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Edited Transcript of CBT earnings conference call or presentation 5-Feb-19 7:00pm GMT

Q1 2019 Cabot Corp Earnings Call

BOSTON Apr 11, 2019 (Thomson StreetEvents) -- Edited Transcript of Cabot Corp earnings conference call or presentation Tuesday, February 5, 2019 at 7:00:00pm GMT

TEXT version of Transcript

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Corporate Participants

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* Erica McLaughlin

Cabot Corporation - Senior VP & CFO

* Sean D. Keohane

Cabot Corporation - President, CEO & Director

* Steven J. Delahunt

Cabot Corporation - VP of IR & Treasurer

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Conference Call Participants

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* Christopher John Kapsch

Loop Capital Markets LLC, Research Division - MD

* David Francis Katter

Robert W. Baird & Co. Incorporated, Research Division - Junior Analyst

* David L. Begleiter

Deutsche Bank AG, Research Division - MD and Senior Research Analyst

* James Michael Sheehan

SunTrust Robinson Humphrey, Inc., Research Division - Research Analyst

* Jeffrey John Zekauskas

JP Morgan Chase & Co, Research Division - Senior Analyst

* Laurence Alexander

Jefferies LLC, Research Division - VP & Equity Research Analyst

* Michael James Leithead

Barclays Bank PLC, Research Division - Research Analyst

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Presentation

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Operator [1]

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Good day, ladies and gentlemen, and welcome to the Cabot Corporation Q1 Earnings Conference Call. (Operator Instructions) Also as a reminder, this call is being recorded.

At this time, I'd like to turn the call over to your host, to Steve Delahunt, Vice President, Treasurer and Investor Relations. Please go ahead, sir.

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Steven J. Delahunt, Cabot Corporation - VP of IR & Treasurer [2]

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Thank you. Good afternoon. I would like to welcome you to the Cabot Corporation earnings teleconference.

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

Last night, we released the results for our first quarter of fiscal year 2019, copies of which are posted in the Investor Relations section of our website. For those on our mailing list, you received a press release by mail. If you are not on our mailing list and are interested in receiving this information in the future, please contact Investor Relations. 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. Each forward-looking statement is subject to risks and uncertainties that could cause actual results to differ materially from those projected in such statements. Additional information regarding these factors appears under the heading Forward-Looking Statements in the press release we issued last night and in our last annual report on Form 10-K that is filed with the SEC and 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 on the Investors section of our website.

I will now turn the call over to Sean Keohane, who will discuss the key highlights of the company's performance. Erica McLaughlin will review the business segment and corporate financial details. Following this, Sean will provide some closing comments and open the floor to questions. Sean?

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Sean D. Keohane, Cabot Corporation - President, CEO & Director [3]

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Thank you, Steve, and good afternoon, ladies and gentlemen.

While the environment in the first quarter was more challenging than expected, we delivered solid results, with total segment EBIT of $105 million and adjusted earnings per share of $0.87.

Results in the Reinforcement Materials segment were consistent with last year despite the challenging environment in China. We completed calendar year negotiations with our major tire customers and realized price and volume gains across all regions for calendar year 2019. This outcome highlights the strength of Cabot's value proposition and the continued strengthening of market fundamentals. Results in the Performance Chemicals segment were impacted by softer automotive demand as well as falling polymer prices leading to inventory destocking. While we faced challenging short-term dynamics in the quarter, we continued to progress on our growth investments for capacity in new applications that will strengthen our position for the long term.

During the quarter, we also returned cash to our shareholders at an elevated level with $82 million of dividends and share repurchases.

And finally, last week, we announced an agreement to divest our Specialty Fluids business. Let me give you some of the details.

Cabot has signed an agreement to sell the Specialty Fluids business to Sinomine in a transaction valued at $135 million. Sinomine is a China-based company principally engaged in the business of solid mineral prospecting and exploration, mining and base metal chemical manufacturing. This transaction is an important milestone in our Advancing the Core strategy, allowing us to maximize the value of the business for our shareholders and focus our resources on advantaged growth initiatives in our core businesses. We believe that Sinomine is a more appropriate long-term owner of the business, and the Specialty Fluids segment will benefit from being part of a leading mineral industry player that will invest in its long-term growth.

Segment EBITDA was $10 million in fiscal 2018, resulting in an attractive multiple of 13.5x. The transaction is expected to close in the third quarter of fiscal 2019, subject to customary closing conditions, and is not expected to have a material impact on fiscal 2019 results.

Turning now to current business conditions. There were a number of short-term dynamics in the quarter that impacted results. The first factor is slowing automotive production in China and Europe. The recent quarter shows a sharp decline in auto builds of 11% in China and 6% in Europe. The impact on volumes was felt both in the Reinforcement Materials segment, particularly in industrial rubber products, and in the Performance Chemicals segment where we experienced a greater impact in Specialty Carbons and Specialty Compounds businesses.

