Q2 2019 Earnings Call
Greetings and welcome to Ingevity second quarter earnings call and webcast.
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A question and answer session will follow the formal presentation.
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I will now turn the conference over to our host Dan Gallagher Vice President of Investor Relations. Thank you you may begin.
Thank you Diego good morning, everyone welcome to Ingevity second quarter 2019 earnings Conference call.
Earlier. This morning, we posted a presentation under the investors section of our website.
If you haven't already done so I'd encourage you to download this file so you can follow along on the call.
You can find it by visiting IR dot ingevity dotcom under events and presentations.
For participants who are logged into our webcast the slide should be visible in the online viewing pain and also available for download.
On slide number two of that deck, you'll see our disclaimer that todays call may contain forward looking statements.
Relevant factors that could cause actual results to differ materially from these forward looking statements are contained in our earnings release and in our SEC filings, including our Form 10-K , and our most recent Form 10-Q .
Ingevity undertakes no obligation to publicly release any revision to these projections and forward looking statements made during the call or to update them to reflect events and circumstances occurring after the date of the call.
Throughout this call we may refer to non-GAAP financial measures, which are intended to supplement not substitute for comparable GAAP measures.
Definitions of these non-GAAP financial measures and reconciliations to comparable GAAP financial measures. Our intent are included in our earnings release and can be found on the investors section of our website.
Our agenda is on slide three.
With me today as always our Michael Wilson, President and CEO , John Fortson, Executive Vice President and CFO .
First Michael will comment on the highlights of the quarter and review the performance of the two segments John will discuss our current financial status our outlook for the year, the remainder of 2019 and our guidance for the rest of the year.
Then Mike will make some brief closing remarks before we open the line for questions.
Mike Smith, President of performance chemicals, and Ed Woodcock President of performance materials will join us for the QNX.
With that I'll turn it over to Michael.
Thanks, Dan and good morning, everyone. Thank you for joining us this morning and for your continued interest in Ingevity.
If you'll turn with me to slide number four you'll note some highlights for the quarter.
Given current market conditions, we are pleased with our overall performance we benefited from our combined organic and inorganic growth strategy in the face of soft macroeconomic conditions, particularly in industrial demand, we delivered strong revenue growth.
Overall revenues in the second quarter were $353 million up approximately 14%.
Compared to the previous year's quarter.
For the first time, we had to.
The benefit of a full quarter of revenue from our newly acquired engineered polymers product line foreign to the acquisition of the Kappa capital Aktone business, a personal holding a b.
Secondly, we saw very strong increase in shipments of our performance materials segments automotive products accelerated significantly by step change in orders in China as automakers increase compliance with National China six regulatory standards.
Lastly, we drove strong price and mix improvements across the board for our products and applications as part of our concerted efforts to focus on margin growth.
This focus manifested itself in the quarter as we posted a 21% increase and adjusted EBITDA on the 14% increase in revenues.
Adjusted EBITDA were $108 million up $19 million from the previous year's quarter.
And for the second consecutive quarter, we achieved an adjusted EBITDA margin of 30% or more up 170 basis points versus the prior year.
While committed to delivering topline growth both organically and Inorganically, we remain steadfast in our commitment to prioritize earnings growth margin accretion and returns on invested capital.
This includes investing in and building capabilities through which we become.
Better technology partners with our customers, but it also includes intentionally transitioning to higher margin applications and occasionally backing away from volumes that don't meet our long term profitability objectives.
This has been our Elmo all along.
And as a result, we posted year over year quarterly adjusted EBITDA margin increases and 12 of the 13 quarters since our spin.
Now if you'll turn with me to slide number five you will see the second quarter results for performance chemicals.
Segment sales in the second quarter were $230 million up 8% versus the prior year period.
Sales into industrial specialties applications and these include printing inks adhesives agricultural chemicals, lubricants, and others were down about $17 million or 14%.
On top of the ongoing secular decline in demand for printing inks. Our results reflect the decision we made in the second half of 2018 to walk away from some printing business in Europe based on sub optimal margins.
To be clear however, we remain committed to providing excellent products and technical service to printing customers, who recognize the value we provide.
In addition, we reduced export sales of tall oil rosin in the quarter and generally speaking many of the niche applications in the industrial specialties area were affected by a slowdown in industrial activity.
Sales of performance chemicals products to oilfield customers were up 2% versus the prior year contrary to last quarter sales growth based on drilling activity outpaced production applications.
That said according to Baker Hughes us rig count at the end of the second quarter was down 3.9% versus the first quarter and based on our information linear feet drilled was relatively flat sequentially.
As a result, we attribute our increased sales into drilling applications to the success, we are having tailoring products to specific oilfield customers needs.
Sales to payment applications were down slightly versus the prior year period.
