Earnings Call Transcript - CBT Q3 2023

Steve Delahunt, Vice President of Investor Relations and Treasurer

Thank you, Chris. 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 third 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 and in our 10-K for the fiscal year ended September 30, 2022, and in subsequent filings we make with the SEC, all of which are available on the company's website. In order to provide greater transparency regarding our expected 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 third quarter highlights and the market environment in our Reinforcement Materials and Performance Chemicals segments. 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 Keohane, CEO and President

Thank you, Steve, and good morning, ladies and gentlemen. Welcome to our call today. In our third fiscal quarter, we continued to navigate a challenging macroeconomic environment. Despite lower volumes in both segments and a tax headwind, we delivered sequential earnings improvement due to the continued strength of the Reinforcement Materials segment. Consistent with the commentary in our June announcement, we continue to see weakness in China and soft demand on a global basis across many of our key Performance Chemicals end markets, particularly in the housing and construction sector and across consumer durable applications. In the quarter, we delivered adjusted earnings per share of $1.42, up 7% sequentially. Reinforcement Materials delivered a record quarter with EBIT of $132 million, up 17% year-over-year and 8% sequentially despite the third consecutive quarter of year-over-year volume declines. This level of performance reflects the resilient nature of this business and the structural improvements we have made over the last several years. EBIT in the Performance Chemicals segment improved sequentially largely due to cost initiatives across the segment. Demand in the segment remained challenged as we saw continued weakness in our key end markets with the exception of battery materials. In the quarter, we generated strong operating cash flow of $243 million and free cash flow of $163 million, of which we returned $38 million to shareholders through dividends and share repurchases. Our balance sheet remained strong with net debt to EBITDA of 1.7 times, and we have $1.3 billion of committed liquidity that has recently been extended to 2027. Our balance sheet and investment-grade credit rating give us the flexibility to continue to advance our long-term strategic priorities supported by our disciplined and balanced capital allocation strategy. Moving to the market environment across both segments, we've been dealing with weak end market demand, so I wanted to take a few minutes to take you through what we are currently seeing. Let's start with Reinforcement Materials where the key end markets are replacement tires in auto OE production. You will recall that replacement tires account for approximately two-thirds of segment volume, with OE production and industrial applications driving the balance. For the first three quarters of our fiscal year, we've experienced year-over-year volume declines with year-to-date volumes down 8% in this segment. The decline is principally driven by a deep inventory destocking cycle, and there is some anecdotal evidence that customers are delaying purchases. When we look at the industry demand fundamentals, we see pretty stable conditions for the passenger car replacement market. Miles driven and the global car park are generally good indicators for light vehicle replacement. Tire demand in the U.S., for example, is holding steady while the global car park continues to expand for the truck and bus segment. Truck tonnage is a good indicator of underlying health, and we can see in the U.S. that this too is holding steady. The performance of these fundamental demand drivers gives us confidence that volumes will normalize when we exit the current destocking cycle. Auto production is the other key end market for this business and accounts for approximately 27% of Reinforcement Materials volumes. Global auto production is one area where we are seeing signs of recovery across North America, Europe, and China. This end market has experienced growth in recent quarters and is projected to grow in 2023, providing some offset to the lower replacement tire volumes. The impact of a pickup in auto production in this segment is seen fairly quickly given the relatively shallow value chain compared to the replacement market. In Performance Chemicals, the external environment remains challenging. Most of our industrial sector end markets are experiencing weak demand, particularly housing and construction. On the consumer application side, we