Ingevity Corp Q3 FY2022 Earnings Call

Good morning. My name is Brika, and I will be your conference operator for today. At this time, I would like to welcome everyone to the Ingevity Third Quarter 2022 Earnings Call and Webcast. All lines have been placed on mute to prevent any background noise. After the speakers' remarks there will be a question-and-answer session. Thank you. John Nypaver, Treasurer of Investor Relations. You may begin your conference.

Thank you, Brika. Good morning, and welcome to Ingevity's third quarter 2022 earnings call. Early this morning, we posted a presentation on our investor site that you can use to follow today's discussion. It can be found on ir.ingevity.com under Events and Presentations. Also throughout this call, we may refer to non-GAAP financial measures, which are intended to supplement, not substitute for comparable GAAP measures. Definitions of these non-GAAP financial measures and reconciliations to comparable GAAP measures are included in our earnings release and are also in our Form 10-K. We may also make forward-looking statements regarding future events and future financial performance of the Company during this call. And we caution you that these statements are just projections, and actual results or events may differ materially from those projections as further described in our earnings release. Our agenda is on Slide 3. Our speakers today are John Fortson, our President and CEO; Mary Hall, our CFO; Ed Woodcock, President of Performance Materials; and Rich White, President of Industrial Specialties and Payment Technologies. In addition, Steve Hume, President, Engineered Polymers; and Eric Ripple, Chief Growth and Innovation Officer, will be available for questions and comments. John will start us off with some highlights for the quarter. Mary will follow with a review of our consolidated financial performance. Rich, on behalf of his Performance Chemicals segment, colleague Steve Hume, will discuss the entire Performance Chemicals segment, and Ed will review the results of Performance Materials. Finally, John will conclude with our outlook for 2022. With that, over to you, John.

Thanks, John, and good morning, everyone. Please turn to Slide 4, and we'll jump right in. Ingevity had another great quarter, and I want to thank everyone on the team for how well they have navigated the current market. This is an environment where we continue to hear other chemical and material companies reduce their guidance and paint a pessimistic outlook. Yet for Ingevity, this quarter, we posted record sales, adjusted EBITDA and adjusted EPS. Our Performance Chemicals segment saw record sales across its businesses and Engineered Polymers, Pavement Technologies and Industrial Specialties. Performance Materials saw significant volume growth as global auto production increased during the quarter. Our consolidated results are directly due to our team's focus on attractive end markets, where customers require unique performance characteristics and where we can gain market share. For example, with increased automotive production this quarter, our Engineered Polymers Capa business sold more higher-value products used in auto applications, such as paint, protective film and gas bumpers. And of course, higher auto production aided performance materials with significant volume growth in our activated carbon and honeycomb products. Another end market where our products are experiencing strong demand is road construction. Municipalities are increasingly asking for sustainable performance-enhancing products like Evotherm, which lowers the amount of energy needed to pave roads while reducing harmful emissions. In the quarter, input costs, including energy, raw materials and logistics, continue to rise, and Industrial Specialties volume was constrained due to lower availability of key raw materials. But by strategically focusing our product mix on derivatized products that bring higher value to both our customers and to Ingevity in markets like oilfield, agricultural chemicals and adhesives, Industrial Specialties was able to post a record sales quarter even on lower volume. In other businesses, we have experienced a lag between the timing of higher input costs and our price increases, either due to the speed with which the costs rose or due to the nature of our supply agreements. These are timing issues that will correct as we adjust prices and represent expected upside into next year. We continue to generate strong free cash flow, and this allowed us to return cash to shareholders, pay down some debt and continue spending on growth initiatives. As we announced a few weeks ago, we completed the acquisition of Ozark Materials and are excited to have the Ozark family of specialty products to support this end market. Our integration efforts are moving forward and remain on track. They are a high-quality team and a great addition to Ingevity. There are tremendous opportunities for our teams to work together to better serve our customers with a broad array of products and technologies. We were also pleased to announce the completion of one of our key organic growth initiatives as we finished the addition of caprolactone polyols production at our Louisiana site. We have been telling you about the demand customers have for our Capa polyols. Our polyols enhance high-performing end-use products such as top coats on auto or planes, coatings on specialty flooring and boats, protective films and footwear by making them stronger and more durable. The addition will increase our global capacity by 40%. Before I turn it over to Mary, you all know that ESG is in our DNA at Ingevity. Our purpose is to purify, protect and enhance the world around us, and we work to achieve this every day. As such, we were extremely pleased when we were awarded the gold rating for corporate social responsibility by EcoVadis. This rating puts us in the top 3% of respondents in the specialty chemicals sector. It is a reflection of who we are, what we do and how we do it. With that, I'll turn it over to Mary to discuss the financials.

