U.S. Markets closed

Edited Transcript of KRA earnings conference call or presentation 25-Jul-19 1:00pm GMT

Q2 2019 Kraton Corp Earnings Call

HOUSTON Aug 8, 2019 (Thomson StreetEvents) -- Edited Transcript of Kraton Corp earnings conference call or presentation Thursday, July 25, 2019 at 1:00:00pm GMT

TEXT version of Transcript

================================================================================

Corporate Participants

================================================================================

* Atanas H. Atanasov

Kraton Corporation - Senior VP & CFO

* H. Gene Shiels

Kraton Corporation - Director of IR

* Kevin M. Fogarty

Kraton Corporation - President, CEO & Director

================================================================================

Conference Call Participants

================================================================================

* Alex Zani

* James Michael Sheehan

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

* John Ezekiel E. Roberts

UBS Investment Bank, Research Division - Executive Director and Equity Research Analyst, Chemicals

* Joshua David Spector

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

* Michael Joseph Sison

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

* Roger Neil Spitz

BofA Merrill Lynch, Research Division - Director and High Yield Research Analyst

================================================================================

Presentation

--------------------------------------------------------------------------------

Operator [1]

--------------------------------------------------------------------------------

Good morning and welcome to the Kraton Corporation's Second Quarter 2019 Earnings Conference Call. My name is Joseph, 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. Please go ahead.

--------------------------------------------------------------------------------

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

--------------------------------------------------------------------------------

Thank you, Joseph. Good morning, and welcome to the Kraton Corporation Second Quarter 2019 Earnings Call. With me on the call this morning are Kevin Fogarty, Kraton's President and Chief Executive Officer; and Atanas Atanasov, Kraton's Senior Vice President and Chief Financial Officer. A copy of our second quarter's news release as well as the related presentation material we will review this morning, is available in the Investor Relations section of our website.

Before we review our results for the second quarter, I'll draw your attention to the disclaimers on forward-looking information and the use of non-GAAP measures included in our presentation and in yesterday's earnings press release.

During the call, we may make certain comments that are not statements of historical fact and thus constitute forward-looking statements. Investors are cautioned that there are risks, uncertainties and other factors that may cause Kraton's actual performance to be significantly different from the expectations stated or implied by any forward-looking statements we make today. Our forward-looking statements speak only as of the date they are made, and we have an obligation to update such statements in the future. Our business outlook is subject to a number of risk factors. As the format of this morning's presentation does not permit a 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. With regard to the use of non-GAAP financial measures, a reconciliation of each used non-GAAP financial measure to its most comparable GAAP financial measure was provided in our earnings release and is included in this morning's presentation material. Following our prepared comments, we'll open the line for your questions.

I'll now turn the call over to Kevin Fogarty. Kevin?

--------------------------------------------------------------------------------

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

--------------------------------------------------------------------------------

Thanks, Gene. And good morning, everybody. Now given the current economic environment, we are generally pleased with our performance in the second quarter. Kraton's results for the quarter of 2019 reflect stable margins with the exception of lower -- and with the exception of lower-than-expected paving and roofing activity associated with adverse weather in both North America and Europe. Overall demand fundamentals were consistent with our internal expectations.

Consolidated adjusted EBITDA for the second quarter of 2019 was $102 million, and this was down just 3% compared to the second quarter of 2018, again principally due to the impact of lower paving and roofing sales in our Polymer segment.

Our adjusted EBITDA margin improved to 20.6%, up from 19.6% in the second quarter of 2018, reflecting improved profitability in our Chemical segment.

Now specifically looking at our Polymer segment results, the second quarter of 2019 was another strong quarter for our Cariflex business, with sales up 10%. While softer demand in China and broader Asia continues to impact sales of specialty HSBC product grades, sales volumes for Specialty Polymers was up 2% compared to the second quarter of 2018. Atanas will provide some further context with respect to the previously discussed lubricant additives headwind in 2019.

The adverse impact of weather on paving and roofing sales on our Performance Products business was the primary driver of the decline in Polymer segment adjusted EBITDA for just the second quarter of last year. As a result, Polymer segment adjusted EBITDA in the second quarter was $60 million, down 12.4% compared to the second quarter of last year. Despite this poor start to the paving and roofing season, price and cost discipline contribute to -- contributed to stability and segment profitability, resulting in the second quarter adjusted EBIDTA margin of 20.2%.

