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Edited Transcript of OEC earnings conference call or presentation 2-Aug-19 12:30pm GMT

Q2 2019 Orion Engineered Carbons SA Earnings Call

Luxembourg Aug 12, 2019 (Thomson StreetEvents) -- Edited Transcript of Orion Engineered Carbons SA earnings conference call or presentation Friday, August 2, 2019 at 12:30:00pm GMT

TEXT version of Transcript

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Corporate Participants

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* Charles E. N. Herlinger

Orion Engineered Carbons S.A. - CFO

* Corning F. Painter

Orion Engineered Carbons S.A. - CEO & Director

* Diana Downey

Orion Engineered Carbons LLC - VP of IR

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Conference Call Participants

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* Christopher John Kapsch

Loop Capital Markets LLC, Research Division - MD

* John Ezekiel E. Roberts

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

* Jonathan E. Tanwanteng

CJS Securities, Inc. - MD

* Kevin William Hocevar

Northcoast Research Partners, LLC - VP & Equity Research Analyst

* Laurence Alexander

Jefferies LLC, Research Division - VP & Equity Research Analyst

* Michael James Leithead

Barclays Bank PLC, Research Division - Research Analyst

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Presentation

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Operator [1]

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Greetings. Welcome to Orion Engineered Carbons' Second Quarter 2019 Earnings Conference Call. (Operator Instructions) Please note, this conference is being recorded. I will now turn the conference over to Diana Downey, Vice President of Investor Relations. Thank you. You may begin.

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Diana Downey, Orion Engineered Carbons LLC - VP of IR [2]

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Thank you, operator. Good morning, everyone, and welcome to Orion Engineered Carbons' conference call to discuss second quarter 2019 financial results. I'm Diana Downey, Vice President, Investor Relations. With us today are Corning Painter, Chief Executive Officer; and Charles Herlinger, Chief Financial Officer. We issued our earnings press release after the market closed yesterday and have posted the slide presentation to the Investor Relations portion of our website. We will be referencing this presentation during this call.

Before we begin, I'll remind you that some of the comments made on today's call, including our financial guidance, are forward-looking statements. These statements are subject to the risk and uncertainties as described in the company's filings with the SEC. Actual results may differ materially from those described during the call. In addition, all forward-looking statements are made as of today, August 2, 2019, and the company does not undertake to update any forward-looking statements based on new circumstances or revised expectations. Also, non-GAAP financial measures discussed during this call are reconciled to the most directly comparable GAAP measures in the table attached to our press release.

I will now turn the call over to Corning Painter.

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Corning F. Painter, Orion Engineered Carbons S.A. - CEO & Director [3]

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Thank you, Diana. Good morning, everyone, and thank you for joining us on our second quarter 2019 earnings conference call. I'll start today's call by providing general comments on our performance and the industry backdrop. Our CFO, Charles Herlinger, will then provide detail on our financial results and related matters for 2019. Then I'll come back and share some closing comments. We will then be happy to take your questions.

Turning to Slide 3. We saw solid performance in the second quarter, which was in line with our expectations when we issued our last release. April, as we said previously, was an improvement from March, May was stronger yet. But in June, particularly in the second half, volumes weakened in many of our end-markets. During the quarter, we drew down our inventory levels, which contributed to a lower overhead absorption, and thus, a negative impact on our P&L of $4.8 million. Despite this, our adjusted EBITDA improved $6.9 million or 10.8% from Q1. Despite Q2, looking forward now to the rest of the year, we see uncertainty in trading conditions affecting demand generally, and with customers continuing to be conservative about their stocking of the more premium grades of our specialty business, as they continue to manage their own supply chains with caution.

While Q2 results improved substantially over Q1, we were down on the prior year record quarter, reflecting the challenging overall market environment for the industry, particularly in the specialty business. While we saw an increase in specialty volumes, both year-over-year and particularly versus the first quarter, mix continued to be weaker than our norm for the reasons just mentioned. In contrast, our rubber business delivered a significant increase in adjusted EBITDA, both compared to the prior year as well as the first quarter, reflecting the impact of the 2019 pricing cycle, coupled with excellent operational performance and stable demand.

A continued healthy supply-demand balance in the rubber markets, coupled with a stable replacement tire market, along with improved volumes, particularly in China, contributed to this positive development. In support of these developments, we remain very focused on actions within our control, such as channel management, closely managing inventory, stepping up our efforts to qualify our products with customers, progressing a number of key marketing programs and tightly controlling costs. In addition, we continued to strengthen our management team, having added new leaders to strengthen our Americas business, global operations and the HR function.

Most importantly, we continue to focus on being cash positive for 2019 and beyond by managing our capital investments and working capital levels in line with the trading environment, with our strong balance sheet underpinning our commitment to the dividend.