have seen that demand for durable goods and electronics has also been weak. Manufacturing PMI has historically been a key indicator of demand in this segment. Currently, manufacturing PMI levels in the U.S. and Europe remain below 50, and China has been oscillating around 50 with several recent data points in contraction territory. Recent housing data, both housing starts and building permits indicate a potential turning point in the U.S., but European permits continue to drop and the China real estate market remains stagnant. Construction and housing demand has a significant impact on our specialty carbons, specialty compounds, and fumed metal oxides product lines. As I mentioned earlier, auto production is one area where we are seeing some promising signs in terms of new car builds. Approximately 25% of Performance Chemicals volume is tied to the transportation OE sector. However, we have not yet seen the impact in our sales due to lingering destocking and the depth of this value chain. Historically, this has taken about two to three quarters to see the impact of a turn in auto production translate into higher demand for our products. As this happens, we would expect a lift in terms of both volumes and product mix as the automotive sector pulls through a high percentage of specialty grades. Finally, the China EV market continues to recover from a sharp sequential slowdown in electric vehicle sales in the March quarter. The June quarter saw sequential growth, though EV sales volumes still aren't back to the level achieved in the December quarter. Our battery materials volumes recovered inline with this trend, with Q3 volumes increasing 29% on a sequential basis and 50% year-over-year. While the volume trend is encouraging, the auto EV market in China is experiencing an increase in competitive intensity as auto OEMs compete aggressively on price for market share, and this pressure is flowing back upstream to the battery producers and material suppliers. As we transitioned into Q4 and look forward through the balance of the fiscal year, we have experienced pricing pressure that is impacting our margins. The impact is concentrated in our China business, particularly where our products are sold into batteries for lower-priced domestic vehicles. Where our products are sold into batteries for export to global OEMs or to customers outside of China, we are seeing stable prices. Given this dynamic in China and the continued delay in the scale-up of one of our Western auto OEMs, we now expect the fiscal year EBITDA to be in the low $20 million range. As we manage through this unexpected period of turbulence in China, our focus is on three priorities: first, market segmentation to focus our efforts on higher-performing batteries, particularly NCM chemistry and on those batteries targeted for western exports; second, we'll continue to carefully manage the balance between volume and pricing; and third, we're aggressively attacking the cost structure across our base products. Over the long term, we believe that electrification will transform the mobility sector, with most growth forecast for lithium-ion batteries in the 25% to 30% CAGR range through the end of the decade. We also expect that the EV and battery market will bifurcate into a China market and a rest-of-world market. We expect the market outside of China will orient more towards higher-performing NCM chemistry, which requires higher-performing conductive additives. We also expect that customers outside of China, particularly the global auto OEMs, will continue with strict qualification requirements and management of change protocols required by the IATF Quality Management System. Additionally, we also expect that the trend towards supply regionalization will accelerate, and this development provides an advantage to a technology leader like Cabot that has a strong global footprint and an ability to scale up capacity and region to meet customer requirements. Over the next decade, the industry will undergo fundamental change as EVs grow in the west, battery supply chains regionalize, and new technologies such as dry process take hold. Over this time, we expect that North America and Europe will grow to comprise approximately 50% of the global battery market. We remain excited about the long-term growth prospects for battery materials and believe it can become a meaningful part of our profitability over time. At Cabot, we have the broadest conductive additive portfolio, a leading global footprint, and the capability to expand in North America and Europe to support our customers' requirements. We believe this value proposition is compelling to customers, and we continue to see momentum with the leading battery producers.

