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Edited Transcript of KRA earnings conference call or presentation 26-Jul-18 1:00pm GMT

Q2 2018 Kraton Corp Earnings Call

HOUSTON Jul 26, 2018 (Thomson StreetEvents) -- Edited Transcript of Kraton Corp earnings conference call or presentation Thursday, July 26, 2018 at 1:00:00pm GMT

TEXT version of Transcript

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Corporate Participants

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* H. Gene Shiels

Kraton Corporation - Director of IR

* Kevin M. Fogarty

Kraton Corporation - President, CEO & Director

* Stephen E. Tremblay

Kraton Corporation - Executive VP & CFO

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Conference Call Participants

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* James Michael Sheehan

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

* Joshua David Spector

UBS Investment Bank, Research Division - Equity Research Associate - Chemicals

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Presentation

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Operator [1]

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Good morning, and welcome to the Kraton Corporation Second Quarter 2018 Earnings Conference Call. My name is Jesse, J-E-S-S-E, and I will be your conference facilitator. (Operator Instructions) Today's conference is being recorded. If you have any objections, you may disconnect at this time. I will now turn the call over to Mr. Gene Shiels, Director of Investor Relations. You may now begin.

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H. Gene Shiels, Kraton Corporation - Director of IR [2]

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Thank you, Jesse. Good morning and welcome to the Kraton Corporation Second Quarter 2018 Earnings Call. With me on the call this morning are: Kevin Fogarty, Kraton's President and Chief Executive Officer; and Steve Tremblay, Kraton's Executive Vice President and Chief Financial Officer. A copy of our news release covering second quarter results as well as the related presentation material we will review this morning are available in the Investor Relations section of our website.

Before turning to the second quarter results, I'll draw your attention to the disclaimers on forward-looking information and the use of non-GAAP measures included in our presentation this morning and in yesterday's earnings press release. Our business outlook is subject to a number of risk factors. As the format of this morning's presentation does not permit the full discussion of these risk factors, please refer to our Forms 10-K, 10-Q, and other regulatory filings available in the Investor Relations section of our website.

Regarding the use of non-GAAP financial measures, the reconciliation of each used non-GAAP financial measure to its most comparable GAAP financial measure was provided in yesterday's earnings release and included in this morning's presentation.

Lastly, a reminder that, effective January 1, 2018, results for the former roads and construction product line under our Chemical segment have been consolidated into adhesive in Performance Chemicals product lines. Results for the second quarter of 2017 have been restated to conform to the new reporting structure.

As is our usual practice, following our prepared remarks, we'll open the line for your questions. I'll now turn the call over to Kevin Fogarty. Kevin.

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Kevin M. Fogarty, Kraton Corporation - President, CEO & Director [3]

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Thank you, Gene, and good morning, everyone. As we anticipated, our second quarter results reflect improved margins and core profitability in both our Polymer and our Chemical segments.

Unit margin increases along with healthy demand fundamentals and favorable mix were all significant contributors to second quarter 2018 adjusted EBITDA of $105.6 million, which was up $4.1 million or 4.1% compared to the $101.5 million we reported for the second quarter of 2017.

The strong second quarter performance in combination with the results for the first quarter of the year have driven growth in the first half of 2018 adjusted EBITDA to $194.2 million. This is up $27.2 million or 16.3% compared to first half of 2017.

Second quarter 2018 results for our Polymer segment were particularly notable with adjusted EBITDA of $68.7 million, up over 9% compared to second quarter of 2017. For the Polymer segment, this is the highest second quarter adjusted EBITDA posting in our history. These results were driven by increased sales of high-value products in our Cariflex and Specialty Polymers businesses, with Cariflex volume up nearly 7% and Specialty Polymers volume up nearly 8% compared to the second quarter of 2017, while Performance Products volume was down 5.8% compared to the second quarter of last year. The lower sales volume was relative to a very strong SBS volume in last year's second quarter.

Moreover, in this year's second quarter, our margins expanded, as we elected to pass on certain volume sales with a less-than-acceptable price in margin profile.

