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Edited Transcript of LXU earnings conference call or presentation 27-Feb-19 3:00pm GMT

Q4 2018 LSB Industries Inc Earnings Call

OKLAHOMA CITY Mar 1, 2019 (Thomson StreetEvents) -- Edited Transcript of LSB Industries Inc earnings conference call or presentation Wednesday, February 27, 2019 at 3:00:00pm GMT

TEXT version of Transcript

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Corporate Participants

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* Cheryl Maguire

LSB Industries, Inc. - Senior VP & CFO

* John Howard Diesch

LSB Industries, Inc. - EVP of Manufacturing

* Kristy Carver

LSB Industries, Inc. - Senior VP & Treasurer

* Mark T. Behrman

LSB Industries, Inc. - President, CEO & Director

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Conference Call Participants

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* Brian DiRubbio

* James Philip Geygan

Global Value Research Company - VP of Research & Senior Analyst

* Jeffrey Richart Geygan

Global Value Investment Corp - President, CEO and Chief Compliance Officer

* Joseph Logan Mondillo

Sidoti & Company, LLC - Research Analyst

* Karl Blunden

Goldman Sachs Group Inc., Research Division - Senior Analyst

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Presentation

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Operator [1]

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Greetings. Welcome to LSB Industries 4Q '18 Conference Call. (Operator Instructions) Please note that this conference is being recorded.

I will now turn the conference over to your host, Kristy Carver, Senior Vice President and Treasurer. You may begin.

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Kristy Carver, LSB Industries, Inc. - Senior VP & Treasurer [2]

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Thank you, Brock. Good morning, everyone. Joining me today on the call are Mark Behrman, our Chief Executive Officer; John Diesch, our Executive Vice President of Manufacturing; and Cheryl Maguire, our Chief Financial Officer.

Please note that today's call will include forward-looking statements, and because these statements are based on the company's current intent, expectations and projections, they are not guarantees of future performance, and a variety of factors could cause actual results to differ materially.

As this call will include references to non-GAAP results, please reference the press release in the Investors section of our website, lsbindustries.com for further information regarding forward-looking statements and reconciliations of non-GAAP results to GAAP results.

At this time, I'd like to go ahead and turn the call over to Mark for opening remarks.

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Mark T. Behrman, LSB Industries, Inc. - President, CEO & Director [3]

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Thank you, Kristy, and good morning, everyone. We're glad that you could participate in our call this morning, and appreciate your interest in LSB Industries.

Today, we will discuss our 2018 fourth quarter results and provide you with our current outlook for full year 2019. I'll begin with an overview of the fourth quarter. And then John will discuss our plant operations; followed by Cheryl, who will review our financial performance and capitalization in more detail. Then I'll return to provide you with our outlook for our markets, and share our current thoughts around 2019 full year expectations for our business. As always, we'll take your questions after we conclude our prepared comments.

Page 3 of the presentation provides highlights for the fourth quarter of 2018. 2018 was a successful year for LSB in several areas.

First, we significantly improved our environmental health and safety performance from the prior year with a deep commitment from our team as we push towards being best-in-class in our operations. We view an improved safety performance as a precursor to improved operating performance. A continued focus on safety and on operational improvements translated into improved ammonia on-stream rates for Q4 2018, as we averaged approximately 95% on-stream across our 3 facilities for the quarter. Many thanks to all our employees for their efforts.

Second, our financial performance for the quarter and year improved significantly. Our revenues for the fourth quarter of 2018 were $94.7 million, a 31% increase from the same quarter last year, after adjusting for the adoption of ASC 606 accounting. Our fourth quarter adjusted EBITDA was $23.3 million, which compares to $1 million of adjusted EBITDA for the fourth quarter of last year. The substantial year-over-year increase can be attributed to a material improvement in pricing for all of the agricultural products we sell in addition to higher volumes for ammonia and UAN as a result of improved operating performance at our Pryor and El Dorado facilities and stronger pricing for industrial ammonia. These positive factors for the quarter were unfortunately partially offset by the impact of a temporary spike in natural gas costs for half the quarter, when we saw prices hit $4.50 per MMBtu as well as the challenging fall weather which reduced ammonia and other product sales. Beginning in early January though, natural gas costs came back in line with expectations to the $3 per MMBtu range.

Page 4 gives you some color on the fertilizer pricing and natural gas cost trends; however, weather is still having an impact on sales of product pricing and inventory levels. Cheryl will provide you with more detail on our financial results later in the call, and I'll discuss the weather impact in my wrap up.

As I mentioned, we were pleased with the operating performance of our facilities during the fourth quarter. In fact, 2 of our 3 facilities were actually above our targeted operating rates, which was encouraging as we headed into the new year. While we continue to have work to do with respect to plant reliability, we're confident that what we're now seeing from our facilities is a direct reflection of the initiatives that we've undertaken largely in the last 24 months. At the risk of repeating what we've been saying for several quarters, this broad-based collection of actions has included leadership changes and capital investments and the implementation of an enhanced maintenance management system and related procedures across all 3 of our facilities. John will get into more detail on our plant operations momentarily.

Overall, for 2019, we see improved product pricing, albeit a smaller amount year-over-year increase than we had in 2018, along with continued improving operating performance leading to stronger production and sales volumes, which we believe will translate into another growth year for LSB in terms of both our top and bottom lines as well as cash flow.

Now John will go into more detail about the performance of our plants in Q4, their current status and provide an update on our operational initiatives. John?

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John Howard Diesch, LSB Industries, Inc. - EVP of Manufacturing [4]

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Thank you, Mark, and good morning. As Mark mentioned earlier, the full year of 2018 was a significant improvement, especially given that the first half of the year was less than our expectations. The second half of the year improved significantly, particularly the operating rates of our ammonia plants as the reliability and operations improvements we have been working on began to make a difference.

Please turn to Page 6 of your slide deck. Overall for Q4, I was very pleased with our operating performance. The El Dorado ammonia plant had 98% on-stream time for the fourth quarter and 88% on-stream time for the year. We have continued to run well for the first quarter at daily rates well over our nameplate capacity. We are planning for a turnaround in August of this year, which will include mainly inspections, heat exchanger cleaning and catalyst changes with the next turnaround planned for 2022.