To cap the quarter off in a positive note, Orion was admitted to the Russell 2000 index on July 1, 2019, a year ahead of the originally planned date. This was the result of a lot of focused work to convert our financial statements to U.S. dollars and U.S. GAAP, and thus make Orion more accessible to a broader investor base.

Looking at the regional markets. Our specialty volumes in Asia were up significantly versus the first quarter, reaching levels comparable to a year ago. Although this recovery in volumes from the first quarter was concentrated in some of our lower-margin products, as customers continue to be cautious with stocking their supply chain with our premium grades and due to some weakness in OEM automobile markets.

In EMEA, specialty volumes held up well compared to the prior year, with somewhat local variations, although the coatings markets continue to display softness in line with this dampened OEM demand. In the Americas, trade tensions contributed to weaker volumes destined for export compared to last year and unfavorable product mix.

We executed our action plan to improve certain sales channels in China and Rubber MRG-related volumes rebounded well from Q1, reaching levels broadly consistent with prior year levels. Our Rubber Americas business remained strong in Q2, with volumes again above prior year levels. We continue to, however, be impacted by worsening unfavorable feedstock differentials in 2019, particularly in this market. These unfavorable feedstock impacts, combined with the costs associated with compliance investments our whole industry is making in the U.S. to comply with EPA requirements means that our rubber pricing levels continue to be below those needed to earn a satisfactory cost of capital, as we have previously discussed.

In Europe, we saw some softening in volumes towards the end of the quarter, and we now expect these softer market conditions to continue in the second half of this year. Annual rubber contract price negotiations for 2020, and in some cases, later years as well are underway with some customers underscoring the healthy supply-demand dynamics in our industry, as summarized for your reference in the appendix on Slide 20.

As mentioned earlier, to deal with the unfavorable feedstock impacts and supported by high levels of utilization, we are taking actions. And in July, we announced price increases of $0.08 per pound for rubber grade carbon black and $0.07 per pound for specialty grade carbon black in North America, and an enhanced price list for certain services. The rubber grade price increase is structured as $0.04 base price increase and $0.04 to account for CVO differential surcharges.

Despite being encouraged by the sequential improvement we have seen as the year progressed, and with it our performance in the second quarter, the macroeconomic environment remains more challenging than we had anticipated at the end of last quarter, especially in the automotive markets. Therefore, for the second half of the year, we anticipate that customers will continue to be running at conservative production and inventory levels for the remainder of 2019, with the usual seasonal effects in the fourth quarter.

Given this change in outlook for the second half of 2019, we are trimming our guidance for the full year adjusted EBITDA for 2019 to the range of $265 million to $285 million from our previous guidance of $280 million to $300 million. Our revised guidance for 2019 also takes into account a continued negative effect of product mix in specialty as well as the negative impact of feedstock differentials in both rubber and specialty.

Please turn to Slide 4. Clear, measured and efficient capital allocation remains a top priority for Orion, as we continue to utilize all the levers at our disposal to deliver on our commitments to shareholders. Specifically, we continue our strong commitment to the dividend at current levels.

Our consistent track record on this from our IPO to date is summarized on the table on this slide. At the same time, we will continue to invest in must-do safety, maintenance and compliance projects to strengthen the foundation of our business. The U.S. EPA-related investments that we and the entire U.S. carbon black industry are committed to, over the next few years, represent the largest portion of our compliance projects by far, with the bulk of these expenditures expected to be incurred in 2019 and 2020. While these onetime capital expenditures could make us a bit more selective regarding other value-enhancing investments, we continue to be confident that a significant portion of these outlays will be reimbursed to us by Evonik under the provisions of our agreement due with them. Due to the length of arbitration, which we have commenced in the second quarter, reimbursement could well exceed 2 to 3 years. While we would rather invest in additional high-value added projects, which are bound in our core business, these outlays on complex compliance projects do, in fact, continue to strengthen the moat around our business. The 2 main impacts being increased technical know-how needed to efficiently compete in our market, and the considerable upfront cost outlay necessary and thus, sharply increased cost of capital associated with adding capacity.

In summary, we remain focused on maintaining a sensible balance between competing uses of capital to underpin our dividend. In times of increased economic volatility, we will proactively manage our discretionary capital spend and working capital investments to balance the competing needs of our business. In practice, this means that during the course of the year, we will periodically review our opportunities and pace our spending accordingly. With the ample runway in our core Carbon Black business, I am especially pleased to have enhanced our leadership team by bringing on strong operational talent with the recent management hires. These new leaders position us well to go after the healthy backlog of value enhancement opportunities, including the development of new products, exploiting new applications, improving product quality, debottlenecking in demand plants and improving our overall efficiency.