Thanks, John. Please turn to Slide 5. As you heard from John, we're very pleased with our third quarter results with sales up 28% and adjusted EBITDA up almost 16%. We delivered a record quarter on the top and bottom lines as our products and technologies continue to demonstrate their value to our customers due to their unique performance attributes and the sustainability benefits they deliver. As we move down to Slide 5, please note that we've excluded depreciation and amortization from gross profit and SG&A in order to provide more transparency to the changes year-over-year. A reconciliation to GAAP gross profit and SG&A is in the appendix. As you can see, our adjusted gross profit dollars were up over 21% year-over-year driven by the higher sales, while our adjusted gross margin declined 220 basis points. This decline was due to margin compression in both segments, driven by continued inflation impacting input costs. Similar to Q2, Performance Chemicals adjusted gross margin was negatively impacted by higher input costs and raw material constraints. The margin compression in Performance Materials was primarily attributed to the timing of raw material cost increases versus the timing of customer price increases, particularly in automotive. We're beginning to see the pace of raw material increases moderate, and we expect to see our gross margins improve as that occurs. SG&A excluding depreciation and amortization, increased about $12 million year-over-year as we continue to fund strategic growth initiatives and also saw higher labor-related costs. Our strong sales performance drove record adjusted EBITDA of $138.2 million, up nearly 16%, while our adjusted EBITDA margin was down about 300 basis points due primarily to the combination of gross margin pressure and SG&A increase. Our quarterly diluted adjusted EPS of $2.09 is a record for the Company. Many chemical companies have commented recently on the negative foreign exchange impact to both their top-line and bottom-line results. As a global company, Ingevity saw some pressure on the top line from the strong U.S. dollar, which negatively impacted sales by about 2%. However, the impact of foreign exchange on our bottom line was not meaningful. We attribute this primarily to a combination of our diverse global sales mix and global manufacturing input footprint. This is another area where our diverse end markets and geographies enables us to perform well despite market volatility. Turning to Slide 6. In the upper left-hand chart, you can see our sales through the third quarter have outpaced full-year sales in some prior years. You've heard us attribute much of the sales growth this year to pricing actions we've taken. I want to emphasize that our ability to increase prices is not just a function of capturing higher input costs. It's also a reflection of our success over several years in managing and upgrading our mix of sales to more derivatized products and technologies that drive higher performance and value for our customers and for us, a win-win. For example, in 2016, about one-third of our sales came from lower-margin commodity products, predominantly in our Industrial Specialties business. Today, that number is cut in half to about 17%. We will continue to focus on improving mix to drive value for our customers and for our shareholders. The upper right chart shows another quarter of strong free cash flow. As you can see in the capital allocation chart bottom right, this allowed us to continue returning cash to shareholders through share repurchases, and we have repurchased over 2 million shares year-to-date, while maintaining leverage within our 2x to 2.5x target area. We completed the Ozark acquisition on October 3rd, so it is not included in these Q3 numbers. I will note, however, that we financed the $325 million purchase price with a combination of cash on hand and borrowings on the revolving credit facility. So our leverage will shift up in Q4, but should stay under 3x and be back in our target range in less than 12 months. In summary, we delivered a strong third quarter, executing well on our organic and inorganic growth initiatives while managing to a balanced capital allocation strategy. Should the business environment worsen, we believe we are well-positioned to manage through the challenges. And now I'll turn it over to Rich for more color on Performance Chemicals.