Our nitric acid plants continue to run very well. The operator has needed to meet our merchant nitric acid and ammonia nitrate sales commitments. On the project front, we are completing final engineering to increase capacity and improve reliability of our high-density ammonium nitrate production facilities. We're also starting detailed engineering on a $7.5 million project to replace the converter reactor in our sulfuric acid plant, which will not only improve the reliability of our plant but also increase production capacity by approximately 20,000 tons annually. This project is scheduled to be completed in the fourth quarter of this year.

Our Pryor facility ammonia plant had 97% on-stream time for the fourth quarter and 89% for the year. That is the highest any on-stream rate for this plant since the restart of 2010. The ammonia plant has been operating very well so far this first quarter of 2019. In 2019, we are concentrating on improving reliability of our urea and nitric acid plants with a number of improvement projects slated to be installed in this summer's turnaround.

The new urea reactor was delivered and set in place this past fall. The final piping, the electrical and instrumentation tie-ins will be completed in the turnaround this summer. The new reactor will improve reliability, efficiency, and add some incremental urea capacity. We have an extensive turnaround in the plant exchangers with numerous catalyst changes, vessel and equipment inspections and overhauls in ammonia, urea and nitric acid plants. Improvements include electrical upgrades in urea and nitric acid, the new urea reactor installation completion and a major overhaul with expanded turbine instrumentation upgrades in our #4 nitric acid plant. We're confident that we will come out of this turnaround with significantly improved reliability in on-stream time.

The Cherokee ammonia plant had 93% on-stream time for the fourth quarter with 94% on-stream time for the year. The ammonia plant on-stream rate was down slightly from past years due to some minor issues coming out of our turnaround, which have all been resolved. The plant is currently operating very well in Q1, and we expect this plant to mirror historical performance. As we expected, additional instrumentation and control upgrades installed during the turnaround of 2018 in the urea plant has improved the reliability of our high-pressure pumps, which we believe will allow us to produce more urea in 2019 than we have historically. The Cherokee 2019 capital plan continues to focus on improving safety and environmental reliability.

The Baytown nitric acid plant operated 100% on-stream time excluding the turnaround during the fourth quarter. At the request of Covestro, the owner of the facility, we are currently in engineering to increase the capacity of this plant that will coincide with the major capacity increase at the Covestro facility. We believe that we will -- this will result in improved economics for LSB.

The operating performance of our facilities continues to improve. The reliability and operational improvement process has laid the groundwork for this improvement through the upgrades in our maintenance management systems and work order processing. We have also identified critical equipment, enhanced our preventive maintenance programs, the next phase of this process and improve our operating and maintenance procedures along with our training programs. We will be concentrating on our communications, particularly at shift change through a structured process as well as conducting leadership training all the way from line supervision to plant management. We're changing the way we were doing things for safe, reliable and efficient operations. The goal is to run our plants best-in-class in the nitrogen chemical space.

I feel good about the direction we're going. As you know, it all starts with ammonia, which is where we concentrated a lot of our efforts last year. I feel comfortable where we are with ammonia, particularly after we completed the 2019 turnarounds at El Dorado and Pryor. We're now putting more focus on our downstream plants of nitric acid, urea and ammonium nitrate, while our operational improvement will not always be linear given the inherent nature of running chemical facilities, the magnitude and frequency of our outages is decreasing. I expect continued year-over-year volume increases as we upgrade our operations and invest in our people.

Now I will turn the call over to Cheryl to discuss the financial results for the 2018 fourth quarter.

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Cheryl Maguire, LSB Industries, Inc. - Senior VP & CFO [5]

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Thanks, John, and good morning, everyone. I am pleased to be taking part in this call for the first time as LSB's CFO.

As many of you know, I've been in the company's finance area since the fourth quarter of 2015, with most of my time since then in the role of Vice President of Finance. As a result, I've taken part in much of the significant progress we've made with respect to our operations and financial results. I'm now excited to be in a more external facing role, and I'm looking forward to speaking with and meeting many of you in the quarters and years to come.

So turning to our fourth quarter and full year results. Page 9 of the presentation provides a consolidated summary statement of operations for the fourth quarter of 2018 as compared to the fourth quarter of 2017, along with a year-to-date comparison.

As discussed during the last several calls, beginning in Q1 2018, we adopted the new FASB revenue recognition standards. We along with many public companies have chosen not to go back and restate our prior year financials or its impact. For us, the biggest change resulting from the implementation of the new revenue recognition standards is that sales and cost of sales from our Baytown facility will no longer be grossed up on our income statement. This has no impact to our EBITDA. As you know, we manage the Baytown facility for Covestro, and as such, going forward, revenue and costs will be recognized more in line with how we view this arrangement. From our perspective, this is a good change as it represents the true economic earnings and margin of that business.

Beginning in Q1, 2019 results will be presented on a comparative basis.

Turning to our results. For the full year 2018, we look at EBITDA, excluding turnaround costs, as a window into the underlying run rate or operating performance of the company. Adjusted EBITDA, excluding turnaround costs, was $72.9 million as compared to $45.6 million for full year 2017. This represents a 60% increase in year-over-year operating performance as a result of improved on-stream time and a stronger pricing environment.

In reviewing our continuing operations for the fourth quarter, excluding the impact of new revenue recognition standards and revenue from a business sold in October 2017, total net sales in Q4 2018 increased 31% to $94.7 million from adjusted net sales of $72.3 million in Q4 2017. This is illustrated on Slide 21.

In our ag business, we experienced stronger average net selling prices for ammonia, UAN and HDAN, which increased 47%, 45% and 18%, respectively, quarter-over-quarter. Our agricultural ammonia volumes increased 38% over the fourth quarter of 2017 as on-stream rates at our Pryor facility were significantly improved. Although improved, overall ammonia volumes were negatively impacted by a poor fall ammonia application season as a result of challenging weather. HDAN volumes were also down as a result of significantly higher rainfall in areas where we typically see HDAN movement in November and December.

Net sales of our industrial products increased due to higher selling prices for industrial ammonia, which are indexed to the Tampa ammonia price. Tampa averaged $345 per metric ton for the fourth quarter of 2018 as compared to $300 a metric ton a year ago. Sales volumes of industrial ammonia also increased versus the fourth quarter of 2017, resulting from improved on-stream rates at our El Dorado facility, which ran at 98% onstream in the fourth quarter versus 77% in the fourth quarter of 2017.