Turning to our Chemical segment, second quarter 2019 results reflect improved profitability compared to the second quarter of 2018.

Adjusted EBIDTA for the segment was $42 million, up 13% compared to the second quarter of 2018, reflecting a 280 basis point increase in adjusted EBITDA margin to 21.2%.

Although sales volume was lower than the second quarter of 2018 in part due to constrained availability of CTO, growth and adjusted EBITDA was driven primarily by higher margins for upgraded product streams and improved operational metrics, including lower fixed cost and cost for planned maintenance.

During the second quarter, we continued a balanced approach to capital allocation. And while the majority of our cash generation is typically in the second half of the year, during the second quarter, we reduced consolidated net debt by $33.6 million.

In addition, we repurchased an aggregate $5 million of shares under our share repurchase authorization during the quarter.

Having covered the second quarter highlights, I'll now turn the call over to Atanas for a more in-depth financial review of the second quarter results. Atanas?

--------------------------------------------------------------------------------

Atanas H. Atanasov, Kraton Corporation - Senior VP & CFO [4]

--------------------------------------------------------------------------------

Thank you, Kevin, and good morning. I'll begin my comments on Slide 5 with a review of the second quarter and year-to-date results for the Polymer segment. Second quarter 2019 revenue for the Polymer segment was $297.9 million, and this was down $40.3 million or 11.9% compared to the second quarter of 2018. The decrease in revenue reflects lower sales volume, and to a lesser extent, lower average selling prices associated with lower average raw material costs.

During the second quarter, we saw strong year-over-year growth for Cariflex as sales volume was up 10.1%, driven by higher sales into surgical glove applications. Relative to the second quarter of 2018, we had higher utilization of the direct connect capacity in Brazil, which is a positive for the Cariflex margins. Despite weaker market demand in China and broader Asia, sales volume in our Specialty Polymers business was up 1.9% compared to Q2 '18, principally due to higher sales into lubricant additive applications versus the second quarter of 2018, partially offset by weaker sales in China and broader Asia.

As we have previously discussed, in 2019, we expect an inventory reduction initiative by a major lubricant additive customer to impact full year consolidated adjusted EBITDA by approximately $17 million. While lower lubricant additives sales was a factor in the first quarter of 2019 results for Specialty Polymers, volume was up in the second quarter of 2019 versus second quarter of 2018.

We anticipate the full year adjusted EBITDA impact will be more of a headwind in the second half of 2019, given the relative sales in the third and fourth quarter of last year.

Demand in Asia remains weak, mainly driven by the economic downturn in China. In general, second quarter demand fundamentals in China were consistent with what we experienced in the first quarter, reflecting a slowdown in consumer demand and conservative posturing on behalf of customers.

The slowdown in China also impacts demand in Japan, Taiwan and South Korea. This slowdown in Chinese demand principally impacts HSBC specialty product grades. They are used in a wide range of end-use applications, including consumer durables, cable gels, wire and cable, automotive, medical and protective films.

As Kevin noted in his opening remarks, in our Performance Products business, wet weather prevailed for most of the second quarter in both North America and Europe. This unfortunately resulted in a slow start to the paving and roofing season and accounts very significant portion of the 13.9% reduction in sales volume for Performance Products. The lower sales volume in Performance Products more than offset growth in Cariflex and Specialty Polymers, and as a result, second quarter 2019 adjusted EBITDA for the Polymer segment was $60.2 million, down $8.5 million or 12.4% compared to second quarter 2018.

However, given the continued implementation of our price right strategy and solid operational performance, the adjusted EBIDTA margin for the quarter was 20.2%, reflecting margin instability in the current environment, which is the hallmark of a true specialty product offering.

Likewise, we delivered adjusted gross profit of $1,075 per ton, consistent with our expectations of adjusted gross profit in excess of $1,000 per ton.

Looking at year-to-date results for the Polymer segment, for the 6 months ended June 30, 2019, Polymer segment revenue was $558.9 million, down 10.9% with $68.3 million compared to the first half of 2018.

As with the second quarter, the revenue decrease for the first half of 2019 reflects lower sales volume and lower average selling prices associated with lower raw material costs.

On a year-to-date basis, the sales volume for Cariflex is up 7.8%. The total Polymer segment volume decline for the first 6 months of the year was the result of a 9% reduction in Specialty Polymers sales volume, primarily associated with weaker sales in China and other Asian markets and by the 7.4% reduction in Performance Products sales volume associated with lower sales of SIS product grades into adhesive applications of lower sales of paving and roofing product grades.