Thanks, Mary, and hello all. Turning to Slide 7. As John mentioned in his opening comments, the Performance Chemicals segment posted record sales across all three businesses in the third quarter. Sales of $337 million are over 30% higher than last year, driven by a product mix that was heavily weighted toward high-performance derivatized products, which command higher prices. This product mix helped offset persistent inflationary pressure for input costs and resulted in a record EBITDA of $77 million for the quarter, 22% higher than last year. Our Engineered Polymers team rebounded strongly from last quarter's unexpected downtime due to constrained raw material availability and ran the plant near capacity for the entire quarter to meet the demand for our polyols and thermoplastics. Customer demand is strong for these high-performance products because they make end products more sustainable by giving them greater durability and resistance to wear and tear. In Q3, we continued to see strong growth in automotive as well as footwear and apparel where the performance attributes of our products are appreciated. One of the fastest-growing end markets for our caprolactone products is automotive paint protective films, where our polyols technology is incorporated to provide film with non-yellowing clarity, self-healing and stain-resistant properties that can help keep vehicles looking showroom new and improve the resale value. Third-quarter sales of $69.5 million were up over 31% from a year ago, fantastic performance. Our Engineered Polymers team has done an excellent job managing customer requirements as demand for caprolactone polyols continues to exceed supply, and they generated greater capacity by completing the polyol production facility at our DeRidder site in Louisiana, which, as mentioned earlier, has increased production capacity by 40%. Production commenced in September, and the first commercial sales took place in October. This is expected to support the future growth of these specialty products, and the geographic location should help serve the customer base in this region as well as reduce global lead times. Turning to Payment Technologies, Q3 sales of $88.3 million, an all-time record quarter, were up over 20% versus last year due to strong paving season. During the quarter, we saw increased focus from municipalities on sustainability, which has led to increased technology adoption in both our Evotherm mix products and pavement preservation product lines. Evotherm enables paving at lower temperatures, extending the paving season and reducing energy consumption as well as overall emissions. Our pavement preservation products save time, energy and money by extending the life of existing roads. As you know, we closed on the Ozark acquisition early in October and are extremely excited as we have begun working with the Ozark team to complement our existing payment technologies products. We are working to leverage the strength of our teams and processes to create synergies such as utilizing the resin we produce in their pavement marking formulations. We expect to capture approximately $5 million of synergies during the next 18 months. Industrial Specialties had a record quarter with sales up over 35% despite a host of challenges during the quarter. We experienced volume constraints due to raw material availability, which limited our production capacity as well as drove higher input costs. In addition, we saw certain customers choose to work down inventory levels as they assess the macroeconomic environment. To meet these challenges, the team continued to focus on derivatized products, which allowed us to capture higher prices to offset increased input costs. We saw double-digit gains in agrochemicals, adhesives and oilfield, all in markets that demand high-performing products. Our technology teams are constantly working with customers to find new applications where our products can purify, protect and enhance the world. In summary, Steve and I couldn't be more proud of the team and what they've delivered during the quarter. Posting these results with all the challenges we face is truly an impressive accomplishment, and we want to thank everyone for their hard work. I will now turn the call over to Ed to discuss Performance Materials.

Thanks, Rich. As you can see on Slide 8, sales of the Performance Materials segment were up over 22% to $144.9 million versus the prior year's quarter. This increase reflects the rebound in automotive production driven by improvements within the global automotive supply chain. Throughout the quarter, we saw sequential volume increases in each month within both our auto carbon and honeycomb products. Our sales in Asia Pacific were up almost 40% versus Q2 of 2022 as volumes rebounded from COVID impact Q2 lows. Q3 North American automotive production was at the highest level since Q4 of 2020, and we're seeing signs that OEMs are rebuilding vehicle inventories. We were quite encouraged by our sales in Europe, which improved roughly 19% year-over-year as the availability of auto parts improved. The EU is still working towards implementing a more stringent regulatory package for auto evaporative emissions, and we're expecting to hear an announcement before the end of the year. Our expectation is that the potential regulations in Europe would look similar to Brazil's requirements and could go into effect as early as 2026. Our sales in Brazil illustrate the impact of more stringent regulations. While Brazil is a smaller sales footprint for us than other regions, our sales have more than tripled compared to last year. We expect continued growth in Brazil over the next several years as regulations are fully implemented. Segment EBITDA was $61.2 million, an 8.5% increase from last year. Segment EBITDA margin was 42.2%, down compared to last year, primarily as a result of increased energy and raw material costs. We typically negotiate prices with our auto customers annually early in the year. Although we increased our prices this year, particularly in the process purification market, the rising inflationary costs throughout the year have outpaced our automotive price increases that were implemented during Q1. I will now turn the call back to John to discuss the outlook for 2022 and for closing comments.