Nitric acid sales also grew by 41%, resulting from higher on-stream rates, combined with expanded marketing efforts. Additionally, we were able to take advantage of several coproducer outages and capitalized on the excess nitric acid production capacity at our El Dorado facility.

Net sales of products into the mining sector increased versus the prior year as we entered into an agreement with the current customer to locate an emotion plant at our El Dorado facility. We began selling AN solution as the feedstock to the emotion plant in the fourth quarter. We will continue to explore further gas plant opportunities at all of our facilities in 2019.

Gross profit increased approximately $22 million, driven by higher overall net sales, combined with improved fixed cost absorption, despite loss sales from a challenging fall ammonia application season and approximately $5 million of negative impact associated with higher gas costs. In the fourth quarter of 2018, we also received a $4.4 million favorable settlement with a subcontractor, responsible for past faulty work at our Pryor facility where the negative impact to our EBITDA was previously recognized.

Selling, general and administrative expenses increased $6.8 million of which approximately $5.3 million was severance and accelerated stock-based compensation related to our former CEO's departure from the company. The remaining increase was primarily driven by higher legal costs.

As discussed on our last call, in early 2016, we received a summons in the case where a subcontractor involved with the construction of our El Dorado ammonia plant is seeking damages from our EPC Contractor. We requested indemnifications from our EPC contractor under the terms of our contracts with them and they have not honored that. We have been vigorously defending against the allegations made by the subcontractor and will seek reimbursement of all costs from our EPC Contractor. We also intend to pursue recovery of damages caused by the subcontractor work performed at our El Dorado facility. While we do expect SG&A expenses to track higher in the near term, due to elevated legal costs, as I mentioned, we expect to recover some or all of these costs.

Overall, adjusted EBITDA for the fourth quarter of 2018 was higher compared to the prior year period because of improved pricings for ag and industrial products, combined with improved average ammonia on-stream rates across our plants. I will bridge the Q4 2017 to Q4 2018 EBITDA for you on Slide 10.

Please refer to our reconciliation of non-GAAP measures beginning on Slide 20 for further information on noncash and onetime costs incurred during the period. To give further clarity on the results of the quarter, Page 10 bridges our consolidated adjusted EBITDA for Q4 2018 to adjusted EBITDA for Q4 2017.

The fourth quarter of 2017 adjusted EBITDA was $1 million versus adjusted EBITDA of $23.3 million for the fourth quarter of 2018. The increase in EBITDA was driven by higher net selling prices, which increased approximately $13.5 million. EBITDA was approximately $9.7 million of this increase attributable to higher net selling prices for agricultural ammonia, UAN and HDAN. The remaining increase was largely attributable to higher industrial ammonia selling prices as the Tampa ammonia price for the fourth quarter of 2018 increased by $45 a metric ton to approximately $345 a metric ton versus $300 a metric ton for the same quarter last year.

Pryor sales volumes and resulting improved cost absorption contributed approximately $9.3 million of additional EBITDA versus the same quarter last year, driven by higher on-stream rates in the fourth quarter of 2018 versus 2017, primarily at our Pryor and El Dorado facilities. This sales volume increase was tempered, however, by the previously discussed weather challenges, which we estimate impacted our fourth quarter EBITDA results by approximately $3 million to $4 million.

As Mark mentioned, market concerns over low natural gas storage levels and cold weather led to a spike in natural gas pricing during the fourth quarter of 2018. As we can see on Page 11, natural gas increased as high as $4.69 per MMBtu during the quarter and averaged $4.50 per MMBtu for the mid-November to mid-December time frame, which was the highest natural gas price in more than 4 years.

We estimate the impact of higher natural gas feedstock costs negatively impacted our fourth quarter EBITDA by approximately $5 million. Additionally, we entered 2019 with higher cost inventory on the books from product produced in December at higher gas costs, that when sold, will impact the first quarter of 2019. Today, natural gas prices have declined to price levels more in line with our and industry analyst estimates, averaging around $3 per MMBtu for the first 2 months of 2019.

Overall, we were pleased with our fourth quarter results, realizing that weather issues are just a predictably unpredictable part of the business that we're in. I'd note that had weather in our primary geographic end markets, then what would be considered normal during our fourth quarter, we estimate that our adjusted EBITDA would have been approximately $26 million to $27 million even with the higher gas cost.

Looking forward to the first quarter of 2019, please turn to Page 12. This page illustrates the average Tampa ammonia price, our average realized net selling prices for UAN and HDAN and our average cost of natural gas for the first quarter of 2018, and compares that to the current Tampa ammonia price, the expected average selling prices for UAN and HDAN based on forward sales of product or current spot market sales prices and the current average natural gas prices we are paying or have hedged.

Also shown is the estimated annual EBITDA impact to us of $10 per ton movement in the Tampa ammonia, UAN and HDAN prices based on 2019 volume outlook and a $10 -- excuse me, a $0.10 MMBtu movement in natural gas prices. Keep in mind that due to seasonality, our quarters have significant variability with the first quarter typically our second best quarter. We are principally sold out on UAN through the first quarter at expected average net selling prices that are showing increases of over $60 per ton over the first quarter of 2018 realized prices.

In January, U.S. nitrogen prices fell as a result of week ammonia demand and high inventory caused by a lower fall fertilizer application season. As a result, Tampa ammonia pricing so far in the first quarter of 2019 has averaged $285 a metric ton, which is $45 per metric ton lower than the first quarter of 2018.

Natural gas pricing, including what we've hedged for the first quarter of 2019 to date, is averaging approximately $0.20 per MMBtu higher versus the first quarter of 2018. As I indicated previously, the difficult weather trends of our 2018 fourth quarter have persisted into the first 2 months of 2019, impacting demand for agricultural products. Very wet and cold weather across much of the U.S. has delayed pre-spring fertilizer applications. That will result in a delay of sales of HDAN ammonia and UAN from Q1 to Q2. But we believe, we will meet our forecast for the first half of 2019.

So to sum up our view on the first quarter of 2019, we expect material year-over-year improvement in the UAN pricing environment. However, we do have some headwinds with the lower Tampa ammonia pricing, combined with delayed sales of HDAN ammonia and UAN. Therefore, we expect the first quarter of 2019 to be in line or slightly below the first quarter of 2018. However, the good news is we have the inventory and are positioned well to make up delayed volume as we move into the second quarter.

