Cabot Corp (CBT) 2020 Q2 法說會逐字稿

Ladies and gentlemen, thank you for standing by, and welcome to the Q1 2020 Cabot Earnings Conference call.

(Operator Instructions) Please be advised that today's conference is being recorded.

(Operator Instructions)

I would now like to hand the conference over to your speaker today, Steve Delahunt, Vice President, Treasurer and Investor Relations.

Thank you.

Please go ahead, sir.

Thank you.

Good morning.

I'd like to welcome you to the Cabot Corporation Earnings Teleconference.

With me today are Sean Keohane, President and CEO; and Erica McLaughlin, Senior Vice President and CFO.

Last night, we released results for our second quarter of fiscal year 2020, copies of which are posted in the Investor Relations section of our website.

The slide deck that accompanies this call is also available on 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.

These forward-looking statements are not guarantees of future performance and are subject to risks, uncertainties, potentially inaccurate assumptions and other factors, some of which are beyond our control and difficult to predict.

If known or unknown risks materialize, or should underlying assumptions prove inaccurate, our actual results could differ materially from those expressed or implied by forward-looking statements.

Importantly, as we cannot predict the duration or scope of the COVID-19 pandemic, the negative impact to our results cannot be predicted.

Factors that will influence the impact on our business and operations include the duration and extent of the pandemic, the extent of imposed or recommended containment or mitigation measures, and the general economic consequences of the pandemic.

Other important factors that could cause our results to differ materially from those expressed or implied in the forward-looking statements are discussed under the forward -- heading Forward-Looking Statements in the press release we issued last night and in our last Annual Report on Form 10-K for our fiscal year ended September 30, 2019, our quarterly report on Form 10-Q for our fiscal quarter ended March 31, 2020, or 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.

Any non-GAAP financial measures presented should not be considered to be an alternative to financial measures required by GAAP.

Any 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 provide an update on the impact of COVID-19 on our business and operations.

Erica will review the key highlights of the company's performance, business segment results and corporate financial details.

Then Sean will provide some context for how we are seeing the second half of the year developing in light of the COVID-19 pandemic.

We will then open the floor to questions.

Sean?

Thank you, Steve.

Good morning, everyone, and welcome to our second quarter earnings call.

First, I hope you and your families are all well at this time.

To start the call, I want to share an update on the COVID-19 situation.

First, I'd like to express my thanks to our first responders, health care professionals and all those who are working tirelessly on the front lines of the coronavirus response effort.

I would also like to thank the entire Cabot team for the way they have adapted to these unusual working conditions and have maintained the focus on protecting our employees, serving our customers and supporting our communities.

We have a long tradition of community engagement, and we are inspired by the many countless acts of kindness and community support from our Cabot team during this time, from donating personal protective equipment and contributing raw materials for the production of hand sanitizer to helping supply food to children who were without access to school meals.

Thank you.

The COVID-19 pandemic is having a significant impact on the world, and our first priority is the health and safety of our employees, customers and all stakeholders.

We were quick to take steps to ensure the safety of our employees, including halting travel, requiring work from home where possible, implementing social distancing measures, restricting access to our facilities to critical personnel, providing guidelines for self-monitoring and screening, increasing sanitation procedures, following strict hygiene rules and providing the appropriate protective equipment and procedures to ensure the safety of our people at our sites all around the world.

Additionally, we've implemented leave policies to help support our employees impacted by COVID-19.

The chemical and materials industry has been deemed an essential industry by most governments around the world.

For Cabot, this means that our production facilities have remained open.

Chemical products are essential building blocks for virtually everything, and Cabot's products specifically support such important sectors as the transportation of goods, the production of medical supplies, the manufacturer of key infrastructure products such as power distribution cables, consumer packaging and the agriculture sector broadly.

That said, many of our plants are operating at significantly lower rates due to the temporary halting of operations by many of our key customers, notably most tire and automotive manufacturers in the Americas and Europe, Middle East, Africa.

Serving our customers during this dynamic time requires that our supporting functions of customer service and supply chain operate flawlessly despite our remote work environment.

I'm pleased to report that all of our business processes, IT systems and technical service teams are performing consistent with the high level of service that customers have come to expect from Cabot.

Now if I move to the impact of COVID-19, here is what we have seen to date in our business.

We first experienced the impact of COVID-19 in China with extended Lunar New Year holiday closures at the end of January and into February.

Many of our customers' plants in China were closed or running at low rates for most of February.

We began to see week-by-week improvement as we move through March, but China volumes in the second quarter were still down 26% for Reinforcement Materials compared to the same quarter in 2019.

In terms of the other countries where we operate in Asia, namely Japan, Indonesia and Malaysia, we experienced limited impact in the second quarter.

We have seen more of an impact in these locations in April as the virus has spread to other parts of the region.

We continue to operate our plants in those countries, however, most at significantly reduced rates.

Moving to Europe and the Americas.

Throughout January, February and early March, we experienced solid demand across our businesses as the impact of COVID-19 was pretty limited up to that point.

By the end of March, many of our tire and automotive customers across these regions began to stop operations and demand was reduced over the last 2 weeks of the quarter.

This led to weaker volumes, mainly in our Reinforcement Materials segment.

At this point, all of our facilities remain open, but they are operating at significantly lower rates to align to lower customer demand.

While supply chain and logistics disruptions have been cited by some companies, we have not experienced any material issues at this point.

In this uncertain economic environment, ensuring strong cash flow and protecting access to liquidity is our top priority.

Our management team is experienced, having worked through several recessionary periods over the last 20 years, and we know in times like this, we must act quickly to generate cash.

