Neo Performance Materials Inc

TSX:NEO

Earnings Call Transcript 2018-Q1

[Operator]

Good morning. My name is Sylvie, and I will be your conference operator today. At this time, I would like to welcome everyone to the Neo Performance Materials First Quarter 2018 Earnings Announcement Conference Call. [Operator Instructions] Ali Mahdavi, who leads Investor Relations and Capital Markets for Neo, you may begin your conference.

[Ali Mahdavi, Capital Markets & IR Executive]

Thank you, operator, and good day, everyone. Today's call is being recorded, and a replay will be available starting tomorrow in the Investor Center on our website located at neomaterials.com.Speaking first today will be Neo President and CEO, Geoff Bedford; then Neo CFO, Rahim Suleman, will provide us with the additional details of our Q1 financial performance. Finally, we'll open the call to questions from our analysts.Please note that some of the information you will hear during today's presentation and discussion will consist of forward-looking statements, including, without limitation, those regarding revenue, EBITDA, volume, gross margin, other income and expense measures and future business outlook. Non-IFRS financial measures will be used during this conference call. Further information regarding Neo's use of non-IFRS measures is available in Neo's Q1 2018 earnings press release, which is available on SEDAR and on our website at neomaterials.com.Actual results or transcript differ materially from those discussed today. For more information, please refer to the risk factors discussed in Neo's most recent quarterly reports, which were filed on SEDAR earlier today and are also available on our website. Neo assumes no obligation to update any forward-looking statements or information, which speak as of their respective dates. Financial amounts presented today will be in U.S. dollars.Now let me turn the call over to Geoff Bedford for opening remarks.

[Geoffrey R. Bedford, President, CEO & Director]