The Polymer segment adjusted EBITDA for the first half of 2019 was $108.3 million, down 4.5% or $5.1 million, largely due to the sales volume impact I mentioned. However, year-to-date profitability for the segment improved with a 130 basis points expansion in adjusted EBIDTA margin to 19.4%, reflective factors, including improved operating metrics and higher sales of Cariflex.

Similar to the second quarter, year-to-date adjusted gross profit is in excess of $1,000 at $1,049 per ton.

I'll now move on to Slide 6 for a review of our Chemical segment. Chemical segment revenue for the second quarter 2019 was $197.4 million, down modestly at 1.5% compared to the second quarter of 2018. The slight revenue decrease reflects a 6.3% decrease in sales volume, partially offset by higher average selling prices for TOFA and for specialty upgraded product streams.

Performance Chemicals sales volume was down 8.9% compared to the second quarter of 2018, and adhesive sales volume was down 1.7%, while growth in our specialty sales volume for tires was up 4.8% compared to the year ago quarter.

The second quarter volume decline in part reflects ongoing constraints on our availability for CTO, which we expect to continue for the balance of 2019. The CTO constraints are the result of a contract dispute with the minority supplier, the impact of industry turnaround activity, and to a lesser extent, disruptions related to Hurricane Michael. We expect resolution to these supply disruptions in 2019 and, as such, we do not expect CTO constraints in 2020.

Although second quarter 2019 sales volume was lower than the second quarter 2018, we achieved improved pricing on TOFA and specialty upgraded product streams and improved operating metrics, including lower cost for plant maintenance, which contributed to an improvement in segment profitability.

Chemical segment adjusted EBIDTA for the second quarter 2019 was $41.9 million, up 13.4% compared to the second quarter of 2018 and segment adjusted EBITDA margin improved by 280 basis points to 21.2%.

As noted in our first quarter call, operational capability at Panama City was restored in late February 2019. Therefore, second quarter results do not reflect a material impact associated with lost revenue as was the case in the fourth quarter of 2018 and the first quarter of this year.

During the second quarter, our insurance carrier provided an additional $7.5 million reimbursement under our insurance policy, which was recorded in the quarters again on insurance proceeds. As you will note in the reconciliation between net income and adjusted EBITDA in yesterday's earnings release and in the appendix of the earnings presentation, $6.9 million of the $7.5 million gain has been treated as reimbursement of hurricane costs incurred to date.

With the first 6 months ended June 30, 2019, revenue for the Chemical segment was $392.8 million, down 5% or $20.8 million compared to the first half of 2018. Drivers of the revenue decrease are similar to the second quarter, including the effect of an 8.5% decrease in sales volume, largely associated with constraint availability of raw materials and lower opportunistic sales of raw materials, partially offset by higher pricing for upgraded product streams.

Performance Chemicals sales volume was down 11.9% compared to the first half of 2018 on lower sales of excess raw materials. And adhesive sales volume was down a modest 1.6%, largely due to first quarter 2019 hurricane limitation, while volume in our specialty Tires business grew by 2.1% compared to the first 6 months of 2018.

On a year-to-date basis, adjusted EBITDA for the Chemical segment was $83.2 million, up 3 -- up nearly 3% compared to the first half of 2018. Higher pricing for TOFA and higher margins for specialty upgraded product streams as well as lower fixed costs and costs for plant maintenance, all contributed to the improvement in segment profitability with the year-to-date adjusted EBITDA margin improving by 170 basis points, 21.2%.

Moving to Slide 7. Consolidated revenue for the second quarter was $495.3 million, down $43.1 million due to the factors affecting segment results. Of the revenue decline, 58% was associated with changes in foreign currency. The second quarter 2019 consolidated adjusted EBITDA of $102.1 million was down $3.6 million compared to the second quarter of 2018. However, as previously noted, improved profitability in our Chemical segment resulted in a consolidated adjusted EBIDTA margin of 20.6%, up 100 basis points compared to the second quarter of 2018.

The second quarter adjusted EPS was $1.58 per diluted share, up $0.70 or nearly 80% compared to $0.88 per diluted share reported in the second quarter of 2018. This improvement is the result of lower interest expense as we benefited from refinancing activities in the second quarter of last year as well as income tax benefits.