All said, the segment's adjusted EBITDA margin was an impressive 20.3% in the second quarter, despite pressure associated with increasing raw material cost in the quarter, particularly from butadiene as well as inflation and transportation and logistical costs, further evidence of our ongoing commitment to price discipline consistent with our Price Right Strategy. Our Chemical segment also saw improved margins in the second quarter, in part reflecting the benefit of price increases announced earlier in this year.

Margin expansion and improvements in core profitability were primarily driven by higher pricing for TOFA and TOFA derivatives as well as sales of other high-value derivative products in both our Performance Chemicals business and in our tire business, where second quarter 2018 results also benefited from improved sales mix and price increases.

Adjusted EBITDA for the Chemical segment was $36.9 million in the second quarter of 2018, and while this was down $1.7 million compared to the second quarter of last year, the decrease was due to plant maintenance costs of $4.8 million in the quarter. Even with the impact of these maintenance costs, Chemical segment adjusted EBITDA for the first half of 2018 was up nearly 12% compared to the first half of 2017. Our Chemical segment results have continued to improve, as we have moved beyond the first quarter of 2017, which we continue to believe was the trough in both pricing and margins for the segment.

Overall, we are pleased with the incremental improvement in core margins we achieved in the second quarter as we continue to focus on realizing the full potential of our Chemical business.

Since the acquisition of our Chemical segment, we have worked to also optimize our capital structure through a series of transactions to lower our overall cost of debt. A key highlight for the quarter was the successful refinancing of our 10.5% Senior Notes. The refinancing is expected to reduce annual cash interest expense by $24 million, enhancing our cash flow profile, facilitating further reduction in outstanding net debt and consolidated leverage.

With those opening remarks, I'll turn the call over to our Chief Financial Officer, Steve Tremblay, for more details. Steve?

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Stephen E. Tremblay, Kraton Corporation - Executive VP & CFO [4]

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Thank you, Kevin, and good morning, everyone. On Slide 5, our Polymer segment had a very good second quarter with adjusted EBITDA, $68.7 million and an associated adjusted EBITDA margin of 20.3%. These exceeded the second quarter of 2017 by 9.4% and 160 basis points, respectively.

Historically, we have recovered increases in raw material cost through selling price increases, and our second quarter results continue to demonstrate this ability. In fact, at the bottom of the graph, we illustrate this point.

During the quarter, selling price increases were implemented such that unit margins, as evidenced by the blue line, have been preserved despite these raw material headwinds. This is consistent with our historical business model and our proven Price Right Strategy.

In addition, we delivered volume growth in Specialty Polymers and Cariflex, which richens the overall sales mix and, therefore, improves overall segment margins.

In Performance Products, our Price Right Strategy led to increased core unit margins, albeit on lower overall sales volumes.

As a result of all of this, our adjusted gross profit per ton was $1,117 per ton in the second quarter 2018, which exceeded the second quarter 2017 by $105 per ton.

Now turning to the Polymer segment cost-reset initiative. I'm happy to report that we continue to

make progress, delivering another $3.5 million of benefit in Q2. And this results in $7 million of incremental savings through the first half of 2018. We also continue to expect that a significant portion of the overall $70 million cost-reset benefit will be achieved by the end of 2018.

For the first half of the year, adjusted EBITDA of $113.5 million represents growth of $18.6 million or 19.6% compared to the first half of 2017. The increase reflects higher unit margins across the portfolio and the effect of a more favorable sales mix as indicated by volume growth in both Specialty Polymers and Cariflex.

Moving now to our Chemical segment on Slide 6, sales volume of 111 kilotons was up 9.1% compared to the second quarter 2017, largely driven by a 16.8% volume increase in the Performance Chemicals end use, which was partially offset by a modest decline in adhesive volumes.

In the second quarter, turnaround cost amounting to $4.8 million had a negative effect on overall segment adjusted EBITDA. But this was largely offset by the improved unit margins in both Performance Chemicals and tires. Adjusting for these turnaround costs, second quarter adjusted EBITDA would have been $41.7 million or nearly 22% of revenue.

Looking at the year-to-date performance, the 2018 results represents a significant improvement in adjusted EBITDA in the Chemical segment. First half 2018 adjusted EBITDA was $80.8 million compared to $72.2 million through the first 6 months of 2017.