Thanks, Ali. And thanks, everyone, for joining us today.We had a very good first quarter of 2018, which I was especially pleased to see following the very strong year we had in 2017. The company's strong performance in Q1 2018 continues the generally positive revenue and adjusted EBITDA growth that we have seen over the past 8 quarters.All 3 business units had higher revenue in the quarter, with consolidated revenue rising to $120 million, a 13% increase over the prior year period. Net income was $8.9 million or $0.22 per share. Adjusted net income was $10.3 million or $0.25 per share. Adjusted EBITDA for the quarter was $19.3 million, down 6.6% compared to the very strong first quarter of 2017, but ahead of 2017's full year run rate.At Magnequench, revenues were up by 17% in the quarter from the prior year, while volume declined 8%. Higher revenue was due primarily to increased selling prices from higher rare earth input costs, which are passed through to our customers. Lower year-on-year volume was largely driven by customers making adjustments to their quarterly purchasing patterns and inventory levels. Our Magnequench unit continues to see demand growth across its end market applications. Looking ahead, we expect demand growth to be led by the growing need for smaller and more energy-efficient motors that are increasingly vital to the applications and platforms in robotics, home appliances and in automobiles. In particular, the global macro trend toward greater electrification of vehicles is a significant driver for Magnequench. Our magnetic materials are used in a number of the smaller, lighter and more energy-efficient micro motors that are increasingly integrated into new vehicle designs.Additionally, our innovative MQU magnetic powders, which contain zero-heavy-rare earths, are also now utilized in electric vehicle traction motors of some Honda hybrid models. That technological advance was made possible by years of closely integrated R&D by Magnequench, our customer and Honda. Partnering with customers and other segments in the manufacturing supply chain to develop new materials and applications is a core component of our strategy and of the Neo corporate culture.Our Chemicals & Oxides segment also had higher revenues on lower volumes compared to the prior year period. C&O revenue growth in the quarter was primarily driven by higher commodity rare earth prices, which are predominantly passed on to customers. Long-term growth trends for many C&O products remain strong, especially for our more highly engineered advanced materials, such as automotive emission catalysts where Neo is a top 3 global supplier.C&O volumes were lower in the quarter due to several factors. We often see quarter-to-quarter variability in customer purchasing patterns, particularly in the separated rare earths segment. Additionally, sales of our auto catalyst products were adversely impacted following production constraints in the fourth quarter of 2017 at our Zibo, China plant as a new wastewater treatment system was installed and commissioned.In general, the long-term demand outlook for C&O auto emission catalysts remains robust. We continue to work closely with our customers to develop innovative, next-generation products that help our customers and vehicle manufacturers meet more restrictive emission standards.In this regard, we also continue to make progress in our efforts to defend and develop our auto catalyst intellectual property. We both vigorously defend against patent infringement suits filed by a competitor, and we are actively working closely with customers to develop innovative, new products that can mitigate the risk of future patent infringement allegations.There are 2 recent developments with respect to patent litigation. On April 18, 2018, China's Patent Reexamination Board invalidated all claims associated with a key Chinese patent held by Rhodia, an affiliate of Brussels-based Solvay. We were very pleased with this decision. While subject to appeal, it reinforces Neo's freedom to manufacture and sell its proprietary automotive catalyst products in the increasingly important Chinese market.On April 23, the U.K. Business and Property Courts upheld a claim of patent infringement against Neo by Anan Kasei and Rhodia pertaining to a European patent. Neo intends to seek permission from the court to appeal that decision. While we are disappointed in this ruling, U.K. sales of Neo products affected by the lawsuit have been relatively insignificant, and we expect no future material impact to sales as a result of the decision. We very much appreciate the continuing support we are receiving from our auto catalyst customers who clearly want us in the market and who know that having multiple suppliers of these materials is a benefit not only to them, but also to their customers, end-use consumers and our global environment.Our third business unit, Rare Metals, had a very good first quarter. Revenue, volume, operating income and adjusted EBITDA were all up compared to the prior year. Restoration of full production capacity at our Silmet facility in Estonia helped to drive higher volume and sales. We benefited from increased demand and higher prices for our products using super alloys in the aerospace industry. We also saw stronger sales of gallium trichloride, a critical material for LED lighting applications. Neo is the #1 global supplier of gallium trichloride used in LED.On a consolidated basis, we completed the quarter with approximately $95 million in cash and negligible debt. Our financial position is further strengthened by relatively low CapEx, low commodity price exposure and an efficient global tax structure. All of these reinforce a high free cash flow conversion rate.So with that, let me turn the call over to Rahim for additional detail on our Q1 financial performance.

[Rahim Suleman, Executive VP & CFO]