Growth here was literally dampened by extreme participate precipitation in the us which resulted in a slow start to the paving season. Despite a strong demand environment of state and federally funded projects.
Against this market backdrop, our sales in North America were up about 6% driven in large part by greater adoption of our innovative Eva with our more mix asphalt technology.
However, north American sales growth was offset by sales decreases overseas, particularly in Brazil as the government. There is enforcing strict austerity measures and in Turkey.
And the performance chemicals segment, we had the benefit of a full quarter of revenue from our newly.
From our new engineered polymers product line.
These results, though were below the prior year's pro forma period. The most significant reduction occurred in monomer sales in Europe due to softer demand and increased competition.
Polyol sales in Europe were also down as our customer saw weaker demand in industrial applications, such as sales gaskets and mining screens.
Polyol sales in Asia grew driven by polyurethane film applications were offset by lower thermoplastic sales and hot melt and shoe adhesives applications.
In North America growth and Polyols and thermoplastics for bio plastics were offset by lower monomer cells.
While market demand proved somewhat softer than our beginning of the year expectation. We are pleased that margins have held steady and that relatively speaking derivatives man was stronger than that for monomers.
Segment, EBITDA were $59 million up 26%.
As we continue to focus on margin accretion, we drove segment adjusted EBITDA margin improvement of more than 370 basis points to 25.7%.
The addition of the high margin engineered polymers products were a significant contributor to the margin increase as where price and mix improvements across the board and the team's tight control of costs.
We are continuing as we have over the past three years to transform this segment towards more specialty applications.
While Kappa engineered polymers provide us with a new technology platform to drive revenue and earnings growth. We are also committed to growing our legacy pine chemicals business through new product innovation. For example, we're working on new ink resins for packaging applications. A segment, we have not traditionally participated in.
We launched a new low colored low odor resin called Alt attack that appeals to a new set of adhesives customers and we achieved initial commercial sales of new rosin based product provides.
Improved efficiency for oil production.
Through these and many other innovations in the pipeline, we feel strongly that in the long run the segment can consistently deliver mid single digit revenue growth, while sustaining our stated goal of mid 20% EBITDA margins.
Turning now to performance materials as you can see on slide number six the segment once again delivered outstanding performance.
Segment sales in the second quarter were a record $123 million up 28% versus the prior year's quarter.
There were two significant drivers of this record increase in revenues.
First sales in China accelerated dramatically as automakers moved in concert with previously announced early implementation of scheduled regulatory mandates.
Automotive Oems are now producing vehicles compliant with the China, six regulatory standard, which calls for evaporated admission canisters equivalent to those for us EPA tier two.
These canisters contain much higher value pelleted carbon products versus granular products.
In fact, our shipments of pelleted products in the country were up in the quarter nine times, our historical average.
The substantial increase in sales occurred despite light vehicle production that was down sharply in China again speaking to the current importance of regulatory drivers versus auto demand for this business.
In our estimation, while not all are yet in production nearly 100% of Chinese vehicle platforms have now been certified as China six compliant.
And we believe that automakers will meet the 60% compliance rate called for in the third quarter.
The second driver is the continuing strong sales of Ingevity patented us tier three and left three gasoline vapor emissions solutions, particularly our honeycomb scrubber products in the us and Canada, we estimate that the industry is at or above the mandated compliance rate of 80% for the 2020 model year vehicles.
And similar to the situation in China. This sales increase occurred despite a decrease in light vehicle production again speaking to the significance of regulatory driven growth in this business.
Lastly in the quarter, we saw a significant increase in pellet sales and the European Union as the industry implements the euro six D. standard as a reminder, the euro Asia requirement calls for the capture of two days of parking emissions versus the prior one day requirement. This shift doubles, the canister volume and increases the use of high value pelleted product.
In the quarter segment, EBITDA were $49 million up $7 million or 15% versus the prior year segment EBITDA.
As discussed we saw impressive volume increases along with solid price and mix in the segment.
These were partially offset by the consumption of higher cost inventory associated with the zoo high China plant scale up over the past couple of years.
Plant spending related to planned maintenance outages at several facilities and by legal expenses associated with protecting our intellectual property.
These expected circumstances resulted in a decrease in segment EBITDA margins from 44.4% in the prior period to 40% and this years second quarter.
As a reminder, it is important to evaluate margins in this segment on an annual rather than quarterly basis due to the potential for lumpiness in quarter to quarter performance arising from outage schedules, both ours and our customers and other issues that might be specific to an a given quarter.
Further it remains our expectation that this segment will deliver slightly accreting margins in 2019 versus 2018 with further accretion in 2020.
Looking forward, we believe that the inevitable shift by various regions and countries to more stringent regulatory standards will continue to fuel growth in this segment well into the future.
What's more we are confident that our technological expertise in this application will enable us to continue to providing leading edge solutions that meet these regulatory demands.