Erica McLaughlin, Executive Vice President and CFO

Thanks, Sean. I'll start by discussing results for the company and then review the segment results. Adjusted EPS for the third quarter of fiscal 2023 was $1.42 compared to $1.73 in the third quarter of fiscal 2022, with growth in Reinforcement Materials offset by declines in the Performance Chemicals segment. Discretionary free cash flow in the quarter was $128 million, and we ended the quarter with $220 million of cash. Cash flow from operations was $243 million, which included a reduction in net working capital in the quarter of $71 million. CapEx in the quarter was $80 million, and we expect full-year CapEx to be approximately $250 million. The balance sheet remained strong, with total liquidity at $1.3 billion and net debt to EBITDA of 1.7 times as of June 30. In the third quarter, we increased our year-to-date operating tax rate from 25% to 28%, driven by an update to the fiscal year forecast and the geographic mix of earnings within the updated forecast. The increase in the operating tax rate included a catch-up of expense for the first half of the fiscal year that we booked in the third quarter, which resulted in an unfavorable impact of $0.10 of adjusted earnings per share this quarter for the catch-up and a total of $0.17 in the year-to-date impact. We expect the fiscal year operating tax rate range to now be between 27% and 29%. Now moving to Reinforcement Materials: during the third quarter, EBIT for Reinforcement Materials increased by $19 million as compared to the same period in the prior year to a record EBIT of $132 million. The increase was driven by improved unit margins from higher pricing and product mix, and our 2023 calendar year customer agreements net of higher fixed costs, partially offset by 8% lower volumes. Globally, volumes were down in all regions in the third quarter as compared to the same period in the prior year, with declines of 10% in the Americas, 12% in Europe, and 5% in Asia. Looking to the fourth quarter of fiscal 2023, we expect Reinforcement Materials EBIT to decrease sequentially due to seasonally lower volumes in Europe and higher fixed costs driven by the timing of spend. Volumes in the fourth quarter in regions outside of Europe are expected to be relatively consistent with the third fiscal quarter. Now, turning to Performance Chemicals, EBIT decreased by $31 million in the third fiscal quarter as compared to the same period in fiscal 2022. The decrease was driven by 9% lower volumes and lower unit margins. Volumes were lower across all product lines except battery materials, and most notably there was a 23% year-over-year decline in fumed metal oxides volumes. Lower volumes in fumed metal oxides were driven by weaker demand in silicones applications and the impact from partner-driven downtime. Lower margins were driven by a less favorable product mix in battery materials and specialty carbons. Looking ahead to the fourth quarter of fiscal 2023, we expect EBIT in Performance Chemicals to be up sequentially due to higher volumes in our battery materials and inkjet growth vectors, while volumes in our larger product lines are expected to remain consistent with the levels experienced in the third fiscal quarter. We expect pricing pressure in the EV value chain in China, as Sean discussed, in the near term to impact battery materials results. Now moving to our cash performance, our outlook for the rest of the year is for continued strong cash generation that will continue to enable our growth investments as well as returning cash to our shareholders through dividends and share repurchases. Year-to-date, we have generated $457 million in operating cash flow. We have spent $166 million year-to-date for capital expenditures, which included spending on growth investments as well as maintenance and compliance projects. As we have talked about before, returning cash to shareholders is a critical component of our capital allocation strategy and has been supported by our operating cash flow. We raised our dividend by 8% in May and year-to-date we have paid $65 million in dividends. In addition, we repurchased $48 million of shares year-to-date for a total of $113 million of cash returned to shareholders so far this year. Our outlook for cash remains positive for the year. We expect strong operating cash flow to continue, given current assumptions on oil prices. Debt levels are sound and are expected to stay around the current level of net debt to EBITDA at 1.7 times, and our full-year forecast for capital expenditures is approximately $250 million. We also expect to continue to return cash to our shareholders. In addition to our quarterly dividend, we anticipate increasing the amount of share repurchases in the fourth quarter, given the strong cash flow forecast.

