong with total liquidity of $1.2 billion and net debt-to-EBITDA of 1.8 times as of March 31. Our operating tax rate was 25% for the quarter, and we anticipate the fiscal year rate will be between 24% and 26%. Now moving to Reinforcement Materials, during the second quarter, EBIT for reinforcement materials increased by $21 million, as compared to the same period in the prior year, to a record EBIT of $122 million. The increase is driven by improved unit margins from higher pricing and product mix, and our 2023 calendar year customer agreements, partially offset by 7% lower volumes and higher fixed costs. Globally, volumes were down in all regions in the second quarter as compared to the same period in the prior year, with declines of 2% in the Americas, 2% in Europe, and 12% in Asia. Lower volumes in Asia were driven by the effects from the COVID outbreaks in China. Looking to the third quarter of fiscal 2023, we expect Reinforcement Materials' EBIT to increase sequentially as volumes are expected to improve, particularly in Asia as demand strengthens after the impact of the COVID-19 outbreaks. Year-over-year, volumes in the third quarter are expected to be slightly down compared to the prior year, aligned with external market expectations. We also anticipate margins to be maintained as pricing in our calendar year agreements are set for the rest of the year. On a fiscal year basis, we continue to expect strong double-digit EBIT growth compared to last year, largely due to the improved unit margins from higher pricing and product mix in our 2023 calendar year customer agreements. Now turning to Performance Chemicals, EBIT decreased by $42 million in the second fiscal quarter compared to the same period in fiscal 2022. The decrease was principally driven by a fumed metal oxide product line, and we experienced a 22% volume decline year-over-year and lower unit margins. Lower volumes were driven by weaker demand in silicones applications and the impact from the COVID outbreaks in China. Lower margins were driven by the comparison to the prior year, where we experienced temporary margin expansion from pricing out of raw materials last year. Additionally, the segment also experienced lower volumes in our Specialty Carbons product line, as well as the negative impact from unabsorbed costs as we reduced inventory levels and unfavorable foreign exchange impacts. In summary, year-over-year the decline was driven by $18 million of lower volumes, $15 million of lower unit margins, $4 million from the impact of reducing inventory levels, and $4 million of unfavorable foreign currency impacts. Looking ahead to the third quarter of fiscal 2023, we expect EBIT to be up sequentially due to higher volumes across all of our product lines, as demand in our key markets improves and margins remain relatively stable. We have seen improvement in segment volumes month-to-month as we move through the second quarter. We have also reduced costs across the segment given the weaker demand environment, which we expect will help improve EBIT levels in the second half of the year. I will now turn the call back over to Sean.

Thanks, Erica. Moving to the 2023 outlook, I feel very good about the continued progress we are making as a company despite the short-term macroeconomic headwinds. At a strategic level, the key drivers of earnings growth remain unchanged. The impact from our calendar year 2023 reinforcement materials customer agreements is driving the record second quarter EBIT in this segment, and the replacement nature of the tire market provides certain resilience in this business. We expect volumes to pick up in the second half of the year with reasonable supply-demand dynamics expected to remain tight, all of which drives our expectation for another year of strong double-digit EBIT growth in the Reinforcement Materials segment. While performance chemicals has been impacted by the weak external demand environment in the first half of our fiscal year, we expect volumes in all product lines to pick up in the second half of the year. We also expect our growth vectors to be strong contributors to the segment recovery in the second half of the year, as sequential volumes improving battery materials and inkjet volumes accelerate driven by penetration in our targeted growth applications. However, given the slower than expected recovery across our Performance Chemicals end markets, particularly in China, and a temporary slowdown of sequential momentum in battery materials, we are adjusting our full-year guidance to be in the range of $6.10 to $6.50. The midpoint of our guidance would imply modest growth of adjusted earnings per share for the fiscal year, which for us, given our fiscal year includes a very weak December destocking quarter. As we think about the quarter and the shape of earnings for the full fiscal year, we expect a significant step-up in the second half relative to the first half, providing strong momentum heading into fiscal year 2024. As the earnings increase in the second half of our fiscal year and based on the anticipated working capital release, we expect operating cash flow and free cash flow to be very strong. In closing, we are confident in our strategic position and believe that Cabot offers a unique growth opportunity. Reinforcement Materials is a structurally improved business with strong earnings and cash flow generation. Performance Chemicals is comprised of industry-leading positions with exposure to long-term macro tailwinds. Battery Materials offers the potential for breakout growth. And we have the conviction and the balance sheet to invest behind this transformational shift in mobility. Our portfolio has strong cash flow characteristics, which can fund or advantage growth investments and return cash to shareholders. Finally, we're a recognized leader in sustainability, and this strength underpins our purpose and our 'Creating for Tomorrow' strategy. With these value drivers firmly in place, we remain on track to achieve the targets outlined in our December 2021 Investor Day. Thank you very much for joining us today. And I'll now turn the call over for our Q&A session.