At this point I will turn the call over to John Fortson, Our Chief our executive Vice President and CFO and Treasurer for a more detailed review of our financial results and our guidance for 2019 John .
Thank you Michael and good morning, everyone.
Turning to slide seven I will provide some additional color on our second quarter results review, our capital structure and discuss our outlook and guidance for the year before turning the call back to Michael for some closing remarks.
As Michael has covered the revenue and EBITDA of the company and its segments I will begin at the DNA line on the income statement.
Ash DNA is up from last year, primarily reflecting the additional costs, both cash and noncash associated with a cap of caprolactam acquisition as well as increased legal expenses, our koresh DNA, excluding legal expenses of $4 million and amortization of 7.1 million included in M&A from the acquisitions was down <unk> percent on a percent of sales basis from 10.2% to 8.9%, reflecting our continued focus on cost discipline across the company.
Net interest expense for the quarter was $13.1 million as a result of the increased debt associated with the Cape acquisition.
Our borrowing rate at the end of the quarter for our revolver was 3.9% and the blended rate of our combined bank term loans was 3.76% the rate on our senior notes remains fixed at 4.5% and the 80 million dollar industrial revenue bond borrowing rate remains 7.67%.
Our provision for income taxes on adjusted earnings was $16.3 million for the quarter.
Our adjusted non-GAAP tax rate for the quarter ending June Thirtyth was 22.1%.
Our GAAP tax rate was 22%.
Our cash tax rate is 7.9%.
We did not repurchase any shares this quarter $392.7 million remained available from our board authorized share repurchase programs.
Diluted adjusted earnings per share in the quarter was one dollar and 36 cents, which is a 22.5% increase from the second quarter of last year.
As of June Thirtyth, Ingevity had 41.8 million basic shares outstanding and 42.2 million diluted shares outstanding.
Turning to slide eight our net debt at the end of the quarter was 1 billion $267.7 million.
Our net debt to EBITDA was 3.23 times at the end of the quarter after peaking last quarter at 3.4 times after the cap acquisition.
Working capital increased this quarter due to the inclusion of our engineered polymers accounts as well as the ramp up and our seasonal businesses, particularly pavement technologies, we continue to hold high inventory levels of activated carbon in anticipation of increased demand in China.
But we do expect these carbon inventories to begin falling in the second half of the year still net working capital as a percentage of sales fell from the second quarter of last year as it did in Q1 versus last year as we continue to tightly monitor our cash positions globally.
Our cash generated from operations in the quarter was $79.5 million.
While capital expenditures were $29.6 million. The result in free cash flow was $49.9 million.
Additional information will be available in our Form 10-Q , which we expect to file next week.
If you turn to slide nine you'll find information on our outlook for the rest of the year.
We are maintaining our guidance across all metrics.
And our performance chemicals segment, given our market assessments in the first half performance, we are taking a conservative view.
We expect revenues and industrial specialties to continue to decline, albeit at a slower rate at least through the balance of the year.
Softening demand as a result of secular decline in inks compounded by sluggish global market conditions will likely continue.
And we will continue to shift our business to higher value uses.
This is expected to result in lower volumes, but higher margins. We are focused on maximizing these priorities and while total pricing has improved the rosin pricing environment remains challenged.
Sales growth and pavement technologies applications will remain somewhat weather dependent.
The demand is there infrastructure budgets are in place states and municipalities are ready and willing to pave. The question is simply can they get all the paving work and before the season ends.
In addition, we expect to continue to see strong technology adoption, which should help slightly with revenues and even more so on profitability.
Given the current flat outlook for crude oil prices, we expect overall volumes to be flat to up slightly consistent with first half performance.
For engineered polymers, we expected the businesses geographic footprint, we will continue to expose it to more global macroeconomic conditions.
That said, we expect revenues to grow sequentially throughout the balance of the year and we continue to believe in the long term value of this technology platform and believe that will be a growth engine for the company.
We remain committed to investing in this business in order to realize that long term potential.
In performance materials, we expect to see strong revenues and profitability benefits from the increased regulatory requirements and we expect business from China to continue to accelerate.
Automakers will be continuing to implement the Chinese six national standard and as Michael stated, we believe that implementation requirements should drive a greater than 60% compliance rate in the third quarter.
What's more Chinese consumers, we pulling through vehicles as they opt for China six compliance.
U.S tier three lottery implementation continues and automakers are continuing to progress past, the 80% level in the us and Canada.
In the European market Carmakers will likely complete implementing a new euro 60 standard in the quarter.
From a cost perspective, we'll be cycling through higher cost product manufacturer during the ramp up of the zoo high plant.
Finally, we will continue to proactively protect our intellectual property. Therefore, we anticipate higher legal expenses to continue over the balance of 2019.