Sean Keohane, CEO and President

Thanks, Erica. Moving to the fourth quarter outlook, I am pleased with how the Cabot team continues to respond despite the challenging macroeconomic environment. The Reinforcement Materials segment posted record results in the third quarter and is on its way to another year of record EBIT results despite weak replacement tire demand throughout the fiscal year from a prolonged destocking cycle. In Performance Chemicals, we expect results to improve sequentially driven by volume growth in battery materials and inkjet. While the larger product lines in this segment seem to have stabilized, albeit at a level well below recent history. Given these factors, we expect adjusted earnings per share in the fourth quarter to be in the range of $1.40 to $1.55, which would bring our full year range between $5.13 to $5.28. As Erica discussed, we expect the fourth quarter to be another strong cash flow quarter to support our capital allocation priorities. Fiscal year 2023 certainly has developed differently than expected. The rapid increase in interest rates has dampened demand across the housing sector and for consumer durable goods. Europe has been in a technical recession, and China's economy has not been the driver of global growth as was expected following their exit from strict COVID protocols. Despite these headwinds, we believe our strategy for tomorrow is the right one for Cabot, with a focus on advantageous growth, innovation, and continuous improvement. By pursuing this strategy, we believe we will grow, transform, and reshape the valuation potential of the company. We continue to execute against this strategy despite a challenging environment. We have a very resilient, structurally different business in Reinforcement Materials, as evidenced by record results despite lower year-over-year volumes. The Performance Chemicals segment remains a mix of high growth, high margin businesses with leading market positions and good industry structure that at the moment is dealing with a unique environment of weak end market demand and a China economy that is yet to rebound post-COVID. We believe that these product lines will recover in line with the underlying end markets. The battery materials product line, while developing slower than we originally expected, remains a compelling growth opportunity for Cabot, and we believe we are well positioned to grow as the EV market expands outside of China. Our cash flow and balance sheet remain very strong in support of our capital allocation priorities. Finally, we're a recognized leader in sustainability, and this strength underpins our purpose and our strategy for tomorrow. I would like to close by again recognizing the entire global Cabot team for their resilience and their commitment to execution as we navigate this challenging macroeconomic period. Thank you very much for joining us today, and I'll now turn the call back over for our Q&A session.

Operator, Operator

Thank you. One moment please for our first question. Our first question will come from David Begleiter of Deutsche Bank. Your line is open.

David Begleiter, Analyst

Thank you. Good morning. Sean, in replacement tires, how long have your prior destock cycles lasted for?

Sean Keohane, CEO and President

Yes, good morning, David. I think certainly the destock that we seem to be experiencing right now is longer than I think history would say. All three of our fiscal quarters have volumes down year-over-year, and our expectation for Q4 is consistent with the outlook that Erica provided, which would say that will probably be four quarters where we're down year-over-year. It certainly feels like a more pronounced destock cycle than history. I think the result, if I, you know, we listen to what the big tire makers say, we should be coming to an end on this. But I think it has been more difficult for people to see this because we came out of COVID, a sharp bounce, then there was a long period of transportation logistics disruptions. Given how many of the tires in the world rely on Chinese exports, I think there were a lot of tires on ships and in the supply chain that were tied up, and it really created a lot of distortion. All of that has been getting worked off this year. But certainly, from our historical experience, David, this one is a bit longer, but I think it's because of those distortions coming out of COVID and the supply chain disruptions that have now worked their way out. As we look across our customer base, it seems that that should be coming to an end here, and as that happens, then we would expect a positive turn from a volume standpoint, and given the operating leverage in the business, that can be quite material.

David Begleiter, Analyst

Very good. And just on your annual contract negotiations, how are they progressing? I know you had a number of annual or two-year contracts. So overall, how are they progressing, and how should we think about pricing for next year in that business?

Sean Keohane, CEO and President

Yes, it's early to say at this point, David, but I would say the annual contract cycle is beginning now and will follow, I would say, a more normal cadence, which is really a fall September through end-of-year cadence. Last year, that was pulled forward a little bit. I would say this year's cycle will probably resemble a more traditional pace. So again, discussions in the fall are likely to happen. We continue to believe that price increases are needed based on increased sustainability costs, as well as the premium in quality and service that we provide to customers. So while I can't comment because it's too early in the process, just as a reminder, we did close several multi-year agreements last year with an incremental price increase in 2024. Our view is that those price increases are the baseline for the rest of our 2024 contracts and should set the level of price increases expected during the negotiations. We'll certainly be updating on our next call as we're deeper into the cycle, and that would be typical.

Operator, Operator

Thank you. One moment please for our next question. Our next question will come from John Roberts of Credit Suisse. Your line is open.

John Roberts, Analyst

Thank you. How much has the energy co-product credit declined for earnings with the lower oil prices that we've had until the recent bounce?

