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Edited Transcript of FOE earnings conference call or presentation 31-Jul-19 12:00pm GMT

Q2 2019 Ferro Corp Earnings Call

Cleveland Aug 5, 2019 (Thomson StreetEvents) -- Edited Transcript of Ferro Corp earnings conference call or presentation Wednesday, July 31, 2019 at 12:00:00pm GMT

TEXT version of Transcript

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Corporate Participants

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* Benjamin J. Schlater

Ferro Corporation - Group VP & CFO

* Kevin Cornelius Grant

Ferro Corporation - Head of IR

* Peter T. Thomas

Ferro Corporation - Chairman, President & CEO

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Conference Call Participants

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* Bhavesh Mahesh Lodaya

BMO Capital Markets Equity Research - Senior Associate

* David L. Begleiter

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

* Dmitry Silversteyn

The Buckingham Research Group Incorporated - Director

* Kevin William Hocevar

Northcoast Research Partners, LLC - VP & Equity Research Analyst

* Michael Joseph Sison

KeyBanc Capital Markets Inc., Research Division - MD & Equity Research Analyst

* Rosemarie Jeanne Pitras-Morbelli

G. Research, LLC - Research Analyst

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Presentation

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Operator [1]

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Good morning. Thank you for joining the Ferro Corporation 2019 Second Quarter Earnings Conference Call. An archived replay of this teleconference will be available through the Investor Information section at ferro.com later today and will be available for approximately 7 days.

I would now like to turn the call over to Kevin Cornelius Grant, Director of Investor Relations and Corporate Communications. Please go ahead.

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Kevin Cornelius Grant, Ferro Corporation - Head of IR [2]

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Thank you and good morning, everyone. Welcome to Ferro's Second Quarter 2019 Earnings Conference Call. This morning, we will be reviewing Ferro's financial results for the second quarter ended June 30, 2019. I'm pleased to be joined by today, Peter Thomas, our Chairman, President and CEO; and Ben Schlater, Group Vice President and Chief Financial Officer.

The earnings release and conference call presentation deck are available in the Investor section of our website. I'd like to remind everyone that some of the comments we are making today are forward-looking statements and are based on our view of conditions and circumstances as we see them today. However, those views may change as conditions and circumstances change. Please refer to the forward-looking statement disclosure in the earnings release and earnings presentation.

Also, today's call will contain various operating results on both the reported and adjusted basis. Descriptions of these non-GAAP financial measures and reconciliations are included in the earnings release and presentation deck. We encourage you to review that information in conjunction with today's discussion. It is now my pleasure to pass the call over to Peter.

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Peter T. Thomas, Ferro Corporation - Chairman, President & CEO [3]

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Thanks, Kevin, and good morning, everyone. Like many companies in our space, Ferro felt the effects of global economic uncertainties in the second quarter. We expect these conditions to continue through the second half of 2019. Ferro's center of gravity is outside the U.S. with approximately 80% of our sales in foreign markets. Some 50% of our sales are, in fact, in Europe. Because of this heavy tilt to foreign markets, Ferro suffered comparatively more from the effects of uncertainties in foreign markets and benefited comparatively less from the robust U.S. economy and companies, more of U.S.-centric.

In addition, the industries we serve, residential and nonresidential construction and automotive, have been particularly impacted by the recent international trade tensions, especially in Europe. Exports from Europe, our largest market, has slowed in these industries. Automakers, in particular, are anticipating continuing pressure from slowing growth in China, weak demand in Europe and prolonged global trade tensions.

We do not have good visibility on the level of demand for the remainder of 2019. There seems to be some near-term firmness in demand in some of our businesses, but we also have customers in some of the industries we serve, who have become cautious with their projections as a result of macroeconomic uncertainties.

Some of our customers have delayed orders and are working through finished goods inventory and raw materials on hand. This suggests to us that demand in these markets will remain tepid for the second half of 2019.

Despite these macroeconomic challenges, Ferro increased the gross margins in the second quarter relative to the first quarter in each of our reporting segments. We also increased the company's adjusted EBITDA margin relative to the first quarter. The margin improvements were driven by pricing as well as the cost management and optimization initiatives that we have prioritized throughout the business.

We continue to advance innovation and optimization initiatives that will drive additional value in both the near and long term. Our product innovation initiatives have generated a pipeline of products for customers and emerging technologies across multiple industries, including energy and power systems, automotive and transportation, industrial, automation, electronics, aerospace, 5G and mobile technologies. We are well positioned for next-generation platforms.

The breadth of our product lines, keep -- deep market knowledge and technical expertise are significant competitive advantages in the current macroeconomic environment. Regarding optimization, we have optimization initiatives underway across the globe, and we are developing additional plans to generate even more efficiencies.

In addition, we are accelerating certain optimization actions, implementing them in 2019, rather than waiting until later in order to more fully reap the benefits in 2020. We will provide additional information on such initiatives as appropriate.

Finally, a word on cash. We remain very focused on free cash flow. We are confident that we will achieve the cash flow targets we set earlier in the year.

I will now turn the call over to Ben for his review of second quarter performance. Following his comments, I will review our segment results and discuss guidance for the second half of 2019.

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Benjamin J. Schlater, Ferro Corporation - Group VP & CFO [4]

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Thank you, Peter, and good morning, everyone. Peter has provided our overview of the broader macroeconomic trends affecting our performance in the quarter. I'll now discuss our consolidated financial results for the second quarter of 2019. Please note that the non-GAAP numbers I refer to are on an adjusted basis, and growth rates mentioned are on a constant currency basis compared to the second quarter of 2018. The financial highlights and results can be reviewed on Slide 4 and 5 in the presentation accompanying today's call which you can find on a ferro.com in the Investor section.