More than offsetting the high turnaround costs were increases in unit margins, primarily for TOFA and derivative upgrade products as well as higher margins in our differentiated tire business.

As Kevin mentioned, since Q1 2017, core unit margins continue to improve in the Chemical segment taken as a whole.

Second quarter and first half consolidated results are reflected on Slide 7. On a consolidated basis, adjusted EBITDA in the second quarter of 2018 amounted to $105.6 million or 19.6% of revenue compared to $101.5 million or 19.3% of revenue in the second quarter of 2017.

First half adjusted EBITDA came in at $194.2 million with an adjusted EBITDA margin of 18.7%. These represent healthy improvements against 2017's first half of 16.3% in terms of EBITDA and 170 basis points in terms of adjusted EBITDA margin.

Similarly, adjusted EPS improved 7.3% in the second quarter and more than 116% in the first half of the year.

I will note that our second quarter adjusted EPS of $0.88 per share included a slightly higher effective tax rate than we originally anticipated, which amounted to approximately $0.12 per share, or in terms of net income, about $4 million. This was due to some discrete items and the mix of our overall global earnings.

Having said that, on a year-to-date basis, the effective tax rate used to determine adjusted EPS was in line with our continued full year guidance of 20% to 25%.

Slide 8 illustrates the additional steps we

completed in the second quarter to lower our cost of capital. We repaid the most expensive tranche of the acquisition-related indebtedness by taking out the 10.5% Senior Notes in favor of a new tranche of 5.25% Senior Notes and using some borrowings under existing lower-cost facilities. The transaction is expected to reduce cash interest expense by $24 million on an annual basis. This was a well-executed transaction. And when coupled with the other initiatives we have taken since the closing of the Arizona transaction, results in a reduction in cash interest expense from $135 million per year as of the closing to $78 million per year as of June 30, 2018, pro forma for this recent transaction. This represents a 32% reduction in the cost of our overall indebtedness.

In addition to lowering the cost of capital, we believe the new ratio of secured and unsecured debt as well as the geographic mix of euro -- of U.S. versus non-U. S. debt provides a flexible, well balance of debt capital structure.

Moving to Slide 9, consolidated net debt amounted to $1.6 billion at June 30, 2018. We provided a bridge from the consolidated net debt at December 31, 2017, to this level of indebtedness at June 30. You can see here the effect of the refinancing cost of $53 million increased net debt from December 31, 2017, which is partially offset by changes in foreign exchange rates associated with the euro and Taiwan borrowings, the latter at our consolidated JV.

Consistent with prior years, I will note that cash flow was generally low in the first half of the year due to seasonality, and it accelerates in the second half of the year.

So excluding the effects of currency on our offshore indebtedness, we continue to expect consolidated net debt to decline by $75 million to $100 million for the full year 2018. This, of course, includes the fees incurred from the second quarter of refinancing, which had the effect of increasing indebtedness by $53 million.

Other than the impact of the fees, our overall cash flow expectation for 2018 is therefore unchanged from prior estimates.

As a result of our EBITDA growth and continued delevering, we expect our consolidated net debt leverage ratio to decline from 4.1 turns at June 30 to less than 4 turns at 2018.

This marks a significant milestone when we compare the 5.4 turns of leverage at the time of the closing of the Arizona transaction.

Finally, with respect to the refinancing, we also effectively pushed out maturities of the non-JV debt, such that the first meaningful debt paydown will not be until 2025.

Before I turn the call back over to Kevin, remind you that the appendix includes modeling assumptions. This most significant change is a lower interest rate assumption as a result of the financing. It's a lower interest expense assumption as well (technical difficulty) cash interest for the year. Kevin?

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Kevin M. Fogarty, Kraton Corporation - President, CEO & Director [5]

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Thanks, Steve. You just heard our consolidated results for the first half of the year reflect margin expansion and good fundamental demand across the majority of the end markets we serve. Compared to the first half of 2017, adjusted EBITDA was up over 16%. We have improved our adjusted EBITDA margin by 170 basis points to 18.7%.

And our Polymer segment, the improved mix and margin expansion in the first half of 2018 provides favorable momentum going into the second half of the year.

We expect price moves for raw materials, such as butadiene, to be rather benign in the second half of the year, and an environment that should provide for relative margin stability.