As Slide 5 shows, we have a pathway to deliver strong cash performance, while continuing to service our dividend and operate within our guidance range, assuming there is no reimbursement under the Evonik indemnity this year, and the swings in working capital balance out over the short to medium term. This shows the ability of our business to front EPA-related compliance costs, and at the same time continue to move the business forward, while navigating a relatively challenging trading environment.

Please turn to Slide 6. This year-on-year EBITDA walk provides key insights into the underlying drivers of our business. Most importantly, you can see the significance of the base price increases, mainly in rubber, more than offsetting negative product mix in specialty. This analysis also shows the impact of both worsening foreign exchange translation impacts as well as the absorption of increased negative feedstock differentials. These 2 factors accounted for nearly all of the overall deterioration from last year's strong quarterly performance at the total group level. This slide also quantifies the year-over-year earnings impact from the inventory drawdown, I mentioned earlier. While this was a headwind for the quarter, we believe it was the right decision as we proactively manage our business, while taking advantage of our improved operational reliability.

Having dissected the second quarter in this manner, you can see that our overall business on an underlying basis remained healthy and developed largely consistent with our expectations. This analysis does, however, also underscore the importance of us recovering the negative impacts of worsening feedstock differentials. Our recently announced price increases, and the CBO differential surcharge are a step in this direction.

Before I pass the call over to Charles, I would like to share that he has decided to retire at the end of this year. I would like to take a moment to thank him for the critical role in the company's development and his many contributions. Charles will continue until the end of the year and will support the search for a replacement and the transition. Speaking personally, Charles has been a tremendous guide for me since I joined Orion. Charles, thank you for all you have done for the company and for being an exceptional colleague.

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Charles E. N. Herlinger, Orion Engineered Carbons S.A. - CFO [4]

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Thank you very much, Corning. Now turning to Slide 7. Year-on-year volumes were up by 1%, adjusted for the plant consolidation in South Korea, and up fully by 2.9% on a sequential basis, driven mainly by our specialty business. Our adjusted EBITDA was $71.5 million for the quarter, with basic EPS and adjusted EPS at $0.41 and $0.53, respectively with our basic EPS a year ago benefiting by $0.35 as a result of the land sale in South Korea. The development of our adjusted EPS versus the prior year as well as the first quarter of this year is essentially in line with the development of our adjusted EBITDA. It's also important to point out that a large part of the decline in our overall contribution margin per metric ton was attributed to unfavorable foreign exchange translation effects, mostly related to the strengthening of the U.S. dollar versus other key OEC currencies. Similarly, to underscore Corning's comments made already regarding the development of our business in the second quarter, we would have been at $76 million of adjusted EBITDA, rather than the reported $71.5 million, had we not seen a strengthening of the U.S. dollar versus other currencies in which we trade.

On Slide 8, on the top left-hand side, the main drivers of the change in contribution margin from Q2 of last year are summarized with a net impact of positive price mix associated mainly with our rubber business eroded primarily by negative FX translation impacts, negative feedstock differentials and inventory movements, as previously commented on by Corning. Although the rubber segment continued to achieve the pricing levels as in the first quarter, this was in large part eaten away by having to absorb worsening negative feedstock differentials. Recovery of these negative feedstock differentials is key to ensuring that we have a stable rubber business platform and indeed, consistent with a long-established general principle that we pass on to our rubber customers both positive but also negative developments in the pricing of our feedstocks we use to manufacture our products.

Moving further down the P&L, it can be seen that the change in contribution margin was also the main driver of the change in adjusted EBITDA, although with some offset by favorable FX impacts on our fixed costs.

The waterfall chart along the bottom of this slide shows that the change in net income, which is mostly driven by the absence in the second quarter of this year of the gain on the South Korean land sale included in 2018.

The development of our adjusted EBITDA as well as a reduced tax impact, mainly associated with the absence of the land sale gain, round out the main drivers of the development of our net income versus last year.

Now turning to Slide 9, showing our cash flow for the first half of 2019 as well as an expectation of cash flow within the provided guidance. For the first half of the year, our cash flow from operating activities totaled $74.1 million, which included an increase in working capital of $5.2 million, associated primarily with changes in our feedstock costs as well as an increase in cash due to net financing activities of $19.4 million, which supported our cash CapEx investment program of $60.9 million at a level consistent with our expectations for the timing of this spend for the first half of 2019. Other uses of cash over the same period included dividend payments of $23.9 million. As a result, our cash position at the end of Q2 2019 was $53.2 million.

The right-hand side of this slide shows detailed underpinning of strong cash performance during the first half of this year, together with the expected development for the remainder of this year.