Our first question comes from John Roberts at Credit Suisse. Please go ahead, John.

Thank you. In Reinforcement, I assume you've got more price in the U.S. than elsewhere. Could you at least give us a qualitative discussion of the regional price trends?

Sure, John. I would say the pricing trends across the western markets were pretty consistent, actually. And that lines up with the pretty consistent structural dynamics in the regions in terms of supply-demand, growth in tire production, and the importance of regionalization of the supply chain. All those factors contribute to a consistent pricing landscape across the Western markets.

And then within the Performance segment, we did talk about masterbatch versus fumed metal oxides, and within fumed metal oxides, I didn't hear any discussion about the semiconductor market weakness.

Yeah. So, let me touch on the fumed metal oxides first, because that's certainly the single biggest driver of the weakness in performance chemicals. Now, this fumed metal oxides market serves principally applications in the silicone space. This is by far the largest volume space in the market. And silicones were down very sharply in this quarter. There were several public company comps in this silicone space, and you can see that their results were down sharply. So I think our dynamic is similar to the overall market. And as Erica said, volumes are down 22% year-over-year in this product line. And as you might recall from the past or Investor Day, this product line is the highest margin business in the segment. When you combine that with the high operating leverage in the business, it's a pretty significant impact. Now, there are also silica sales into the semiconductor space. Those have diminished over time as next-generation nodes have moved to other forms of abrasive particle, either colloidal silica or products that we don't participate in. That being said, we do still have a meaningful legacy tail of silica into the CMP or semiconductor space. And that too was declining, but the largest driver here, John, was the contraction or the lower demand in the overall silicones space.

Thank you. Our next question comes from the line of Josh Spector, UBS. Please go ahead, Josh.

Yeah. Hi. Thanks for taking my question. In your slides, you have a comment on Performance Chemicals that margins are expected to remain stable from 2Q'23 levels. I wanted to really understand that better. I mean, your margins were about 9% in the quarter. You talked about cost savings and improvements. Do you mean that they're going to be stable at that level or are they going to improve on those levels?

What we mean, Josh, is that the unit margin, so price minus variable cost, will remain stable. Obviously, the EBITDA margins will improve over the quarter, as we get higher volumes and more coverage of the cost base, and then some of the cost actions that we're discussing flow through. So when we say margins, we're talking about that sort of price minus raw spread. That's what we mean.

Okay, got it. Makes sense. And just on your battery materials business, you mentioned the new win where you are now serving nine of the top 10 largest producers. I wonder if you can give some context around that. Are any of those exclusive? Are you supplying the majority of the conductive carbon into those formulations? Or are you more qualified for that platform? So how much of it materializes into sales specifically for Cabot versus giving you the optionality to do so?