On the right of the slide you'll see that we are maintaining our guidance for the year in sales of between 1.3, and 1.36 billion and adjusted EBITDA between 390 and 410 million.
In comparison to our view at the beginning of the year from a revenue perspective, we expect performance materials will be stronger and performance chemicals, maybe lighter, but when all of sudden nine we expect to hit the revenue ball right down the middle of the fairway.
As important.
Both segments are expected to deliver margin accretion in 2019.
So the accretion will be stronger in performance chemicals.
We are also maintaining guidance on our tax rate capital expenditures and target net debt ratio for the year.
DNA for the year adjusting for the cap acquisition will be in the high Eightys millions for the year, approximately 25 million for Kappa and between 60 and $65 million for the legacy business.
With that I will now turn the call over to Michael.
Thanks, John .
In summary, I think given the current environment, particularly outside the U.S. and the weather conditions here impacting payment. Our overall performance. This quarter reflects the benefits of our growth strategy and the more insulated nature of some of our markets as John as detailed we remain committed to and confident in our guidance for the year.
I appreciate the work and efforts of our 1700 50 employees worldwide. They are a distinct competitive advantage for us. We continue to believe very strongly in the long term potential of our company. We hope you share our enthusiasm for Ingevity at this point operator, we'll open up the call to questions.
Thank you.
At this time, we will conduct our question and answer session.
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Our first question comes from Mike Tyson with Keybanc capital markets. Please state your question.
Hey, guys nice quarter.
Yes in terms of performance materials.
Another really strong quarter there into Q.
You just noted that you felt 19 in terms of sales growth would be better is that already done meeting with the better come into keyword is the is the second half actually accelerating a little bit better than your expectations as well.
Hi, Bob This is Michael Olson I believe that the trends we've seen in the first half the year will continue through the second half so really a bit stronger throughout.
Got it and then.
Can you maybe give us a little bit more color on cap.
Engineered materials business to 34 million is.
How how did that do pro forma year over year and then when you think about the second half of the year. How do you think that comparison will sort of flush out and then maybe.
Maybe talk about the 2020 potential that business as you as you really you know.
Spent every year on year, Belden, and probably have some new project potential wins going forward.
Yes, Mike again Fourq for cap in the second quarter revenues were down versus the prior year comparison on a pro forma basis as we as we called out.
As you also indicated in our comments I mean, we believe that going forward for the balance of the year, we will see sequential revenue growth in that business Q3 and Q4.
So any sort of negative comparisons to prior year will continue to shrink and clearly as we move into 2020, we expect that business to move back to pretty significant growth into a applications area, where we've talked about.
Markets at growing at 6% on a on an average basis and historically the business has been able to grow faster than that I. Just think that we have a business that unlike our legacy chemicals business is much more.
Geographically distributed evenly around the globe and therefore, much more exposed to markets in Europe , and Asia, where are the business has been more insulated by a stronger us economy.
Great. Thank you.
Our next question comes from John Mcnulty with BMO capital markets. Please state your question.
Hi, Thanks for taking my question.
Clearly the performance materials business continues to Hum, along and it seems like the volumes and revenues or maybe even higher than what you expected does that get you through the inventory kind of Nick that you were seeing in China up faster than originally expected and can we start to see the margins improve sequentially as we move into into Threeq or is that still more of a four Q timeframe.
I think in terms of a terms of cycling through all of the inventory, it's still going to be some time in for Q.
Before we're through all that and it will depend upon sort of the pace of orders coming in.
Just in terms of the margins. However, we've repeatedly said that on a full year basis, we expect.
Margins in the segment to be slightly accretive to where they were in 2018, which someone correct me, but I think they were 42.3%.
So if you think about what we posted so far year to date, we posted 47% in Q1, 40% in Q2.
So you can kind of do the math for the rest of the year to figure out where it has to be based upon your expectation for revenue.
Got it fair enough and then when you think about the engineered polymers business and it's getting better in 2020, I guess, if we have a similar kind of macro backdrop I assume the 6% would be would be a little bit on the aggressive side, but I guess, how how would you think about.
The growth rates as you look at 2020, if the macro is kind of more stable or flattish.
Well sitting here today, John My expectation is that we will return to that growth rate as we move into 2020.
Clearly macroeconomic conditions matter I, just think there's a little bit of.
Of movement going around in terms of the competitive activity, particularly as a competitor at brought back capacity and.
As people look to kind of rebalanced their position in the marketplace. So I think with that behind us and with more time to continue to advance new project development and new applications.
We ought to be able to deliver solid growth in 2020, so Mike as anything you'd like to add to that I was just going to further emphasize the ongoing nature of the projects in the portfolio that the team is working on and especially on the derivatives side, both polyols and thermoplastics that.
We've got high confidence that those will continue to grow and contribute to growth next year.
Great. Thanks, very much for the color.