Now turning to Slide 10, showing our key balance sheet metrics as of June 30, 2019. The company's noncurrent indebtedness as of the second quarter was $638.3 million, with net debt of $651.8 million, taking our Term Loan B debt and local debt into account, which represents a leverage ratio of 2.39x LTM adjusted EBITDA. Due to our refinancing activities in recent years, interest costs, which are largely capped on the Term Loan B instrument remain very competitive.

With my retirement date now formalized at the end of 2019, a core element of my final phases to Orion is to help support a well-orchestrated transition. This obviously starts with ensuring that Corning and the board have all the support they need in selecting a qualified candidate and then, ensuring that there is a smooth handoff. In my time at Orion, it has been gratifying to see the continued evolution that the commitment of our entire workforce has delivered.

I will now pass back to Corning.

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Corning F. Painter, Orion Engineered Carbons S.A. - CEO & Director [5]

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Moving to Slide 11, showing our key quarterly specialty metrics, volumes improved year-over-year as well as sequentially, although gross profit per ton remained around the level of Q1, with mix being the main challenge, followed by FX translation effects. Excluding the FX effects compared to last year, adjusted EBITDA and gross profit per metric ton were $33.4 million and $680, respectively.

On Slide 12, we take a deeper look at the main drivers in the specialty business year-over-year, with higher volumes, only partially offsetting the negative impact from significantly weaker mix and with unfavorable FX impacts, negative feedstock differentials, an increase in fixed costs and some energy impacts further impairing performance.

Global trading conditions are quite volatile, and we believe mix will remain somewhat of a headwind in the second half of the year. The appendix to our slide presentation includes a summary of the key metrics we have used to drive our expectations for the remainder of the year, with a particular focus on changes in these metrics since the last quarter update.

Please now turn to Slide 13. Rubber volumes were up 0.9% sequentially, and up by 0.3% year-on-year when adjusted for the plant consolidation in South Korea taking place at the end of Q2 last year. This growth should be seen within the context of a healthy overall tire demand, driven in large part by replacement tire demand, but with a more challenging trading environment for our MRG products, where demand in large part is linked to OEM automobile activity. Having said this, MRG volumes improved compared to the first quarter of this year, largely due to the channel management actions recently taken. Gross profit per ton was up $34 per ton from a year ago on the back of pricing gains despite significantly negative FX and feedstock differential impacts. Our adjusted EBITDA reflected the progress made at the gross profit level, and we hit our expectations for this quarter at $40.5 million.

Without the negative FX translation impacts compared to a year ago, our GP per metric ton and adjusted EBITDA would have been $311 per metric ton and $42.6 million, respectively.

On Slide 14, we provide more detail on these changes versus last year, highlighting the favorable development of pricing and mix, with unfavorable FX effects and negative differentials being offset by improved fixed cost levels and energy-related items.

On Slide 15, you can see the forward rates for the U.S. oil market with this graph being, as you would expect, largely similar for other regions. Compared with the projection of the forward curve at the end of Q1, the pricing spread between high and low sulfur grades has increased. We continue to work hard to raise our non-index prices to recover these costs. We remain confident that we will be able to recover these Marpol-related 2020 costs although we may experience some fluctuations between our quarterly results relating to timing effects.

Please now turn to the next slide, where we've summarized the various initiatives that are well underway or indeed already ticked off the list, with a reminder that despite progress recently made, we believe our rubber segment has a lot more opportunity.

Next, I would like to briefly update you on some governance initiatives we have completed. From an ESG perspective, we added sustainability to the charter of the Board committee, we now call the Nominating, Sustainability and Governance Committee. We established long-term environmental sustainability targets for the company, and we issued our first sustainability report, which I invite you to download from our webpage. We also adopted shareholding requirements for key executives and board members.

I would like to thank the sustainability team for leading the charge on this important topic.

Thank you.

Turning to Slide 17, we summarized key assumptions upon which our guidance is based. Especially given the current economic backdrop, we continue to focus on actions within our control, making progress on our profit improvement program, continuing to work on pricing excellence, utilizing this time to gain qualifications on new products and entering new markets like lithium-ion batteries. Our outlook is based on assumptions that oil prices, exchange rates and feedstock impacts will not materially change from the average level seen in the second quarter of 2019. Other elements of our guidance are noted in the appendix section of our slide presentation.

We are currently pacing our non-EPA capital expenditures for 2019 to be in the range of $75 million to $80 million, comprising of base CapEx and the already announced specialty line investment in Ravenna, Italy. We expect U.S. EPA settlement-related CapEx to be in the range of $60 million to $65 million, before any reimbursement to us by Evonik for this expenditure. As we actively evaluate our capital allocation strategy, we are committed to keeping our dividend stable as our strong and efficient financing structure provides necessary support.