Thanks, Ed. On Slide 9, you'll see our revised guidance. As we've said, demand continues to be strong. So we have raised the range of our sales and EBITDA guidance. We will also spend less in CapEx this year than expected, but we remain committed to maintaining safe and reliable plants while also investing in organic growth initiatives that bring value to the Company. As we look forward to the end of the year and into 2023, we are monitoring the broader economic environment. Much is being said about a potential recession in the coming months, particularly in Europe. Demand remains robust in our businesses. However, customers in a few markets, adhesives and certain engineered polymers customers, are signaling a focus on inventory destocking in Q4. It's unclear today if this destocking is short-term in nature or something more sustained. At a high level going forward, we expect continued benefits from the recovery in auto production in both the Performance Materials segment and our Engineered Polymers business. Although production numbers still low today, we should see them continuing to improve over the next several years, and we will benefit. Additionally, we should benefit in our enlarged Pavement Technologies businesses as infrastructure spending continues to flow into municipalities for road construction and repair. Engineered Polymers margins have suffered due to energy costs, freight and other material cost inflation in Europe. We are adjusting prices accordingly and expect to benefit into next year as their margins improve. For Industrial Specialties, while we face higher pine-based raw material costs and may see potential slowdowns in orders due to economic conditions, we see the benefits of the new regulatory-driven biofuel market beginning to take hold. Increased use of alternative raw materials to supply both the chemical industry and biofuel markets are also exciting opportunities for us to offset any recessionary pressures in our legacy markets. Finally, you'll see on Slide 10 that we are planning to host an Investor Day event next spring. Originally, we planned to have it in December, but in an effort to increase transparency to you, the investors, we are in the process of evaluating how we report our businesses. We didn't want to have an Investor Day and potentially change how we show and explain our business too in the next quarter. We will complete our assessment and hold the Investor Day early next year. We're in the process of rescheduling and we'll keep you posted, but our goal is to give you all as much information as possible about Ingevity. We look forward to sharing with you what we believe are exciting opportunities for us to continue to grow and further increase our profitability. And we hope you will share our enthusiasm for Ingevity. With that, I'll turn it over for questions.

Your first question from the phone lines comes from John McNulty of BMO Capital Markets.

Really solid results. So I was curious on the Performance Materials business. I guess, how far or can you quantify how far you might be behind on the price versus raws situation? And then I assume that catches up pretty quickly since you are the big supplier in the industry. Is that right?

So look, as Ed alluded to, we do an annual price increase in that business. So you will see us in early next year raise prices to our customers, and we will get back that margin. I don't really want to quantify the exact hit because, as you know, John, as we've always said, quarter-by-quarter, things can vary. We have outages, et cetera. But our intent will be to return to what we consider to be more normalized margins for that business, which are more in the mid- to high 40s. So that is where we plan to go.

Got it. Fair enough. And then paving obviously, pretty strong numbers, pretty strong numbers across the board really. But I guess at this point, can you speak to how you're seeing 2023 layout? It sounds like you've gotten a lot of incremental interest from the municipalities. I would assume some of this gets planned out a year in advance. So I guess, can you speak to how things are maybe starting to look for 2023?

It's a bit early to provide a full picture since these are annual paving campaigns. However, as we approach the end of 2022, the weather has been quite warm. When the weather stays warm, we have the opportunity to pave longer into the season, which is a positive sign for the end of this year and the beginning of next year. We're optimistic, particularly in the U.S. with the infrastructure spending, and we anticipate that funds will start to flow. That said, we need to see how the rest of this season unfolds before establishing plans for next year.

Got it. Fair enough. Maybe I can squeeze one last one and just around Ozark. So I know you haven't owned it particularly long. Can you tell us what you're seeing right now, the overlap of that business versus your paving business in terms of customer base and how maybe you can leverage areas there where one has a relationship and maybe the other doesn't? And then also...