Turning to Slide 4 in the second quarter. Net sales declined 2% to $393.9 million. Adjusted gross profit declined 9% to $111.9 million. Adjusted SG&A expense was $63.3 million or 16.1% of net sales. Adjusted EBITDA declined to $62.7 million or 15.9% of net sales and adjusted EPS declined to $0.35.

The performance in the quarter compared to prior year was lower as expected. We anticipated the margin expansion across all our reporting business segments. The overall business margin improved to 180 basis points to 28.4% sequentially.

For the second quarter, there were a few non-GAAP adjustments, primarily related to our corporate development, acquisition and optimization activities. First, in cost of sales, we have adjustments of approximately $3.6 million, primarily due to costs related to optimization initiatives.

In SG&A, we have onetime adjustments of $8.3 million in the quarter consisting of $5.1 million related to legal, professional and other expenses related to certain corporate development activities and the remaining for certain optimization initiatives, including the North American manufacturing optimization we announced earlier this year.

Turning to restructuring and impairment, there was an adjustment of approximately $10.3 million in the second quarter, $5.9 million of this is an impairment charge related to our Performance Coatings reportable segment business. The remainder is related to actions to achieve our ongoing optimization initiatives and acquisition synergies.

Finally, in the quarter, in other income and expense, we have adjustment of about $400,000, primarily related to a gain on divested assets offset by a purchase price adjustment related to an acquisition that is beyond the measurement period.

Now moving to SG&A. In the first quarter adjusted SG&A expense was $63.3 million or 16.1% of net sales compared with $63.6 million or 15.8% of net sales in the prior year quarter as stated on a constant currency basis.

This brings me to adjusted free cash flow. Adjusted free cash flow for the quarter was an inflow of $18.3 million compared to a use of $5 million in the prior year. We have reconfirmed our prior full year free cash flow conversion guidance of 45% to 50%. We define adjusted free cash flow from continuing operations as GAAP net cash flow provided by operating activities, less CapEx. Then we add back cash used for our recently announced manufacturing optimization, acquisition-related items and restructuring activity.

The most meaningful components for the quarter are as follows: Starting with GAAP net income of $11.1 million, we add $15 million of depreciation and amortization, less $44.3 million for working capital, plus $1.6 million of a change in other balance sheet items, less $5.2 million of other noncash P&L items to arrive at cash used from operating activities of $11.4 million on a GAAP basis.

From there, we subtract $14.3 million of capital expenditures and add cash received on other receivables of $21.1 million to arrive at $4.6 million of free cash flow use in the second quarter. Our practice has been to adjust this number for cash flow related to our strategic activities. These include: one, cash related to our recently announced manufacturing optimization; two, M&A-related cash flow; and three, cash flow restructuring programs. The quantification of those 3 adjustments for the quarter are as follows: $15.6 million for the optimization projects, $3.3 million related to M&A and $4.2 million related to restructuring. When we add these items back to our GAAP numbers, this brings adjusted free cash flow for the quarter to $18.3 million compared to a use in the prior year of $5 million. The details of this calculation and the related reconciliation to GAAP operating cash flow can be found on Table 12 in the press release.

Regarding our balance sheet and cash flows. Second quarter adjusted free cash flow was strong and reconfirmed our full year adjusted free cash flow conversion targets of 45% to 50%. Further, we finished the quarter at 3.6x net leverage. As we think about the full year, we expect leverage to be at or below 3x at year-end. This change from our view from last quarter was primarily driven by our expectation for lower EBITDA offset by better working capital and CapEx. And with that, I'll now turn the call over to Peter to walk through each of the business units and discuss our update on guidance. Peter?

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Peter T. Thomas, Ferro Corporation - Chairman, President & CEO [5]

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Thank you, Ben. Now I'll take you through second quarter performance in our reporting segments. Let's begin with our Performance Coatings segment. Performance Coatings volume were down slightly from the prior year by 0.5%. Our net sales on a constant currency basis were down 4.4% to $178.2 million. Adjusted gross profit decreased to $40.9 million from $48.2 million.

On a more positive note, gross margins improved in the second quarter of 2019 relative to the first quarter by 310 basis points, increasing from 19.9% to 23%. We've seen a certain cautiousness among our Performance Coatings customers, both end customers and distributors have been destocking over the past 3 quarters. They have been focusing on working capital and keeping their inventory levels low, and we expect that they will continue to do so for the remainder of the year because their customers still lack visibility as to their future requirements.

We also have experienced some earlier-than-expected summer holidays among our customers. Some customer started taking summer holidays in the second quarter, whereas these normally will begin in the third quarter. It is not yet clear to us how long these holidays will last. There may be that the lower demand in the second quarter from earlier holidays will result in higher demand in the third or fourth quarters. We just don't have clear visibility on that yet.

Likewise, with end customers and distributors carrying low levels of inventory, an uptick in the industry could quickly translate into additional demand for our products. But, again, we just don't have good visibility.

Now let's look at our Performance Colors and Glass segments. In the second quarter, Performance Colors and Glass volumes declined 16.3%, with net sales on a constant currency basis down 2.6%. Adjusted gross profit decreased to $39.9 million from $43.8 million in the prior year. Despite the lower sales, we did increase gross margins by 100 basis points, increasing to 33.7% in the second quarter from 32.7% in the first quarter.