Yeah. So the way it typically works in battery materials is you get qualified into a battery program or a battery platform. And then as that platform grows and proliferates, so does our participation. That's typically how it works. For example, legacy platforms that Cabot may not have been in typically don't get switched out; it has much more to do with winning new programs. As the program ramps, we expect our sales volumes to ramp up with that. Typically, because these are going into automotive applications, there's usually a primary and secondary supplier to a program because the auto OEMs require that sort of supply redundancy. It's really program-driven. And so, as the program ramps, assuming there's success that the customer intends, then we would see the flow-through of that.

Thank you. Our next question comes from the line of Jeff Zekauskas of JPMorgan. Your line is open, Jeff.

Hi, morning. This is Lydia on for Jeff. It seems like contracts for Rubber Black have started early this year. What are you seeing across different regions?

Sorry, Lydia, could you just say that again? I said something about contracts and regions? Sorry.

Yeah, it's just — we've heard that the contract negotiation for Rubber Black has started early this year. So just wondering, what are you seeing for pricing across different regions?

Yeah, so it is early in the process. Normally, the contract discussions begin over the course of the summer, and then progress into the fall period. Certain customers have approached us to start negotiations for 2024. I think there are a lot of moving parts. However, I think what happens as the Russia sanction date nears in 2024 and how the China feedstock economics could serve as a potential replacement for the Russian material, for example, in Europe, these are important dynamics to watch. I would say it's early in the process here. I would remind you that we did close some negotiations in 2023 that were multi-year agreements with incremental pricing in 2024. I think this does give us some momentum heading into '24 and sets a market reference. While certain conversations have begun, it's early in the process. That said, I would say the structural supply-demand dynamics in the Western markets remain unchanged and favorable, and we expect that to continue.

Thank you. And your cash flow from operations this quarter is higher than for your full year last year. So can you talk about the changes here and maybe talk more about your expectation for the rest of the year?

Sure. Operating cash flow was strong this quarter, as the EBITDA improved from earlier in the year; that's part of it. I would say it's really working capital. Last year, we had increasing raw material costs that caused increasing levels of investment into the working capital. We see that those raw material costs are coming down this year, and so you see a positive contribution or source of cash from working capital in the second quarter. We expect that to continue as we move through the year. So that goes to the comments I made where we would think another in excess of $50 million would be released from working capital in the back half of the year. We expect continued very strong cash flow from operations as we go through the rest of 2023.

Thank you.

Thank you. Our next question comes from the line of Laurence Alexander of Jeffries. Please go ahead, Laurence.

Hi, it's Dan Rizzo on for Laurence. You mentioned the circular tires, the new product. I was just wondering how we should think about the growth within that product. Is it going to be something, I assume not, but is it the growth trajectory as battery materials? Could there be something of that magnitude or will it be a longer timeline?

Yeah, you're referring to the EVOLVE Sustainable Solutions Technology launch, Dan? The technology platform that we launched, our goal here is to develop products that offer sustainable content with reliable performance. I think most importantly, at an industrial scale. I think we're in a great position to do that. We'll be leveraging the circular value chains and materials that are recovered from end-of-life tires, as well as any renewable or bio-based material options and processes that can reduce greenhouse gas emissions. These are the levers that we're pulling under the EVOLVE platform. If you think about how this should develop over time, we anticipate driving revenue starting in this year. We expect to see a material impact from the EVOLVE Sustainable Solutions over a five to ten-year period. This is driven by the speed of adoption of new technologies in the rubber industry, as well as how our tire customers' greenhouse gas goals are set up between here and 2050 carbon neutrality. But I would think about this as a longer-term play that really aligns with the sustainability needs of our customers, and frankly, society's pressures around sustainability. We're excited about it because we believe we bring an ability to commercialize, develop, and commercialize these technologies, and do it at scale, which there are startups and others that play in this space but can't bring things to market at scale the way we can. So that's how I would think about it, Dan.