Cost discipline was also a contributing factor, specifically you'll note that second quarter SG&A expense is down $3.5 million compared to the second quarter of last year.

For the first 6 months ended June 30, 2018, consolidated revenue was $951.7 million, down $89.1 million or 8.6%.

As I covered in my segment discussion, the decrease is largely a reflection of lower sales volume in both segments. Lower average selling prices in our Polymer segment is associated with lower average raw material costs, partially offset by higher average selling prices for upgraded product streams in our Chemical segment. In addition, $31 million of revenue decrease was associated with changes in foreign currency.

Consolidated adjusted EBITDA for the first 6 months of 2019 was $191.5 million, down $2.8 million versus the first 6 months of 2018. However, the associated margin was 20.1% compared to 18.7% for the first 6 months of '18.

As we turn to Slide 8, I'll provide some comments about our full year outlook. In the second half of 2019, we do not anticipate a significant change in current demand outlook in China and broader Asia compared with what we have seen in the first half of the year. We continue to expect that inventory management actions by a large lubricant additive customer will have an impact on full year 2019 adjusted EBITDA with a majority of the impact to occur in the second half of the year. And as noted earlier in the year, relative to 2018, we expect an increase in plant maintenance spending of approximately $7 million, which will largely impact second half results. The effect of weather on the second quarter 2019 paving and roofing volume represents approximately $8 million to $10 million of adjusted EBITDA impact. The nature of the paving and roofing business is that delayed activity cannot be made up in a subsequent quarter due to the reality of finite availability of cruising equipment. As this second quarter impact will now flow to our full year results, we now believe that full year 2019 adjusted EBITDA will be toward the lower end of our original guidance range of $370 million to $390 million.

Turning to a look at net debt on Slide 9. During the second quarter, we maintained a disciplined approach to capital allocation, applying free cash flow to both reduction in consolidated net debt and to share repurchases. At June 30, 2019, our consolidated net debt on a constant currency basis was $1.507 billion. This was down $33.6 million from the $1.540 billion at March 31, 2019.

In addition, during the quarter, we repurchased an aggregate $5 million of shares under our repurchase authorization program. On a full year basis, we now expect to reduce consolidated net debt, excluding the effect of foreign currency and the impact of share repurchase activity by approximately $170 million. This view takes into consideration our expectation that our full year 2019 adjusted EBITDA will be at the lower end of our original guidance of $370 million to $390 million, which translates into a proportional reduction in expected cash flow available for debt reduction. Our previous expectation for debt reduction was based upon an assumption of flat working capital for the year. A delayed start in the paving season resulted in higher inventories at the end of second quarter, which we expect to liquidate in the second half of the year.

One housekeeping item to note on consolidated indebtedness. At June 30, 2019, the current portion of long-term debt was $110.1 million. This relates to the indebtedness of our KFPC joint venture in Taiwan, which is 50% owned by Kraton and 50% owned by our partner Formosa. As noted in last quarter's call, we currently expect to extend the maturity through January 2022.

And with this, I'll turn it back to Kevin for closing comments.

--------------------------------------------------------------------------------

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

--------------------------------------------------------------------------------

Thanks, Atanas. And once again in the context of a somewhat challenging market environment with paving and roofing sales below our expectations, and of course, with continued headwinds in China and broader Asia, our second quarter results demonstrated margin resilience and the benefit of broad end-market diversification. For our Polymer segment, the adjusted EBIDTA margin of 20% continue to reflect the value of our innovation-led specialty product offerings. And in our Chemical segment, we saw improved profitability compared to the second quarter of 2018 driven by higher pricing for upgraded product streams and improved operating metrics.

With the exception of the weather-related impact on the quarter's paving and roofing markets, overall demand in the second quarter was reflective of the diversified end markets we serve very much in line with our expectations, essentially, a continuation of the trends we saw in the first quarter. The factors impacting our sales in China are associated with ongoing trade issues and weaker overall demand.

With respect to tariffs, we continue to leverage our HSBC plant in Mailiao, Taiwan, a non-U. S. supply point for many of our specialty polymer grades we sell into China. And while resolution of trade issues and tariffs could have a positive impact on near-term demand fundamentals, in our view, the more significant factor driving demand weakness in China is the decline in consumer sentiment, credit availability and the overall slower demand growth profile which has led to a conservative posturing by our customers.