That being said, I would like to point out, however, last year, raw material price trends and market dynamics contributed to a particularly robust third quarter with respect to paving volumes and margins that are not likely to reoccur in the third quarter of this year.

Nonetheless, demand fundamentals remain good across the wide range of our polymer end-use markets. And while our second quarter paving volume was down relative to the very strong second quarter of 2017, first half 2018 paving volume was up 2% compared to the first half of last year.

Based upon current activity, the third quarter should shape up to be another solid quarter of paving demand for our performance Polymers business.

In our ongoing focus on innovation and differentiation, the unique product offering of our Specialty Polymers business has continued to demonstrate solid volume trends. The sales volume up 7.8% in the second quarter of 2018, following volume growth of 5.7% in the first quarter of 2018 and 6.8% in the fourth quarter of 2017.

This volume growth has been driven by sales into specialty applications such as oilfield, medical packaging, personal care products, lubricant additives and cable gels.

In many cases, these sales are associated with unique polymers developed by Kraton to meet specific customer needs, supporting key mega trends in the marketplace. Volume trends in margin profile for these differential offerings highlight the value of our innovation and application development programs.

Over the past year, we have also further refined our research and development approach directing resources towards polymer and application development opportunities that we believe have the potential for rapid commercialization and favorable market growth. These efforts have resulted in tangible successes, and I believe, our current pipeline of R&D projects is the best I've seen in several years.

Looking at our Chemical segment, we have continued to see incremental improvement in core margins as we move beyond the early 2017 trough. As noted earlier, our Chemical segment adjusted EBITDA was down slightly in the second quarter versus the second quarter of '17. This was due to the impact of plant maintenance cost of nearly $5 million in the quarter. As evident in the 12% increase in first half 2018 adjusted EBITDA for the segment, we have seen good demand and improved pricing for TOFA and TOFA derivatives and other derivatized products. These derivatized products, many from the crude sulfide turpentine chain, are contributing to growth and margin enhancement through our differentiated offerings such as those in our tires business.

Furthermore, price increases announced earlier this year have contributed to margin improvement in the TOFA chain and demand has been favorable, driven by factors, such as healthy activity levels in oilfield markets.

Thus far in 2018, margin recovery for tall oil rosin and rosin esters has been more muted, the price increases serving largely to offset increases in raw material costs.

With regard to our Chemical segment innovation programs, we are very pleased with the progress we have made in building an innovation pipeline since we acquired the business. Many of these innovation opportunities are presented by tapping into cross-developmental potential for our Chemical and Polymer technologies. For example, through unique combination of our rosin esters and our polymer technology, we have developed a system for road-marking applications, resulting in a high-performance durable road-marking compound at a lower total system cost. We are pursuing further opportunities to innovate in the road-marking space utilizing our innovations from our Polymer segment.

In our adhesive business, we continue to see growth opportunities for rosin ester formulations with improved color and reduced color -- excuse me, with improved color and reduced order. One such example is SYLVALITE 9000, which was introduced in the market in early 2017. While SYLVALITE 9000 is increasingly being embraced by customers, our innovation teams continue working to achieve further step changes in color and order characteristics. In addition to the price and performance benefits of these improved products, they are based upon renewable resources, which is important to Kraton and to our customers, given the increased focus on and appreciation for sustainability in today's world.

We truly believe in the value-creation opportunities that exist in developing and providing high-performing, environmentally-sensitive products.

I'll note that we have recently published our second annual sustainability report, and hope you will take a moment to read the report to learn more about our commitment to sustainability at Kraton.

A few comments now about strategic execution. In the first half of 2018, we have started to leverage key projects intended to optimize the global manufacturing footprint in our Polymer segment, specifically the new HSBC expansion in Mailiao, Taiwan, our direct connect production process in Paulinia, Brazil, for our Cariflex business, and our USBC expansion in Berre, France.

In the second quarter, production volumes in Mailiao continue to ramp and was net income positive through June 30, 2018.

We are nearing plant production capacity in Paulinia and are therefore expecting incremental contributions from the benefits of the direct connect production going forward. With the completion of these key components of our $70 million cost-reduction plan for the Polymer segment and having delivered the $65 million of synergies associated with the acquisition of our Chemical segment, we are now positioned to unlock additional value through cash flow expansion and innovation-led organic growth. And as mentioned, the recent and successful refinancing of our 10.5% notes and the associated interest savings will contribute further to our cash flow profile improvement.