The outlook for new car production calls for improvement as we progress through our fiscal year, which should positively impact our results. Another factor in the quarter was the rapid decline in raw material costs. As you can see from the middle chart on the slide, feedstock indices in both China and North America decreased sharply in the quarter. In China, this rapid decline was after an inventory build in front of the winter season and coupled with the softer demand environment. The result of all this was a competitive pricing environment that led to lower margin in the quarter. For the rest of the world, this decline in feedstock will produce a margin squeeze in Reinforcement Materials in the second quarter. However, this is expected to be a positive impact for Performance Chemicals as lower costs flow through the supply chain.

Additionally, as you can see in the chart on the right, polymer prices declined in China and EMEA in the quarter resulting in customer destocking, which impacted volumes in our Specialty Carbons and Specialty Compounds businesses. As polymer prices begin to flatten and increase, we would expect volumes to return to normal levels with upside from additional restocking possible. These factors are forecasted to improve as we progress through the year. Therefore, we anticipate the back half of the year will be stronger than the first half. Our order book improved in January compared to the first quarter, including stronger European volumes. And although we've seen continued uncertainty in China so far in the second quarter, we remain confident in the fundamentals of our China business and the outlook for the second half of the year as we anticipate a recovery in the auto OEM market and customer restocking after the Chinese New Year. We've been through these cycles before in China and remain confident that our leadership position there puts us at a unique advantage compared to the rest of our competitors.

Now moving to our commitment to our capital allocation strategy.

During the quarter, we returned $82 million in cash with $62 million in share repurchases. Over the past 9 months, we've repurchased $188 million in shares, which amounts to a reduction of the share count of 5%. We are equally committed to our dividend payout. We increased our dividend 5% last year and have increased it by 43% since 2016. We paid $80 million in dividends in 2018 and $20 million in the first quarter of fiscal 2019.

I will now turn it over to Erica to discuss the business results in more detail.

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Erica McLaughlin, Cabot Corporation - Senior VP & CFO [4]

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Thanks, Sean, and good afternoon to all of you on the call.

Let me now turn to the segment results beginning with Reinforcement Materials. EBIT from Reinforcement Materials for the first quarter of fiscal 2019 was consistent with the first quarter of fiscal 2018. The segment benefited during the quarter from higher volumes and improved pricing and product mix from our 2018 tire customer agreements. These benefits were offset by lower margins in China, as Sean discussed. The volume growth of 1% in the first quarter as compared to the same quarter of the prior year was due to increases in Americas and Asia, partially offset by lower volumes in Europe.

Looking ahead to the second quarter, we expect the solid performance from Reinforcement Materials to continue supported by volume and margin gains as customers transition to calendar year 2019 tire agreements. However, we expect to see a margin squeeze in the second quarter due to the rapid decline of global feedstock costs during our first fiscal quarter, which will result in a temporary pricing and cost mismatch. In addition, the challenging environment in China is expected to continue into the second quarter with an anticipated strengthening of volumes and margins after the Chinese New Year. This is expected to result in a stronger second half of 2019.

Now turning to Performance Chemicals, EBIT decreased by $11 million year-over-year due to lower volumes and temporary margin squeeze and higher costs related to growth investments. Lower volumes were driven by softening automotive demand and customer inventory destocking in China and Europe that resulted in a 3% decrease in volumes in performance additive and a 2% decrease in formulated solution. The lower margins were in our Specialty Carbons and Specialty Compounds product lines. This was driven by a precipitous decline in raw material costs during the quarter, which challenged our ability to implement price increases as the high cost feedstock purchased in the fourth fiscal quarter of 2018 was sold through. We also saw improvement in the Metal Oxides business as results fully recovered in the quarter from the impact we saw in the fourth quarter of fiscal 2018.

Looking ahead to the second quarter, we expect volumes and margins to increase sequentially in both our Specialty Carbons and Specialty Compounds product line, driving a sequential improvement to overall business segment results. Demand in Europe is expected to begin recovering after the recent slowdown in automotive demand from emissions testing regulations. We have also seen signs that polymer prices have flattened and are beginning to increase, which we anticipate will lead to higher demand in our Specialty Carbons and Specialty Compounds product line. In addition, we expect margins to improve as lower raw material costs flow through the P&L. Although the uncertainty in China is expected to continue into the second quarter of fiscal 2019, we remain confident in the fundamentals of the business and the outlook through the second half of the year.

Now moving to Purification Solutions. In the first quarter of fiscal 2019, EBIT decreased by $9 million compared to the same quarter of last year. This was driven by a $5 million decrease from royalty payments received in the first quarter of fiscal 2018 that have since ended. In addition, we continue to experience both lower volumes and margins from continued competitive intensity in mercury removal and other North America powdered activated carbon application.

Looking ahead to the second quarter, we expect to see sequential improvement from actions being taken in our transformation plan to focus the portfolio, optimize our assets and streamline our organizational structure. Additionally, we continue to pursue strategic alternatives for this business.

For our Specialty Fluids segment, first quarter fiscal 2019 EBIT increased by $12 million as compared to the first quarter of fiscal 2018 due to an increase in project activity as compared to the prior year. As we move to the second quarter of fiscal 2019, we expect solid business results as our existing project activity continues. We anticipate the divestiture to be finalized during the third quarter of fiscal 2019, and we expect there will be limited impact to our full year business results.