Demand was generally subdued with many of our customers taking a wait-and-see approach. We expect the weakness in demand relative to 2018 from automotive customers to extend through the remainder of 2019, although the weakness maybe less pronounced than in the first half of the year.

With the global automotive production having declined 6% in the first half of 2019 and an industry forecast of an approximately 4% decline over the course of 2019, this suggests comparatively less weakness in the second half of the year.

Last year, our automotive business grew mid-single digits mostly due to strength in Europe and Asia Pac. But this year, we are experiencing weakness in our Automotive business across all regions. Our Automotive business was down approximately 12% in the second quarter as our customers destock and work down their inventory levels.

Our North American Electronics Materials business grew approximately 7% in the quarter. This was driven by sales of multilayer film, pastes and tapes for sensors, dielectrics and capacitors.

Decoration was down mid-single digits in the quarter compared to the prior year, as we had some large off-cycle orders last year that were not repeated.

Now turning to Color Solutions. In the second quarter, Color Solutions net sales on a constant currency basis were up 3.6%, while volumes were down 8%. Adjusted gross profit decreased to $38 -- $30.8 million from $31.1 million in the prior year. As with our other reporting segments, we delivered sequential quarter margin improvement in Color Solutions, here a 110 basis point increase, to 31.6% from 30.5%. Demand for our pigments was soft in the second quarter due to the continued unseasonable weather in United States and a continued shift away from blue shades in the automotive sector.

Demand remained strong for our surface technologies products in the second quarter, which was driven by continued 5G platform development. Looking ahead, the second half of 2019 likely will compare less favorably to the same period in 2018 because last year, we benefited from an off-cycle ramp-up in demand from the semiconductor sector.

As I said earlier, global trade uncertainties are weighing on our business. Customers are being cautious about ordering in this environment. We anticipate that the current state of limited visibility will persist through the second half of 2019.

Current macroeconomic uncertainties, the associated difficulty predicting customer demand and our expectation that these circumstances will continue for the balance of 2019 have led us to lower our guidance for the year.

Turning to Slide 8, you will see our updated guidance range for adjusted EPS. We now anticipate an EPS of $1.17 to $1.27, rather than $1.35 to $1.45. We also have updated our guidance for adjusted EBITDA. We now anticipate adjusted EBITDA of $225 million to $240 million, rather than $250 million to $260 million. We are not lowering our guidance on free cash flow conversion. We are maintaining guidance on free cash flow conversion of 45% to 50%.

I'll finish my prepared remarks this morning with a discussion of our priorities for the second half of 2019. We are focusing on the things within our control to best position Ferro to compete and win in the markets we serve.

In the second half of 2019, we will continue to prioritize our innovation and optimization initiatives, including removing fixed costs from our manufacturing operations; accelerating optimization initiatives so that we realize more benefits in 2020; rationalizing customers and product portfolios for profitability; and developing new products and applications for our customers' next-generation markets. In addition, we will focus on generating free cash flow and managing our balance sheet.

So that concludes our prepared remarks. Kevin, we're now ready to take questions.

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Kevin Cornelius Grant, Ferro Corporation - Head of IR [6]

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Operator, would you please open up the line?

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Questions and Answers

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Operator [1]

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(Operator Instructions) Our first question comes from the line of David Begleiter with Deutsche Bank.

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David L. Begleiter, Deutsche Bank AG, Research Division - MD and Senior Research Analyst [2]

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Peter, can you discuss [updates] for optimization savings the expectation for savings in 2020. What do you expect for savings to be beyond 2020 from the optimization initiatives?

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Peter T. Thomas, Ferro Corporation - Chairman, President & CEO [3]

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Thanks, David. And okay, so let's take a look at what we have been saying actually starting last year when I first kind of mentioned that we had some other things in our pipeline that we would probably introduce pretty quickly, if you remember. As we are ending through, what we call, program 1 of our optimization, which has been, what's announced as the $30 million initiative, which of course we are on track to deliver that. I mentioned last year that we probably had another $15 million or so that we might think of, but I didn't provide any more granularity. But I did I want to mention back then that everyone should understand that we would not wait until the last minute if we saw economic conditions start to decline.

So where we stand today, we will give you a flavor. We have dug into our optimization pipeline. You should look at next year contribution from 2 programs. The first program was the $30 million, one that we initiated back in 2016. And you should see a contribution of that that are approximately $20 million as we mentioned before.

We have program number 2 underway. It has a value of about $40 million. And the expectation from that program with that it would contribute another $15 million or $20 million next year. So on a go-forward basis from the total of $70 million optimization programs we have announced, we are looking at somewhere between $35 million and $40 million of contribution.

And on the go-forward basis, you would see that the remaining part of that $40 million would probably come through '21 and '22, and we do have other activities in the pipeline. But, again, at this point to premature for us to share any more details around that, but do know that we are in fact launching and actually, have started the new program to $40 million contributing $15 million to $20 million next year on top of that $20 million from program 1. Does that help?

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David L. Begleiter, Deutsche Bank AG, Research Division - MD and Senior Research Analyst [4]

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Very helpful, Peter. And once these savings initiatives are in place, how you think about operating leverage or incremental margins on the volumes as they flow through this more leaner cost structure?

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Benjamin J. Schlater, Ferro Corporation - Group VP & CFO [5]

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David, it's Ben. Yes, look, all these programs are focused on reducing the fixed cost primarily within the manufacturing facilities. And so from a leverage perspective, as volume ramps, we should see these fall through almost dollar per dollar from a margin perspective.