As we look at the second half of the year, we are not expecting a rebound in demand in China and broader Asia. Overall, we expect demand to be generally in line with what have seen in the first half of the year. That said, China will remain a very important key growth market for our Specialty Polymers business in years to come with growing -- with growth continuing to be supported by our robust innovation pipeline.

For our Chemical segment, we expect stable market fundamentals for TOFA demand and pricing for the balance of the year. We continue to believe the -- that incremental improvements in Chemical segment profitability may be realized when and as market prices for commodities C5 tackifiers adjust at a minimum to reflect the increase in underlying feedstock costs seen over the past few years. They should allow for improved pricing in our rosin ester portfolio then.

In the meantime, we will continue to focus on projects that can enhance profitability and that facilitate expansion of market opportunities in our adhesive business. I'm referring specifically to our ongoing innovation efforts to make significant improvements in color and stability in our rosin ester offerings.

As Atanas noted, for the first half of 2019, our Chemical segment results have been impacted by constrained access to CTO. These constraints are a result of a number of issues, including an ongoing dispute with a minority supplier, a relatively heavy mill shutdown schedule resulting from planned mill maintenance as well as unplanned outages, including disruption associated with last fall's impact from hurricanes and lower pulp mill rates due to market conditions. With these conditions -- we expect these conditions will ease in the second half of this year.

More importantly, in 2020, we expect our access to CTO to increase significantly. This increased access relates to the terms of our supply arrangement with International Paper. Under the terms of our agreement, CTO from mills acquired by International Paper, such as Temple-Inland and Weyerhaeuser, fall under our supply arrangement with International Paper when existing supply contracts of acquired mills terminate. This increase in CTO access is expected to position our Chemical segment for growth in sales volume beginning in 2020. It represents a value driver that we identified when we acquired the Chemical business.

Based on our assumption that global demand fundamentals we saw in the first half of the year continue in the world third and fourth quarters and acknowledging that the shortfall in paving and roofing sales in the second quarter may not be offset in the second half of the year, we now expect full year of 2019 adjusted EBIDTA to be toward the lower end of our original guidance of $370 million to $390 million. Needless to say, we will strive to capture market opportunities that provide upside to our overall results.

As many of you know, for Kraton, the third and fourth quarters are typically our stronger quarters for cash generation. We have maintained a disciplined approach to capital allocation, and we reduced consolidated net debt by $34 million, and we repurchased an aggregate $5 million of shares under our repurchase authority in the second quarter. Debt reduction will remain a primary focus, and we will continue to execute on operational efficiencies and overall cost discipline. We expect meaningful reduction in consolidated net debt in the second half of the year. Although our low expectation for full year adjusted EBITDA translates to our planned reduction in consolidated net debt for the year, we still expect to reduce consolidated net debt by approximately $170 million, excluding the impact of foreign currency and activity under our share repurchase authorization. This would result in consolidated net debt leverage ratio to be approximately 3.5 turns at year's end.

And lastly, we appreciate the interest that our stakeholders have shown in the strategic review of our Cariflex business, which we announced last February.

In terms of the process, I can say that the progress has been consistent with our internal time line, and we have been pleased with the level of initial interest. The initial phase of due diligence is in the process of being completed. As such, it is possible that we will have an update to share with you by the end of the third quarter.

With those comments, we're happy to open the call up for questions. Turning it over to you, operator.

================================================================================

Questions and Answers

--------------------------------------------------------------------------------

Operator [1]

--------------------------------------------------------------------------------

(Operator Instructions) Our first question comes from Mike Sison of KeyBanc.

--------------------------------------------------------------------------------

Michael Joseph Sison, KeyBanc Capital Markets Inc., Research Division - MD & Equity Research Analyst [2]

--------------------------------------------------------------------------------

Kevin, in roofing, if the weather is improved or is better in the third quarter, how much growth can you see if, yes, your customers probably have some backlogs that they will like to wrap up here in the second half of the year?

--------------------------------------------------------------------------------

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

--------------------------------------------------------------------------------

Yes. Mike, I mean it's a very good question. Look, the reality is there is that backlog. But as Atanas commented in his comments, there's only so much capability to go. Now roofing obviously has a little bit different context than paving because paving is still somewhat project-driven in the summer months. That being said, one other thing just I want to make sure you're aware of is, because of the softness in the second quarter, we have a definite sense that inventory is going in the third quarter are probably higher than would they otherwise be going into the second half, if you will, of the summer season. And for that reason, that's why we've kind of been a little bit cautious here and saying that we'll be able to make that up.