Sean Keohane, CEO and President

John, I think certainly last year energy prices were higher, and those have moderated. In the full year numbers this year, we're running about $5 million per quarter lower in energy center benefits, so 2023 versus 2022, so something in the order of $20 million on a full-year basis, 2023 versus 2022 down.

John Roberts, Analyst

And then are all carbon black producers reducing production similarly, or are you seeing any significant share shifts from some of the suppliers continuing to run full out?

Sean Keohane, CEO and President

No, we're seeing real stability there. I think our volume declines are consistent with what, on average, the major tire producers are experiencing themselves. So we're not seeing any share shift here, and that would not be expected. As you know, agreements or multi-year agreements have certain volume targets attached to them. You typically don't see movements inside of the contract periods. If you look at this business, you have relatively stable but modest growth rates. It’s very important in terms of the key levers of success in running the business. You want stability of volumes, grow at the market rate, manage the pricing and product mix in a stable way, and then continue to drive technology and operational efficiency in the plant. So high OEE. We keep our assets and uptime high and drive the energy recovery that you touched on. Those are really the drivers of success here and not really share grab. That's not how we think about the business.

Operator, Operator

Thank you. One moment please for our next question. The next question will come from Josh Spector of UBS. Your line is open.

Joshua Spector, Analyst

Yes, hi. I just had a couple of questions on the battery business. So I think, Sean, if we look back a couple of quarters, you originally thought that business could do north of $40 million in EBITDA, I believe, this year. Now you're talking low $20s if I heard you correctly. Can you go through that and maybe parse out how much of that is volumes versus some of the pricing pressure here? And I'll stop there, and then I'll have a follow up as well. Thanks.

Sean Keohane, CEO and President

Sure. Good morning, Josh. So certainly you're right. At the beginning of the fiscal year, we had been seeing a consistent sequential quarterly growth in the market, and our expectation was that this trend would continue for the year. That core assumption, in combination with an expected ramp of volumes at new customers, particularly outside of China, is what informed our expectation for the year. Then as the year progressed in Q2, we saw a significant sequential decline in EV sales in China. The market was down pretty sharply, and we commented on that, which disrupted this trend of sequential growth that we had been seeing. That was driven by several factors, certainly the COVID-related disruptions that were occurring at that time had a distorting effect on things as well as the significant decline in key raw material prices, particularly lithium, in that March quarter. It really drove our behavior of destocking. Finally, the Chinese government had incentives for EVs in place, and those expired at the end of December, which impacted buying behavior. This impact in China from all of these things definitely caused us to lower our outlook in Q2. Now since that time, we have seen a pickup in volumes in China starting in April, and this continued through our Q3, as we commented on. However, while volumes began the sequential recovery, we have seen price pressure in the EV auto EM market that has really intensified. I think this was visible as Tesla reduced prices there and it set off a bit of a price war for auto EV in China as they were competing for market share, and this has created pricing pressure in the battery resulting in impacts flowing back up to both batteries and the materials chain as we move into our fourth quarter. While the current environment in China is challenging, it is concentrated in the lower-end domestic Chinese vehicle market. The market for the U.S. and Europe remains stable from a pricing standpoint, and Chinese batteries that are sold for export to Western auto OEMs remain stable as well. It's really about thinking through the segmentation of the market here. This is a real priority for us: focusing our market segmentation on higher-performing batteries and balancing share and pricing, and on the more base end of our product line, really focusing on cost reduction. Over time, what we see is that the market is clearly bifurcating into a China market and a rest-of-world market. We expect the rest-of-world market to behave consistently with the auto market norms, where there are strict qualification requirements and management of change protocols, et cetera. We also expect this market is going to continue to regionalize. All of that creates momentum for growth outside of China and for more predictable and durable profit pools. Inside of China, we expect the market to bifurcate there as well, with lower-end vehicles on one end, where the Chinese government is promoting EVs aggressively, and the lower end of the market, with offerings in the $10,000 to $15,000 per vehicle range, which is very cheap. On the higher end side, you see traditional vehicles that are a bit more premium. Our view is that the lower end will use more base conductive additives, and pricing and margins here will probably cycle with demand, and this will be consistent with what we've experienced in China over the years across our other markets. We expect the high end of the market will require higher-performing conductive additives, which should command higher pricing and margins. Managing these segments in a differentiated way will be really important for us as we manage through this unexpected turbulence in China. In the long term, we see the growth fundamentals here remaining intact, and we see the growth expected outside of China. In the U.S. and Europe over the next 10 years is expected by most forecasters to represent about 50% of the market. The requirements, therefore, and the profit pools outside of China will remain very attractive and more durable. Inside of China, it will be about how we segment the market and choose our places to participate that orient more towards higher value. So that's a bit of what's going on in the market and how things have developed over the course of the year, how it evolved differently than what was originally expected and informs our initial outlook.