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David L. Begleiter, Deutsche Bank AG, Research Division - MD and Senior Research Analyst [6]

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Actually, I was asking more about once these are in place, anything about the volumes as they flow through, what type of incremental margins you would expect to realize on the new -- on the volumes flowing through this cost structure?

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Peter T. Thomas, Ferro Corporation - Chairman, President & CEO [7]

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Do you want to get into the specific details of that?

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Benjamin J. Schlater, Ferro Corporation - Group VP & CFO [8]

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I think the easiest way to think about it, David, is look, these programs will be focused on -- in many areas of the world with respect to various different geographies. And I would think that from a volume flow-through perspective, the volumes that will be carrying through should carry through similar margins from our contribution perspective that -- to what we see today. So for example, 28% gross margins today, we would expect new volumes to fall through at 28% margin plus the reductions from a fixed cost perspective. So I wouldn't assume anything... Yes. yes.

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Operator [9]

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Our next question comes from the line of Rosemarie Morbelli with G. Research.

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Rosemarie Jeanne Pitras-Morbelli, G. Research, LLC - Research Analyst [10]

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Peter and Ben, I was -- so this is a large cut in EPS expectations. And I was wondering if you could talk about what is taken into consideration, I mean, in more details than what you mentioned earlier, in that -- year-end, and how comfortable are you with the -- with these new projections?

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Peter T. Thomas, Ferro Corporation - Chairman, President & CEO [11]

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Yes. Thanks, Rosemarie. At the end of the day, we -- this whole guide down we would share with you is a bit on the conservative side. And it's all driven on volume and mix because in conversations with all of our customers, quite candidly, none of them are sharing that they have much visibility over 2 to 3 months, and anything that goes on for the balance of the year is as much of a guess to us as it is to them. And so having said that, we had a run of about 22 quarters in a row where our S&OP process was plus or minus 2%, which is world-class. And over the past 3 quarters, it's been terrible, and it's because of the data that we need in order to plan our productions and which we use the guide -- provide guidance.

And just to give you a perspective, so you have an understanding of this. We have over 6,000 customers in 100 countries, and we make 21,000 different SKUs. So you can see when you have a precipitous change in the marketplace, how challenging it's been over the past few quarters, first 2 quarters being really the fourth and the first of getting that data 80% of our business is driven by 700 customers, so we are in constant conversation pulling and extracting data from those customers across the globe. And their lack of visibility has led to our inability to plan all those different SKUs.

However, I will tell you as time is going on, yes, we do have a little bit more of a perspective, why? Because our customers have been in draining both fixed end-product inventories as well as base raw materials. We have seen a continued thinning out of every customer throughout the world that we serve and that they're really working on a program of minimizing their working capital for the balance of the year. And that's what they are sharing with others.

So having said that and having 3 quarters of terrible information, knowing the macroeconomic the way we are seeing and putting our bent into it, we decided that it's probably be prudent for us to have a conservative guide in the way that we feel really good that we can deliver against those expectations considering we still aren't getting enough information from our customers.

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Rosemarie Jeanne Pitras-Morbelli, G. Research, LLC - Research Analyst [12]

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So when you say conservative, Peter, are you expecting then to -- I mean, are you expecting a further decline in the demand or just staying at current level?

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Peter T. Thomas, Ferro Corporation - Chairman, President & CEO [13]

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Yes. At the end of the day, if world is catastrophic like it was last year, that would probably err on the side of the low side.

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Benjamin J. Schlater, Ferro Corporation - Group VP & CFO [14]

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Yes, Rosemarie, I think the way we've sort of thought about it, Rosemarie, is I think from a sensitivity perspective, if you we would continue to see, let's say, for example, GDP in Europe moved lower, you can see a sensitivity to the downside. Conversely, if we see expectations clear up with respect to volatility, either from underlying economic demands, for example, GEP, or with respect to things like the tariffs, I think you could see a sensitivity to the upside as well.

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Peter T. Thomas, Ferro Corporation - Chairman, President & CEO [15]

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Yes. And another way of looking at it too, Rosemarie, is I shared some data that we never really discuss before with the magnitude of our customers and the fact that we can produce 21,000 products. You have to -- really what's been very interesting is, as our customers, every one of them, not isolated to just 1 category, every one of them are tightening and becoming more razor-like to even just-in-time [inventories]. We have customers that are planning orders 3 or 4 weeks in advance, midway through, they change in orders. So you can imagine what we have to do with our planning considering we make some end products. And not all of them are like blow-and-go type things. It really does interfere with our ability to be more predictable, but the fact that the inventories are tightening up. And the fact that we do -- are starting to acclimate ourselves to this just in time, we see more orders at lesser volumes. And so all that added together, what we are seeing is there's no doubt in our mind that our customers are preparing for a 2020 that's probably like 2019, and we're hearing that from a lot of our customers.

So I think the exercise of really thinning up their inventories to start 2020, and what one we would find is the appropriate type of inventory mix is something that we're really paying attention to. We believe that's going to happen. And I think we're in a better state of preparedness now that we have been in this for 5 quarters. The more you are into something, the more accurate you're becoming, I can tell you that. Our monthly forecast accuracy starting to get a little bit better. So -- I mean, that's what we are.