Go ahead.

Sorry, please continue. Also, could you remind us about the significant seasonality in this business? It would help us model it correctly for 2023.

Absolutely. First and foremost, Ozark is a valuable addition to our company. We've visited them at various locations, except for one in North America, and they have an excellent team and a solid business. There are numerous opportunities for us, given that while the end product is different, our customers often occupy the same building or even the same room. This proximity allows us to take advantage of their strengths where we may have gaps and vice versa. As they expand internationally, particularly in North America, including Canada and Latin America, we are poised to offer them capabilities they currently lack. This is an exciting prospect for us. In terms of seasonality, it aligns closely with our existing payment business as it is influenced by weather conditions. For instance, once snow covers the ground, paving becomes quite challenging, affecting road work. The main profitability within that business, which can exceed 70%, generally occurs in the second and third quarters. However, I would consider the first and fourth quarters as shoulder seasons. As I mentioned, we are experiencing a good fourth quarter, thanks to the warm weather, although this is not guaranteed every year.

Yes. So it sounds like maybe I'm accidentally front-running the new reporting metrics for next year. But given the volatility in Capa's input costs recently, but also very strong performance on the sales side. Could you speak maybe just qualitatively about the trend in that business, maybe gross profit per pound or some other similar metric that gives us a bit more insight than just the consolidated segment margins?

Well, yes. So I guess the way to think about it, Vincent, you're correct. That business, because it's based in the U.K., is grappling with issues that are even more challenging than what we have here in North America. So its margins have come under pretty significant pressure while they've been able to actually see phenomenal demand increases for their product. Truthfully, I think they got a little behind in terms of their ability to keep up with price increases, but I think we're going to fix that. We've already started implementing price increases over there to recapture that. I think speaking to your comment about gun-jumping the segment. Part of the challenge when they were operating as a consolidated segment is they didn't have as much visibility as we would like them to have into their cost structure, and we're going to fix that. But we'll get their margin back over the course of next year.

Okay. Sounds good. And then I was just curious what your read is right now on European biorefining of CTO. It looks like there's still just the same three plants that we know for sure are processing CTO, but just wondering if you had any additional insights into that market if they're fully online? And as an aside, how much pressure are you seeing on U.S. CTO availability with Russia now out of the European market?

Yes. Please proceed, Rich.

Thank you for the question. The CTO market is very dynamic. Globally, there are about 2 million pounds of CTO, with 1 million pounds in the U.S. and 1 million tonnes in Europe. Approximately 200,000 tonnes are expected from Russia, but that is not happening for various known reasons. In response to your first question, we continue to observe additional production capacity in the biorefinery market, which we expect to grow, especially with the Red 2 initiative. Regarding CTO, we are experiencing inflation in the raw materials and anticipate that situation to persist. Overall, the market will remain dynamic for the foreseeable future.

Okay. Perfect. And then just one, hopefully, a quick one on Performance Materials. Just curious what the areas of process purification are that you've had particular success in recently. And if that pricing power you referenced there is outperforming the traditional activated carbon competitive products?

Yes. This is Ed. Most of our process purification revenue comes from North America. Our method, which uses sodas and phosphoric acid, creates a unique pore structure that our competitors' materials lack. We are the only carbon manufacturer in North America utilizing this process, unlike those that use raw materials such as bituminous coal or lignite coal. The uniqueness of our process and products provides us with inherent performance advantages that competitive carbons do not possess. Therefore, we have strengths in several areas, and we realize the benefits through our pricing.

We now have a question from John Tanwanteng from CJS.

It's actually Pete Lukas for John this morning. Just following up on Ozark. Anything you can say to quantify any expected synergies at this point now that it's closed?

As Rich said, we expect roughly $5 million in synergies that we would capture over the next 18 months.

Great. Very helpful. And then just jumping to any updates on Euro 6 and China 6 regulations and when they're expected to be finalized and implemented.

Yes. This is Ed. We're expecting an announcement in November from Europe around the regulatory package that they're putting in place. We expected, as I said earlier, to be similar to what Brazil has. So ORVR with some diurnal emissions requirements, be it either 300 milligrams or 500 milligrams. I think are the two options that are on the table. But we do expect an announcement in November with some timing of adopting the regulations beginning around 2026 would be our best estimate.