Thank you. Our next question comes from Ian.
No with Oppenheimer and company. Please state your question.
Hi, great. Thank you guys.
Yes, I just want to key in on the question on the nine times increase from historic levels in China.
That's obviously more than the increase that youre seeing curb vehicle.
So, what's what's driving that or whats the see the delta there. Thanks.
Yes, so when we talk about the historical level, we're really talking about periods up through the third quarter of 2018, because we start to see some adoption of the China six standard beginning in late last year.
The what you're seeing is a shift away from historically a powdered market.
To the pellet that to the to pellets as the primary material in the canisters.
So were simply reporting on what what we're seeing in terms of trying to give you some indication of the level of growth by looking at those pellet volumes versus that historical average so.
I don't have that answer the question for you precisely just based upon the content value that your reps that you can do some math to yen right.
And then today becomes a multiplier.
Now our carbon going into.
The canister right and it's got a higher.
Price to it because you are using higher quality stock right and you've got a market share shift going on right. So when you factor all that in that's how you get to that nine times.
The share shift is right.
Missing.
Okay. Good and then just touching the margins here.
To to participate on the oilfield side, you said you were selling more specialty.
Does that mean, we should expect higher margin there.
And then also just on the chemical business in general.
With all the initiatives you now putting in.
Is there a new target on the chemical side or margins or what should we be expecting there. Thanks.
Now on the oilfield side, what we're referring to is the fact that it's like a lot of our other businesses I mean, it's fairly custom and what we do we're actually tailoring product formulations for specific customers. If you think about drilling muds, they're very complex mixtures of of chemicals and everybody's got a different formulation. So by working to meet a specific customers need we can provide a more tailored product I think that gives us sort of stickiness with the customer, but also gives us the opportunity.
To sell higher margin higher value products to those customers in terms of your second question on overall margins. We we've indicated that and performance chemicals that are sort of target between now and 2020 twos to drive margins in that business to the mid Twentys EBITDA margins on a sustainable basis, we havent given any guidance beyond that to this point.
Additional memory and Thats, an annualized number right I mean as you know.
In Q1, and Q4 are different from our Q2 Q3, just because of the impact of America.
In those quarters right. So.
Trying to get to mid Twentys on an annual basis sustainably.
Okay, great. Thank you very much.
Our next question comes from Jim Sheehan with Suntrust Robinson Humphrey. Please state your question.
Thanks, I was curious about your comment that Chinese consumers are preferring China's six vehicles. If you could elaborate that on that comment and also where do you see automobile inventories in China today.
Yeah, Let me take the first one and I'll pass the second one to fed woodcock to comment but.
The preference for China, six vehicles is that the Chinese.
Consumers are more savvy about regulatory packages probably.
Then say consumers for us vehicles and the reason for that is that China has a history of allowing our or taking older models that are on older regulatory packages and ultimately not permitting them for use particularly in dense urban areas. So.
As consumers are in China are looking to buy a new car. They want to have the latest regulatory package because they want to have certainty of the ability to continue to drive that vehicle for the life of the vehicle. So.
We've seen that as a significant factor over the last couple of quarters and in fact, one of the things the China auto market has gone through.
Mostly during the second quarter was a big reduction of inventories, but it was a lot of China five vehicles that they had to get off lots.
And there were substantial discounts discounting by dealers to move those vehicles, both to consumers or to move them to more remote regions of the country.
I think Ed probably can give you a good sense of where inventory levels now are yes, Mike Michael.
Absolutely correct on that we feel that they've cleared through the China five inventory with the discounts that they've given us in the marketplace and what this does is now it frees up opportunity for the Oems too.
Basically produce.
Refill the dealer lots with China six vehicles. So we we expect now that that inventory is clear and we are going to see more product more demand for our products as they are starting to produce and fill the dealer lots with China six vehicles.
Very helpful and.
You.
Deliver pretty strong margin expansion in performance chemicals this quarter year over year I was wondering if you could just break that down between what was due to the cap acquisition versus.
Improve tofa pricing or increased derivatives Asian.
Okay.
Yes, Jim I guess without getting too granular on it I would say.
I would attribute about half the margin accretion to the addition of cap on the improvement in the <unk> and the product mix and the other half.
To margin improvement in the legacy businesses and a lot of that clearly is driven by the shedding away of the least profitable business that we basically talked about the printing business that will begin moving away from in the second half of last year.
Obviously, we.
We continue to see benefits from higher Tofa pricing year over year I think for this year versus the prior year quarter. It was up about 7%.
So there's a lot of different things contributing to that along with.
Tightly controlling costs and Mike I don't know if you have anything you would add I guess the other one last thing would be the improvements specifically in pricing in payment as well as the benefit of mix in payment.
Driven by the strong Eagle Therm sales in North America in the quarter.