On this front, we are taking aggressive actions to reduce inventory levels and accounts receivable which, combined with lower oil prices, will result in a significant release of working capital in the second half of the fiscal year.

This countercyclical cash flow profile is a distinguishing feature of Cabot.

In the 2009 financial crisis, Cabot generated strong cash flow from operations despite the significant short-term reduction in volumes, which allowed us to respond quickly as demand returned.

We've also taken timely and prudent steps to lower costs in the near term, while balancing our ability to respond quickly when the demand for our nondiscretionary products returns.

We eliminated all discretionary spending, stopped travel, curtailed production, tightened plant spending and I temporarily suspended my salary in the third quarter.

In addition, cost-reduction actions that were underway prior to the COVID pandemic, such as the move of our shared service center in the U.S. to Latvia and the streamlining of our management structure, are now providing significant cost savings in the back half of the year.

We anticipate these efforts will yield a reduction of $45 million of cost in fiscal year 2020.

These cost reductions will partially offset the negative impact from COVID-19 and the cost associated with growth investments.

Finally, we have further reduced our capital expenditure forecast by another $25 million.

We've deferred CapEx where possible, including the delay of some of our growth projects, and this will reduce our capital expenditures to approximately $200 million for this fiscal year.

In terms of capital allocation, we remain committed to our current dividend level and are confident in our cash flow outlook to support this.

During the second quarter, we repurchased $10 million of shares early in the quarter, but we have since halted our repurchase activity as part of our prudent cash flow management actions.

We do not anticipate repurchasing shares for the remainder of the fiscal year.

These actions will continue to strengthen our already solid debt and liquidity position.

Our operating cash flow generation has been consistently strong.

And since fiscal 2015, we have generated over $2 billion in cash.

We are confident that our operating cash flow will be sufficient to fund the dividend and support the capital expenditure needs of our businesses.

In terms of our debt maturity profile, it is staggered with no maturities until fiscal 2022.

On the liquidity side, as of the end of March 2020, we have $1.3 billion in cash and committed facilities, and we were well below our debt-to-EBITDA covenant in our revolving credit agreement, which we believe provides ample liquidity cushion for these uncertain times.

We anticipate strong operating cash flow in the second half of the year, resulting in a stable debt profile.

I will now turn it over to Erica to discuss the results for the second quarter.

Erica?

Thanks, Sean.

We delivered solid results in our second quarter despite the impact from COVID-19.

Total segment EBIT was $95 million, and adjusted EPS was $0.77 for the quarter.

The estimated total impact from COVID-19 in the second quarter was $21 million of EBIT, driven by lower volumes, primarily in China.

We were pleased to see EBIT in the Reinforcement Materials segment increased 30% sequentially, and volumes in the Performance Chemicals segment increased year-over-year.

As a reminder, our second quarter of fiscal 2019 included $12 million of EBIT from our Specialty Fluids business, which did not repeat given the divestiture of the business in June of last year.

Finally, we continued our commitment to return cash to shareholders with $20 million in dividends, and as Sean mentioned, $10 million of share repurchases.

Now moving to the segments, I will start with Reinforcement Materials.

EBIT in Reinforcement Materials for the second quarter of fiscal 2020 was unchanged as compared to the second quarter of fiscal 2019, even though the segment saw lower volumes, largely due to the impact of COVID-19.

Globally, volumes declined 14% in the second quarter as compared to the same period of the prior year, primarily due to a 20% decrease in Asia, where we saw the biggest impact from COVID-19.

We also were impacted in Europe, where volumes were down 13%, and in the Americas, where volumes were down 8% as March was impacted by the spread of COVID-19 in those regions.

Offsetting the lower volumes were higher margins due to pricing and mix benefits in both our tire and industrial products product line.

Feedstock protection mechanisms in our customer agreements that were designed to cover MARPOL-related effects worked as expected to ensure that our feedstock pass-through principles were upheld.

Looking ahead to the third quarter, we expect results in Reinforcement Materials to be severely impacted by COVID-19 as the temporary tire and auto customer shutdowns in Europe and the Americas will significantly impact volumes.

We also expect Asia Pacific volumes to be weak as a significant part of that region's tire production is export-related.

Our current expectation for the third fiscal quarter is for volumes to be down in the range of 40% as compared to the same quarter last year.

We expect margins in the segment to be unfavorably impacted by the rapid drop of feedstock prices as the combination of lower yield and energy center benefits as well as the temporary feedstock timing mismatch due to the sudden drop of customer demand will result in an estimated EBIT impact of $15 million to $20 million in the third quarter.

Now turning to Performance Chemicals.

EBIT decreased by $7 million year-over-year due to a less favorable pricing and product mix in our metal oxides product line.

The lower pricing in metal oxides continues to be due to a slowdown in the key transportation and industrial end markets, primarily in Europe and China, and an increased competitive intensity exacerbated by the impact of COVID-19 in China.

In the quarter, volumes increased 6% year-over-year in Performance Additives and 8% in Formulated Solutions.

Performance Additives volumes benefited in the quarter from higher sales in specialty carbons and from our new China fumed silica plant.

Formulated Solutions volumes increases were driven by our specialty compounds product line as we realized the benefit from our recent acquisition in Southeast Asia.

Looking ahead to the third quarter, we expect the sequential volume decrease from the impact of COVID-19 in Europe and the Americas.

However, demand is expected to remain more resilient for products sold into consumer and infrastructure applications.

We also anticipate the challenging pricing environment in the metal oxides business will continue.

Now moving to Purification Solutions.

In the second quarter of fiscal 2020, EBIT increased by $2 million compared to the second quarter of fiscal 2019.

This was driven by higher margins from improved pricing and product mix in our specialty applications.