I want to address something, Peter. There have been rumors regarding the new requirements that circulated in some European publications. The headlines do not accurately reflect our business situation. When you see statements like "they're not changing it, they're going to keep it the same," they are primarily referring to the tailpipe. If you thoroughly read the lead copy, you would find that the emissions relevant to us, specifically our Evaporative emissions, are still included, along with other regulations that will become stricter, such as those concerning tires. I just want to make that clear for everyone. We're aware of those articles, but they don't accurately represent what will happen to our business.

Very helpful. And last one for me. Just if you could talk about what you're seeing in terms of M&A opportunity today from a pipeline perspective? Or are you more concerned with integrating what you have and maybe doing other things with your cash?

Well, I mean, obviously, we just closed on something like a month ago. So right now, in the near term, we're definitely focused on making sure we maximize the value between ourselves and Ozark. Look, our capital allocation priorities really haven't changed. I mean, obviously, to the extent we move into a recessionary environment, we do generate a lot of cash, and we have the ability to pivot that to protect our balance sheet as needed. But longer term, we're going to continue to grow the business, and we're going to look at M&A, and we're going to look at continuing to return capital.

And I'll add to that. M&A, as you know, can be a long process. We had actually been looking at Ozark for quite a while before we brought that transaction to completion. So we're looking for good fit, good strategic fit and has to be the right opportunity. So we have a pipeline. We continue to manage the pipeline. We don't sit on our hands and wait to digest any acquisition. We're always looking, but we are balancing our leverage, cash flow and making sure that the opportunity is strategic and a good fit for the Company.

Yes. Thanks for entertaining some more here. I wanted to follow up on that Performance Materials question that I left off with. I'm just wondering, you've had a lot of success in moving production into that market. Obviously, very aware of its advantages there, but automotive was always the cream of the crop. As automotive comes back, I think we've been saying that every year for three years, but let's say it comes back. How are you thinking about balancing your allocation of capacity between those two businesses if you want to maintain a good relationship in the process purification space?

Yes, Vincent, this is Ed. Obviously, what we'd be seeking is where can we place our products for the highest value and the highest margin contribution to them. And we'll continue to do that. That is primarily our automotive segment and the honeycombs as well. We do have some high-value segments within our process purification, and we'll protect those, but there's some lower-value opportunities where we produce product for water markets, which really help us from a contribution margin standpoint, but we'd much rather be selling automotive products and other higher-end products that we've got into the market. So we'll easily walk away from water markets to swap out for automotive sales.

Okay. No, that makes a lot of sense. And then we've talked about this in the past. I believe most of your participation in the biodegradable plastics space is more selling to compounders, but it feels worth asking, there's a very big PLA investment planned in the U.S. from a mature supplier. And now that you've started to build out some capacity of Capa here, are there any thoughts around maybe an even more significant investment with a large offtake partner on the upstream side of the bioplastic space?

We prefer not to discuss specific customers because we play a significant role in their formulations and competitive advantages. However, I can share that we are always looking to expand capacity where our customers require volume. We are considering another monomer streamline, having recently completed the polyols project in Louisiana. We will continue to invest in and grow that business as our customers need additional volume.

Okay. Very fair. And then just one last one, I promise because you tipped your hand on what the price was. I had a coin flip between sulfuric and phosphoric acid. But when you talk about recovering margins next year, obviously, you have price power. But if I'm not mistaken, phosphoric acid is already largely corrected back to pre-2022 levels, it looks like. So maybe just absent pricing activities, what's the lag effect on when that will move through your margins?

Yes. We'll introduce pricing starting on January 1st. We typically try to help our customers so that they can recapture the cost. So as you look at Japan, their fiscal year begins April 1st, and so we'll have a price increase there as well so that they can, again, make sure that they put the prices that we're putting in, so they can recover them from their various suppliers.

One of the benefits we have, though, Vincent, as you know, is this is not a cost-plus-type of business. So we discuss price increases; it's typically tied to more than just one individual variable.

The next question comes from John Tanwanteng from CJS.