Thanks and.
Lastly, at Pine chemical competitor disclose that they're taking less CTO from a supplier or are you seeing any changes in your CTO availability or supply demand dynamics.
Well to be clear CTO supply did not impact us in terms of our ability to serve markets or customers. So we have adequate CTO supply that being said as you know CTO is a byproduct of of Paul processes in particularly Kraft pulp from Softwoods and because of.
Lower demands and paperboard and packaging materials.
Those pump manufacturers are producing less pulp so seats CTO has been less available or abundant.
But it's a very strategic raw material for us we plan carefully out throughout our network of suppliers on an annual basis and.
We're not seeing anything that I would call a shortage I would say if anything given some of the softer conditions. We've seen in the marketplace, it's kind of help balance that CTO supply and demand dynamics.
Thank you.
[noise].
Our next question comes from Jon Tanwanteng with CJS Securities. Please state your question.
Good morning, Thank you for taking my question.
Could you perhaps provide some color on how much asphalt business windoor pavement business were pushed out by the weather.
Well I think as we reported in the U.S., we saw year over year growth of about 6%.
In the quarter. My guess is if we hadn't had the weather impacts that growth rate would have been as high as 10% for the U.S.
So its not in substantial and I think you know to John's point, the encouraging part of all this is is that the funding is there the projects there our customers are ready to ready to do the paving it's just they've got to have the ability to do it and as we know there is a paving season that.
Can be pushed so far into the fall depending on whether it's just a matter of getting those projects executed at this point.
Understood. Thank you and then you launched a new product recycling asphalt.
And then.
Typically new pavement that seems like a pretty big deal can you talk about the addressable market opportunity to go to the growth rates and how soon that could impact or piano.
Yes, it, especially around the insulin product that allows a 100% of the road bed to be.
To be recycled using 100% of the aggregate using fresh asphalt and the indolent product.
Mike May have some specifics on this again I think it's an exciting new technology that will certainly drive growth going forward like a lot of what we do these things come at singles versus home runs and then payment which is a slow industry to adopt change.
You got to sort of fight the Battle project by project, but Mike any other color you would add to that yeah, why wouldn't really be a position to provide kind of specific market opportunity, but the objective of the customers choosing freeze recycled content is very strong and that is has been an area, especially in or even from technology and throughout our paving business.
That we have focused on so this is a yet another I'd say a tool in our tool kit to make sure that we can take full advantage of that.
The trend in the marketplace.
Okay, Great and then just on the material side, you mentioned the drag from maintenance and.
Higher inventory costs and legal expenses I wanted to focus a little bit more of the legal expense.
In particular are they increasing beyond your expectations has anything changed there Tom is there any update you can provide on the defense of your products in the market.
No John I would think from a cost standpoint, it's more or less in line with our expectation I mean, I think the unfortunate part is.
No cost to defend our intellectual property could or could run us for the full year in the range of $10 million to $15 million.
That's not insignificant to the performance materials segment I think in terms of the status of the litigation. There is unfortunately, not a whole lot new to report.
Legal system seems to move at a glacial based there are some calendar dates for the various cases that range from end of 2019 as to latest third quarter of 2020.
So we just have to see our way through that at the end of the day, our ultimate objective would be to collect any relevant damages and also recover our legal fees, but that's all very speculative at this point in terms of how it's going to play out is just.
Just not a lot of new information.
Okay, great. Thank you.
One one last one of a kind of the.
Commentary on cap and the second half do you expect to grow sequentially through the year do you expect it to actually grow year over year or will that still decline in Q3 or Q4.
I think the year over year comparisons may may still be negative, but there will be less negative clearly than what we saw in Q2. This was probably the worst of those comparisons and we do expect that that that growth going forward each quarter. So on a sequential basis.
Understood. Thank you very much.
Our next question comes from Paretosh Misra with Berenberg. Please state your question.
Thank you good morning, so in performance materials that it sounds like in the U.S., a you're expecting some benefit from a sequential eight incremental sequential adoption off a tier three <unk>, what's a good way to think about it a year, maybe now at 75% or so and going to 80% like how would you describe it.
No I've heard talked I would say that as of now U.S. automakers are probably at least 80% compliance at or slightly above that threshold and again. The next regulatory step up isn't to the 2020 model year vehicles are 2022 mile Your vehicles, which would come out a mid 2021.
But as we've talked about on on a couple of previous calls we don't really expect automakers to wait for that next deadline to make a step change in compliance, we actually seemed to be sort of a gradual march toward 100% compliance and the way I would anticipate that rolling out from this point forward is every time it automaker goes into refresh model. Your platform. They are likely to go ahead and make it compliant.
With U.S. tier three requirements, it's difficult or just to get it down.
Quarter to quarter, but I mean, I think of it as somewhat linear right. We're sitting here sort of 80% now you've got.