--------------------------------------------------------------------------------

Michael Joseph Sison, KeyBanc Capital Markets Inc., Research Division - MD & Equity Research Analyst [4]

--------------------------------------------------------------------------------

Right. Got it. So -- and then I guess, you had a good first half in terms of EBITDA, given the environment. Now when we look at the second half at the lower end, EBIDTA will be lower. Is that going to be consistent with both segments? Or is there a potential pick up in one of the segments that might kind of offset some of that weaker second half?

--------------------------------------------------------------------------------

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

--------------------------------------------------------------------------------

So -- I mean, look, the main driver of that kind of hesitancy on our part is the fact that we're not assuming we're going to make up that difference in paving and that's by -- to a large extent, the largest difference between what we originally thought and what we're thinking now.

--------------------------------------------------------------------------------

Operator [6]

--------------------------------------------------------------------------------

Our next question comes from Chris Kapsch from Loop Market -- Loop Capital Market.

--------------------------------------------------------------------------------

Alex Zani, [7]

--------------------------------------------------------------------------------

This is Alex Zani on for Chris. On the Cariflex process and potential assets sale, can you characterize the interested bidders? Is it solely strategics or maybe private equity firms, too? And can you also share with us anything about the valuation threshold and our conditions that you might decide not to sell the asset?

--------------------------------------------------------------------------------

Kevin M. Fogarty, Kraton Corporation - President, CEO & Director [8]

--------------------------------------------------------------------------------

Yes. I'll answer the second part of your question first that we're not going to comment on that. Obviously, we have a definite view working with our Board on what we believe the intrinsic value of this business is. And as I said all along, we have to be at or above that to create shareholder value. That being said, it's a fairly balanced level of interest that we've seen from both types of buyers that you mentioned. So I wouldn't say weighted one way or the other.

--------------------------------------------------------------------------------

Alex Zani, [9]

--------------------------------------------------------------------------------

Got it. And so as a follow-up. Assuming the sale did go through for Cariflex, we understand your priority for the proceeds would be to reduce debt. In that scenario, if the asset is sold, what would you do as a target leverage ratio for the pro forma remaining company? And I guess we're putting the cart before the horse, would you consider establishing a dividend and/or buying back stock in that performance scenario?

--------------------------------------------------------------------------------

Atanas H. Atanasov, Kraton Corporation - Senior VP & CFO [10]

--------------------------------------------------------------------------------

Yes. This is Atanas. Thank you for your question. So just the first part of your question, we will use the proceeds from a sale -- the sale happens to principally reduce our debt. That's been our stated focus and that remains our #1 priority. With that, our target leverage ratio is at 3x or less. And with respect to dividends or anything else, that would be an internal discussion between us and our board, and we will be very prudent with respect to how we allocate capital.

--------------------------------------------------------------------------------

Operator [11]

--------------------------------------------------------------------------------

Our next question comes from Josh Spector of UBS.

--------------------------------------------------------------------------------

Joshua David Spector, UBS Investment Bank, Research Division - Equity Research Associate - Chemicals [12]

--------------------------------------------------------------------------------

So just on the Specialty, if you kind of isolate out the lubricant additives sales, could you characterize how the rest of the portfolio has been growing over the first half of this year?

--------------------------------------------------------------------------------

Kevin M. Fogarty, Kraton Corporation - President, CEO & Director [13]

--------------------------------------------------------------------------------

Well, the reality is the rest of the portfolio hasn't been growing because of the effect of China. China is down somewhere between -- depending on the month, we can say it's been down somewhere between 10% and 20% versus where we think China should be. That's pretty extreme numbers but it gives you a sense of what's happening in China. On the other hand, our U.S. business has been very good. I mean we're very healthy, we've got good growth pipelines with our customers, and specifically, a couple of key innovation projects have taken hold. And we're very pleased with the results we've seen.

--------------------------------------------------------------------------------

Joshua David Spector, UBS Investment Bank, Research Division - Equity Research Associate - Chemicals [14]

--------------------------------------------------------------------------------

Okay. That's helpful. And just on the CTO supply constraint. So I mean if I look at your volumes for the first half year-over-year, down around 9%, what part of that would be due to supply constraints on the CTO side?