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Rosemarie Jeanne Pitras-Morbelli, G. Research, LLC - Research Analyst [16]

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That is helpful. If I may ask 1 other question. You talked about rationalizing customers and products, could you give us a feel for how much have you eliminated, I am assuming a low margin type of customers? How much in revenues is at stake? And as they are out of the picture, what could be the positive impact on the margins? Have you calculated then?

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Benjamin J. Schlater, Ferro Corporation - Group VP & CFO [17]

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We're looking at it, but we're not in a position to discuss it yet, openly. So just hold on to that, and I think over time here, we will be able to share a little bit more. But at the end of the day, customer product and rationalization should not be stagnant, it should be fluent. And this is particularly a good environment to exercise that a little bit more than we have.

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Operator [18]

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Our next question comes from the line of John McNulty with BMO Capital Markets.

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Bhavesh Mahesh Lodaya, BMO Capital Markets Equity Research - Senior Associate [19]

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This is Bhavesh Lodaya for John. Peter, if you think about priorities for cash flow, you mentioned that products optimization programs will take priorities, which makes sense. Could you also touch on where buybacks and M&A coming in that list? And expectations for capital allocation for there as we look ahead?

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Benjamin J. Schlater, Ferro Corporation - Group VP & CFO [20]

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It's Ben. Sure. I think -- as Peter mentioned, we're focused on capital required to reduce the fixed cost of the business. I would say beyond that, our first priority is debt paydown and reducing leverage. I think most of the projects that we're focused on from an optimization perspective would indeed be delevering. Beyond that, I would say, M&A and stock repurchases probably come after that. So again just to reiterate, we are focused primarily on rightsizing the cost structure with what's happening with respect to the top line number 1 and secondly, on debt repayment.

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Bhavesh Mahesh Lodaya, BMO Capital Markets Equity Research - Senior Associate [21]

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And as we look at the M&A pipeline, maybe just following up from that, can you add some color as to what you're seeing out there? And is there any change in your outlook?

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Peter T. Thomas, Ferro Corporation - Chairman, President & CEO [22]

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Yes. Our pipeline still remains very robust. As usual, we continue to look for things like we have in the past, and we have a handful of things that fit that category. we're in various stages of conversation. Of course, that would be more of what you've seen in the past. So they are kind off on the side. And as we mentioned in the past 2 quarters, we've solved it prudently, particularly in this environment to continue with our strategy like we have for 6 years is, how do we now move a bit faster at an inflection point of creating an even better version of what we are ultimately creating more shareholder value. That was really the thrust into this year, and that's why you haven't heard of any short-term deals or deals like we have in the past.

So we have mentioned on the last 2 calls that we continue to evaluate strategic options that will enhance shareholder value. We believe that we've selected a few things that we're currently evaluating, and we're in various stages of considerations. We feel very good about the momentum of some of those activities. And of course, something that would be a little bit more meaningful sometimes takes a little longer for various reasons. But we still feel very good.

And I think that what's important to underscore, and I'm glad you brought the question up, because I think everyone always wants to know what we are doing. But I think there's -- I think the question more to ask is, you know how we have been executing our strategy, you know we have a plethora of pipelines for everything, and I think you should ask yourself a question at this inflection point as we define it, what we would Ferro wants to do in a way that would create a more shareholder value to Kind of a portfolio because our desire, from the very beginning, is to create a better version of ourselves. And I think that's what every company should do.

So in consideration of that, when we talk about what we want to look at, I think, you have to take a look at what would be some of the key differences from our current portfolio? That's the kind of questions we want to discuss because we are in this for a long term. Everything that we're doing is still in the framework of our strategy that we laid out 6 years ago. I think the fourth phase is a self-explanatory around innovation and optimization. You can see in times like these, we are pulling all the levers on delivering the $70 million optimization, there's more in the pipeline, much like I just mentioned we continue to buy like we have in the past with acquisitions or we can really trying to step change and create a more valuable franchise.

So from that, you want to say, what would be the key differences from our current portfolio? What is strategic? What would Ferro mean by evaluating strategic options? What would it do to the portfolio? Does it make sense to the shareholders? And it's this, we want to really look at a more tightly focused portfolio. We want a more specialty-oriented business mix. We want higher average gross margins. We want a modestly higher underlying market growth rate. We want to market end-use mix less concentrated on construction, and we want a relatively larger positions in higher growth markets and applications that we have been feeding over the past 6 years.

So when you think about that, that should make sense. That would create a more valuable franchise and that is what we're focused on because the next question is well, that's great, and what is it that you see both in terms of regional mix or end market mix? Well, at the end of the day, from a regional mix, certainly, you can see how Eurocentric we are, And the idea would be we like a much more balanced North American and European position.

From an end market mix, you know that we're heavily concentrated in construction, and it would be a pretty good strategic aim for us and target to have our top 4 market segments -- 5, all be pretty equal between mid-single digits, up to 15% to 20%. So from a strategic perspective aside from just what are you doing, rather than answering that directly, which I have, I'm giving you the differences from the current portfolio, and also, the mix in the end markets. So you have a perspective of the thought that's going into what we are doing and hopefully, what will be successful, I mean, again, upgrading the portfolio in a very shareholder-friendly way. Does that answer your question?

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Bhavesh Mahesh Lodaya, BMO Capital Markets Equity Research - Senior Associate [23]

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Absolutely. Certainly appreciate the color and the thoughts.

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Operator [24]

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

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Kevin William Hocevar, Northcoast Research Partners, LLC - VP & Equity Research Analyst [25]

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When I look at the gross profit bridge in the 10-Q, pricing remained slightly positive in the period and raw materials turned into a nice tailwind there. So how should we think of that dynamic going forward? Do you think pricing can continue to remain on top of raws? Or do you see this dynamic changing at all?