For the near term, our focus remains on debt reduction. And while our expectations for reduction in consolidated leverage in 2018 have been modestly revised due to the cost associated with the refinancing of those 10.5% notes, we still anticipate ending 2018 with a consolidated net leverage ratio of less than 4 turns. And with the normalized cash flow expansion we expect for next year, we plan to achieve our leverage target of less than 3 turns in 2019.

So to close, as we move into the second half of the year, our Polymer segment is coming off a record second quarter, and we continue to see good margin progression in our Chemical segment. Our results for the first half of 2018 were very much in line with our expectations. And better than our expectations for the second half of 2018 is continuation of these favorable dynamics and good overall operating performance.

With those comments, we'd be happy now to open the call up to take some questions.

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Questions and Answers

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Operator [1]

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(Operator Instructions) First question on the line is from Jim Sheehan from SunTrust.

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James Michael Sheehan, SunTrust Robinson Humphrey, Inc., Research Division - Research Analyst [2]

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Could you comment on your TOFA price increases? What are prices up year-over-year in TOFA?

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Kevin M. Fogarty, Kraton Corporation - President, CEO & Director [3]

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Well, I mean, so if we look at the price increase initiatives that we are -- put in place at the beginning of the year from a TOFA perspective and the TOFA related derivative products, I mean, we saw good success in implementation of those price increases reflecting, as you know, very healthy favorable market conditions. Overall, I'd say the prices are up in the 5% to 6% range relative to last year, but nevertheless, we'll continue to monitor the marketplace to see if the market continues to improve and warrants further increases.

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James Michael Sheehan, SunTrust Robinson Humphrey, Inc., Research Division - Research Analyst [4]

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Great. And on the new product innovation, can you give us some color on how much you expect new products to be contributing to top line growth over the next couple of years?

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Kevin M. Fogarty, Kraton Corporation - President, CEO & Director [5]

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So we are relentless in our focus on measuring just exactly that, Jim, which is how much of our revenue is derived from innovation products, and we have set targets for ourselves that at least 20% of our revenue should be able to be achieved by true innovation. When I mean true innovation, I mean that which is commercialized in the last 5 years. Of course, this is a moving trend because you have materials to come off and go on, so it can be a little choppy year to year, but as we measure it versus a trend line, there's no reason why we can't achieve that relative goal in a relatively short period of time.

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James Michael Sheehan, SunTrust Robinson Humphrey, Inc., Research Division - Research Analyst [6]

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Terrific. And on your Slide 5 chart, regarding the sensitivity to butadiene prices, it seems like your SBC margins per ton have become fairly resilient to changes in butadiene. How have you achieved that improved margin stability over time?

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Kevin M. Fogarty, Kraton Corporation - President, CEO & Director [7]

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So resilient infers that it just happens and I can assure you, Jim, that's not the case. But they have reflected the fact that we, through our Price Right Strategies, are very predictable in terms of our behavior in the marketplace with respect to passing those cost increases through. That's part of the Price Right Strategy. We always like to say that we expect our customers to predict their behavior just as quick as we do. It's just very important to recognize that in -- what has been historically from time to time, a kind of a volatile butadiene pricing market that we have to be very timely and disciplined in the way in which we pass those raw material costs through.

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Operator [8]

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Next question is from Josh Spector of UBS.

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Joshua David Spector, UBS Investment Bank, Research Division - Equity Research Associate - Chemicals [9]

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Just a question on Chemicals and pricing within there. Again, so if I look year-on-year, I guess, I expected that pricing will potentially be up, given higher energy prices and given some of the volume growth on the Chemical side, maybe it's a mix within performance. But I'm curious if there's anything else going on that we should be watching when we're trying to model the top line there?