Thanks, Geoff, and good day to everyone.In our Magnequench segment, revenue for the quarter was $56 million compared to $47 million in the prior year period, a 17% increase. Volume declined to 1,527 tonnes compared to 1,659 tonnes in the prior year period, a decrease of 8%. As Geoff noted, this was due to several factors that were largely specific to Q1 2018. However, Magnequench continues to benefit from operational improvements, strategic purchasing and an increased selling price, primarily due to certain underlying commodity rare earth price increases.Operating income for the quarter was $13 million, up from $11 million in the prior year. That was an increase of 18.4%. Adjusted EBITDA for this segment was $15.5 million in the quarter compared to $13.4 million in the prior year, an increase of 15.1%. For reference, adjusted EBITDA for the full year 2017 was $49.4 million.Turning to Chemicals & Oxides. That segment booked revenue of $45 million in the quarter, a 5% increase from the prior year period. Volume declined 13% to 1,987 tonnes (sic) [ 2,007 tonnes ] from 2,290 tonnes in the prior year period. As in our Magnequench segment, this revenue gain for C&O was primarily due to higher commodity rare earth pricing. The substantial portion of these higher commodity costs are passed through to our customers in our product pricing, while others are tied to market price. As Geoff mentioned, volumes in the C&O rare earth business declined compared to the prior year due to several factors that were largely related to timing within the quarter. However, the long-term outlook for C&O products remains strong.C&O operating income for the quarter decreased to $2.1 million from $4.7 million in the prior year period, a 55% decline. C&O continued to experience higher premium freight costs associated with our auto catalyst business as we continue to refill the supply chain following the installation of the new wastewater treatment system in our Zibo, China plant. We estimate that these premium freight costs will continue, although at a steadily reducing rate, into the second quarter of 2018. The impact of the additional freight costs plus potentially lost sales is estimated to be between $3 million and $4 million in this past quarter.Adjusted EBITDA for C&O in the quarter was $3.5 million compared to $8.3 million in the prior year period, a decrease of 57.4%. As a point of reference, adjusted EBITDA for the full year 2017 was $25.3 million.Turning to Rare Metals. Revenue for the quarter was $23 million compared to $18 million in the prior year period, an increase of 24%. Volume rose 45% from 93 tonnes in the prior year period to 135 tonnes in Q1. Operating income more than doubled in the quarter, rising to $2.5 million from $1.2 million in the prior year period. This improved operating performance was due to increased sales, particularly of higher value-added products and a favorable product mix. In addition, the segment continues to realize the benefits of higher production capacity, higher flow-through margins and operational improvements, particularly at our Silmet production facility. Adjusted EBITDA for Rare Metals was $3.8 million in the quarter compared to $2.6 million in the prior year period or an increase of 44.8%. And for reference, adjusted EBITDA for the full year 2017 was $9.1 million.On a consolidated basis, let me note the following additional results and activities in the quarter. Neo's SG&A expense was $13.1 million for the quarter compared to $10.9 million in the first quarter of 2017. The increase relates to lower SG&A in the prior year period than that for the full year 2017 generally, as certain SG&A costs were project-based and may be higher or lower in any given quarterly period.Neo invested $4.4 million in R&D expenditures in the quarter, representing 3.7% of consolidated sales. That compares to $3.3 million of R&D spending in the prior year. The company continues to prioritize R&D investments in new applications and developments for our products, which helps strategically to position Neo to better meet customer needs for technical solutions.CapEx spending for the quarter was $2.3 million, which compares to $1.4 million in the prior year period. The majority of these capital expenditures related to project performed at our Zibo, Tianjin and Silmet facilities.Cash taxes paid in the quarter were $2.9 million. And we closed the quarter with $94.5 million in cash on hand after paying a $3 million dividend to our shareholders on March 29, 2018. We have approximately $29.3 million available under credit facilities with nominal amounts drawn. A quarterly dividend of CAD 0.095 per common share was declared on May 9, 2018, for shareholders of record at June 22, 2018. And as part of our ongoing normal-course issuer bid, Neo purchased 16,600 shares with an aggregate disbursement of $0.2 million in the quarter.In summary, our financial position is strong. Our operational efficiencies continue to improve, and we are seeing robust and sustained demand growth across all of our business segments. And the high-quality earnings that we are delivering are significantly enhancing long-term shareholder value in the company. Geoff, back to you.

[Geoffrey R. Bedford, President, CEO & Director]

Thanks, Rahim. Over its 20-plus year history, Neo's built strong and sustainable positions in the markets we serve. Growth in these markets is being driven by large and long-term macro trends that are only increasing the importance and value of the functional materials we make. As we continue to work with customers to develop new advanced materials that are engineered specifically for their needs, we improve both our customers' performance, sales and margins as well as our own. We see this as a sustainable, unique value proposition for our customers and for our shareholders.

[Ali Mahdavi, Capital Markets & IR Executive]

With that, operator, let's open the call for questions.

[Operator]

[Operator Instructions] Your first question comes from the line of Yuri Lynk of Canaccord Genuity.

[Yuri Lynk]

A little surprised by the 10% decline in auto catalyst sales in C&O. Can you just provide a little more color on what went on there? Was it just inventory movements? Or -- and the outlook for the rest of the year vis-a-vis that decline witnessed in Q1.