Page 13 outlines our capital structure at the end of Q4 2018. We ended the quarter with $26 million in cash and over $37 million of availability at quarter-end, giving us total liquidity of approximately $63 million. As discussed on our last call, we generally have somewhat higher working capital needs in the fourth quarter as we build inventory going into the spring season. This was particularly true this year due to the shorter fall ammonia application season and the resulting ammonia inventory build. Additionally, we delivered product to several customers with extended short-term payment terms as a means of optimizing our inventory and storage capacity headed into the spring season. This has translated into a short-term working capital use of approximately $10 million, which we expect to receive back in the first half of 2019 as we sell down the inventory and collect on receivables.

Although outstanding debt at quarter-end was approximately $425 million, including the unamortized discount and issuance costs associated with our debt, we also had outstanding preferred stock of approximately $212 million, including approximately $72 million in accrued and unpaid dividends.

Moving to Page 14, we outlined our free cash flow. Cash provided from operations for the 12 months of 2018 was approximately $17.6 million compared to $2.3 million for the 12 months of 2017. Additionally, cash flow from operations includes approximately $43.5 million and $31.9 million in 2018 and '17, respectively, related to semi-interest -- semi-annual interest payments on our senior secured notes. As you recall, 2018 included approximately $8 million of additional accrued interest payments that were settled in connection with the refinancing that we completed in the second quarter.

Capital expenditures, predominantly related to reliability and maintenance investments were approximately $37 million for the full year of 2018. With respect to financing cash flow, as we mentioned on earlier earnings calls, during Q2, we refinanced our previous senior secured notes of $375 million and received net proceeds of approximately $390.5 million from issuance of the new senior secured notes, which extended our maturities and provided us with greater financial flexibility to execute our strategy.

For the 12 months of 2018, we consumed $7.6 million of our cash balance, which is an improvement of $18.8 million compared to the prior year period, reflecting our improved operating cash flow.

Looking forward to the full year of 2019, the metrics we're providing on Page 15 and 16 are meant to serve as points of reference for how we currently think about our targets for the year. We tried to capture potential variation in factors, such as demand, on-stream rates and cost levels by using ranges.

With that said, we do not plan to provide updates to all these metrics on a quarterly basis, with the exception of sales volumes, or if there is a substantial change to our view on one or the other items. Product sales volumes for the full year of 2019 are presented on the top half of Page 15.

As a result of anticipated improved operating rates combined with a continued marketing focus to increase our sales volumes, we do expect material improvement in volumes compared to 2018, despite a 30-day turnaround at Pryor and a shorter 14-day turnaround at El Dorado. Following these turnarounds, Pryor will be on a 2-year turnaround cycle, while El Dorado and Cherokee will be on a 3-year turnaround schedule.

The bottom of Page 15 includes our projected turnaround costs for 2019 of approximately $8 million, which represents costs associated with contractors, repairs and supplies. These are actual out-of-pocket expenses and do not include any lost contribution margin or lost cost absorption from the production and sales of product that will forgo during the 30-day and 14-day turnarounds.

As you are aware, under our current accounting policy, the full $8 million will be expensed as incurred, which may be different from some of our peers, who are capitalizing and amortizing these expenses between turnarounds. We expect the majority of this expense along with the lost contribution margin and cost absorption during the downtime to impact our third quarter results.

Page 16 covers a range of variable and fixed plant expenses as well as SG&A that we are estimating for 2019. Also, you will note that reliability and maintenance CapEx inclusive of all capital spend during the turnarounds will be $30 million to $35 million. Additionally, included in that capital spend, we plan to install a new sulfuric acid converter at our El Dorado facility during Q4 2019, which will cost approximately $7.5 million.

We expect this new converter to significantly improve the reliability of the sulfuric acid plant, while increasing the annual production capacity from approximately 140,000 tons to 160,000 tons allowing us to take advantage of attractive market conditions. We are finalizing the equipment financing for this capital project.

Now I'll turn it back over to Mark to wrap up.

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Mark T. Behrman, LSB Industries, Inc. - President, CEO & Director [6]

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Thank you, Cheryl. As I stated earlier in the call, we expect 2019 to be a growth year for LSB as a result of year-over-year pricing improvement, coupled with higher production and sales volumes driven by operating rates generally consistent with the strong performance of our facilities delivered in the second half of 2018.

Turning to Page 17. As Cheryl just discussed, product pricing was a tailwind for us through the second half of 2018. On the ag side, higher prices were driven by diminishing supply as domestic capacity that came online during 2017 was absorbed by the market in addition to reduced volumes of low-price product being sold into the U.S. by China and others.

More recently, however, U.S. nitrogen prices have trended downward due primarily to the impact of a weak fall ammonia application season as many farmers simply didn't have the ability to apply ammonia due to a very wet and then cold last few months of 2018 across the U.S.

As I mentioned earlier, the early part of 2019 hasn't been much better with the ground in our key geographic markets either frozen and snow-covered or cold and extremely wet, both not conducive to applying ammonia for preplant or for the sales of HDAN, UAN, urea and other fertilizers.

Not surprisingly, U.S inventories of ammonia and other fertilizer products are now quite high, leading to selling price pressure in most of these products. Specifically, the Tampa ammonia price dropped from $355 per metric ton in October to $285 per metric ton for January and has stayed there for February, while urea prices have trended down approximately $60 per ton during that same time.

The good news is that we believe this is a short-term dynamic as, ultimately, the weather will likely improve. And at that point, we would expect a mad dash for farmers to apply fertilizer aggressively in an effort to catch up on the lost opportunity over the past several months in the fall. As Cheryl mentioned, our order book reflects this as we are principally sold out on UAN for the remainder of this quarter, with orders into Q2 at selling prices of approximately $60 per ton higher as compared to the same period in 2018.

Additionally, ag ammonia is principally sold out for the remainder of this quarter, with some orders into Q2 as well at selling prices approximately $50 per ton higher relative to the same period in 2018. So while Tampa ammonia is currently a headwind, we are expecting year-over-year pricing improvement for agricultural products in 2019, albeit a more modest increase relative to the significant jump we saw in 2018.

Given the rebound and demand that we anticipate, once the weather turns favorable, the key will be logistics as there will likely be great demand for product in a compressed time period. We have been very focused on positioning product in locations, where we can expedite delivery upon request while optimizing our storage space at the same time.