The business also reduced fixed costs in the quarter, driven by savings from the previously announced transformation plan.

Looking ahead to the third quarter, we expect COVID-19 to have a negative impact on volumes in our specialty applications, which also negatively impacts product mix in the segment.

Fixed costs are expected to be lower due to asset curtailments, which should partially offset the volume and margin headwinds.

I will now turn to corporate items.

We ended the quarter with a cash balance of $142 million, and our liquidity position remains strong at over $1 billion.

During the second quarter, cash flows from operating activities were $24 million and year-to-date operating cash flow was $129 million.

Total capital expenditures for the second quarter of fiscal 2020 were $51 million.

And as Sean mentioned earlier, we are now expecting capital expenditures to be approximately $200 million for the full year, down from the forecasted $225 million last quarter, given current business conditions.

Also in the quarter, we returned $30 million to shareholders through $20 million in dividends and $10 million of share repurchases.

We have halted share repurchases for the remainder of the fiscal year, given the current business conditions.

Our year-to-date operating tax rate was 29%, and we anticipate the fiscal year rate will be between 29% and 30%.

The increase in the operating rate from our guidance last quarter is largely due to the impact from COVID-19 on the projected geographic mix of our earnings.

I will now turn the call back over to Sean.

Thanks, Erica.

As we look ahead, there is significant uncertainty as to how demand will develop over the coming months.

I would like to share with you some of the indicators we are watching that help guide us.

First, from a portfolio standpoint, Cabot's business is exposed to 3 high-level sectors: automotive production, replacement vehicle tires and consumer- and infrastructure-related applications.

With roughly 25% of our sales linked to new vehicle production, we are looking to industry analysts such as IHS, LMC and others as we model what the shape of a recovery could look like.

With the exception of China and North Asia, April auto demand globally was down over 50% in each subregion that IHS tracks and as much as 80% in Western Europe.

China is a more positive story as April demand was actually up slightly and provides one view of how quickly we might see a recovery in other regions once economic activity opens back up.

While signs point to April being the bottom as automakers in Europe, Middle East and Africa and the Americas restart production, it is still difficult to predict the specific timing and magnitude of such a recovery.

Approximately 40% of our revenue is linked to replacement tires for cars, trucks, buses and off-the-road vehicles, and demand for the June quarter is expected to be significantly lower than the prior year, given the shelter-in-place orders across the world and the temporary closures of many of our customers' tire plants.

While LMC forecasts show that the China market for light vehicle replacement tires is expected to be down only 3% as the industry in that country continues to come back online, Europe and North America are expected to be down over 30% year-over-year in the June quarter.

Replacement tire demand typically rebounds more quickly than OEM tire demand, so we would expect a faster rebound in the replacement tire market, just as we're seeing in China right now.

In order to understand the pace of recovery in the near term, there are some real-time miles driven indicators that we are tracking closely.

Apple is publishing daily information on their mobility trends page that show searches for driving directions on their maps app by city, state and country.

In addition, INRIX publishes similar data about miles driven trends.

While we are still far from where we were prior to the pandemic, these data sources are showing positive trajectories in the last few weeks as many countries are starting to ease the social-distancing recommendations.

The remaining 35% of our sales is tied to consumer- and infrastructure-related applications, which have been resilient thus far, particularly where they are supported by clear consumer needs and government stimulus.

These types of applications tend to be less cyclical and provide diversification in our Performance Additives and Formulated Solutions businesses.

With this backdrop of external indicators, I will provide some color on what we expect to see in our businesses.

While the second fiscal quarter results were solid, we did experience a significant demand decline in Europe and the Americas in late March related to COVID-19 that we expect to continue and to have a pronounced effect on the third quarter results.

At the segment level, we expect a significant reduction in demand in Reinforcement Materials in the third quarter due to temporary tire and automotive customer shutdowns in Europe and the Americas.

Volumes in April were 54% below the prior year April.

We are seeing many customers restart plants at the end of April and into May, albeit at low utilization rates, and we would expect April to be the low point of volumes for the quarter.

In Asia Pacific, we see a mixed picture as China's domestic market has substantially recovered, though exports from China and Southeast Asia are impacted by weakness in western economies.

In Performance Chemicals, we expect product mix in specialty carbons and compounds to be negatively impacted by a further decline in underlying automotive demand globally.

In April, volumes were down 3% in Performance Additives and up 1% in Formulated Solutions compared to April of the prior year.

Strength in packaging, agriculture and infrastructure applications partially offset continued weakness in automotive and building and construction.

Though the volumes in this segment have held up quite well in March and April, we expect to see some weakening from these levels in May and June, although not to the same magnitude as we would expect -- as we expect in Reinforcement Materials.

While demand is expected to be weak in the quarter due to COVID-19-related restrictions, our operating cash flow is expected to remain strong as net working capital should be a significant source of cash in the second half of the year.

I anticipate operating cash flow to be approximately $200 million in the back half of the fiscal year.

I hope this helps provide some color in terms of what we are seeing in our markets.

Given the lack of visibility into underlying demand due to COVID-19, we will not provide adjusted EPS guidance for the balance of the year at this time.

We will continue to update you as we have more information and as visibility improves.

With the current uncertainty, we have focused our efforts on stress test scenarios.

We know that the underlying demand for many of our products, particularly the replacement tire market, has proven to be quite resilient through recessionary periods and that the cash flow tends to be bolstered by an oil-related working capital release.

Looking back to the 2009 financial crisis, we experienced volume declines in the range of 25% to 30% across our businesses during 3 consecutive quarters.

Demand recovered quickly, however, in 2010, with volumes returning to pre-2009 levels.

This experience demonstrates the robustness of our end markets and the nondiscretionary nature of many of our products.