[Rahim Suleman, Executive VP & CFO]

Sure. It's Rahim. I'll take that, Yuri. So the 10% decline in C&O, we'd attribute it to a couple of dynamics. One is kind of quarterly purchasing patterns of customers that may go up and may go down at any given quarter that could relate to diesel, that could relate to three-way catalysts. But we think that's probably a smaller portion of the element and just movements in that general universe. But as you know, we're up to being able to more than produce enough product to support our customers post the implementation of the wastewater treatment system. But during our ramp-up period of time, we make choices in terms of which customers need supply the most. And that would have led us to potentially losing some of the opportunities or having some of those opportunities pushed out later in the year. Our view is that we're very comfortable and very confident with the long-term growth pattern within the auto catalyst segment. And if you kind of look at our production sales growth, kind of excluding this period where we've kind of redid the wastewater treatment system, you'd see a sustained growth pattern. And we see that continuing into the future.

[Yuri Lynk]

Okay. The $3 million to $4 million impact from the wastewater treatment facility, does that -- that's a revenue impact, just to be clear? And would that just drop right down to EBITDA as well?

[Rahim Suleman, Executive VP & CFO]

No. Actually, $3 million of it would be a premium freight impact. But then there's some element of lost sales that, obviously, we can't quantify exactly, so we just put a range on that number. But $3 million of it is premium freight. And that's what we see kind of as we've been now over to -- able to overproduce production requirement. We've been making progress to refill the supply chain, which is why we say that it will be steadily decreasing through the next quarter.

[Yuri Lynk]

Okay. A second one for me. Can you comment just on the legal expenses in the C&O segment vis-a-vis last year and how they're -- how you envision them tracking? Any change to your expectations there?

[Rahim Suleman, Executive VP & CFO]

Well, we haven't specifically carved out kind of legal expenses that are hitting the P&L in any given quarter. What I would say is that, quite honestly, we spent a significant amount last year. We thought that the activities really ramped up in 2017. So there was a healthy amount of spend through 2017. Early 2018, I would say, is not dissimilar to the first portion of 2017. But I would say that our expenses were higher in the back half of 2017 as well.

[Operator]

Your next question comes from the line of Scott Fromson of CIBC.

[Scott Douglas Fromson]

Just on the Magnequench business. Are the precision motor volumes trending up enough to fully offset the lower hard disk drive revenues or volumes?

[Geoffrey R. Bedford, President, CEO & Director]

So I think, generally, the precision motor volume, plus some of the MQU applications, are growing faster than we're seeing the decline of HDD, yes. Quarter-to-quarter...

[Scott Douglas Fromson]

Okay. And Geoff, raw material inputs cost, how do margins in the precision motor segment or a portion of that business compare to the HDD margins? Or maybe what I'm actually asking is what's the margin outlook for Magnequench?

[Geoffrey R. Bedford, President, CEO & Director]

Yes. So the HDD margin is a better margin product, no question. I think the precision motor margin is -- some are as good, some are not as quite as good, and it really depends on the application. This -- and I'm talking on a per-kilogram basis. And then when you look at the MQU, which are typically much larger volume on a per-kilogram basis, margins are slightly lower.

[Operator]

Your next question comes from the line of Mac Whale of Cormark.

[MacMurray Davidson Whale, Analyst of Institutional Equity Research]

Just following up on that, actually, on the margin per tonne in Magnequench. It looked quite high. We thought we'd see that come down a little bit. Is -- how much of that might have been due to buying some material at a pretty favorable point in time? And I'm wondering how sustainable that would be.