Joshua Spector, Analyst

Thanks, Sean. I appreciate that. Just two quick follow-ups: one, your exposure to China today in this business versus where you aim to be a couple of years from now. Can you give us some numbers there? And then second, just has anything changed on the supply side and carbon nanotubes? Is that an area you're seeing more pressure or is it relatively broad across your portfolio?

Sean Keohane, CEO and President

Yes. So first, I'll take them in order, Josh. In terms of the China market today, it represents for the whole market about 70% of batteries made in China. Our geographic makeup is similarly skewed, probably even a bit higher than that in terms of our portfolio. What we would expect, as we look out over the next 10 years, is that the U.S. and Europe will grow to represent about 50% of the battery market, and we would certainly be targeting at least that level of breakdown across our portfolio. However, given our position, our global footprint, and our breadth of technology, the orientation of the market outside of China towards NCM because they want longer range, those will orient towards higher-performing products in our view. We would hope to win a disproportionate share. On the second question, on the supply side, the market inside of China is certainly very dynamic. We have seen new entrants developing here over the recent period. Customers, certainly, given the pricing pressure in China right now at the EV level, are getting more aggressive about pricing and trying to develop additional alternatives. Our focus is on segmentation: on the higher end of the market, we see prices more stable because the performance is higher. Certainly, on batteries that are exported to global auto OEMs, the same thing is true. In China, it will be about how we segment the market towards the higher-value product lines, and that will be our key area of focus.

Operator, Operator

Thank you. One moment please for our next question. The next question will come from Jeff Zekauskas of JP Morgan. Your line is open.

Jeffrey Zekauskas, Analyst

Thanks very much. I know that it's early to talk about carbon black price negotiations in Europe and the United States for 2024, but is the general posture that the carbon black companies think that prices should be up and the customers think that prices should be down?

Sean Keohane, CEO and President

Hi Jeff, I think that's perhaps a reasonable summary. If you look at our business, we have a percentage of our business that has multiyear agreements with the second year bringing price increases. I know some of our competitors that have commented publicly have the same. The view is that those price increases are kind of the baseline for the rest of our 2024 contracts and should really set the level of price increases, I would say, number one. The environmental costs continue to rise in this business, and those costs have to be recovered. The fundamentals there have not really changed. As we head into the negotiations here, I would say the supplier capacity picture remains as structurally we have commented on in the past, so no change there. We are going to see restrictions or sanctions go in place around Russian products into Europe in 2024. I think the supply picture remains very important for customers, and I think that getting supply reliability will be pretty critical for them.

Jeffrey Zekauskas, Analyst

Okay. And in China—the traditional China carbon black tire markets, can you talk about the price raw material spreads, whether they're narrowing or expanding? And can you talk about the effect of Russian imports of carbon black into China if there are impacts?