--------------------------------------------------------------------------------

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

--------------------------------------------------------------------------------

Almost entirely. I mean we kind of categorize it that way. And I think part of that -- and the large part of that as far as the first half is concerned is we were just in a surplus position last year so we resold that feedstock. We are just not in a position to do that. So that's a big chunk, if not whole, about a half of the first year volumes in CTO one year to the next.

--------------------------------------------------------------------------------

Joshua David Spector, UBS Investment Bank, Research Division - Equity Research Associate - Chemicals [16]

--------------------------------------------------------------------------------

Okay. That's helpful. And just one quick follow-up along with that. If you've got or you had that volume this year, what part of your market is kind of asking for that material? And where that material be going and not be detrimental to price?

--------------------------------------------------------------------------------

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

--------------------------------------------------------------------------------

So we would have been obviously delighted to have more CTO to process, and we would have been able to place it well in the TOFA markets because of the robustness of the markets we serve. And needless to say, what that's prompted us to do is to be very kind of disciplined and selective in terms of where we upgrade or where we sell TOFA today.

--------------------------------------------------------------------------------

Operator [18]

--------------------------------------------------------------------------------

Our next question comes from Jim Sheehan of SunTrust.

--------------------------------------------------------------------------------

James Michael Sheehan, SunTrust Robinson Humphrey, Inc., Research Division - Research Analyst [19]

--------------------------------------------------------------------------------

Regarding your net debt reduction target of $170 million, do you think that level is achievable even if macro flows further in the second half?

--------------------------------------------------------------------------------

Atanas H. Atanasov, Kraton Corporation - Senior VP & CFO [20]

--------------------------------------------------------------------------------

Yes. Our debt target reduction of $170 million takes into account our updated guidance, which is the lower range of the $370 million to $390 million. And -- so the short answer is, yes.

--------------------------------------------------------------------------------

Kevin M. Fogarty, Kraton Corporation - President, CEO & Director [21]

--------------------------------------------------------------------------------

And just like everybody in these types of industries, the only think I would add to what Atanas said is, we don't expect further slowing. I mean things are pretty slow in some parts of our markets like China today. But needless to say, that means we have to be extra prudent on watching our inventory levels, and we certainly intend to do that.

--------------------------------------------------------------------------------

Michael Joseph Sison, KeyBanc Capital Markets Inc., Research Division - MD & Equity Research Analyst [22]

--------------------------------------------------------------------------------

And it looks like butadiene prices are trending lower, is that a margin tailwind for your business? Or will your pricing come down commence certainly with the raw material?

--------------------------------------------------------------------------------

Kevin M. Fogarty, Kraton Corporation - President, CEO & Director [23]

--------------------------------------------------------------------------------

Well, you've been following us for a long time, I think, Jim. Our price right strategy is very much driven by the value of our material in the marketplace, and to the extent, we see some raw material decline, which I confirm to be the case, we're going to do to our best to preserve that margin improvement.

--------------------------------------------------------------------------------

James Michael Sheehan, SunTrust Robinson Humphrey, Inc., Research Division - Research Analyst [24]

--------------------------------------------------------------------------------

And you've lowered your tax rate guidance to 10%. I think it was 20% to 25% before. What's driving that change?

--------------------------------------------------------------------------------

Atanas H. Atanasov, Kraton Corporation - Senior VP & CFO [25]

--------------------------------------------------------------------------------

What's driving -- a couple of things. We basically benefited from a -- from the release of a favorable tax positon related to the resolution of an audit. So that's a significant driver for this year. And the rest of it is, if you look at our tax-efficient structure overseas, so we've actualized our estimate for the remainder of the year and 10% is what we are seeing.

--------------------------------------------------------------------------------

Operator [26]

--------------------------------------------------------------------------------

Our next question comes from Roger Spitz of Bank of America.

--------------------------------------------------------------------------------

Roger Neil Spitz, BofA Merrill Lynch, Research Division - Director and High Yield Research Analyst [27]

--------------------------------------------------------------------------------

Is the lubricant additive customer that's destocking the HSBC product, is that related to the delay in the GF-6 regulatory standard implementation? And if so, would you get some of that volume back in 2020 when GF-6 is expected to be implemented?