While the length of a downturn is difficult to predict, our view is that there will not be a fundamental reduction in demand for our products from COVID-19.

Furthermore, we expect to realize the countercyclical cash flow profile that we have experienced in previous recessions.

In addition to analyzing the 2009 financial crisis, we ran various stress test scenarios to determine the impact on cash flow generation.

These scenarios included volume reductions of up to 40% below the prior year.

In each scenario, the working capital release was significant due to lower feedstock prices and aggressive working capital actions, thereby underpinning solid operating cash flow.

In all scenarios, our expected strong cash generation allows us to fund the dividend and capital expenditures and maintain relatively consistent debt levels.

So while we are managing the near-term impact on demand from the COVID-19 pandemic, I feel very good about the long-term future of Cabot.

First and foremost, Cabot is a market leader in each of our businesses, holding either the #1 or #2 global market position across all businesses.

Our global footprint is unparalleled, allowing us to serve our global customers in all regions, optimize our supply chain and deploy innovation and best practices on a scale that many competitors cannot replicate.

Cabot has a long technology heritage, and we are excited about the potential of key growth investments in transformative applications such as batteries, elastomer composites, now called E2C, and the emergence of the packaging sector for our inkjet business.

In each of these cases, we are leveraging favorable market fundamentals and are making prudent investments to create long-term earnings potential for Cabot.

Our recent acquisition of Sanshun, a leading carbon nanotube producer for the battery sector, will strengthen our position in conductive carbon additives.

In the most recent quarter, we announced the commercial deployment of the first E2C solutions to help tire manufacturers unlock superior performance sustainably and economically.

Both developments position us to capitalize on the transformational potential of these markets.

Cabot's portfolio also has some enduring financial characteristics.

Our revenue base is geographically diverse, and we have generated consistently strong cash flows even during recessionary periods, given the countercyclical nature of our working capital.

And we have always maintained a prudent approach to balance sheet management with a long-term commitment to our investment-grade rating and ample liquidity.

This posture serves us well in times like this, allowing us to weather the storm and accelerate into the recovery with our assets and strategy intact.

While the COVID-19 pandemic is certainly challenging all companies, we have conviction and are advancing the core strategy, and we have the financial strength to navigate the storm.

Thank you for joining us today, and I will now turn the call over to the operator for our question-and-answer session.

(Operator Instructions) Our first question comes from the line of Mike Leithead from Barclays.

I hope you're all staying well and healthy.

Thank you, Mike.

First question, just on the Reinforcement Materials side to start.

A few questions around the trends heading into the third quarter.

First, you called out 54% volume declines in April, but can you maybe just give us some color on how the regional dynamics between China and the rest of the world?

And second, just the $15 million to $20 million EBIT that you called out, was that just the margin effect or is that incorporating the volume hit as well?

Yes.

Mike, I hope you and your family are all well also.

So in terms of the April volumes, it was certainly most pronounced in the Americas and Europe, Middle East, Africa.

And so that significant decline was very pronounced there.

And no surprise, I'm sure, given what you've read about the tire manufacturers having temporarily closed plants in those regions pretty much across the board.

Now in China, we saw plants coming back online throughout the month of March, week by week getting a bit better, and the domestic market for tires has bounced back pretty well.

Of course, the export market is impacted by what's going on in the West.

And then with respect to North Asia, the declines were a little less pronounced.

So it varies a bit by region, but I would say most pronounced in the Americas and Europe, Middle East, Africa, given, again, what the majors have done in terms of temporary closures.

And I think the shelters in place have really restricted mobility for -- during the period of April.

Now in terms of the margin impact of $10 million to $15 million that we mentioned here, roughly about half of that will be a onetime impact in the quarter, and these are margin impacts, so not reflecting volume declines.

So when you look at dramatically lower oil, as you know, there are really 3 effects on our business.

First, when feedstock prices are lower, we see some compression as the benefits from our yield projects are less valuable at lower oil prices.

And second, our energy center revenue is typically linked to energy prices where they operate, and so lower feedstock prices generally correlate with lower energy center prices.

And then the third impact comes when prices fall very suddenly.

As we saw a very sharp drop in combination with a simultaneous demand drop that we saw, this sort of a shock drop, if you will, when this happens, we see a mismatch in feedstock inventory that we've purchased to meet our customers' forecast and when they finally take those volumes.

I think this is certainly an unusual situation, and we're working closely with our customers to keep the spirit of our matching principle intact.

So the combination of these 3 margin factors is the impact of $15 million to $20 million that was quoted for the third quarter, but that is not including the impact of lower volumes.

And again, we'd expect about half of that impact to be onetime in the third quarter.

Got it.

That's really helpful color.

And then second, I just want to dig in a bit into the fumed metal oxides business, which I think should be (technical difficulty) performance segment, but it seems like that's kind of one of the main weak points right now.

So can you just walk through some of the dynamics of what's going on in that market and how you think the market balances itself out over the next 1 to 2 years?

Sure.

So let me start, I think, first and foremost, Mike, by talking about demand.

The demand environment has been softer, particularly in Europe and China.

And we have a significant presence in both regions and, in particular, in China.

China makes around 40% of the world's silicones.

And of course, fumed silica is tightly linked to that chain.

So weaker demand in Europe and China and in key end markets like automotive and construction has been a significant impact.

In fact, in calendar 2019, we estimate the market in fumed silica globally actually contracted.

So this is a market that over time has grown pretty consistently 4% or 5% a year.

It actually contracted in 2019, and that was, of course, pre-COVID.

So the further demand weakness is, I think, exacerbating things and driving up competitive intensity in the region.

In addition, some supply has come on stream recently.