Yes. That's quite all right. Yes, most of my questions have been answered, but I just wanted to ask you on the paving side. Maybe this is a very difficult question to answer, but can you give us a little bit of color on paving and how much per se goes into single-family homes and that area of the market compared to the other areas? And maybe what you're seeing on both sides in both areas.

This is Rich. The majority of our product does not go for single-family homes and driveways. Those are more commercial products that you see that you can get at a Home Depot or Lowe's. But most of ours is for highways, highways and roads and whether it's our Evotherm pavement preservation product and mainly on highways and roads and not on residential homes.

We now have Daniel Rizzo of Jefferies.

With Payment Technologies, as you set up the contracts with the different municipalities, is there a take-or-pay component where they have to buy a minimal amount each year regardless of weather or a contractor? How does it work?

This is Rich again. No, there is not a take-or-pay for the municipalities. They go to a certain amount of product and they use it as they need to pay various mileage of roads.

Ultimately, we have tanks on-site that are metered and controlled by sensors. We drop the tank, and they pull from it as needed, using it for as long as they can until the weather changes. When it needs to be refilled, we take care of that.

But they will buy a certain amount for the contract. They will still take the whole tank or two tanks or whatever they think is going to be required, correct? That doesn't change or does it?

Yes. Well, they're able to tell us the job that they're going to be working on for that season and then that job is then the formulation for that job is in debit on how much they want to need, and that's how they go about providing the product. But again, to your initial point, it's not a take or pay. It's just based on usage level and what's going to be needed to pave a certain amount of road.

Okay. You mentioned the $5 million in synergies with Ozark. I assume you're referring to cost savings over the next 18 months. Have you quantified any potential revenue synergies, or did I miss that? You mentioned that some clients are in the same building, so if you could clarify that, I would appreciate it.

Yes, Dan, we are currently focused on cost synergies, and the figures we mentioned are indeed cost-oriented. We do anticipate revenue synergies as well, although many people tend to underestimate these as they can be more difficult to achieve and identify in financial statements. We are optimistic about the array of opportunities we will provide to customers, and I expect you will hear more about that in the future. In the meantime, we will keep you updated on the cost synergies that we achieve.

With Ozark and your business, is there a long lead time for new contracts? It will likely take a couple of years before we see any results due to the nature of the process.

No. I don't agree with that. That's not really true, Dan. I mean, it's just that the issue that we run into with the top line, and I share Mary's view, it's very subjective what is actually a synergy versus what is something that was just normal course business. And we think there's opportunities for our salespeople to work together to complement each other. There's opportunities for them to enter markets. They're not in today to our salespeople. But we're not going to look at it and call it a 'synergy.' It's going to be more sales growth as you move forward. What we're focused on is capturing the cost synergies because those are real, tangible, quantifiable, and we can move the needle.

I want to emphasize that we are very excited about the growth synergies that John mentioned, specifically how the Ozark business can leverage our extensive global payment network. Ozark primarily operates in North America, with products made in the U.S. and to some extent in Canada, but not in Mexico. However, considering our presence in Europe, South America, India, and Australia, we see a much broader opportunity for the Ozark portfolio that we're eager to explore.

We now have Michael Sison of Wells Fargo.

This is a question for Mike. Looking ahead to 2023 and considering a potential recession, you briefly mentioned this earlier in the call, but could you provide more insight on how you expect your segments to perform in such a scenario? I understand that auto production is anticipated to increase and may not benefit Performance Materials, but regarding Performance Chemicals, which has industrial exposure, do you see that as a potential risk?

Yes. Let me explain our perspective. We think about these matters daily as it's our job. We aim to plan for the future and be ready for any eventualities, and we are prepared. Firstly, we anticipate improvements in auto production, primarily because it’s starting from a low baseline. This will positively impact both our Performance Materials and Engineered Polymers segments, serving as a counterbalance to a possible wider industrial recession. Additionally, our Payment Technologies business, which we’ve recently expanded, will benefit from increased infrastructure spending. Historically, during recessions, governments tend to ramp up this kind of spending to demonstrate action and create jobs, which will benefit us in those key markets. Regarding our legacy pine chemicals business, we have been managing significant inflation for the past few years and have worked diligently to reposition that business. As mentioned, we've halved our merchant sales, which constituted a third of our sales back in 2016, though that wasn’t widely known. Currently, it represents about 17%. I believe this economic downturn will differ from the previous one, which was exacerbated by issues in the Far East that were not market-related but driven by a plant shutdown connected to turpentine, causing unusual price spikes. This will not factor into our current situation, relieving some pressure for the next downturn. As we have shifted away from these underivatized commodity products and broadened our raw material base, some of our end markets may weaken. However, we feel well-positioned to manage these challenges and pursue growth opportunities to offset potential declines. We are evaluating the situation market by market and remain ready to adapt as it unfolds.