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Benjamin J. Schlater, Ferro Corporation - Group VP & CFO [26]

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Kevin, it's Ben. No, I think you're going to continue to see more of the same. I think what's reflected in the guidance is continued headwinds from a price raws perspective. I think that -- we believe that there would be more in the second half than they were in the first half. But you should continue to see that dynamic through the third and fourth quarter.

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Kevin William Hocevar, Northcoast Research Partners, LLC - VP & Equity Research Analyst [27]

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Okay. And then do you potentially imposing antidumping and countervailing duties against ceramic imports -- the tile imports from China. Wondering if that would have any impact on your Tile Coatings business at all? Could it be a benefit to some of the other regions as they may start picking up the slack and exporting more to the U.S. or conversely, maybe some Chinese products could find its way into some of your other regions on the negative side. So curious if -- or those that balance out? Does it matter? Just kind of curious if that has any impact on your Tile Coatings business?

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Peter T. Thomas, Ferro Corporation - Chairman, President & CEO [28]

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Yes. So that's a good question. And I think that from the surface, what you would find is maybe a little more advantageous for the North American or particularly the U.S. manufacturers of tile, and of course, that would benefit us. But our tile business already up -- is up this year because we are focused on the high-end. And it's a kind of different to mention than just the commodity flooring that's been coming in from China.

So last year, we had high-single digits growth. This year, already, we are up 4% to 5%. But it's, again, it's how we are positioned with our portfolio on 40% of the business worldwide and at the upper end, and it's not contaminated with the lot of the commodity tile at the low end or even in the mid-range, kind of. And so we'd suspect that the U.S. customers would -- top producers would benefit something like that. As it relates to -- interesting enough, if things are slowing down in China, of course, there's other issues with them dumping product everywhere else. But as we navigate because of how we're positioned in the portfolio, that really we're not seeing that bothering us as much. We just don't view it as a problem. It's a benefit overall worldwide for us.

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Kevin William Hocevar, Northcoast Research Partners, LLC - VP & Equity Research Analyst [29]

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Okay. Perfect. And then last question, you're able to maintain the free cash flow guidance, which seemed to imply pretty strong cash generation in the back half of the year. So wondering, Ben, how you're able to do? Did it just boil down to tight working capital control? Or maybe just help us to understand how you are able to maintain that side of guidance?

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Benjamin J. Schlater, Ferro Corporation - Group VP & CFO [30]

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Yes. Very similar to last year, Kevin. So the majority of the cash is generated in the last 2 quarters of the year with a majority of that being generated in the fourth quarter. And remember the cash flow guidance is really an efficiency metric with respect to how many dollars of EBITDA ultimately flow through to free cash flow on an adjusted basis. So -- but yes, I think what we're saying is our fall off from EBITDA from a guidance perspective is being partially offset with better working capital and lower CapEx in the back half of the year.

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Operator [31]

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Our next question comes from the line of Mike Sison with KeyBanc.

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Michael Joseph Sison, KeyBanc Capital Markets Inc., Research Division - MD & Equity Research Analyst [32]

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In terms of '19 and just wanted to get a feel for the volume impact on EBITDA outlook, meaning, when you start to $59 million in '18, you have cost savings, you have acquisitions, you have kind of -- should have plus on raw materials, and I think that was a plus, whatever, $20 million, $30 million in the prior outlook. And to get to your new guidance that would imply kind of $50 million or $60 million negative from volume. So is that kind of the right math? And is that the right number to think about that could come back in 2020 if demand is better?

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Benjamin J. Schlater, Ferro Corporation - Group VP & CFO [33]

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Mike, it's Ben. I think it's a little high. The short answer to your question is, yes. If demand repayment returns I think that's the right number to sort of think about coming back. But let's be clear on sort of the ranges, if you will. I mean from a -- moving from '18 to sort of the updated guidance for '19, we continue to expect sort of this basket of optimization and acquisitions in raw materials to be in that sort of $23 million to $27 million range. FX is going to be a headwind of $8 million to $10 million. I'm now speaking on an EBITDA basis.

And then the base company is really the difference, so that's going to put you in sort of the high 30s, low 40s, call it sort of $38 million to $44-ish million. And that's really the kind of the swing that we could see if volume comes back. I mean when we think about the guidance update for the back half of the year, this was the vast majority of it based on just lower volume in mix. So you're right to say that when that returns, we should see it come back.

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Michael Joseph Sison, KeyBanc Capital Markets Inc., Research Division - MD & Equity Research Analyst [34]

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Got it. And then I think you said, Peter, the optimization or the cost savings were net $20 million plus $15 million to $20 million, how much cash will you need to use to get that savings next year?

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Benjamin J. Schlater, Ferro Corporation - Group VP & CFO [35]

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Yes. So Mike, we haven't come out with kind of the complete number yet. What I can tell you is the program that we just launched and that this is in the queue, but since we are just out yesterday, we said it will cost us about $5.5 million or sort of the initial portion of it. And as we get deeper into that program, more likely into the third and fourth quarter, we'll update everybody on the complete costs here.

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Michael Joseph Sison, KeyBanc Capital Markets Inc., Research Division - MD & Equity Research Analyst [36]

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Got it. And then one quick one. I thought in your commentary you talked about some manufacturing inefficiencies because of the optimization program. How much is that going to be this year? And then does that sort of come back in 2020 as you reconcile some of those inefficiencies?