Now I would like to move to Q&A.

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Questions and Answers

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Operator [1]

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(Operator Instructions) Our first question is from John Roberts with UBS.

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John Ezekiel E. Roberts, UBS Investment Bank, Research Division - Executive Director and Equity Research Analyst, Chemicals [2]

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Charles, it has been a pleasure to work with you, and you set the bar high for your successor.

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Charles E. N. Herlinger, Orion Engineered Carbons S.A. - CFO [3]

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Thank you very much, John. Really appreciate that.

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John Ezekiel E. Roberts, UBS Investment Bank, Research Division - Executive Director and Equity Research Analyst, Chemicals [4]

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I am suspecting that the automotive engineered plastics area was among the weaker areas in the specialty blocks area. I wonder if you could compare and contrast that with the manufactured rubber products area. So I would say they normally go coincident with each other, but it sounded like you had more self-help and some channel management issues in manufactured rubber that at least maybe has delayed the effect on manufactured rubber into the second half?

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Corning F. Painter, Orion Engineered Carbons S.A. - CEO & Director [5]

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John, it's Corning. Let me respond to that. So you might recall that earlier in the year, we talked about how we were making some changes in channel management, particularly in China. And that, that was a headwind at that point. But we were -- thought this was the right thing to do for the long term. So more than just demand, our numbers were impacted negatively by taking those actions. And I think what we're saying at this point is, we've got those actions behind us, we've recovered that volume. So that was sort of getting back to where we were detached from really the market value. So I would say, in general, our MRG, it obviously outpaced what you'd see for OEM production or engineering plastics going into new cars.

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John Ezekiel E. Roberts, UBS Investment Bank, Research Division - Executive Director and Equity Research Analyst, Chemicals [6]

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You'd expect them to roughly track engineered plastics and MRG rubber on a forward basis?

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Corning F. Painter, Orion Engineered Carbons S.A. - CEO & Director [7]

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Right. Also, the majority of engineered plastics are really going into consumer goods, appliances, consumer electronics, and that sort of thing, not automotive. So the one sector of that, that is automotive, that should track long-term with MRG. But generally speaking, it's only that one segment of engineered plastics.

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Operator [8]

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Our next question is from Mike Leithead with Barclays.

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Michael James Leithead, Barclays Bank PLC, Research Division - Research Analyst [9]

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Charles, again, it's been great working with you since the IPO, and best wishes on your retirement. First, on specialty, it looks like you saw a bit of a pickup in demand sequentially, but GP per ton remains pretty challenged, actually it maybe a little bit below the past 2 quarters. So can you just maybe peel back the composition a bit of that? I'm guessing it's primarily a mix situation that's still weighing on gross profit per ton there?

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Corning F. Painter, Orion Engineered Carbons S.A. - CEO & Director [10]

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Yes. So I'd say there's maybe 3 ways to look at this and not just what's happening, but what can we do with it. So number one, FX is a pretty big impact. And in time, where we can shift as appropriate, where we have U.S. dollar feedstocks to move our selling prices into U.S. dollars, I see that as a positive. Obviously, we want to drive the more premium markets. So think of coatings and it's everything from auto, but also Marine Coatings, protective, decorative, that kind of thing. We're just talking about engineered plastics, things like that. One of the long-term drivers in this business, though, is that some of the lower margin end-markets for us, let's think about Black Pipe, they are, in general, growing at a higher rate than some of our premium ones. And so that's a drag on this. However, it's still a lot higher than rubber carbon black. So for us, as a group, I mean, we want that business. We're going to continue to drive it, but that's going on. And I mean, if you think about net EBITDA for the company, that's a good thing.

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Michael James Leithead, Barclays Bank PLC, Research Division - Research Analyst [11]

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Got it, okay. That's a helpful breakdown there. And then on cash, the cash flexibility. Obviously you've paced out CapEx a bit the past 2 quarters. Can you maybe just talk through what has been either moved out or canceled in your capital plan? And also, what further flexibility you might have on cash management, if conditions don't improve much over the next couple quarters?

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Charles E. N. Herlinger, Orion Engineered Carbons S.A. - CFO [12]

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Mike, Charles, here. We really haven't -- we've just paced it as we thought we would do pretty much. We didn't think it would be evenly distributed over the year. We do have some flexibility to manage some projects. But we're basically on track with where we expected to be on the EPA work, and indeed, with the other major initiatives that we're undertaking.

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Corning F. Painter, Orion Engineered Carbons S.A. - CEO & Director [13]

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I mean, we have a backlog of projects, good things that would add to EBITDA, whether it's through productivity or debottlenecking. And it's a matter of just prioritizing that. And to be clear, the EPA work, it's heavy spend this year, next year. Next fall, we are mechanically complete in Ivanhoe, we have the vast majority of this behind us.