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Kevin M. Fogarty, Kraton Corporation - President, CEO & Director [10]

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Well, I mean, there's clearly always a mix issue and pretty much everything we do at Kraton, and so that can happen from quarter-to-quarter as you look at the TOFA and TOFA derivatives. And so when we measure price increases, obviously, it has to be like apples-to-apples across the same grades. And I can assure you that in the case of our TOFA and TOFA related products, the price increases are going through. But from time to time, there is a mix issue in the quarter. And so that's why we're more focused on the overall margin profile than we are just a pricing profile.

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Joshua David Spector, UBS Investment Bank, Research Division - Equity Research Associate - Chemicals [11]

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Okay, makes sense. I guess, what I'm trying to understand is so where would pricing have been down? So I've pricing down around like 7%. TOFA, I understand C5, C9 rosins. I guess, I think pricing will be up a little bit. What area is down? Or is it just much greater mix of a lower priced product?

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Kevin M. Fogarty, Kraton Corporation - President, CEO & Director [12]

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Yes, I think it's clearly -- we're not seeing any negative momentum in terms of pricing these days. We managed, both in our Polymer business and in our Chemical business, to use, from time to time, volume as a means to make sure that our price increases are solid and secure. And then if I think about it in the context of your specific question about which products perhaps -- we sell different -- we sell a variety of different markets in the TOFA end-use segment. And some of those markets clearly are at lower price points, and therefore, margin profiles than other markets. We like to grow in the higher value-added markets clearly, but from time to time, as I just mentioned, we'll use volume to move material into some lower market and that lower market margin segments and that can reflect in the overall, therefore, weighted average profile of the business.

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Operator [13]

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Next question is from the line of Christopher Kapsch from Loop Capital Markets.

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Unidentified Analyst, [14]

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This is Ryan filling in for Chris. So in pine chemicals, has there been any noticeable change of competitive behavior on behalf of your key rivals in the space since the closing of Ingevity's acquisition of Georgia-Pacific? And separately, is the competitive dynamic benefiting you at all from petrochemical-derived inflation for non-pine based alternatives for the markets you address?

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Kevin M. Fogarty, Kraton Corporation - President, CEO & Director [15]

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So, it's -- look I'm not going to answer that first question, because that's -- well, I mean, I could go on and on and on about the competitive dynamics in all our markets and it probably wouldn't be appropriate for this time. But in terms of your second question, clearly, we've been watching very closely as crude oil continues to rise, how that's affected particularly our adhesive business, the alternative materials, the hydrocarbons that you reference. And so far, it's apparent to us that there hasn't been a significant step improvement in overall hydrocarbon values that we price against in the marketplace. That being said, of course, with the rising crude oil price in and itself, we're not seeing any erosion per se because it -- that provides for a higher floor through which people are pricing off of, but what has been a historical fairly consistent relationship between higher crude oil prices and, therefore, higher hydrocarbon values still hasn't manifested itself in the marketplace.

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Unidentified Analyst, [16]

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Great. And then my next -- my other question is that in your Polymer segment focusing on really impressive profitability in terms of gross profit per ton, we're curious about how much of that outperformance is from a favorable mix versus a favorable variance of pricing over ECRC-based raw material costs? And to the extent mix as a contributor is it more seasonal, structural in nature?

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Kevin M. Fogarty, Kraton Corporation - President, CEO & Director [17]

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Well, compared to the 2 things you mentioned, there's an element -- a little bit of element of both. But generally speaking, we're not seeing dramatic changes in shift in terms of the actual product mix. Where we do see shift change is in terms of the relative amount of innovation materials that we're offering. And therefore, by virtue of the fact that those are differentiated sales, they do carry with them a higher margin profile just naturally. That's what you would expect and that's exactly what happens. So that can affect mix, but in terms of the overall makeup of the marketplace, we're pretty consistent in terms of the types of markets we serve, particularly in our Polymer business.

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Operator [18]

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(Operator Instructions) Speakers, no questions at this time. Mr. Shiels, you may proceed.

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H. Gene Shiels, Kraton Corporation - Director of IR [19]

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Thank you, Jesse. Well, we want to thank all of our participants this morning for their interest in Kraton. There will be a replay of this call available later on this morning. To access that replay, you may dial (800) 551-8152. With that, we'll conclude our call. Thank you.

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Operator [20]

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Thank you, Mr. Shiels. This concludes the Kraton Corporation Second Quarter 2018 Earnings Conference Call. You may now disconnect.