We're also working with our carrier partners to ensure that we have appropriate truck availability for delivery of product. We believe that when the spring application season gets fully underway, suppliers that are ready to deliver on demand will capitalize on the strongest pricing. Pricing for our industrial products is also closely held to the Tampa ammonia price. So, in essence, industrial ammonia prices have declined for the same reason that agricultural ammonia has, temporarily high inventories due to the bad weather, induced weak fall fertilizer application season, followed by the harsh winter weather throughout much of the U.S. At the same time, the U.S. economy remains strong as evidenced by continued solid GDP growth and rising rates of industrial production, which bodes well for us as the leading merchant marketer of nitric acid in North America. As a result, we expect that as ammonia inventories are consumed by the ag market, industrial prices will also rise.

Page 18 outlines our business improvement initiatives. Given our focus on the operating initiatives that John outlined earlier, we expect our production facilities to continue to show improved operating performance, and are targeting an average on-stream rate across all 3 of our ammonia plants of 94% for the year. We expect this to translate into a healthy increase in production and sales volumes and enable us to gain further operating leverage on our fixed cost basis. We also expect an overall margin improvement on the sale of our products as we continue to review our current product sales and continue to focus on expanding partner relationships with many of our customers that create opportunities that are win-win for both parties. We made great progress in this regard in 2018 and expect to further these efforts in 2019.

Lastly, we are continuing to revamp our procurement and logistics areas. We have made good progress in both areas to become more efficient and reduce direct costs; however, there are still opportunities for improvement.

Over the course of 2019, we expect these opportunities to translate into improved financial results, leading to an increase in our free cash flow generation, which, in turn, will enable us to strengthen our liquidity position and provide us with the financial flexibility to begin looking at opportunities to gain scale to better leverage our corporate platform.

That concludes our prepared remarks, and we will now be happy to take your questions.

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Questions and Answers

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Operator [1]

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(Operator Instructions) Our first question today comes from Joe Mondillo of Sidoti & Company.

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Joseph Logan Mondillo, Sidoti & Company, LLC - Research Analyst [2]

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So my first question just on the on-stream rates, looking at 2019 versus 2018, you mentioned that the fourth quarter was a $9 million contribution relative to the improved on-stream rates. Considering relative to the 94% rates that you are expecting across the 3 plants, is there any way you can quantify like you did in the fourth quarter sort of what that contribution would be to improve profitability for 2019 if you hit that 94% relative to what you did in 2018?

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Mark T. Behrman, LSB Industries, Inc. - President, CEO & Director [3]

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Yes. I think, Joe, we don't give out guidance. And so, in particular, we're not going to really split out how much is price and how much is improvement from operating rates.

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Joseph Logan Mondillo, Sidoti & Company, LLC - Research Analyst [4]

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Okay. I assume there is maybe some upside to that 94%, especially maybe Cherokee. Cherokee has run almost consistently above 94%. Is that a possibility? And then also, looking at EDC, EDC has run sort of below 90% the last couple of years, I believe. Any -- are you optimistic that you can get better productivity at EDC as well?

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Mark T. Behrman, LSB Industries, Inc. - President, CEO & Director [5]

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Yes. So I mean, the 94% is an average of all 3 facilities. So as we've talked about on previous calls, and I think, John, even talked about earlier in his comments, we would expect Cherokee and EDC to have higher operating rates than Pryor. I think we're still making -- we're making a lot of progress at Pryor. I don't think we're there yet, and we wouldn't expect that Pryor would be on par with the other 2 facilities. As John did mention though, we have an extensive turnaround scheduled for later on this year. And we think getting through that turnaround and the work that we're doing will set us up for Pryor to run close to what our expectations would be for the other 2 facilities in 2020.

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Joseph Logan Mondillo, Sidoti & Company, LLC - Research Analyst [6]

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All right. And are you surprised that what you've -- I guess, in the fourth quarter, and I guess, seems like, currently Pryor is running really good. Are you surprised at all of the production that you're getting out of that plant before finally replacing that urea reactor?

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Mark T. Behrman, LSB Industries, Inc. - President, CEO & Director [7]

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No. I think a big focus up at Pryor, as John mentioned, really has been the ammonia plant. Everything starts with ammonia, right? If we don't make ammonia, we can't make downstream products, we can't sell product. So I think the team has done a great job over the last couple of years really focusing on the reliability of the ammonia plant. And we're pretty comfortable that we can run certainly at 90-plus percent out of that plant for the full year, and we'll see as we improve throughout the year, and certainly, after the turnaround. So no, I don't think we're surprised. I think that's the plan that was put in place. And as John mentioned, after our focus of the ammonia plant, and we're still continuing to do work there, the focus then will turn more towards the nitric acid plants, and in particular, the urea plant. So we feel comfortable, as I said, that we're making progress up at Pryor. It's obviously slower than you expect, but little by little.

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Joseph Logan Mondillo, Sidoti & Company, LLC - Research Analyst [8]

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And sticking with Pryor, I guess, natural gas prices, I believe, have been very favorable, particularly at Pryor due to, I guess, some supply issues and not being able to get that natural gas out of the Permian. Is that dynamic consistent to what you saw in 2018? And will that change at all in 2019?

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Mark T. Behrman, LSB Industries, Inc. - President, CEO & Director [9]

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Yes. It will change. I think, for a good part of 2018, we saw significant basis differential, so a basis advantage with gas up at Pryor. A lot of that had to do with no takeaway capacity. Those dynamics have changed slightly. There are some pipelines that are being built up out of the SCOOP and STACK area, which is where they're pulling gas. But also LNG is becoming much more prevalent, all right. I mean, everyone is talking about LNG and exporting LNG. So those producers up in SCOOP/STACK region of Oklahoma are also able to move gas down the pipeline to the Gulf. So LNG will have some impact on their ability to get gas out as well. All of that really translates into a basis differential that's probably narrowing a little bit. We still will enjoy a basis differential -- a positive basis differential out of Pryor versus our other 2 facilities, but it probably narrowed a little bit.

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Joseph Logan Mondillo, Sidoti & Company, LLC - Research Analyst [10]

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Okay. And in terms of the turnarounds, I believe, you called out -- on this call, you called out $10 million of costs in the third quarter of '18, and I believe, on the third quarter call last year, you called out about $5 million of cost absorption, so call it about $15 million headwind in the third quarter of '18. You called out, for this third quarter in terms of the turnarounds, $8 million of costs. Is there any way to at least compare, if not, quantify the cost absorption in third quarter, the effects there, relative to that $5 million that you saw in the third quarter of '18?