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 $645 million. During the first quarter of fiscal 2019, cash flows from operating activities were a use of $39 million, which included an increase in net working capital of $111 million, largely due to higher inventory levels brought on by lower volumes and the timing of payables. Based on current feedstock prices and the targeted reduction of working capital days, we expect working capital to be a source of cash for the full fiscal year with the decline starting in the second quarter.

Capital expenditures for the first quarter of fiscal 2019 were $54 million and are expected to be approximately $250 million to $275 million for the full year. We have reduced this range for the full year given the current business conditions while preserving our advantaged growth investments related to 2 new fumed silica plants and our ongoing carbon black debottleneck projects. We anticipate our sustaining and compliance capital will be in the range of $125 million to $150 million per year over the next few years, inclusive of the environmental capital we need to spend. After completion of our current fleet of growth investments and environmental capital projects, we would expect total capital spending to return to a more normalized level.

As previously discussed, we returned cash to shareholders through $20 million in dividends and $62 million of share repurchases. Our operating tax rate was 24% for the quarter, and we anticipate the fiscal year rate will be between 23% and 25%. The increase in the new tax -- in the tax rate from 21% in 2018 is driven by the U.S. tax reform. Although the new legislation reduced the U.S. tax rate, it also included additional taxation on income of foreign entities starting in 2019. For Cabot, we have a significant amount of earnings outside of the U.S., and this additional tax causes a significant headwind for the year in the amount of $0.20 of adjusted earnings per share.

I'll now turn the call back over to Sean.

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Sean D. Keohane, Cabot Corporation - President, CEO & Director [5]

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Thanks, Erica.

Now I'd like to give you an update on our segment outlook for 2019. For Reinforcement Materials, we continue to see a supportive environment with high industry utilizations globally. We are very pleased with the results of the 2019 tire agreements with price increases and volume growth in all regions. The majority of our agreements remain as 1-year deals. However, with a few customers, we have reached multiyear agreements with price increases in each year.

In the second fiscal quarter on a year-over-year basis, the effects of the China automotive softness and the negative margin impacts from the rapid decline in global feedstock prices will more than offset the gains from the 2019 customer agreements. With the softness in feedstock impacts behind us in the back half of the year, we would expect the quarterly EBIT run rate to increase to $75 million to $85 million per quarter starting in the third fiscal quarter.

In Performance Chemicals, we anticipate results to recover sequentially in the second quarter, driven by a volume recovery in Specialty Carbons and Compounds as automotive demand improves in Europe, Middle East and Africa and China and destocking abates. With the rapid decline in feedstock prices in November and December, the segment should also benefit from a feedstock tailwind as we expect to hold current pricing levels throughout the second quarter. Furthermore, in the fourth quarter, we expect to begin to see the benefit of our new fumed silica plant in China coming online. Therefore, we expect this segment will see a significant sequential step-up in EBIT in the second quarter, and then increase to a quarterly run rate of $55 million to $60 million as we gain momentum in the back half of the year.

In Purification Solutions, we expect to see sequential EBIT improvement from higher unit margins, primarily driven by improved product mix within the specialty applications. The previously announced transformation plan that focuses the portfolio, optimizes our assets and streamlines our organizational structure will have a positive impact on the segment as we move through the year. Thus, we still anticipate the business will deliver EBIT in the range of 0 to $10 million for fiscal 2019.

Finally, the Specialty Fluids segment continues to benefit from key projects in the Asia, Middle East and Africa region with visibility for solid performance in the second quarter. As discussed, we expect the sale of this business to close in the third quarter of fiscal 2019. Therefore, based on the challenging first half coupled with a stronger second half results for the company, we expect full year adjusted EPS to be in the range of $4.20 to $4.60. This range would result in earnings growth of 4% to 14%, respectively, in spite of the near-term challenges and the tax rate headwind. To counteract the business challenges, we are focusing on controlling costs, tightening capital expenditure and working capital levels, delivering on recently negotiated customer agreements and managing pricing in this dynamic environment. We remain confident in our ability to deliver these results and in the fundamentals of our business, our leadership positions and the robustness of the industries we serve. Finally, as we continue to execute our Advancing the Core strategy, we are committed to delivering another strong year of earnings growth, investing for the future in our core businesses, divesting noncore assets and returning cash to shareholders.

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

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Questions and Answers

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Operator [1]

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

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Michael James Leithead, Barclays Bank PLC, Research Division - Research Analyst [2]

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I guess first question on the EPS guide. I was hoping you could offer a simple bridge versus last quarter's guide. I think the tax rate bumped up 1% and 1Q is a bit soft. So any full year bridge you could provide versus what you offered last quarter would be helpful.