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Benjamin J. Schlater, Ferro Corporation - Group VP & CFO [37]

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Yes. I think the easiest way to think about that, Mike, is that a lot of this happened in the first half of the year. So if you think about what's happening from a product perspective, we are transitioning a very significant amount of product as it relates to the sort of the total percentage of Ferro revenue around the world to put it in more efficient facilities. That, obviously, creates friction between the 2 facilities that are transferring that product. So we saw some of that friction in the first and second quarters.

I would say that that's sort of onetime in nature. I don't -- we don't expect that to repeat. In the -- for the first half of the year, that number was somewhere between $6 million and $10 million. So it's a sizable number that a lot of which was expected by the way, but that's sort of a sizable number that we wouldn't expect to repeat next year once these transfers are complete.

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Operator [38]

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Our next question comes from the line of Dmitry Silversteyn with Buckingham Research.

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Dmitry Silversteyn, The Buckingham Research Group Incorporated - Director [39]

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Couple of them, if I may. First of all, if I look at the volume weakness in your segments versus the market weakness that you mentioned, Peter, it looks like you are like 2 to 3x more negative on volume than the market has declined. Is that the impact of destocking? Or is there a mix of components in that volume mix number that's actually pushing it down that much?

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Peter T. Thomas, Ferro Corporation - Chairman, President & CEO [40]

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Yes. It's both. It's both of those. I think the volume piece, what we like to do is, that's a good question. We wanted to read that in. If you look at our proxy, GDP for Ferro, right now as it's coming out around the world is we're really about -- we should be seeing for our mix of products of about 1.5% growth. And we did a correlation between that global growth relative to the magnitude of the overall destocking of our customers. And what you would find actually is the rate of that destocking is actually higher than the 1.5%. So that's why we're starting to feel a little bit better about our ability to forecast as we would forecast and it is becoming easier with our customers because they are really, really thinning out to meet their inventories. I mean it's probably the lowest it's been for quite a long time for a lot of people, maybe even dating back to 2010 and '11 as we understand.

So we know that we are growing or the demand for our products is much greater than what we're showing because of the destocking in the mix. And I'm -- thanks for bringing it up because we are getting market share in every segment. So as we -- again, it was really -- we have been working on that concept for a couple of months on trying to understand the rate of decline of inventory relative to when they started to purchase it versus where it is today and what our growth is and what you're going to start to see in some segments. That's why I mentioned they're starting -- we're starting to see some firmness in a way that you could have some upside strangely enough, some upside potential in the fourth quarter, but we don't want to say that right now. But I can tell you there's a couple of market segments that we may get a surprise that it actually moves up a little bit in the zone where it would show what our growth rate is. So that's a bit of an upside here going in the next 5 months, actually.

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Dmitry Silversteyn, The Buckingham Research Group Incorporated - Director [41]

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Got you, got you. And then just a second question, you sort of guided down expectations for the year after the first quarter earnings call. It sounded like you took a lot of the macro recovery out of your outlook by that time, and now you're guiding it down again here 3 months later. So I guess my question is, what didn't happen? Or what did happen that you didn't expect in terms of why the guidance was lowered for the second time this year? And how did you -- did you feel that you've taken enough air out of the expectations balloon now to where you're going forward if some of these things you talk about happens, there is going to be some momentum building into 2020 on the demand side, not just on optimization cost savings side?

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Peter T. Thomas, Ferro Corporation - Chairman, President & CEO [42]

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Yes. Unfortunately, I guess, maybe I wasn't clear enough earlier. I provided some more color around that situation. Again, with the company our size, and 6,700 customers around the world and 21,000 SKUs and 80% of our business is driven by a very needed information matrix from our top 700 customers, that's part of the problem. It's our customers, candidly their inability to provide us with the accuracy of their forecasting as their businesses were declining and they had a lot of inventory and like I said, it just took us -- it's taking us a while to get to where we feel that we're more comfortable. Again, a lot of this is driven by the demand from the markets.

And that's just an explanation. And it's been challenging for our business of our scale. It's very hard to what to cite unfortunately because of our scale. The shock absorber benefit that we put in that we thought -- if you go back, Dmitry, I know we've had discussions. We -- in fact, you were sitting here in our office, and we mentioned to you that we thought '18 and '19 were going to be soft. And that in order to catch the knife by the handle that we were going to go ahead and pull the trigger in our $30 million initiative because we thought that the $30 million benefit would be enough of a shock absorber. And of course, you see what's happened. It's helpful, but it's also now what we're seeing not enough, and that's why we are pulling the $40 million program.

But again, as time goes on, we -- our forecast accuracy with our customer gets better, because of the thinning out of the inventory.

Now to your point, that's the big question. What would the fourth quarter be? Is the fourth quarter is going to be, I think everyone hopes that this year isn't going to be like last year, and I don't think there a lot of people that really feel that way, I know our customers don't, but we have to err on the side of caution. But what I will tell you is that we do see that it will continue to thin in what we would define as being a very orderly and incremental way, nothing that's really drastic, which lend yourself to what now happens in the first quarter of 2020.