--------------------------------------------------------------------------------

Kevin M. Fogarty, Kraton Corporation - President, CEO & Director [28]

--------------------------------------------------------------------------------

No. This is much more in the context of a customer viewing safety stock inventory in the context of where they want -- how they want to allocate risk, and they feel like they're in a position -- some of that's driven by the reliability of the supplier that we represent. They are in a much better positon, obviously, to liquidate some cash for their own benefit. And when that process is completed, yes, we expect we'll be able to pick those volumes back up, and this by no means represents anything associated with their overall demand.

--------------------------------------------------------------------------------

Roger Neil Spitz, BofA Merrill Lynch, Research Division - Director and High Yield Research Analyst [29]

--------------------------------------------------------------------------------

Got it. And then the minority CTO supplier contract dispute, what is that supplier doing with the CTO? Is it supplying a domestic competitor or internationally or just holding on during the dispute?

--------------------------------------------------------------------------------

Kevin M. Fogarty, Kraton Corporation - President, CEO & Director [30]

--------------------------------------------------------------------------------

No. No. They're reselling the material into the marketplaces.

--------------------------------------------------------------------------------

Operator [31]

--------------------------------------------------------------------------------

Our last question in queue comes from John Roberts of UBS.

--------------------------------------------------------------------------------

John Ezekiel E. Roberts, UBS Investment Bank, Research Division - Executive Director and Equity Research Analyst, Chemicals [32]

--------------------------------------------------------------------------------

Could you comment on any channel inventory issues we might look forward to hear in the rest of the year in the paving and roofing area, given how weak the seasonally -- like usually strong seasonal second quarter turned out to be so weak?

--------------------------------------------------------------------------------

Kevin M. Fogarty, Kraton Corporation - President, CEO & Director [33]

--------------------------------------------------------------------------------

I want to make sure I answer that question correctly. Can you -- you are asking if we believe if there's higher inventory?

--------------------------------------------------------------------------------

John Ezekiel E. Roberts, UBS Investment Bank, Research Division - Executive Director and Equity Research Analyst, Chemicals [34]

--------------------------------------------------------------------------------

Yes. Was the end consumption even lower than the decline that you had in your sales, so that there is some channel inventory that has to be absorbed given the third quarter?

--------------------------------------------------------------------------------

Kevin M. Fogarty, Kraton Corporation - President, CEO & Director [35]

--------------------------------------------------------------------------------

Yes. There is no doubt that as a result of that weather trend that we talked about in the second quarter and going into the second half of the year, inventories were higher than they would have otherwise been. And so before you could even get to the question of, will we be able to make up that pent-up demand, you've got to consume through that inventory that our customers are sitting on.

--------------------------------------------------------------------------------

John Ezekiel E. Roberts, UBS Investment Bank, Research Division - Executive Director and Equity Research Analyst, Chemicals [36]

--------------------------------------------------------------------------------

Any quantification you can give us in terms of either days of inventory or when you might get to, sort of -- how long it'll take you to where your sell-in will be equal to sellout in the channel?

--------------------------------------------------------------------------------

Kevin M. Fogarty, Kraton Corporation - President, CEO & Director [37]

--------------------------------------------------------------------------------

Again, the whole answer to your question lies in the ability for our customers to be able to put the right level of assets together to complete the project schedule that they had in mind for the summer. And to some extent, that's limited. And quite frankly, to some extent, that's limited also by making sure there's favorable weather in the second half of the year. Now one thing we are always mindful of when it comes to our paving business, in particular, is the length of the summer season because if this summer season, both in Europe or North America, extends into the fall, there's no question our customers like to try to complete their project work.

--------------------------------------------------------------------------------

Operator [38]

--------------------------------------------------------------------------------

There are no further questions in queue at this time. I will now hand the call back to Gene Shiels for closing comments.

--------------------------------------------------------------------------------

H. Gene Shiels, Kraton Corporation - Director of IR [39]

--------------------------------------------------------------------------------

Thank you, Joseph. Well, we want to thank all of our participants this morning for their interest in Kraton and their thoughtful questions. A replay of the call will be available on our website through a link available under the Investor Relations tab, and there's also a telephonic replay. To access that replay, you may dial (800) 285-0609. Thank you. That concludes our call this morning.

--------------------------------------------------------------------------------

Operator [40]

--------------------------------------------------------------------------------

Thank you. This concludes the Kraton Corporation's Second Quarter 2019 Earnings Conference Call. You may now disconnect.