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Sean D. Keohane, Cabot Corporation - President, CEO & Director [3]

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Sure, Mike. I think when we discussed the range last quarter, I think there were several drivers that would put you in either the upper, lower or somewhere in that range that we talked about. I think the key factors we discussed at that time were how the China market develops during the winter season, I think, certainly a big factor. The level of destocking or overall demand that we might see across our Performance Chemicals segment was another significant factor as well in terms of how we were thinking about that range. As we sit here today, we're definitely seeing the China environment in the near term as a bit more challenging than we expected, and the destocking and automotive slowdown has been a bit more pronounced as we sit at this point in the year. So I think the combination of those 2 factors combined with the tax point that you bring up, I think, is why we modestly adjusted that range to the $4.20 to $4.60. I think at the low end, this implies a 4% increase. At the top end, of course, 14% and the midpoint around 9%. And so I think performance in that range, particularly, if we can end up around the midpoint would certainly be quite strong given current market environment and so we're aggressively focused on this.

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Michael James Leithead, Barclays Bank PLC, Research Division - Research Analyst [4]

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Got it. And then if I could follow up on capital deployment, buybacks or share repurchases have meaningfully stepped up the past 2 quarters. Is it fair to assume we should remain on a similar pace going forward, given where shares are today?

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Erica McLaughlin, Cabot Corporation - Senior VP & CFO [5]

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Mike, so this is Erica. I'd say that we've been buying at an elevated level for the last couple of quarters. And so as we look at Cabot's liquidity and the cash outlook for 2019 and certainly, the current share price, we feel that this is a very good use of cash for Cabot and for our shareholders. And so our strategy, as you know, includes the targeted cash return. And so we'd anticipate it continuing to repurchase shares as we move through the year. I'd say it's certainly something that we evaluate on how much, and it will continue to depend on a few factors in terms of our cash flow generation, the share price and then the other uses of cash for Cabot.

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Operator [6]

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Our next question comes from David Begleiter from Deutsche Bank.

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David L. Begleiter, Deutsche Bank AG, Research Division - MD and Senior Research Analyst [7]

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Sean, just on China, can you discuss the competitive intensity of the market and how it developed in the quarter and your level of confidence that this is a -- it’s truly temporary and will pass us by?

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Sean D. Keohane, Cabot Corporation - President, CEO & Director [8]

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Yes, I think when we think about China, it's important to think about it probably both in the short term and the long term. Let me try to give a little bit of color on the short term first here, right. I think there are really 3 key factors to discuss here. I think the first is that probably for the first time ever, China auto production declined year-over-year in 2018, but there was a particularly sharp drop in the fourth quarter. And the drop in auto production was the result of pretty high levels of automotive inventories, and ultimately, a lack of consumer demand that caused the manufacturers to slow down production. Now as we sit here, forecasters are predicting that this will recover following the Chinese New Year and as we progress through the year, and there's some discussion about how stimulus measures might even accelerate that. But I think that's one factor. I think the second is really around volatility in coal tar pricing in China. And so there was a quite sudden drop in Chinese coal tar prices in the quarter. So pretty steep. And this, coupled with a softer demand environment, drove spot prices down in carbon black. You might remember last year at this time, we actually had a bit of a fly-up in coal tar prices that benefited us in Q1 and Q2. So I think coal tar prices in China, they tend to move a little bit differently than global fuel oil prices because the underlying drivers of steel and aluminum being a big impact there, but a big factor here was certainly the coal tar prices. So while they have since recovered much of the dip already, we're working hard to get spot prices back to the levels we saw as we were exiting 2018. I think the third factor here is certainly the trade uncertainty, and it's a big-picture point, but it definitely is impacting general sentiment. And I would say it's creating a certain amount of caution both in consumers, but also in industrial players up and down the value chain. And so we have to see how that plays out here. So those are the things we're managing in the short term. But I think it's important to look at the factors that give us confidence around the long term and test how do we still feel about those. And I would say those are very much intact. And the first is that the Chinese market still produces, pushing close to 40% of the world's tires and that there's a very large and growing domestic market there as well as these tires are exported around the world. And this whole chain, this value chain, is pretty structural and vital to the global automotive, truck and bus and OTR tire market. So I think that is -- that's a quite solid fundamental, I would say. The second is that the Chinese domestic automotive market is now the largest market. There's been significant growth in automotive, new vehicles over the years. So the car park has grown significantly, and many of these cars are still yet to enter their replacement cycle. And as you know, the replacement market drives the majority of the Reinforcement Materials business. And then I would say, third, on the feedstock side, coal tar production and carbon black, we see them as largely in balance and tightening over time because of our view on virgin steel production declining over time. And so that fundamental, we think, remains intact and will, I think, provide a pretty balanced and more consistent feedstock versus carbon black dynamic in China. And then finally, environmental enforcement, another key fundamental in our long-term view. We see this as a continued priority for the Chinese government. I think, over time, that will value -- that value will accrue to Cabot as a result of that, and it will likely lead to some long-term favorable restructuring in the market. So I think those factors that give us a lot of confidence around our China position I think remain intact, and we're managing through some short-term dynamics here between Q1 and Q2.

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David L. Begleiter, Deutsche Bank AG, Research Division - MD and Senior Research Analyst [9]

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Very helpful, Sean. And just lastly, on Specialty Fluids, why is that not in disc ops now? And I assume it's still in the guidance for the full year, correct?