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Operator [14]

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Our next question is from Kevin Hocevar with Northcoast Research.

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Kevin William Hocevar, Northcoast Research Partners, LLC - VP & Equity Research Analyst [15]

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I'd also like to extend my congrats, Charles, it has been a pleasure working with you these last several years.

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Charles E. N. Herlinger, Orion Engineered Carbons S.A. - CFO [16]

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Thanks very much, Kevin. I'll be around for a while.

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Corning F. Painter, Orion Engineered Carbons S.A. - CEO & Director [17]

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I'd like to stress that also.

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Kevin William Hocevar, Northcoast Research Partners, LLC - VP & Equity Research Analyst [18]

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And in terms of the -- you called out the differential impact in the quarter. Could you give us a little bit of color there? Did that get worse as the quarter progressed? And how you've kind of seen it since here in July. And it sounds like you expect, correct me if I'm wrong, that, that kind of remained stable. But obviously, IMO is still kind of developing there. So could you give us just a little bit more color on that, kind of how that's trended, what it's like now and expectations here as we go forward?

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Corning F. Painter, Orion Engineered Carbons S.A. - CEO & Director [19]

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Right. So as we've gone through the year we've seen at this point (technical difficulty) demand. I think we look for that to be more stable as we go through the rest of the year.

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Kevin William Hocevar, Northcoast Research Partners, LLC - VP & Equity Research Analyst [20]

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Got you. Okay. And then you're taking pretty significant pricing actions here in the U.S. Can you give us some thoughts there on what's baked into guidance from those actions? And do you need -- is the U.S. where you're seeing it the most, and that's why we're seeing action there? Or are the other regions also being impacted, and you might have to take action in those regions at some point as well?

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Corning F. Painter, Orion Engineered Carbons S.A. - CEO & Director [21]

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Well, so I would say the U.S. -- in Europe, we have some of the CBO pass-through mechanisms already in place. So that, in particular, is more of an opportunity for the U.S. That said, we see us as being oldest, as Charles said in the prepared comments, it's that's sort of the deal between us and our customers that we're not in the oil business, that we pass through gains and losses and where these differentials go and that they need to go through to the customers, and we're committed to driving that hard.

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Kevin William Hocevar, Northcoast Research Partners, LLC - VP & Equity Research Analyst [22]

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Okay, got you. And then last question on the Rubber business, usually, if I look back seasonally, the first quarter EBITDA isn't all that different than the second quarter. But this year, there was pretty meaningful improvement there from 1Q to 2Q. So what drove that improvement sequentially?

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Corning F. Painter, Orion Engineered Carbons S.A. - CEO & Director [23]

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Well, so as I mentioned earlier, we made a big recovery in our MRG position in China. And I'd say that was an important part of it.

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Operator [24]

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Our next question is from Jon Tanwanteng with CJS Securities.

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Jonathan E. Tanwanteng, CJS Securities, Inc. - MD [25]

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Congrats again, Charles, on the retirement plans. My first question is, what are your expectations for feedstock pressure heading to the second half at this point? Did you increase prices in line with that expectation? Or just a catch-up to where inputs have gone to date only?

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Corning F. Painter, Orion Engineered Carbons S.A. - CEO & Director [26]

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So I think, exactly where we are in pricing and how all that works out is sort of commercially sensitive. And you can imagine, we've got these discussions going on. Our view is is that, as those move, we should be able to recover those from customers, different contracts of different mechanisms. And if you look at our price increase formula or the announcement that we made, we talked about adjusting that going forward to explicitly have a differential surcharge.

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Jonathan E. Tanwanteng, CJS Securities, Inc. - MD [27]

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Okay. Got it. And then, have you contemplated the impact to us even more tariff and trade headwinds that have been threatened by the White House just yesterday?

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Corning F. Painter, Orion Engineered Carbons S.A. - CEO & Director [28]

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Yes. Yes. We noticed that tweet as well. So those specific tariffs, they don't really hit materials that we trade in. They do affect, obviously, overall global economic volatility. And to a degree, that's why we came out with a range. We hadn't anticipated that tweet obviously when we put this all together, but we continue to believe we can make this guidance.

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Jonathan E. Tanwanteng, CJS Securities, Inc. - MD [29]

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Okay, got it. And then finally on -- SG&A was a lot lower than we expected. Can we expect that run rate to hold? Will it move up and down appreciably from these levels as we go into the second half?