Sean Keohane, CEO and President

Yes. In terms of our margin profile in China, Jeff, it's pretty stable right now. As raws move around that market, it's more of a spot market that tends to adjust very quickly. The price raws recovery is basically matched, and the unit margins are holding pretty steady, though at a lower level than where they were a couple of years ago. In terms of Russian product into China, maybe I'll just sort of pull the lens back a bit. The Russian exports right now are down about 50% from into Europe, from where they were pre-Ukraine invasion. Again, there are sanctions on the books that will go into effect at the end of June 2024. So that number based on those sanctions arguably has to go to zero. What's happening with the product and where is it going? Some of the product is going into markets like Turkey, which has a pretty good-sized tire production base with no carbon black production in-country, so some of it is flowing there. Some of it is flowing to the Middle East; some of it is flowing into China. We're not seeing that flow have any material impact on the competitive dynamics in China because the market is just so big. A few hundred thousand tons flowing into a market that is somewhere in the order of probably 7 million or 8 million tons is not really changing the dynamic there. The market has its competitive intensity, and the Russian stuff isn't really changing that.

Jeffrey Zekauskas, Analyst

Okay. Thank you for that. And then lastly, can you talk about your specialty black volumes, both in the second quarter and year-to-date? What kind of growth or contraction are you experiencing? And how's the profitability of that business?

Sean Keohane, CEO and President

Yes. Certainly, across Performance Chemicals, we have seen weak volumes, and it's really driven by weakness in the end markets. In specialty carbons, that is definitely the case. We've seen weaker volumes. I would say the carbons volumes are pretty similar to what we summarized for the overall segment—down around 9% in the quarter. While that's sort of headline volume, you also have a mix factor here where some of the higher-end mix that pulls through much stronger margins has been weak. While the auto sector is beginning to recover in terms of production, we typically see a lag in that given the length of these value chains that we sell into. We've not yet seen that translate into our business. As a result, we're not getting that mix uplift that we would normally get. As the lag works its way out from the auto builds, that should flow through. Overall, there's a mix impact on the business today. In terms of profitability, it is down in the business, very similar to the overall declines in the segment.

Operator, Operator

Thank you. One moment please for our next question. The next question will come from Chris Kapsch of Loop Capital. Your line is open.

Chris Kapsch, Analyst

Good morning. Many of my questions have been addressed, but I have a couple more. I want to dive deeper into the discussion about battery materials, and I appreciate the detailed information provided. I understand the distinction between the Chinese and Western original equipment producers, with China focusing on low-priced, low-value cars and using LFP batteries, while Western markets lean towards NMC for longer-range vehicles. However, I'm curious about the role of conductive carbon in these batteries and why it seems to differ so much. To my knowledge, irrespective of the battery chemistry, there are components necessary for facilitating electron flow between the cathode and anode. So, what factors in the construction of LFP batteries in China have intensified competition? Is it merely the mindset of the manufacturers? You hinted at this, but I would like to know how significant this dynamic is across the entire battery value chain. Is there a greater emphasis on carbon nanotubes, or does this also pertain to the traditional conductive carbons produced in standard reactors?

Sean Keohane, CEO and President

Yes. A couple of things here. At a high level, what you have in China is a battery market that is more oriented towards LFP rather than NMC. Inside of China, it tends to be more LFP. While it's true that they both require conductive carbon additives and the volume loading is not materially different across those two, you can have a very different level of performance. Some of the low-end batteries in China, LFP might have ranges of about a hundred miles, where these are going into EVs sold to consumers in Tier 3 and Tier 4 cities, resulting in a lower-performing battery. Pricing intensity is definitely higher at the lower-priced end. The low-end battery producers are more aggressive and less disciplined around qualification standards because they're being sold as local domestic vehicles at a very low price. That's a bifurcation. The higher end of the market requires more premium products. We see prices more stable, and customers are more discerning about quality at the higher end. This will impact how we manage our sales strategy.