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Mark T. Behrman, LSB Industries, Inc. - President, CEO & Director [11]

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I would tell you that with prices up year-over-year, then the $5 million impact from cost absorption is going to be higher this year than it would be -- than it was last year. So that $15 million impact in the third quarter of last year will be higher this year.

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Joseph Logan Mondillo, Sidoti & Company, LLC - Research Analyst [12]

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Okay. Great. And then, I wanted to ask about SG&A, the -- even if you'd exclude the severance costs, SG&A was up, and you called out the fact that it was because -- largely because of the legal costs. The guidance for SG&A suggests that these legal costs will go away assumingly, I guess. Is that the right way to think about that? Do you expect any more legal costs related to the subcontractor issue?

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Mark T. Behrman, LSB Industries, Inc. - President, CEO & Director [13]

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Yes. I mean, I think up -- the incurrence of legal costs related to this issue is principally being incurred. It is possible that we will see some additional legal costs, but I don't think it will be as material as it was in 2018.

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Joseph Logan Mondillo, Sidoti & Company, LLC - Research Analyst [14]

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Okay. And regarding sort of the recovery, or I guess, could you quantify how much costs you have expense related to this issue? And what's the total cost that the whole -- the legal costs and the issues related to the whole issue, what would that total cost be so we can get an idea of, you said, you're hoping to get all of it back, but obviously, may be you won't. Any idea about that?

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Mark T. Behrman, LSB Industries, Inc. - President, CEO & Director [15]

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Yes. I don't think we've really quantified what that cost is. So I'm certainly not going to -- probably not in a position to discuss it right now.

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Joseph Logan Mondillo, Sidoti & Company, LLC - Research Analyst [16]

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Okay. And then, in terms of pricing, I guess, especially for the first quarter, I understand that volumes may be a little lower due to these delay of sales, but in terms of pricing, relative to spot, have you sold forward at all those attractive prices that we saw in the back half of '18? Or how can we think about forward versus spot realization in the first half or the first quarter?

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Mark T. Behrman, LSB Industries, Inc. - President, CEO & Director [17]

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Yes. I think, as both Cheryl and I'd pointed out on UAN, we're principally sold out for the first quarter, and we have taken some orders in the second quarter. So we have some forward sales. And I think we feel really comfortable with the price. I mean, I think Cheryl talked about first quarter pricing for UAN at about $200 a ton or higher. So we like the pricing. For ammonia, we've got a forward order book as well that certainly takes us out for the rest of this quarter and into some in the fourth quarter as well. We've got some ability to take some additional spot orders into this -- in this third quarter for when the market opens. And we think that the pricing is pretty attractive. We're seeing relative to NOLA pricing or the Tampa pricing, we're seeing in-win premiums for ammonia sold as fertilizer. So we're happy with the pricing. On HDAN, I think we've got a pretty healthy and solid forward order book there. And so we're just waiting for the weather to allow the movement of product. And so that should take us, certainly, through this quarter and into the second quarter.

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Joseph Logan Mondillo, Sidoti & Company, LLC - Research Analyst [18]

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Okay. So fourth quarter, it looks like you saw a discount in NOLA prices, especially on UAN. You think that will essentially reverse and you should see sort of a premium in the first quarter?

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Mark T. Behrman, LSB Industries, Inc. - President, CEO & Director [19]

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Yes. I don't -- I can't tell you what -- I don't remember what the NOLA UAN price was in the fourth quarter. I can just tell you that where our pricing is, and we're seeing that north of -- for UAN, north of $200 a ton today.

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Joseph Logan Mondillo, Sidoti & Company, LLC - Research Analyst [20]

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Okay. And the ammonia prices in terms of NOLA, you expect that also to be sort of favorable in terms of NOLA prices?

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Mark T. Behrman, LSB Industries, Inc. - President, CEO & Director [21]

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Yes.

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Joseph Logan Mondillo, Sidoti & Company, LLC - Research Analyst [22]

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Okay. You also mentioned the procurement and logistics that you talked a lot about at the Investor Day last year. I believe you were thinking potential savings of $5 million or maybe more. Is that baked into your SG&A guidance? Is there upside to those savings throughout this year? Could you just talk about what's going on there? And I know there's a lot of different dynamics, just given freight and potentially barge prices. Could you just sort of address how your thinking about the benefits from what you're doing there?

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Mark T. Behrman, LSB Industries, Inc. - President, CEO & Director [23]

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Yes, sure. So I think we spoke at our Investor Day and I think we even spoke on some conference calls of about $3 million to $5 million of annual cash savings primarily from procurement as opposed to logistics. There'll be some on the logistics side. I think we realized between $2.5 million and $3 million of annual savings, and we put it in place starting for 2019. Most of that's going to not be in SG&A, it's going to be in cost of sales. So it's really plant expenses, which rolls up to cost of sales. So I think there is still some more upside. I think we can probably capture another $2 million, as I said, $3 million to $5 million over the next 12 to 18 months. First, you attack the low-hanging fruit, and then you go after some other opportunities. So I think we'll still be able to realize some of that.

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Joseph Logan Mondillo, Sidoti & Company, LLC - Research Analyst [24]

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Okay. And last question for me, just regarding -- there's a lot of, I guess, puts and takes with the working capital. It sounded like you're going to see some recovery in some of the receivables, about $10 million in the first half of the year. How can we think about working capital needs or uses for 2019?

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Cheryl Maguire, LSB Industries, Inc. - Senior VP & CFO [25]

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Joe, this is Cheryl. As you know, we typically build inventory going into the spring season, and we saw that inventory down in the first half of the year. So working capital is generally at its lowest in the summer months. Once the cooler temperatures come around in the fall, we'll start building up inventory again in the October to December time frame to get ready for spring season. The only other thing I'd mention is, we've talked about this recently that we're thinking differently about our summer fail and our fall fail requirements. And that could mean we store more inventory in the low season. So we can sell it at higher prices in season.

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Mark T. Behrman, LSB Industries, Inc. - President, CEO & Director [26]

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But you're probably talking about anywhere from $5 million to no more than $10 million of additional working capital for that temporary period of time.