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Erica McLaughlin, Cabot Corporation - Senior VP & CFO [10]

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Yes. So it will be in the operating results through -- when we own it. We expect to close in Q3, and then it would come out. It has not been moved to disc ops just because it's immaterial in total for Cabot.

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David L. Begleiter, Deutsche Bank AG, Research Division - MD and Senior Research Analyst [11]

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And it is in the guidance, correct?

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Erica McLaughlin, Cabot Corporation - Senior VP & CFO [12]

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Yes, it's in the guidance.

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Operator [13]

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Our next question comes from Jim Sheehan from SunTrust.

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James Michael Sheehan, SunTrust Robinson Humphrey, Inc., Research Division - Research Analyst [14]

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Could you provide some color on where you see carbon black inventory levels currently? And do you have any visibility on an end to destocking, both in Reinforcement and in Performance Chemicals?

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Sean D. Keohane, Cabot Corporation - President, CEO & Director [15]

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Well, certainly, we saw a pretty pronounced destocking in Performance Chemicals. And I think that is because typically the value chains there are a little bit deeper. So more players in the chain, and so you can get some distortions from the front of the chain all the way to the back of the chain, number one. And then number two, there is a significant part of this segment that gets sold into plastic applications, for example, where movements in underlying polymers can have a significant impact on how people in the value chain behave. And typically, what you see is when raw materials or polymer prices decline, then people are really destocking and pulling back on inventory because they're afraid of getting caught with high-cost inventory. And so you see that. And then on the flip side, when polymer prices are moving up, you often see that kind of restocking effect because of the psychology that tomorrow's price is going to be higher than today. So this is a pretty well-known phenomenon across the sort of plastic space. And because a significant part of this segment goes into that, we can be impacted by this type of thing. Now we saw a pretty pronounced destocking across the first quarter. And as we look at results or volumes in January, we do see a step-up versus the first quarter. And so I think that starts to tell us that after probably 4-plus months of some destocking that, that is hopefully coming to an end. I think there is also some anecdotal evidence as well. You see customer behavior start to change in -- on the way down, you see customers ordering just the bare minimum, sometimes trying to order a couple of times a month and break their orders up and -- versus a more normal pattern would be kind of place orders once in the month. So I think we're beginning to see signals in our January numbers and in some of the anecdotal behavior that would say that we're probably near the end, we hope, on the destocking in Performance Chemicals and returning to a more normal level. I think in the tire market, there's certainly some destocking that occurs. The value chains, it may be not as deep as some of the Performance Chemicals applications, but there certainly is some of that. And we saw in China, as there was an excess of vehicle inventory, that, that led to some level of lower orders and in destocking throughout the chain. But I think we're probably in a -- getting close to a more normal level now.

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James Michael Sheehan, SunTrust Robinson Humphrey, Inc., Research Division - Research Analyst [16]

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Great. And moving to Purification Solutions, how much of a volume benefit do you expect from automotive applications in China for both 2019 and 2020?

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Sean D. Keohane, Cabot Corporation - President, CEO & Director [17]

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Yes, so that application, as you know, Jim, is a sort of a specified application, so you get qualified in for the vapor canisters. And we're -- we have a position in that market today. We're the #2 player in that market, although a smaller share than the market leader. And as we've said before, we view the China market as a real upside as the regulations for these vapor canisters get implemented. We see it as more of a jump ball than maybe some of the established markets. And so we're keenly focused on that and are working our way through qualifications with customers. But the material -- materiality of impact in 2019 and 2020 would be pretty small. What we would expect to see is qualifications. But as those then translate into volumes, you're beginning to push out beyond that 2019, 2020. That will start to ramp more in the '21, '22 period.

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Operator [18]

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(Operator Instructions) Our next question comes from Jeff Zekauskas from JPMorgan.

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Jeffrey John Zekauskas, JP Morgan Chase & Co, Research Division - Senior Analyst [19]

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In terms of the Performance Chemicals business, I think your sales were roughly flat year-over-year, and there was a sharp decrease in operating profits. Do you regard that decrease as all temporary, having to do with raw material fluctuations?

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Sean D. Keohane, Cabot Corporation - President, CEO & Director [20]

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Yes. So as we look at Q1, for example, the results were down and were really driven by 3 factors. One is volume is significantly tied to destocking and some automotive weakness, so number -- point number one. Point number two is a margin squeeze. So in Specialty Carbons, as we saw oil in our fiscal Q4 of 2018 being really at the peak, you'll remember oil was sort of marching up all throughout our fiscal 2018 and then dropped precipitously. I think it declined somewhere on the order of 35%. So a pretty sharp decline in feedstock cost in our fiscal Q1. And so there's a bit of a squeeze as the higher-cost stuff flows through. Now we had been out in the marketplace raising prices all throughout last year in Specialty Carbons, keeping up with this constant run-up of oil, and then with the very sharp drop, that challenged in certain applications our ability to continue to raise prices. So our approach here is shifting more to holding prices. And when that's happened in the past, we've demonstrated that we can substantially hold. So I view that as a somewhat temporary margin squeeze, but those are the factors behind it. And then the third point is that we are making some investments for growth, principally around the new fumed silica plants and bringing on costs for people and training staff and getting them ready to ramp up when we start. So if you look at those 3 things, they are roughly equal in terms of how much of the year-over-year decline we saw. You can think about them as roughly $3 million to $4 million each. And so when I look at well, are those permanent or are those temporary? I see them as more temporary. The destocking, as I commented on earlier, we see that beginning to abate. And then on the margin squeeze, it's a timing in flow-through, a point. And in the past, when that's happened, we've demonstrated holding prices. And then the growth investments, we start to get the benefits from our Wuhai silica plant in Q4. So that's a timing thing as well, where the revenue will start to match the costs in the back part of the year. So that's sort of the factors, Jeff, and what happened and how we think about it.