Two years to get to the next one and things of this sort of a linear step up every quarter and that's about the best we can give you guys in terms of.
Thanks, Yeah, no. That's helpful and then as a follow up you you flagged. Some I believe you flagged some weakness in Brazil, and Turkey in the construction or the pavement business. How big are these two countries as a percentage of that that business.
Well, if I think about our payment business overall, it's about 75% that is a U.S. North America based U.S.U.S. in Canada. So you know the rest of the world at about 25% as it turns out we had tough comparisons for those two countries last year.
Okay. So Brazil, they were leading up to an election, there was a lot of payment activity infrastructure activity going on and with the election, and a new administration and Alistair any measures that kind of turn that spec. It off so I think a lot of it is politically motivated I think in some developing economies you've got tougher economic situations than you do.
Certainly in the U.S. and another developed economy. So.
While those while that business outside the U.S. for US is a smaller percentage of the total portfolio within the application area in any given quarter. It can matter and in this quarter. It happened to matter and I say all that against the backdrop of we want to continue to grow our payment out of his business outside the U.S., we see a value proposition there and other countries, that's analogous and many many times to the U.S. So we want to continue to grow in those markets but.
They are less consistent then the U.S. market for sure.
Understood and if I could ask just one last one as kind of a big picture run beyond these regulatory changes that are in place.
And U.S. Shine on Europe , what like what else are you seeing any anything to flag.
[noise] well again, we have a.
Major initiatives being adopted Us, Canada, Europe , and China right now.
The one that has been named that has not yet started as Brazil, which would change to go to the tier two standard by 2025 and Theres a published ramp up schedule that we have for that and I think we've had in and some of our presentation materials.
But I think beyond that paradox, the important point is to recognize.
A couple of things first while Europe has taken a step with euro six d. from one day of parking captured a two day of parking capture theres still well behind with where the U.S. has now and even China, that's moved to to a tier two standard.
China at tier two is still lagging the U.S. standard so.
We know there's work underway in both Europe , and China to look at what comes next but even outside those three areas. After they complete the current wave of adoption.
You still now have 50% of the world's vehicles that are on the equivalent of a U.S. 19 seventies early 19 eighties evaporative emissions standards. So.
It seems inevitable to us that there will be further adoption in the future of additional countries and tighter regulations and those that have already moved.
But those rules haven't yet been promulgated or put enacted into law. So we just can't talk with specificity about them, but we certainly don't subscribe to the theory that some have the once this current wave of adoption has done that this is somehow going to revert to the Saar rate for internal combustion engines globally.
We expect to can see continue to see strong regulatory adoption fueled growth well into the future.
Great. Thanks, guys.
Question for next is from.
Chris Kapsch with loop capital markets. Please state your question.
Yeah. Good morning, guys and so I had a question among performance chemicals segment.
You made a formal comment about.
Some of those.
Products or applications being sensitive to the industrial economy Im just curious if if there's a way to characterize that as being skewed more towards tore.
Based products are derivatives or tow products are dribs and the reason I ask is obviously the.
The percentages of those product that you get from refining CTO are fixed by nature basically so I'm wondering if if there is an imbalance in the economic sensitivity to the demand there is it enough to influence your intended.
Refinery operating rates in order to to optimize the margins that you are targeting.
Okay, Great. That's a great question. So the first answer is no it's not significant enough really to impact how we're operating our refineries and just to be clear about that it's always our objective to run the refineries to meet demand right. So.
And within the fractionation between Tofa and Tor, we still see relatively healthy balance. So in other words in order to supply one segment. One type of applications were not producing in excess of something else, we still maintain that operating model of basically running to toward demand.
Largely because when you think about the split I mean, we always talk about how we want to drive toward derivatives, but if we look at our total book of business today.
We're only derivatized thing about 40% to 45% of our tofa, whereas the percentage of raws and work to grow tizing as much is much higher than that.
But I think to your first point because when I look at the market applications. It is rosin that is being more impacted by the sort of industrial applications. Because when you think about our pavement business and you think about our oilfield business those are by and large more tofa based and they of course are more specialty in nature. So a lot of the rosin is being moved through the industrial specialties applications area, and it's there and things like printing inks, where.
We're seeing the softness so Mike if I got that right would you add to that no I think thats exactly correct Michael and.
And we'll see the decline is has been in the inside on from both secular nature and some walkaway of some very low margin business and two to a little bit lesser extent not choosing to support low margin export kind of merchant rosin, but everything else seems very much in line.
Well just a follow up just based on what you said, if you're if the demand for the Tofa based oilfield and paving.
Applications generally from and there are some you know some sensitivity to industrial weakness more on the tour side do you ER.
We and we're going to end up short.
Tofa, if we run the refinery rates to meet toward the man.