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Joseph Logan Mondillo, Sidoti & Company, LLC - Research Analyst [27]

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So looking across the year, is it sort of too early to sort of tell how that would fall in place in terms of what the year looks like? Or do you think you're positioned to maybe generate cash for working capital? Or does it depend on how the market translates and how much inventory you're building in the back half of the year, that kind of thing?

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Mark T. Behrman, LSB Industries, Inc. - President, CEO & Director [28]

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Well, I mean, I think we definitely expect to generate cash. It's way too early to determine how much cash we generate just to -- a lot of it will depend...

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Joseph Logan Mondillo, Sidoti & Company, LLC - Research Analyst [29]

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On a working cap basis I'm referring to?

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Mark T. Behrman, LSB Industries, Inc. - President, CEO & Director [30]

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Yes. I think it's too early to tell. A lot will depend on the pricing in the summer fill program and what our strategy is as far as positioning product.

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Operator [31]

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The next question is from Karl Blunden of Goldman Sachs.

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Karl Blunden, Goldman Sachs Group Inc., Research Division - Senior Analyst [32]

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We've got into it a little bit there at the end regarding cash flow and capital allocation over time. You mentioned some you'd explore opportunities to gain scale. Interested in your thoughts on what those could be? What kind of size you're contemplating? Obviously, it's a bit of a longer-term question, but just want to understand what you're focused on?

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Mark T. Behrman, LSB Industries, Inc. - President, CEO & Director [33]

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Sure. I think we said on the last couple of calls that we believe that there should be further consolidation within the fertilizer space. This industry in North America is really dominated by 3 of our main competitors, and then there are a number of other smaller competitors, including ourselves. I think scale is important in this industry for lots of various reasons, just sheer financial strength is one, the ability to move product, diversity of product, logistics and procurement opportunities. So we will look to see if we can be part of or leave that consolidation. But I don't want to discount us doing anything on the industrial side of our business. We have a small sulfuric acid plant out of El Dorado. We know that business well. We've been in the business for a long period of time. So if there are opportunities to combine or merge or acquire with other sulfuric plants or assets of companies, we'd certainly be open to doing that. The same on the nitric acid side. We're the largest merchant marketer of nitric acid in North America. We know that business. We're known in the industry to be the leader in that business. So we'd love to have the ability to acquire or merge with some other assets there as well. So I think we'll be open-minded as we look around and see what opportunities might make sense. I mean, at the end of the day, they've got to really make sense and they've got to be accretive to shareholder value. Well, scale is not worth doing just for the sake of scale.

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Karl Blunden, Goldman Sachs Group Inc., Research Division - Senior Analyst [34]

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And that will make sense. It sounds like some of the things you mentioned there would require some cash, some -- potentially not in the sense of a merger. When you're thinking about use of cash and your priorities there, how do -- does that growth or tuck-in acquisitions, how would that -- how would you prioritize that relative to debt reduction or reduction of the preferreds outstanding?

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Mark T. Behrman, LSB Industries, Inc. - President, CEO & Director [35]

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Well, I mean, I think you have to look at returns, that's probably the most important thing. Clearly, we've got a preferred stock that's outstanding, that is relatively expensive. And I don't think we've been shy historically about talking about our desire to try and redeem that and reduce that or ultimately replace it. So I don't think that's changed. But as opportunities come up, I think you have to at least explore them and see if they really make sense. And so we'll do that. And if there is an opportunity that comes up that we think is -- ultimately is an increase to shareholder value, then we'll have to weigh the different options in the use of capital.

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Operator [36]

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The next question is from JP Geygan of Global Value.

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James Philip Geygan, Global Value Research Company - VP of Research & Senior Analyst [37]

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Your plant operations have improved. And you talked about a number of factors that led to that, including leadership changes, capital investments and maintenance procedures. Page 7 of your deck provides a nice overview on your progress on multiyear plan, but I was hoping you might provide a little color around this checklist of 7 items, assess where you are in this process? What sort of incremental improvement we might expect? And as you begin to focus on downstream production versus the ammonia production, how that might affect your financial results, particularly margin?

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Mark T. Behrman, LSB Industries, Inc. - President, CEO & Director [38]

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Well, I mean, again, as we've probably talked about a number of different times, everything starts with ammonia, right? So the one good thing about nitrogen facilities is all along the manufacturing change you have the ability to make and sell each product individually. So the only reason really to upgrade to a downstream product is because you can have a greater margin. Otherwise, we would just sell straight ammonia. So I think, when we look at this, and we look at it all the time, we call it product balance, we really look at our ability -- in some cases, on the industrial side and the mining side, specifically, we've got contracts. And those are longer-term contracts, and we have got commitments with those contracts. So we certainly can't switch product around where we won't deliver on those contracts. But where we don't -- where we have the ability to move product around, we continually look at that and see where our best margins are. So I don't think anything really changes by having better or more reliable operations. I mean, it gives us more product for sale, more potential product for sale. But the same thought process that we have today, we will continue going forward.

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James Philip Geygan, Global Value Research Company - VP of Research & Senior Analyst [39]

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Recognizing that this is an ongoing process that at certain level will never end, how far or long are you in terms of between where you've come from and where you'd like to be?

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Mark T. Behrman, LSB Industries, Inc. - President, CEO & Director [40]

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Yes. So I get that question all the time. I guess, the way I would categorize it, I use baseball terminology. We're in the top of the seventh inning. So we've made a lot of progress, but I don't think we're there yet, clearly. And so we've got a bit more work to do. We've talked about, over the last year and a half, really revamping our maintenance management system and work order process system and some of the other operational initiatives that we've had. But we are embarking on kind of a next level of initiatives that John alluded to. And so that's an ongoing process. When you're talking about training and you're talking about changing operational behavior, that goes on and on and on. As you said, it's continuous. And so that will -- that program itself, the specific program is probably a 2-year, 2.5-year program that we're investing. And it's really an investment in people, more than it is in equipment. Certainly, we need to invest appropriate amount of capital, but we feel that the investment in our people is just as important. And so we'll continue to do that. So top of the seventh inning, we hope that we make significant progress and believe that we can make significant progress throughout this year. And that's why I alluded to the fact that, I think, particularly, at Pryor, we'll have a lot of improvement, and we expect a lot of improvement this year so that we can run that facility and that ammonia plant at higher operating rates, and certainly, the ammonia plant more towards the mid-90s operating rate.