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Jeffrey John Zekauskas, JP Morgan Chase & Co, Research Division - Senior Analyst [21]

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Okay. Your environmental spend in the United States, does that finish up this year? And I think in Erica's comments, she talked about capital expenditures coming down to a more normal level, but I don't think she specified what that level was. I know you're coming to the end of your fumed silica spending, so can you give us an idea of your capital outlays over the next few years as best as you can tell?

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Sean D. Keohane, Cabot Corporation - President, CEO & Director [22]

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Yes, so on -- first on the EPA, so we will have a plant that is coming onstream this year. And in preparation for that, we've been building some inventory because of the shutdown to tie in and bring that onstream. So that would be -- that would leave us -- after that one is done, that leaves us with one more plant. And that is in 2022 when that one will come onstream. So there will be capital spend leading up to that. And then at that point, the U.S. EPA-compliance spending will be complete. So that's kind of the timing, one coming on this year. And then as that finishes, another one -- the final one beginning to ramp for the 2022 time period. And that's consistent with when everybody has got to be compliant across the industry. Now on the growth investments, we have, as you know, 2 fumed silica plants coming on in fairly close timing, which would be somewhat unusual, but for all the right reasons, makes sense for us to continue to invest here and extend our position. But you wouldn't normally see that. So as the second plant finishes and comes onstream in 2020, we've got one coming on at the end of 2019 and another one in 2020, then you'd expect the fumed silica investments to drop back down to a kind of more normal growth level. And rather than having 2 coming on, you might have a plant come on every kind of 3 years or something. I mean, these things are lumpy, as you know, but that would be kind of the timing of things. So we do see as the EPA in the U.S. as that capital comes to a close, and as we digest these 2 silica plants, that we'll come down to a more normal growth level of spend. And when you add that to the sustaining and compliance at a more normal level, I think you'll see a step-down in CapEx.

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Jeffrey John Zekauskas, JP Morgan Chase & Co, Research Division - Senior Analyst [23]

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Okay. And then finally, how did your conductive carbons business do in 2018? How did it do in the December quarter? How do you expect it to do in the first quarter?

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Sean D. Keohane, Cabot Corporation - President, CEO & Director [24]

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Yes. So Jeff, you're referring to the conductive carbons for the battery applications?

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Jeffrey John Zekauskas, JP Morgan Chase & Co, Research Division - Senior Analyst [25]

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Yes, that's exactly what I'm referring to.

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Sean D. Keohane, Cabot Corporation - President, CEO & Director [26]

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Yes, yes, so we're excited about this one. I mean, this has been growing very well for us. So our sales into lithium-ion batteries basically doubled in 2018, and we're continuing to get qualifications with all of the major players. It's principally an Asia-Pacific market, although ultimately, once qualifications happen, they'll set up plants in various places around the world to produce the batteries. But we feel really good about this one. And over the next couple of years, this starts to get to be a material contributor for Performance Chemicals. So I think we didn't really see much impact in terms of, let's say, destocking effects or things like that, that we did in other parts of Performance Chemicals. I think this one is building pretty steadily.

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Jeffrey John Zekauskas, JP Morgan Chase & Co, Research Division - Senior Analyst [27]

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How much do you think you'll grow this year?

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Sean D. Keohane, Cabot Corporation - President, CEO & Director [28]

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So it depends a bit on how the timing of the qualifications come in. But I would say, we'll probably grow 40%, something in that range, again, as qualifications ramp and you get full year effects, plus you start to get new qualifications coming in. So it's still growing at a pretty big clip. I mean, much faster than the underlying growth rate. The underlying growth rate of lithium-ion batteries is probably somewhere more around 15%, maybe 15% to 20%. So ours is growing faster as we win qualifications as well as get the growth from sort of the underlying growth of the application.

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Operator [29]

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Our next question comes from Laurence Alexander from Jefferies.

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Laurence Alexander, Jefferies LLC, Research Division - VP & Equity Research Analyst [30]

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Two questions. First, just on the destock/restock discussion. Given how the destock cycles were spread over slightly more than a quarter, how much volume do you think you would get back, assuming that commodity prices are just stable from here? How much of a tailwind are we looking at for either the next 6 months or the next 9 months or whatever interval you think is the right metric?