And so the combination of weaker demand and supply coming on stream, which tends to be somewhat lumpy in terms of when it comes on, thereby pressuring the near-term pricing.

So while these factors certainly present near-term challenges, I think the fundamentals of the business remain attractive.

The business, as you pointed out, has historically been a business with very strong profitability and high EBITDA margins.

And again, demand has grown in this business over time, above GDP in that sort of 4% to 5% level, because silicones have pretty strong performance characteristics in terms of demand substitution.

And then finally, feedstock access and strategic integration, I think, will continue to determine long-term growth and profit levels.

And on this front, I think we're really well positioned with our strategic fence line partners, Dow Silicones.

This industry has historically been well balanced between feedstock in Wuhai in silica demand, leading to pretty limited new entrant risk.

Now I think feedstock, as you know, is a byproduct of both silicones production and polycrystalline silicon production, and so these fence line relationships are pretty critical.

You can't just go to the market and buy this feedstock.

But capacity additions can definitely be a bit lumpy given the economic scale of investment here and demand growth has historically soaked that capacity up in a relatively short period of time.

So I think it's a question of how demand responds, but the sort of industry structure and industry fundamentals remain intact from our perspective.

So it's a demand question, Mike.

Our next question comes from the line of Josh Spector from UBS.

So just a follow-up from the prior question about the margin impact on Reinforcement in the quarter.

You talked about half of that being temporary, half of that maybe being ongoing.

I guess if oil were to stay in this around $30 range, would you expect around that $10 million EBIT impact per quarter to persist through the rest of this year?

Or another way, would you expect around kind of a $40 million annual impact based on where prices are?

So you're right, Josh, about half we would expect to be onetime, and that's sort of the amount related to this sort of very sudden or sharp drop in terms of both oil and demand.

And then the other factor is really dependent on where oil is.

And now it's rebounded a bit here, certainly from the lows that we saw in April.

But it really comes down to where those oil prices are and what the absolute dollar value is then on the yield projects that we do and the energy center benefits that we have.

Okay.

I mean do you guys share any sensitivity to your EBIT for every dollar move in feedstocks at all?

We don't because it's a pretty difficult one to -- there are so many variables here.

I mean, I think it's driven by which grades you're making can have significantly different sort of fundamentals.

And then the feedstocks and where you are in the world, they're quite different in China than they are in other parts of the world where one market is coal tar and disconnected at times from global fuel oil prices and then rest of the world tends to be a little bit more on global fuel oil.

So there's just so many factors that are impacted here.

It's difficult to reduce it to a rule of thumb.

But I think the key thing to understand is that when the price is lower, we do see those yield and energy center effects.

By the same token, we see a significant offsetting working capital benefit as the balance sheet deflates and significant operating cash flow generated.

So this pattern, I think, has been demonstrated over a very, very long period of time.

If you go back 20 or so years, you'll see that operating cash flow profile pretty consistently.

Okay.

And then, I mean, if I could one more just on reinforcement price/mix in the quarter.

I mean, that was really strong at the EBIT level.

Wondering if you could just break that down between how much of that was the benefit of your new contracts in Western markets versus maybe other effects within China and the rest of Asia?

Yes.

So definitely, the arrangements, both in terms of pricing and mix from our contracted customers around the world, both in tire and industrial products, contributed materially in the quarter.

And so despite a pretty significant volume decline in the quarter on a year-over-year basis, results were flat, so a pretty strong result there.

And the offset was basically -- to that was basically margin and pricing in Asia, principally China.

So they were sort of offsetting.

Our next question comes from the line of Jim Sheehan from SunTrust.

Can you just talk about, in Performance Chemicals, what kind of decremental margins can we expect in the fiscal third quarter?

Say it again, Jim?

I'm curious about decremental margins in Performance Chemicals in the third quarter and rest of the fiscal year.

And so when you say decremental margins, Jim, I want to make sure I understand what you mean by that?

Well, you're expecting the top line to come down significantly.

I'm just trying to think about the margin impact of that.

I mean, you sort of gave some color on that in Reinforcement Materials, but not in Performance Chemicals.

Yes.

Yes.

So I think the most significant thing that you'll see is continuation of what was occurring in Q2 and in the prior quarter as well around FMO.

If you look across both carbons and specialty compounds, margins have performed and held up there.

So I would say the margin profile, sort of at the unit margin level, would be fairly consistent with what occurred in the most recent quarter that just happened.

And now the question will be, how do volumes perform?

I mean in the most recent quarter, we had impacts from an already weak auto, and we certainly would expect that to persist.

But that negative mix has been running through the business for over the past year, almost 1.5 years, as weaker OEM auto builds have played out.

So I think in terms of the Q2 to Q3, the fundamentals that drive margin will be largely unchanged.

It's just a question of where the volumes come out.

Okay.

And question on Purification Solutions.

You talked about your specialty volumes being down, and I want to know specifically on your specialty business in Europe.

Did you lose any business in that region?

And once the economy normalizes, do you expect to recover that specialty business or have you changed your approach to that market?

Yes.

No change to approach here, Jim.

The specialty market remains a focus, and there were certainly some impacts, but I would call them COVID-related impacts rather than any fundamental changes in market or competitive activity or any change in strategy from our side.

That all remains the same.

So I think it's really just some COVID impacts that began coming through in the month of March across Europe.

So no -- nothing new to really speak of there.

Our next question comes from the line of Jeff Zekauskas from JPMorgan.

In fumed metal oxides, you talked about negative pricing because of increased competitive activity.

I thought fumed metal oxides were mainly an over-the-fence relationship.

And so I'm puzzled as to where increased competitive activity can come from.

I can understand how at lower volumes, maybe your returns are lower.