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Charles E. N. Herlinger, Orion Engineered Carbons S.A. - CFO [30]

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No, it should be pretty much around where it is now. I mean, we benefit on our fixed costs through FX, those costs that are not denominated in dollars, and with the strengthening dollar it is not set to the FX negative impact of the contribution margin level. But generally, where we are at the moment is a pretty good representation.

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Jonathan E. Tanwanteng, CJS Securities, Inc. - MD [31]

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Got it. And then finally, I don't know if you mentioned it earlier, but was there an update on the Evonik negotiations at all?

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Corning F. Painter, Orion Engineered Carbons S.A. - CEO & Director [32]

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Well, just to say that we mentioned last time, we were likely to file for arbitration. And indeed, we did in the last quarter.

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Jonathan E. Tanwanteng, CJS Securities, Inc. - MD [33]

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Okay, understood. So moving forward, but no definite time line?

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Corning F. Painter, Orion Engineered Carbons S.A. - CEO & Director [34]

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No, no. I think, again, we run this business as though that's not coming in tomorrow. We're highly confident we're going to make a substantial settlement with these guys in the fullness of time, but we just run this company as though that's not coming in tomorrow.

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Operator [35]

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(Operator Instructions) Our next question is from Chris Kapsch with Loop Capital Markets.

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Christopher John Kapsch, Loop Capital Markets LLC, Research Division - MD [36]

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So question, following-up on the discussion around differentials. Just so the greater magnitude of adverse differential that you're seeing, how much would you attribute that to this ongoing transition to the refinery industry's ongoing transition to IMO 2020?

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Corning F. Painter, Orion Engineered Carbons S.A. - CEO & Director [37]

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Well, we see a substantial portion in that. Things like, as they make that transition, shifting more to diesel, which makes CBO, our feedstock material, less available. So from our perspective, there is a strong linkage there.

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Christopher John Kapsch, Loop Capital Markets LLC, Research Division - MD [38]

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Okay. And then if I look at the differential headwind by segment it's more pronounced, and it's not just because the rubber segment is bigger, but it's more pronounced -- actually, it's more pronounced in the Specialty segment and vis-a-vis the rubber segment, and that's a little counterintuitive because more of your business on the rubber side is under contract. And I thought, under contract you have a little bit more coverage in terms of some of the clauses that -- and you just referenced some in Europe, but some of the clauses that have been baked in to try to address when these disconnects happen in terms of feedstock differentials. So I'm just wondering why is it that you're seeing more of an issue here on the specialty side for differentials vis-a-vis the rubber black? Why are you seeing more of an issue on the rubber black vis-a-vis the specialty side?

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Corning F. Painter, Orion Engineered Carbons S.A. - CEO & Director [39]

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So let me just speak to both groups, okay. So in specialty, we tend to be using more of the lower sulfur feedstock. So the exact dynamics with that are a little bit different than what we see in the rubber, where we tend to use the higher sulfur feedstocks, particularly in the United States. So they have a slightly different, let's say, underlying dynamic, underlying differential.

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Christopher John Kapsch, Loop Capital Markets LLC, Research Division - MD [40]

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Got it, okay. That makes -- so you're more dependent on the higher sulfur feedstocks in rubber black with more carbon?

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Charles E. N. Herlinger, Orion Engineered Carbons S.A. - CFO [41]

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In rubber black, yes.

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Christopher John Kapsch, Loop Capital Markets LLC, Research Division - MD [42]

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Okay. That explains it. And then, so you talked about -- I mean, there is a pretty substantial degradation in the profitability in the specialty side, you talked about a couple things that you're trying to do internally. What -- just more generally, what would be sort of inflections in which end markets, which would help that overall mix for that business to recover, as you see the macro playing out over, not so much the balance of 2019, but maybe into 2020?

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Corning F. Painter, Orion Engineered Carbons S.A. - CEO & Director [43]

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Right. So I think the way to think of that is, if you were picturing a graph of our profitability and thinking like, where is the midpoint, like GP per ton? And then what products are, let's say, on the good side of that midpoint, it's moving those. So that is almost anything in coatings, so it could be auto, it could be decorative, happy homeowner, marine, protective, whatever, it's pretty much anything in engineered plastics. Areas like adhesives and sealants beyond automotive, in particular, because that's a pretty large volume for them. It's inks and think about toner cartridges, and I hope you all own toner cartridges that are high-quality and don't jam. It's a range of those end marks that would be an improvement for us as well as them simply having a higher growth rate than some of the lower ones.

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Operator [44]

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(Operator Instructions) Our next question is from Laurence Alexander with Jefferies.