All right. Thank you. And then you mentioned or it was mentioned that there was an improvement in working capital because of the drop in oil prices. I was wondering if there's a rule of thumb with oil and its relation to working capital, such as a $10 movement in oil translates into an X movement in working capital, or how we should think about that?

Sure, Dan. The general rule of thumb is about a $1 change in oil is about $5 million in working capital. It does usually happen over a period of two quarters, typically, as you'll see the inventory repriced quickly and then the accounts receivable might move into the following quarter. But that's the rule of thumb.

Thank you. Our next question comes from Chris Kapsch of Loop Capital. Please go ahead, Chris.

Good morning. If I think about the guidance, modest guidance reduction, it sounds like it's predominantly attributable to trends in the Performance Chemical segment. You mentioned the silicon industry weakness. If you can rank order the other contributors, especially maybe the Specialty Carbons, maybe there's some residual destock there, and the slower momentum in battery materials. You also mentioned the improving demand transfer across the segment on a monthly basis; wondering if that trend is characteristic of each of those different businesses and how it's persisted thus far into the third quarter through April?

Erica will take that first part.

Yeah, Chris, I think if you think of the impact in the quarter, fumed metal oxide is by far the largest driver of the decline. Next, I would say it would be our Specialty Carbons business. Our volumes are down about 5% in that business, which drove a reduction in most of the inventory or unabsorbed costs because of the inventory reductions in carbon. So that would probably be secondary. The temporary decline here in EV sales in Q2 was also impactful. I would probably say it's in that order. As we think about the volume recovery, I'd say through Q2, pretty broad based in terms of month-to-month improvement as we move through the quarter. Battery Materials also improved in April. So from the exit in Q2 into April, volumes and battery materials have improved, which is good. In some of the other businesses, I'd say April was a bit weaker than March, but overall stronger than the January-February run-rate. The order book for May looks pretty strong across the businesses, and so that's what our outlook takes into consideration.

Just a couple of additional comments there. The midpoint of the range is roughly flat to fiscal '22. But that was a record in our fiscal year with a 25% growth over fiscal '21. A couple of things here. One is that would be a result after offsetting about $0.50 EPS headwind from interest and unfavorable FX. Additionally, it's important to remember that given our fiscal year-end of September 30, we're pulling in a very weak December quarter. When you look at second half momentum, I think that's an important picture.

Got it. And then my follow-up focuses on the Battery Materials space. A key theme has been security of supply concerns for a variety of battery materials. To the extent that you're having tremendous success with the nine out of the top 10 lithium-ion battery producers globally, just curious how that theme plays into your relationships with those customers. Are they expecting you to partner with them globally? How is that playing out? Do you have visibility into their demand requirements in different regions? Is that starting to influence your growth capital plan? Thank you.

Sure. Well, certainly, I think a couple of things are going on in the battery market. It's been principally a China market up until now, as well. About 75% of batteries are produced in China, making it relatively small outside of China. However, significant battery investments are being constructed and coming online over the next two to three years and into the end of the decade. A couple of things will happen, Chris. First of all, you're seeing a lot of non-Chinese battery players building outside of China. I think you'll probably see some sort of bifurcation between the Chinese battery market and the rest of the world. Customers that we are working with in Europe and the U.S. value regional supply, and the ability to provide that to them is very important. Typically, what happens is you get qualified in a program with a given battery maker. As that particular program proliferates, you grow with that. It's often hard to predict how quickly it will ramp up; that’s why I think there can be some unevenness in the way this market develops. Cabot's global scale, our footprint, and ability to build out capacity regionally for these customers as this market bifurcates is an advantage for Cabot. And so, we’re investing behind that and are building out capacity to meet that.

Thank you. At this time, I would like to turn the conference back to Sean Keohane for closing remarks. Sir?

Great. Thank you very much for joining today. Thank you for your continued support of Cabot Corporation. I hope you have a safe day.

This concludes today's conference call. Thank you for participating. You may now disconnect.