But I don't understand the increased competitive activity characterization.

Sure.

So Jeff, 2 things on fumed metal oxides, and you may refer back at some point -- I know, certainly in Investor Day 2018, we talked through this.

It's important to remember there are 2 types of feedstock the fumed silica market globally.

One is a byproduct out of the silicones chain.

And you're right, a significant portion of that volume, though not all of it, is over the fence back to the silicones producer, who then uses that fumed silica in their field compounds.

So they're downstream finished compounds.

So that tends to largely be in balance, although there is a certain amount of the silica produced from that feedstock that goes into, what we call, the merchant market.

So it's not self-consumed.

The other big source of fumed silica feedstock is from the polycrystalline silicon market.

So when you produce PCS, there is a byproduct called (inaudible), which is used to produce fumed silica.

And there's no corresponding downstream offset.

A poly producer doesn't consume any silica in the making of their PCS, so that material then goes out into the merchant market.

Now over time, both the feedstock from silicones and the feedstock from poly have been in balance with overall silica demand.

There are, I think, 2 factors that are playing out right now around competitive intensity.

One is related to demand, and so that poly-based fumed silica is still trying to find a home.

And with lower demand, that can lead to competitive intensity.

And then the other thing that's going on is, I think, a shift in the polysilicon market.

As China continues to expand its poly capacity, I think, at the expense of Western poly producers, people like Wacker and OCI, so you may have seen recently both of them took pretty significant impairments on their recent poly expansions because they're finding it difficult to compete in the poly market with the Chinese producers who are building plants in the Northwest of China and have low-cost silicon metal and very low energy cost.

And these are the 2 big inputs for making poly.

And of course, most of that poly is consumed in solar panels, which are fabricated in China.

I think the Western market poly players are suffering, and you're seeing that in some of these impairment announcements.

But that's the other factor here.

While that shakeout is going on, people are still trying to compete in the poly market, and they are producing some byproduct feedstock and they're trying to sell it into the fumed silica market.

Again, over time, the fumed silica market needs feedstock from both silicones and poly to support its sort of 4% to 5% long-term growth rate.

But in the short term, these 2 factors are playing out.

So I hope that helps give a little more color on the near-term competitive intensity.

Yes.

Thank you for that.

With oil coming down as much as it's come down and coal prices moving lower, is Cabot more advantaged or less advantaged in producing carbon black in China when you look at your cost dynamics today versus, say, where it was 3 months ago?

Yes.

I would say with respect to China, so our view and the way this industry has played out is China is for China, that's basically how we participate.

And so our coal tar feedstock dynamics are very competitive, and we benchmark against all of the players there in China in terms of profitability.

And so I think no real change there.

I think where perhaps your question is going is sometimes the dynamics of coal tar and global fuel oil can diverge, and that can cause some flows of carbon black out of China.

Again, traditionally not Cabot.

We've been more of a China is for China model.

But you've seen some competitor material flow out into places like Southeast Asia or at times when the ARB was at its peak in terms of how wide open it was, there was quite a bit of material flowing into Europe.

We're not seeing that now for some time that that ARB has closed.

And so we're not seeing any significant changes in that relationship.

Prices were higher in Reinforcement Materials in the quarter.

Was that all U.S.-based positive pricing or was there positive pricing in other regions?

There was positive pricing in all of the other regions with the exception of, I would say, China, so -- which is a spot market for us.

So -- but no, there was pricing and mix improvements in all regions.

And then lastly, you talked about difficulties with your energy centers.

I never exactly understand what that is.

Is that you produce maybe power by cogen and you sell power to grid, and so it's worth less?

What exactly is the energy center hits you're speaking of?

Yes.

So -- no, that's exactly right, Jeff.

So we have cogeneration facilities at many of our plants, and we use the BTU content in what's called our tail gas to produce productive energy to either offset our own needs.

But a lot of times, we're -- most of the time, we're selling that energy to an industrial partner.

But those arrangements have a link to underlying energy prices because their alternative -- of course, the alternative is a different fuel to produce the energy.

We're using our tail gas, but the competitiveness of that is linked to energy prices because someone can produce the same power with an alternative energy input.

But that's what we're saying.

So as we've mentioned a number of times over the years, I think the impact of lower oil on the energy centers, they're still above cost of capital projects for us.

But in absolute dollars, they earn less when oil is lower.

Our next question comes from the line of David Begleiter from Deutsche Bank.

This is Katherine Griffin on for David.

Curious about the $45 million of cost savings.

It sounds like some of it may be temporary, reduced travel expenses, salary reductions and things of that nature, but some of them may be more permanent, such as sharing service centers.

Could you just talk about or characterize how much of that saving is structural and permanent versus temporary?

Yes.

I think we're certainly pulling all levers right now, Katherine, and some of that is cuts in discretionary spend that as demand returns and visibility improves, then some of that will naturally come back in, in order to sustain our operation over time.

And then -- and some of it is structural.

So things like our creation of global business services and the management structuring -- structure changes that we implemented within the past year, those types of things would be structural.

And so you could probably think about it in the zone of half-half, as about half of it being structural and about half of it being sort of temporary pullbacks to try to manage costs.

And of course, these structural actions, we initiated those before COVID, and we did those in order to help us fund some of the investment in long-term growth projects that we're excited about, like our energy materials activity as well as our elastomer composites activity.

But that's roughly a way to think about it.

Great.

And I know you already sort of talked about this, but just want to make sure I understand.

Could you just talk about the extent that you realize benefits from lower raw material costs, given that volumes are expected to be much lower?

Would you expect to see a greater tailwind in fiscal Q4 versus fiscal Q3 from lower raws?