So even though we might think and I -- we all feel this way here at Ferro that 2020 for all the macro reasons you're hearing out there, whether it's we are saying that nothing is going to happen with tariffs with China for 12 months for whatever political reasons, we still feel all that negative whatever it is that's surrounding is going to put a damper on all of our markets segments. But it doesn't mean that if going into the first quarter, there might be, to your point, kind of a pushing the gas pedals of the floor here to ramp up to make sure that the right inventory is in place. And I would suspect that you might even see us

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Unidentified Analyst, [43]

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What's causing this prolonged weakness in the tile coatings business. It seems like there is more to it than just construction-related weakness or just uncertainty. I'm very curious in particular if tile -- particularly high-end tile is starting to see competition from other materials maybe a shift back toward natural materials or any kind of a shift to consumer preferences. I know that LVT is out there in certain applications where you can -- it would compete with the tile. Can you maybe just address some of those core reasons why we're seeing this weakness for so long?

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Peter T. Thomas, Ferro Corporation - Chairman, President & CEO [44]

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Yes. What I would say, Mike, don't get too heavy on it. The bottom line is that everything that you are seeing from a macroeconomic perspective, there's nothing underlying. But we are gaining market share. Our customers had a lot of inventory. We're tracking the decrease in demand quite candidly. When you look at the rate of decrease, like I mentioned, our tile business is actually outperforming the market, which is growing at 0% to 1%. You would find that, that that drain leading into what's going on in the second half of the year, may lead that our tile business actually growing at about 3%, 3.5%. That's one to mention.

As it relates to taking away from the high end, I think, you may want to remind yourself with our Tile business is. It's a Tile Coating Solutions business. It's not our tile business. So we're all about the design and the content that goes on the tiles.

So think of it this way, you mentioned LVT. That's a wonderful product. We really like that. We've done some work on it, we understand it. It has some very good benefits. The biggest benefit of LVT, although I will qualify this by saying it's not impacting us and I'll get into that, but I do want to put a commercial for LVT. It's a very -- we like flooring, we like design, that's a product category for a single application. And what we see in that particular product is a much better design characteristics than the low market tile or even a low end of the mid-market because you get good design characteristics. And the fact that it's cheaper to install is really the driver behind why would knock off the low end as well as some of the lower or mid-cut of the business. But as it relates to the high end, we're not seeing any of that penetration as a product category on 1 application.

Reasons being is that you know the cost of installing tile is very expensive versus blow and go with vinyl tile. It's very easy to do it when you're mass marketing town homes or whatever the case is. It's just so much easier to deal with. But when you really drill in to the details of the functionality, which we -- the ceramic industry is on, the color, depth and the topography of the design and the durability and the resistance to a lot of different elements, it just isn't as good, but it's certainly a beautiful product, and I think it has its place.

So Mike, and other thing too, and I know you know this, you can't look at us as just the flooring business. One of the beautiful things about what we've done with the tile business, again, LVT product category 1 application. So if you look at our tile business as you watched it over the past 5 years, it has other optionality. I mean do you think -- let me put it to you this way, do you think you can put LVT on the outside of a house? Would you put LVT on the outside of a commercial building? Would you put LVT as a countertop? Would you have LVT as a dining room table design? Do you see big 5-foot by 6-foot, 6-foot by 9-foot blocks and rectangles of LVT being used for a plethora of construction activities? The answer is not really.

So what we're getting at -- look us not as a -- just a product category for a flooring, we are a design coating solutions company covering a plethora of applications. So in a big scheme of things, that's the reason why we've been growing faster in the market over the past 4 years and why that 1 little piece of a product category for 1 application really a big scheme of things, we don't view it as a problem, although we do like that product, really.

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Unidentified Analyst, [45]

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All right. And then I wanted to move over to the Color Solutions business. I was wondering if you can talk about the additional ultramarine capacity that you put in place in Columbia? Have we started to see that benefit in Q2 results? And maybe how much of that additional capacity is still [they're spoken] for at this point?

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Peter T. Thomas, Ferro Corporation - Chairman, President & CEO [46]

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Yes. I think we mentioned last quarter, yes, we are up and running. There is still good global demand for Ultramarine, but as I mentioned in the last quarter, the automotive applications are slowing Ultramarine blue, and I think you may be aware or maybe you're not, but I'll mention it. The ultramarine blue product is a very special product for us and everybody else who makes it. It has wonderful benefits in terms of design characteristics and the certain use and shadowing that it delivers both on the -- mostly on the exterior, but do you know that ultramarine blue is a very critical pigment in black interiors as well as blue tiles. And I don't know if you've noticed, last time we were talking about the automotive applications, particularly around the exterior paints. But now, a lot of interiors are moving away strangely enough from the black and the dark blues and the blue hues. If you look at cars that are being produced, you'll find that interiors are becoming -- moving away from darker colors and more to things that seem to be a little brighter or a little more natural or kind of brighter and generally more of a feel-good interior, kind of a space. We are saying that we are hearing that from customers. That's what the consumers want. They want a brighter interior and they like lighter colors right now. It makes them feel better, and I think that you're seeing a little bit of a sluggishness for us and everybody else in ultramarine blue.

However, because the demand is tight, we're not doing too badly with it, but we do feel that over the next 6 months that we'll see a pickup in the business. Because our overall pigments business is actually picking up and stabilize around the world. We feel really good about it and we just see ultramarine being part of that. And we are going to be in a really good position to take advantage with the capacity we have and maintain our 3:1 relative market share versus our nearest competitor.

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Kevin Cornelius Grant, Ferro Corporation - Head of IR [47]

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We would like to thank you, everyone, for joining us on the call today. We appreciate your interest in Ferro, and we look forward to discussing our results with you, again, next quarter. And enjoy the rest of your day.

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Operator [48]

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That does conclude the conference call. We thank you for your participation and ask that you please disconnect your line.