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James Philip Geygan, Global Value Research Company - VP of Research & Senior Analyst [41]

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Okay. Natural gas prices spiked late in the year, which you talked about. Can you shed some light on how you either prepare hedge or pass these costs through?

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Mark T. Behrman, LSB Industries, Inc. - President, CEO & Director [42]

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Yes. So historically -- or certainly, the last 2 years, I'll talk about the last couple of years. We will buy natural gas to match forward sales. So that's a pure hedge, where we can lock in our margin. We have not typically gone forward on just gas purchases without having a sale. Clearly, we and others were probably shaken a little bit in the spike that we saw -- the significant spike that we saw in the fourth quarter. So as we sit here today, strategy really hasn't changed that much, but we did lock in about 75% of our gas for February and for March in addition to the forward sales that we had at prices that, I think, Cheryl alluded to, around $3. Actually, thinking about it, we really locked in at EDC and at Cherokee. We did not lock in at Pryor.

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Jeffrey Richart Geygan, Global Value Investment Corp - President, CEO and Chief Compliance Officer [43]

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Okay. And my final question is on the Baytown and Covestro relationship. You briefly touched on an expansion that was going on or what you plan to undertake there. Can you give us a sense of the scale of that expansion?

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Mark T. Behrman, LSB Industries, Inc. - President, CEO & Director [44]

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No, I really can't. It's -- I feel uncomfortable talking about sort of the relationship down in Baytown with Covestro. They have announced publicly that they're going to do a pretty substantial expansion of their own facility down in Baytown and that's public knowledge. So clearly, if they do expansion, which is on the MDI side, they're going to need more nitric acid. So we're in conversations with them as you would expect and the different options that they have and how we might fulfill the needs of additional nitric acid.

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Operator [45]

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The next question is from Brian DiRubbio of William Blair.

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Brian DiRubbio, [46]

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Just a couple of housekeeping questions. I know we're running late, so I'll try to keep this quick. You mentioned during the script in the release, they were -- you delivered project -- product to several customers with extended short-term payment terms as means of optimizing inventory storage capacity. Can you quantify how much that was?

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Mark T. Behrman, LSB Industries, Inc. - President, CEO & Director [47]

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How many tons?

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Brian DiRubbio, [48]

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No, dollar amount?

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Mark T. Behrman, LSB Industries, Inc. - President, CEO & Director [49]

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I'd probably say it was in the neighborhood of $5 million.

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Brian DiRubbio, [50]

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Okay. And that was sales that would normally be in the first quarter that you just sort of put forward a little bit?

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Mark T. Behrman, LSB Industries, Inc. - President, CEO & Director [51]

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No. Actually, it was sales that were in the fourth quarter, but we extended the payment terms a little bit to work with our customers.

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Brian DiRubbio, [52]

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Got it. And with inventory at current levels, and obviously, given the slow start to the planting season, do you have to lower operating rates to sort of manage inventory at your storage levels?

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Mark T. Behrman, LSB Industries, Inc. - President, CEO & Director [53]

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Well, we really haven't had to do much of that at all so far. We're lucky in that we've got pretty decent ammonia storage at all 3 facilities. Unfortunately, what we have had to do, and it was a decision, you always have that decision, right? You can turn down the operating rates if you fill up and you can't sell the product or you can move product between facilities. And so we were able -- we've got very large storage capabilities down at El Dorado. And so we were able to move product, particularly out of Pryor down to El Dorado into their storage facilities. The bad part is, you incur freight when you do that. So there is some cost related to that.

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Brian DiRubbio, [54]

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Okay. And as we think about just the weather right now, is there -- how should we think -- the weather forecast for the next 40 days still indicate very cold weather. Is this sort of a period in time where plantings just don't get done? Or is it all just put into the second quarter?

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Mark T. Behrman, LSB Industries, Inc. - President, CEO & Director [55]

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Well, generally speaking, farmers insurance doesn't kick in until April 1 anyhow. So they've got until April 1 to plant. Our expectation or our hope anyhow would be that the weather breaks before then. But I can't predict -- I mean, none of us can predict the weather. So I think it's just more of a waiting-out period.

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Brian DiRubbio, [56]

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Understood. And then just final question. The vendor settlements that you had, that was $4.4 million, that was considered a reduction in COGS, if I saw the notes correctly?

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Cheryl Maguire, LSB Industries, Inc. - Senior VP & CFO [57]

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Yes, that's correct. When we originally incurred those costs, they were in cost of goods sold. And so the recovery goes against the cost of goods sold.

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Brian DiRubbio, [58]

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Okay. So on a sort of -- on a go-forward basis, if we sort of try to level set this fourth quarter to next fourth quarter, we're really thinking about no more than $18.5 million, $19 million EBITDA number sort of a true comp number as we think about fourth quarter of '19?

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Mark T. Behrman, LSB Industries, Inc. - President, CEO & Director [59]

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Well, I guess, on the pure numbers, I would agree with that. I mean, I would hope that we didn't -- we truncated fall ammonia application season, which we hadn't seen in a while, we don't have again. So I guess, it depends on how you look at that internally. We took about $5 million hit in the fourth quarter for having a very shortened ammonia application season. So the $4.4 million principally offset that. So we would hope not to see that again.

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Brian DiRubbio, [60]

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Okay. And just one final question. You mentioned you still have high cost inventory in the system. As a percentage of your inventory, is that pretty much all the $29 million of inventory, is that all high cost, should we all consider that high cost?

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Cheryl Maguire, LSB Industries, Inc. - Senior VP & CFO [61]

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No. The way that I would look at it is, we generally run about $2.4 million of MMBtus of gas a month, and gas in the fourth -- and actually, in December, if you think about it on a 30-day turn, gas was about $1 higher. So $1 on $2.4 million is probably your impact that you should see in the first quarter.

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Operator [62]

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There are no further questions. I'll now turn the conference back over to Mark Behrman for closing remarks.

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Mark T. Behrman, LSB Industries, Inc. - President, CEO & Director [63]

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Well, we appreciate everyone's interest in LSB Industries, and hope to deliver continued good results and improving results in the quarters to come. Thank you so much.

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Operator [64]

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This concludes today's conference. You may all disconnect your lines at this time. Thank you for your participation.