So it depends which business you're talking about.

If you're talking about Reinforcement...

Maybe on an overall basis, yes.

Well, it depends which business you're talking about.

If you're talking about Reinforcement Materials, then the feedstock costs are effectively a pass-through to customers, and -- but you would see at lower oil prices impacts on our margins from our -- lower benefits from our yield projects and energy centers, so that's the dynamic, but you get a working capital release.

In specialty carbons, part of our Performance Chemicals business, there's less formula exposure in that business.

It tends to be more sort of spot market pricing-driven.

And so as raw materials decline historically across major parts of that application space, we've been able to retain prices while raw materials decline.

And so we would expect that to happen, though there's a lag there at currently lower demand that could take a quarter or 2 before we see that.

But that's -- those are the 2 impacts to lower raw material prices.

Our next question comes from the line of Laurence Alexander from Jefferies.

Should we factor in any degree of inventory reduction that would then help incremental margins in -- sort of in the recovery?

Laurence, I'm sorry, could you repeat the question about inventory reduction?

I didn't quite hear it.

Sorry.

Will you -- should we be factoring in some degree of Cabot reducing its own inventories sharply this summer, which would obviously hurt margins this summer but then help in the fall or in next winter?

Well, definitely, right now, the focus is on bringing inventories down and driving that cash flow in the second half.

And so that will come with a negative EBIT impact.

Basically, the under-absorption is the way to think about it.

And then as demand improves, then you would see the sort of reversal of that as inventory and working capital begins building back up, then you would see that sort of reverse itself.

So I think directionally, that's right, Laurence, and the question is exactly the timing of how that demand recovery looks.

But that's the dynamic that will play out.

And then is that under-absorption factor included in or separate from the $15 million to $20 million you called out?

In terms of the $15 million to $20 million that we called out, that is not included in that.

So those are just margin effects from lower oil prices affecting both the yields as well as the energy center benefits and then that sort of temporary mismatch from that very sudden drop in both oil and demand.

So those would be margin effects, but the under-absorption would be an independent factor.

So not included in that number.

And then could you help -- I guess, the shift in name from CEC to E2C, can you give us a sense for where we are with the commercialization of that product?

And what the time line might be to be able to sell to third parties apart from your original development partner?

Yes.

Sure.

So maybe just a bit of a refresh here, because we're building momentum and so speaking about this perhaps a bit more.

So you'll remember the elastomer composite technology that we licensed to Michelin some time back, and they have been building that out in their product portfolio.

And so while that has continued, that's a royalty-type arrangement.

We have an ability to develop this outside of that.

And so we've continued to do that over the last several years and have been building out both the customer portfolio as well for this.

And so we have launched what we're calling our new brand for elastomer composites, and that's called E2C.

So the product offering in this range, where we actually make and sell product as opposed to the original licensing agreement to Michelin, this product is called E2C.

And we've launched products here for the heavy mining equipment space, where our investments in efficiency and automation create strong demand for high-performance rubber materials.

And so I think this is going well, and we're generating sales now in this -- with this E2C offering.

And I think the question will be how does it ramp-up over time?

And of course, this is very difficult to predict.

Certainly, we think the potential here is significant.

If you look at the overall market for rubber compounds in both the tire and industrial products industry, it's pretty significant, of course.

The question will be which applications is this a fit for?

And the early space is certainly in heavy mining equipment tires, but we're also in development for long-haul trucking and performance tires for electric vehicles.

So these are in play as well.

But this industry, from a development standpoint, understandably doesn't move at a really quick pace because it's got to go through its own tire testing and there is safety and liability issues here.

So it's a question of pace.

But we're pleased with the way revenue is beginning to build with this E2C offering.

Our next question comes from the line of Kevin Hocevar from Northcoast Research.

Curious, as lower oil prices mentioned, it should be favorable to working capital.

How should we think of that in the back half of the year?

I think you mentioned that you expect all of cash from operations to be $200 million in the back half.

But what does that imply for the working capital benefit?

Yes.

So the working capital release will be significant, Kevin.

And if you look back at previous recessionary periods, whether it's in '09 or even 2015 for many in the chemical sector was somewhat recessionary because of weakening in China and other factors there.

And what you saw in that period was a very significant working capital release.

And that, of course, comes from the lower oil prices flowing through.

As well as in a recessionary period, we are very aggressive in terms of our operating dynamic and how we run our plants and how we bring working capital down.

And so we have confidence in that profile that's been demonstrated over time is going to show through here in the third quarter and the fourth quarter.

And it's going to be a material contributor to that roughly $200 million-ish operating cash flow number that we talked about.

Okay.

And then on the -- I know -- I don't know, a couple of quarters ago, maybe a year or 2 ago, you announced some debottlenecking and an expansion.

And I want to say, Indonesia or Thailand or -- but curious, it looks like you're scaling back CapEx a little bit.

Curious how these -- if you're slowing any of these debottleneckings or if you're delaying the expansion?

Just curious, if any of those are being affected by your slowing CapEx.

Yes.

Yes.

Important question.

And the answer is yes.

We're scrutinizing the growth projects very aggressively right now and deferring progress on those until we have more visibility into demand.

And just as a reminder, our hierarchy in terms of capacity expansion always starts with OEE first, so overall equipment effectiveness, and driving the uptime and rates of our units is, of course, the most efficient capital we can -- capacity we can unlock.

The second would be low-cost debottlenecks in our existing plants.

And then the third option would be brownfield expansion, like we've announced in Cilegon.

But I think right now, all growth capacity projects are being slowed and aggressively scrutinized.

And we'll have to see how the demand picture unfolds here.

And as we have more visibility into what that looks like, that will dictate how we throttle those projects.