No because what what we would do so less so the under advertise tofa as I said, we're only dramatizing, 40% to 45% of it. So we we would balance that out. It is it is true that because of current demand you know we're not we're not operating our refineries at a 100% utilization again, we're going to keep those in balance with what we see is the demand side.
Okay. That's helpful. Thanks, and then just I don't know if you'll parts it's for us but.
I appreciate the comments, it's better to look at performance materials.
Margins on an annual basis, but if you look at the the the 440 bips year over year decline in this quarter just curious how much.
In terms of its order of magnitude how much of that was attributable to the deep the penalty associated with the.
The higher cost inventories that are currently being shipped to China I'm, just trying to understand because if in fact that we bleed off that inventory by fourth quarter trying to get a sense for what the benefit that would be on a run rate basis in 2020.
Right. So in terms of that differential in margin from 44.4 to 40 I gave you three drivers right. I gave you the consumption of higher cost inventory I gave you a legal expenses.
As the second one and then fire outage costs those three items combined account for 100% of that differential and if I had to break it down between the three the inventory consumption is higher is slightly higher than the other two so in terms of its impact.
Okay. That's helpful. And then one last one just you mentioned no real update on the legal front, but did so just to be clear. There. There has has or has not been issued by the courts. A preliminary injunction against defendants were defendants in terms of the alleges infringement either sampling are using infringing products.
No the preliminary injunction that we filed against BSF was the motion for that was denied but we were not surprised by that a preliminary injunction is a very high hurdle.
And we do not believe that that decision in any way impact the strength of our underlying claim.
Okay. Thank you.
[noise].
Our next question comes from Daniel Rizzo with Jefferies. Please state your question.
Just to follow up on the last question. So in addition to the BSF walk through I mean are there others out there that are kind of similar in nature for I mean is it just kind of the out what will be the only mean one.
We have filed legal actions against one other a company which is Molly.
Which is a tier one supplier to the automotive industry.
We have a proceeding.
Against them, both in Federal Court and with the International Trade Commission and the Federal Court case has actually been suspended.
Pending the outcome of the ITC complaint.
And I believe that supposed to be ruled on by the into the fourth quarter November now that's the trials.
Yes.
Probably a year and a new year in the first quarter.
And what about IP protection in China that would seem to be a little bit more difficult I was wondering I know something you've addressed in the past because just remind us what's in place. They are given the headlines we read elsewhere about what issues with that with that subject.
Yeah. So just a couple of things first of all recognize that the U.S. in Canada are the only two markets that are on the U.S. EPA tier three California left three standard and use the honeycomb scrubbers. So that's the only market for which the patent has any kind of jurisdiction today, even though it's filed in other countries now that is our what we call. Our 844 patent. So that is the original patent which expires in March of 2022. It does not really have applicability today in Europe , or China or anywhere else because the market.
Is it a very different place now we do have a new patent.
Which we referred to as the 869 patent which is not as broad as the original 844 patent, but we have estimated could cover as much as 30% to 70% of future internal combustion engine design that pattern is applicable.
In China, but only to the point that China moves to a regulatory standard that would require its teachings.
Okay, but.
But I guess the internet via the properties like intellectual property around the the pellets themselves how is that.
Those are not under Patton.
Our sort of state of the art product that BW Cisco.
Pwc 15, or backs 1500 has been off patent for close to a decade, maybe more.
The issue there is one of know how.
And despite being off patent.
No one has really been able to replicate the efficacy the consistency and the absorb the characteristics of that product.
And particularly its ability to meet the life vehicle use standard.
And I would Dan site are which I know you've heard us talk about our.
Change in margin share in China as they have moved from what is historically of actual out of 100 market end of X. 1500.
As evidence of our.
Efficacy and strength and maintaining that technological leadership.
Okay.
And then just one more question if I may So you mentioned about pavement technologies and the weather issues pushing things until third quarter. Ultimately if there is so it's an early frost are just bad weather in the fall and the winter again. It just gets pushed in Celesio has never lost sales. It's just a matter of timing delays it could take potentially over over more than a year correct.
Yeah, but that's what happens if they can get it in the current paving season, they have to push it to the next season.
You're right typically the funding stays in place the project priorities stays in place and.
Some of that actually happened last year, some some projects.
They got let Texas was a great example for implementation last year, they had hurricane and other issues didn't get done and that's why the backlog coming into this year was was as big as it was so.
Our customers are very disappointed that weather has gotten the way of them executing these projects.
All right. Thank you very much.
Thank you ladies and gentlemen, there are no further questions at this time I will now turn the conference back to management for closing remarks. Thank you.
Thank you everyone for your time and interest. This morning, we've we remain very positive about our long term business outlook. We look forward talking with you again next quarter, but we have a great day.
Thank you. This concludes today's call all parties may disconnect have a great day.