Okay. And then also just touching on raw materials. You noticed that you've seen 60% increases in some of your key inputs. Can you speak to which ones are the worst in terms of inflation? And are there any that are more business into coming down? I know you said some raws have eased.

We are experiencing inflation across nearly all of our raw materials. The price of crude tall oil has significantly increased. All segments of our Performance Materials are facing pressures from rising phosphoric acid and energy costs, affecting logistics and freight as well. It's challenging to pinpoint a single factor that could change our situation if it were to decline. We manage these aspects with great care, having specialists dedicated to our supply chain to ensure effective oversight. Our teams are focused on transportation efficiency to reduce costs, work on energy management, and we have dedicated buyers. We also implement pricing adjustments to compensate where necessary. While current costs remain high, they do not seem to be rising further, which is a positive sign.

The next question comes from Christopher Kapsch from Loop Capital Markets.

I had a couple of follow-ups. You mentioned some potential destocking in the pine chemicals segment, particularly in non-derivative product lines. I'm curious if you could clarify whether you were referring to more TOFA or ROR. Any insights on this would be appreciated.

Yes. That's not exactly what we said. What we observed is what we believe could be some destocking in two very specific end markets. One is in adhesives, specifically packaging adhesives, which is quite narrow, but we did notice some destocking and slowdowns there. Additionally, we saw this trend in a few of our Engineered Polymers businesses. So that's all we've observed so far. We're monitoring the situation, but that's really all we have seen as a company.

Okay. Well, I was just curious then on the Rosin side for the adhesive end market. Is it enough to alter your calibration in terms of your refinery run rates in the fine-tunes business?

No. As you know, Chris, we are limited by our volume capacity. We can optimize our operations, but we still have significant distance to cover.

In regard to the inflation of feedstock costs, specifically in relation to the pine chemicals business, I'm curious about the impact of energy costs on your CTO expenses since the Georgia-Pacific acquisition. Is the inflation mainly driven by the global supply-demand dynamics of CTO, or could the recent drop in energy prices, as indicated by WTI moving down from earlier peaks this year, help reduce CPO costs?

It's an interesting question, and it deserves a longer conversation. So maybe we can discuss it in our follow-up. The truth is that the CTO is primarily driven by the global supply and demand for the marketplace, regardless of the situation with oil. There is a connection to fuel, so as fuel costs decrease, the value of biofuel also declines, and they tend to move together. As those pressures lessen, it could theoretically put some downward pressure on CTO prices. However, right now, it's about the supply and demand dynamics among all of us who use it.

Fair enough. Lastly, to follow up on your comments regarding recessionary scenarios and the absence of a spike in turbine time prices, should I take that to mean there is no real incentive for Chinese gum Rosin producers to pursue natural turpentine? Therefore, you wouldn't expect an oversupply of that competitive material becoming Rosin.

Well, it depends on how you define oversupply. But as you know, what happened last time because that turpentine plant went down, the Chinese went out and tapped trees to get at the turpentine and they got Rosin as a byproduct. That's not the normal marketplace for that type of gum Rosin. And that situation is in the rearview mirror. It was at this point two years ago. We don't see that happening. So we think while you might see some pressure because we always look at gum Rosin pricing during the harvesting season, it will be more manageable than what we saw the last time. And we also are managing it ourselves by staying away from merchant sales markets. So we're attacking it from both angles.

Thank you. As we have no further questions, I'd like to hand it back to John for any final remarks.

Thank you, Brika. That concludes our call. Thank you for your interest in Ingevity, and we'll talk to you again next quarter.

This concludes today's conference call. You may now disconnect your lines.