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Sean D. Keohane, Cabot Corporation - President, CEO & Director [31]

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Yes. So I think the destocking and restocking is difficult to project specifically, because I think in some ways, people are waiting for a certain amount of clarity around the U.S.-China trade framework. And so there's just no doubt that, that is casting sort of a cloud of caution in our customers when we talk to them about this. But I think what we've seen -- so the best thing we can do is look at experience. And when we have seen declines because of polymer prices dropping, then you can definitely see months where you might be 10% to 15% lower volume month over -- on a monthly basis, year-over-year, you might see that for multiple months in a row. Now clearly, that's more than what's happening with underlying demand, right? So then you start to -- if they -- if the prices start to move back up, then you would definitely see that 10% to 15% pickup on the other side for a number of months until you get back to normal. So that's what our history would tell us around both Specialty Carbons and our Specialty Compounds business. But specifically, how that will play out this year is a little bit different in that everyone is just exercising, I would say, a little bit extra caution until they see what's happening with the trade situation with U.S. and China.

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Laurence Alexander, Jefferies LLC, Research Division - VP & Equity Research Analyst [32]

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And then when you think about the Chinese car park, the dynamic that you're seeing there, what is your latest thinking on when we should see a crossover between the replacement market having enough volume to be the main driver of demand rather than the swings in the OEM production?

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Sean D. Keohane, Cabot Corporation - President, CEO & Director [33]

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Yes. So if you look at a typical car, you'll replace the tires kind of about every 4 years, something in that range. And so if you look at the China auto build here over the last 4 to 5 years, it's been building progressively. And so I think you'll start to see it. Our assessment is that, that cycle to replacement largely holds for China as well, and so you'd start to see that begin to kick in. To get the full effect of that now larger car park, we're still probably 2, 3 years away. But you're definitely seeing the ramp in the replacement cycle because auto sales have been going up pretty steadily here over the last 4, 5 years. So we're not at steady-state yet, which gives us confidence over the long term here that the fundamentals of the domestic tire market and the fact that they make almost 40% of the world's tires, those things, I think, are important fundamentals and are absolutely intact here despite the near-term dynamics.

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Laurence Alexander, Jefferies LLC, Research Division - VP & Equity Research Analyst [34]

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And then just lastly, to the extent that you've -- I mean, I guess for the last few quarters, you've been characterizing customer negotiations or focus on longer-term tightness in the supply/demand balance. Has anything about the uncertainty of the recent environment and the severity of the destocking and the unusual nature of production decline in China and so on, has all that conspired to make them a little bit less positive, that they know just how tight the market will be? And so has the pressure on the negotiations eased a bit? Or can you give us some sense of whether or not they're shrugging this off or not?

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Sean D. Keohane, Cabot Corporation - President, CEO & Director [35]

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Yes, I don't think there's any real change. And we certainly don't see that, because if you put the China situation to the side and you look at rest of world, then we still see pretty strong and strengthening fundamentals there. And I think our customers see that as well. And therefore, valuing supply security, reliability, a partner that they can develop new grades with, someone who's environmentally responsible, all of these factors, I think, are still driving the conversation. And so no real change at all there, Laurence. I think the long-term view is -- still holds, and people know that there'll be some destocking and restocking at times. But it's really the long term that's driving it here, and that's what we continue to see in our customer conversations.

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Operator [36]

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Our next question comes from Chris Kapsch from Loop Capital Markets.

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Christopher John Kapsch, Loop Capital Markets LLC, Research Division - MD [37]

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Yes, I had a few follow-ups. So I know there's a focus on China here, but in your volumes in Reinforcement Materials for Asia were up 3%. So I'm just wondering if you could parse out just the magnitude of the negative trends in China in volumes in the quarter vis-à-vis the rest of the Asia region, where presumably, were relatively healthy.

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Sean D. Keohane, Cabot Corporation - President, CEO & Director [38]

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Yes, Chris, so I think in -- we report out an aggregate Asia Pacific number because there are pretty significant linkages across the region, number one. But you can see that, in total, the Asia Pacific numbers were still pretty healthy despite the fact that China was weaker. And so we were down a little bit in China, but not much. And I think that speaks to the fact that we're a preferred supplier there. I think we're well spread in terms of our customer book of business, with a very significant presence with all of the key local players who tend to dominate the replacement market, whereas the global manufacturers tend to be a little bit more indexed towards the OE market. And so I think as a result, our volume impacts were down a little in the quarter, but not that much. The bigger challenge here was the factor around how coal tar prices dropped so sharply at a point when people had built inventories in anticipation of the winter season. And that combination of factors created some near-term pricing pressure and some squeeze. And so we'll work our way through that. But from a volume standpoint, we actually, we feel quite good given the current environment.

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Christopher John Kapsch, Loop Capital Markets LLC, Research Division - MD [39]

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Yes, so just to follow up on that. It -- so down a little bit. Do you feel, given how sharply the automotive builds were down in the fourth quarter, that you actually gained share against that backdrop? And then on the mismatch between cost and pricing creating the squeeze, remind us, I assume that you're on a FIFO cost accounting and how much sort of too much inventory did you have? In other words, when do we see this normalization of margins happening? It sounds like a little bit in the fiscal second quarter but much more so second half?