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Laurence Alexander, Jefferies LLC, Research Division - VP & Equity Research Analyst [45]

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So three questions related about the specialty carbon black business. First, can you talk a little bit about structural changes that might take several years to implement, but that could help improve the baseline for the business? Secondly, given this description of the businesses having like the good versus bad margin portions, what's the difference in the growth rates that you're seeing there? And then third, the discussion around gross profit, excluding FX, is that intended to signal or reflect customer psychology, that margins cannot improve unless the dollar moves in the right direction?

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Corning F. Painter, Orion Engineered Carbons S.A. - CEO & Director [46]

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Okay. So let me take those, starting from the top. On structural, I think just for sensitive reasons. We don't necessarily want to go into everything in there. But it's -- amongst the things are making sure you've got the capacity for your higher-margin products, it is making sure you've got the ability to sell them and support that with your customers. It tends to be more differentiated products, a more differentiated engineer-to-engineer sort of sale.

In terms of growth rates, well, we'd have to look at one for each end-market, and we see that as somewhat commercially sensitive. But in general, it's sort of looking at the aggregate, we would say the lower margin ones have been growing at a higher rate. And FX, we put that in the report, really, just for the investor community, just to give a sense of -- so what's business performance, what's really translational FX.

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Laurence Alexander, Jefferies LLC, Research Division - VP & Equity Research Analyst [47]

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Have you looked historically at how the business has done catching up to the FX effect? I mean what's the lag effect?

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Corning F. Painter, Orion Engineered Carbons S.A. - CEO & Director [48]

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So that's an interesting question. I think that most of this has been the FX simply moving, bouncing in a range. If you're going to look back over now several years, though, generally speaking, we've seen the U.S. dollar strengthening, and that's been a challenge. I think the thing for us in this is to look at where we're especially using dollar-denominated or dollar-driven energy prices as our feedstocks. And then moving those customers into a dollar-denominated sales price. And that would not take this out or dampen this at least going forward.

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Operator [49]

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We now have a follow-up question from Chris Kapsch with Loop Capital Markets.

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Christopher John Kapsch, Loop Capital Markets LLC, Research Division - MD [50]

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Thanks for explicitly talking about the walk on the different contributors to the EBITDA bridge. On the inventory panel, and I'm focused on the specialty segment, in particular. Just wondering, is -- so the inventory drawdown affected absorption variances, $4.8 million, I think you said in this quarter, what do those variances look like over the balance of '19, has that inventory hit to been taken, and now your production rates should flow through in cost accounting on a more normalized basis? Or is this going to drag on profitability for the balance of '19 until we have a stronger demand environment?

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Operator [51]

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Please check to see if your phone is muted. We're unable to hear you.

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Christopher John Kapsch, Loop Capital Markets LLC, Research Division - MD [52]

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Can you hear me now?

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Operator [53]

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I can hear you, Chris. I can't hear the speakers.

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Christopher John Kapsch, Loop Capital Markets LLC, Research Division - MD [54]

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Did they hear the question? Sorry.

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Operator [55]

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I'm not sure. Hello sir, are you there? We're unable to hear your speaker line. Please check and see if it...

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Christopher John Kapsch, Loop Capital Markets LLC, Research Division - MD [56]

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Yes, I am here.

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Operator [57]

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We are having technical difficulties? Please stand by for one moment.

(technical difficulty)

(Operator Instructions)

Okay. Speakers, you're back into the conference. Please proceed.

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Corning F. Painter, Orion Engineered Carbons S.A. - CEO & Director [58]

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Hi, Chris. Sorry, everyone, for that. I'm not sure what happened. We had to shift rooms.

But the short answer is, we think we took out most of what we needed to do in terms of volume in the second quarter. If we see trading conditions move or whatever, we, of course, can take actions again. But I think we've seen the majority of it.

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Christopher John Kapsch, Loop Capital Markets LLC, Research Division - MD [59]

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Okay. So the penalty to -- on a cost accounting standpoint has been confined to the second quarter, essentially, in the Specialty segment?

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Corning F. Painter, Orion Engineered Carbons S.A. - CEO & Director [60]

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Correct. There was an impact in both segments in the quarter, just for the record. But yes, we've made the adjustment we think we need to make.

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Operator [61]

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(Operator Instructions)

Okay. There are no more questions at this time. I would like to turn the conference back over to management for closing remarks.

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Corning F. Painter, Orion Engineered Carbons S.A. - CEO & Director [62]

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So first of all, I just thank everyone for the time with us. Sorry for the interruption to the phone connection. And then one more time, just personally and live, thank you, Charles, for all your work to Orion. Charles will be with us through this year. But nonetheless, we've just made the announcement, and I just want to express my great appreciation for your guidance and driving this company forward over so many years. Thank you so much.

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Charles E. N. Herlinger, Orion Engineered Carbons S.A. - CFO [63]

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Thanks a lot, Corning, and thank you, everyone.

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Operator [64]

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