Chris Kapsch, Analyst

Got it. I appreciate that. Just as a follow-up, and I appreciate your comments about the market segmentation approach and a little bit of a pivot on the strategy addressing this growth opportunity. But does the evolution of this market dynamic influence your intent with respect to capital allocation to grow capacity as this market grows? In other words, are you going to focus only on installing the capability to supply the western markets and walk from the large and growing domestic market in China, or how are you approaching that? Thanks.

Sean Keohane, CEO and President

Yes. I wouldn't say it's any fundamental shift but a bit of an adjustment in our approach. It will be guided first by our choices around segmentation. We continue with our intentions to build capacity there to support customers. We'll time that with how customer projects are advancing. Most battery gigafactories are targeted to come online in the 2025 through 2028 period, so we'll be looking to synchronize our capacity adds with that. In China, again, segmentation will be critical here. We're managing our capacity adds to match that. Last year, we brought on a significant tranche of specialty carbons capacity in China, and given the market's slower recovery, that is making more capacity for high-value battery grades in China off our existing network. We can serve that adequately without significant increases in our near-term capacity, so we'll manage that carefully in China tied to our segmentation approach. Outside of China, it's really no change in the aiming point; we just need to ensure we synchronize it with customers' timing.

Chris Kapsch, Analyst

That's helpful. If I could just sneak in one last one about the fumed metal oxide business. Under what scenarios would you be able to underwrite a recovery—a more pronounced recovery in that business? Is it dependent on the semiconductor end market recovery? Is it going to piggyback off of China stimulus and recovery there? Or is there something Cabot can do specifically to drive a recovery?

Sean Keohane, CEO and President

Yes. The semiconductor and silicone space, which drives the largest part of the fumed silica business, has been very weak. If you look at the end markets for silicones, building and construction is the largest one, and that has been quite weak globally. We need to see a turn in building and construction in order to provide more stable volumes in that business because volumes are off greater than 20% year-over-year, and it is the highest margin business in the Performance Chemicals portfolio. It's impacting us with those weaker volumes. Housing recovery and building and construction is one. Silicones also go into the automotive sector, and as auto builds improve with a bit of a lag, we should see improvement there as well. Semiconductors have been beginning to pick up a bit more now, which is good, but we need to see the end markets improve a bit here. There are some mixed signals; we’re seeing maybe some early signs of housing and construction beginning to turn. I wouldn't say that's the case yet in Europe or China, but we’ll have to see how that evolves in the coming quarters.

Operator, Operator

Thank you. One moment please for our next question. The next question will come from Laurence Alexander of Jefferies. Your line is open.

Laurence Alexander, Analyst

Good morning. So I guess first of all, do you have any end markets by region where customers are clearly telling you inventories are too low? And secondly, can you give an update on how the conductive carbons platform is evolving? Should your operating leverage to an improvement in EV sales be different in 2025 than it was in 2023? Can you just give a sense of what the underlying technology development is looking like?

Sean Keohane, CEO and President

Sure. Thanks, Laurence. In terms of end markets and inventory positioning, it certainly seems like we're at the end or near the end of destocking. Our customers are not seeing inventory levels at normal safety stock. They're below that. They are ordering to meet their current demand, not building stock in anticipation of growth. We see order pattern behavior where customers order a couple of times a month instead of once. They have a cautious posture on inventory. When a turning point happens, customers will need to rebuild inventories to a more normal level to support demand, but we've not seen that yet. That's a characterization of inventory side. Regarding the conductive carbons technology evolution: we have a range of conductive carbon additive technologies in our portfolio. Over time, we see that as the proportion of NMC batteries increases, the need for higher-performing carbons and blends of conductive carbon black and carbon nanotubes will become more important. No real change there. We continue to develop both of those product lines for differentiated performance, especially in these higher-end batteries. As volumes grow, we will see operating leverage benefits. Great. Well, thank you very much, Chris, and thank you all for joining the call today. I appreciate your continued support of Cabot and look forward to speaking with you next quarter. Thank you very much.

Operator, Operator

This concludes today's conference call. Thank you for participating. You may now disconnect and have a pleasant day.