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Sean D. Keohane, Cabot Corporation - President, CEO & Director [40]

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So I think what we will see -- because of the very sharp drop in feedstock costs both in -- if you use the U.S. Gulf Coast data point that we shared in the presentation as a proxy for everything outside of China, you saw something like a 35% drop there. So it was really, really sharp at a point when inventories built a little bit, demand was slower. And we're building some inventory ahead of some turnarounds and an EPA startup. And so that caused a little bit of a mismatch. Normally, we're trying to match this as tight as possible so that there is no mismatch, but we would expect that, that would work its way out in Q2. So we will see impacts of that in Q2, but would expect that will work itself out in Q2. And then we'd be at normalized levels from there on out.

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Christopher John Kapsch, Loop Capital Markets LLC, Research Division - MD [41]

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And then if that normalization happens and Erica referenced working capital being a source of cash for fiscal '19, do you -- just order of magnitude, the anticipated cash you expect to extract from working capital, assuming a more normalization does, in fact, proceed? So that would be helpful. And then finally, also, can you just comment on this IMO volume down 8%. How much of that's tied to transient issues owing to the changeover in emission regulations in Europe?

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Sean D. Keohane, Cabot Corporation - President, CEO & Director [42]

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Yes. So Chris, why don't I take the last one first, and then Erica can elaborate a bit on the working capital point. So it was definitely an impact from the backlog related to these testing -- emission testing regulations in Europe. I think others have -- has seen and experienced that as well. Where it tends to hit a little bit more is in our industrial products business because that's tied more to new car builds rather than to tires, which have a more heavy replacement component to it. So I think there's a significant part of that negative 8% that is tied to that backlog, which we expect to start to unwind. And then as auto builds improve as we progress through the year, then that picture gets better as well. So that's how we see that, a bit more of a transient issue and one that will work its way out. I think Erica -- maybe Erica, on the working capital?

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Erica McLaughlin, Cabot Corporation - Senior VP & CFO [43]

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Sure. So Chris, I think on the working capital, again, we built a little over $100 million in the first quarter. And so when you look at current feedstock prices, we'd expect all of that to come back out through the remaining 3 quarters. You'll see it start in the second quarter as we start to see inventory values come down and then receivables as well. I think that further to that, when we think about where we'll end the year, quite dependent on where the feedstock prices will be towards the end of the year. And so as we think about it as more of a rule of thumb that for every dollar per barrel change in the price of oil, you're going to see somewhere around a $6 million or $7 million benefit. So if you look at September prices to where we end September, then that would give you a magnitude of what it could be. But certainly, as we move through the year, we'd have a better idea towards the end of the year as that's shaping up as to where the price is at that point.

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Operator [44]

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Our last question comes from David Katter from Baird.

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David Francis Katter, Robert W. Baird & Co. Incorporated, Research Division - Junior Analyst [45]

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A quick question on Specialty Fluids. I think you mentioned that it is in guidance, but also that the impact to overall earnings would be minimal. Any chance you can kind of tell us what segment EBIT contribution you're expecting from Specialty Fluids or that's baked into your EPS guidance?

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Erica McLaughlin, Cabot Corporation - Senior VP & CFO [46]

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Yes, sure. So again, we say it's minimal because it's included in the range. So we're just not -- we're not assuming that there's any impact in our range guidance that we just gave that's outside of what we expect. The business earned $10 million of EBIT in the first quarter. I think we gave a range of $10 million to $15 million last quarter. It's still in that range. And again, we record earnings until we close, and then once it's closed, we would not. So roughly, we think we'll close sometime in the third quarter, so we'd have a quarter or so where it would come out.

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David Francis Katter, Robert W. Baird & Co. Incorporated, Research Division - Junior Analyst [47]

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Got you. That's helpful. And then on the fumed silica plants in China, can you remind us about the magnitude of the earnings contribution from those 2 plants and maybe the cadence? How long will it take to get to whatever run rate earnings you're expecting from those 2?

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Sean D. Keohane, Cabot Corporation - President, CEO & Director [48]

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Sure. So just to remind you, we've got the plant in Wuhai coming onstream in the fourth quarter. These things typically have a ramp to them, so you commission and then you ramp volumes up. And so the projects, this particular one is about $60 million of capital and would have IRRs in the kind of low 20s percent range, something like that. So you can get a sense from that once we get to run rate what the earnings level would be. I think our view is we expect to begin seeing contribution from that in the fourth quarter. But again, it will be in ramp phase. You might see a few million dollars that starts to hit in the fourth quarter, and then we get to full ramp in 2020.

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Operator [49]

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Thank you. This concludes the Q&A session. At this time, I'd like to turn the call back to Sean Keohane, President and CEO, for closing remarks. Please go ahead.

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Sean D. Keohane, Cabot Corporation - President, CEO & Director [50]

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Great. Thank you very much, everyone, for joining today, and we look forward to speaking with you again next quarter. Thank you.

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Operator [51]

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Thank you, ladies and gentlemen, for attending today's conference. This concludes the program. You may all disconnect. Good day.