But certainly, right now, the environment looks, at least in the short term here, sort of different than what was assumed when those were launched.

But it's really a question of demand visibility, and we need to see how things unfold here.

Historically, the replacement tire market has been quite robust, and we would expect that same dynamic to continue as this -- the lockdown begins to release and people start moving again.

Our next question comes from the line of Chris Kapsch from Loop Capital Markets.

So my first question is going to focus on that unit cost headwind that you alluded to.

In other words, the impact from lower fixed cost absorption.

Is there any way you could quantify what you expect that impact might be or how long you anticipate that headwind?

I guess that's sort of the $64,000 question.

Or at least could you qualitatively talk about what your strategy is in terms of your operational curtailment, like are you doing it across the board or is it selective operating rate reductions?

Any way to sort of qualify or quantify what -- how you're navigating the lower demand environment.

Yes.

Yes.

And obviously, this is focused on Reinforcement Materials.

Sure.

Yes.

Yes.

Thanks, Chris.

So in terms of the inventory change impact or the under-absorption, we've historically referred to it as inventory change impacts, that, of course, is tied to whether we're building or depleting inventories, and we'll be aggressively bringing inventories down over the back 2 quarters here.

And so we'll see effects of that flowing through the last 2 quarters.

And I think then the shape of that after that is going to really depend on how demand is responding.

And if demand is beginning to pick up again, then naturally, you would see some reversion there.

So that's the phenomenon, and we definitely expect there to be a significant cash release from inventory in both back quarters of the year, Q3 and Q4, but a corresponding impact on the under-absorption on the P&L.

Now in terms of our curtailments, it really depends.

I would say, generally across the board, we're significantly curtailed right now with the exception of China, which is in a little more advanced state of domestic recovery here.

Now the specific curtailments, they do vary by plant because the customer portfolio by plant and by reactor line is a little bit different.

But I think it's safe to say that with volumes down in the range that we've talked about and where LMC is calling for, our curtailment sort of at a system-wide level match that.

But they do vary by plant.

Okay.

Got it.

And just as a follow-up to that, with early signs of China approaching normal economic -- -- new normal economic conditions maybe, what are your utilization rates currently at your various facilities in China?

So the utilization rates across the company right now are kind of managing in and around kind of half.

So 50%-ish, of course, as we're pulling down inventories to match the demand outside of China.

China is certainly much better than that.

But it's not back to utilization levels that it was before the pandemic because a certain amount of the tire market in China is supporting exports, and that export market is impacted by the weakness because those tires are going to the West.

So we're certainly much, much higher than our system average in China, but we're still not at the very high utilizations that we were operating at.

And we won't see those return in China until the export tire market begins to show some improvement.

So the domestic market in China definitely is recovering, but export market is going to be, I think, looking for that signal from the West before that improves.

Got it.

That's helpful.

And then one of your peers disclosed that they're seeing meaningfully higher CapEx needs to complete their EPA compliance projects.

I'm just curious if you're seeing a similar increase in spending needed to accomplish what you need to do under the consent decree.

So are you seeing that for yourself or other players in the industry?

Chris, this is Erica.

So we still believe the range that we've given, most recently the $175 million to $200 million of spend, is the right range.

This would be spending for us through calendar year 2022 to meet the timing and the consent decree.

So we don't see any change from that right now.

We started this a bit earlier.

We were one of the first to sign the consent decree with EPA.

And so at this point, we have roughly about half of that spent, and we'll spend the rest through 2022.

Okay.

And then -- but if I could just follow up on that, given that the industry clearly is deploying more capital for these SOx and NOx compliance projects, and the narrative generally has been that the pricing -- certainly, domestic pricing just hasn't been adequate to earn a return on that capital.

And so that's been an impetus for affirmative pricing actions that have been achieved in these annual pricing contracts.

So is there any way to talk about kind of like that sort of more secular need for the industry to earn that return on capital juxtaposed against the current weaker environment?

Any way to think about how those conversations might look like later this year because the fact is even though there's a weak demand environment that's going to persist probably in the second half, the returns still aren't adequate, right?

So any way to talk about that juxtaposition.

Yes.

Yes.

So let me take that one, Chris.

So certainly, we have spent a lot of time, and I think broadly, this is an important industry issue, where in order to provide long-term supply reliability and surety to our customers and to do it in a way that is ever more sustainable, and all of our customers care about sustainability and have their own goals related to that, and so this -- these investments are clearly lined up to support the sustainable and consistent supply of carbon black over time, and that does mean that pricing has to move higher in order to get a cost of capital on that and return on that.

And ultimately, that will have to get pushed down the chain to us as tire consumers who will pay some small increment for a more sustainable tire.

And so that's the narrative, and that's what that we have been pushing and stressing with our customers, and it's been an important underpinning of pricing in this industry.

Now does that change with COVID?

No, I don't think it does.

We'll have to see how demand responds here and begins to recover, and that's always a factor in the sort of rhythm of the business.

But that necessity has not changed and our conviction around that has not changed, and we'll continue to advance that narrative and make progress with our customers on this front, because it's the only way that we can provide sustainable supply to them over a long period of time, and I think they know that.

At this time, I'm showing no further questions.

I would like to turn the call back over to Sean Keohane, President and CEO, for closing remarks.

Great.

Thank you all, again, for joining us today, and I hope you and your families remain healthy and safe.

Thank you, again, for your support of Cabot, and we'll look forward to seeing you and speaking again soon, hopefully maybe in some more traditional forums, like investor conferences and the like.

But in the meantime, stay safe.

Thank you.

Ladies and gentlemen, this concludes today's conference call.

Thank you for participating.

You may now disconnect.