[Rahim Suleman, Executive VP & CFO]

Yes. I think that there's a balance of factors that are involved there, including, as you said, the purchasing of material at a particular point in time and the lead lag factor that does exist in terms of the rare earth pass-through element of the business. So kind of as we've said last year that there is kind of overall, longer period of time, you can see a sustainable margin emanating from Magnequench. And in any given quarter, it might be higher or lower due to some of those timing impacts. But I think that the -- so the level of pricing we have now, we've got pricing and cost reasonably converging. But there might still be some lead lag there. But this is -- between 2017 and 2018, when you put the period together is where we see fundamental margins to be.

[MacMurray Davidson Whale, Analyst of Institutional Equity Research]

Okay. And on pricing in C&O, like, because of the shift in the mix, is that sort of price per tonne sort of an odd quarter? Like, should we look at something more like the average of last year in terms of the trend for that?

[Geoffrey R. Bedford, President, CEO & Director]

Yes. I think quarter-to-quarter, because of mix, it can be -- it can change. So probably better to look over a longer time period, which would be more reflective of what we would think going forward, I mean, subject to rare earth prices being somewhat stable.

[MacMurray Davidson Whale, Analyst of Institutional Equity Research]

Okay. And then the -- just my last question on the SG&A. I would think I was looking -- thinking more around the $60 million level for 2018. I think we've talked about that in the past. I was wondering whether the decline in the quarter, if there was some sort of quarterly unusual thing in there.

[Rahim Suleman, Executive VP & CFO]

No. I mean, I don't think so. Generally, I think that within SG&A, there are generally ups and downs, like smaller types of ups and downs just due to timing. I can't speak specifically to the definition of SG&A that you're using, whether you're using like stock-based comp in that number or not. But I think SG&A was, I think, a little bit higher from a quarterly timing perspective than we had envisioned. But I mean, there are projects that come up that can move that. So I think it's kind of on the edges.

[Operator]

[Operator Instructions] Your next question comes from the line of Mark Neville of Scotiabank.

[Mark Neville, Analyst]

I just want to follow up on Yuri's questions on the auto catalyst sales. I guess, just sequentially, I was a bit surprised it didn't ramp up a bit quicker just given that the water treatment facility was down in Q4. So I don't know if there's any production issues or just ramping issues or anything you can point to specifically there.

[Geoffrey R. Bedford, President, CEO & Director]

Well, I think the -- because of the pipeline, production impacts in Q4 sort of spill and then hit you in Q1. I would say that in the quarter, we brought that plant back up maybe not as quickly as we otherwise would have liked to. But generally, the production, where we sit today, certainly, we're running as we would like to see that plant run. So there might have been some of that, but a lot of it was timing. But generally, as we look out at the auto catalyst markets, again, the anomaly in Q4 and Q1, we still see good growth in those markets as we look ahead here.

[Mark Neville, Analyst]

Yes, I can appreciate the longer-term trend, but again, just -- I guess, just shorter term when we look to Q2, Q3. We, again, presumably should see a bit of a ramp as you continue to fill the supply chain from [ Q1 ]?

[Geoffrey R. Bedford, President, CEO & Director]

Yes. We would -- we do not expect that -- where the plant is running today, we should be able to meet the demand that we have in front of us. And we are making progress, as Rahim said, on filling that supply chain. But we do expect some premium freight in this quarter as well as we work through that.

[Rahim Suleman, Executive VP & CFO]

Yes, Mark, I mean, most of the filling of the supply chain, I would say, there is a smaller impact on product sales. We've done a great job in managing our customers. And yes, as we've talked about, there has been some impact that we've worked with our customers through. But I think most of the supply chain on the premium -- that leads to the premium freight is really about us just having the right stock in all the locations. Customer impact has been there, but it's minimal.

[Mark Neville, Analyst]

Are you still paying premium freight today? Or is it -- are you still paying it today?

[Geoffrey R. Bedford, President, CEO & Director]

Yes, to a lesser extent, but yes.

[Mark Neville, Analyst]

Okay. And just continuing on the volume trends in Magnequench, it was -- the volumes are pretty good and absolute, but year-over-year, you're down. Again, I don't know what happened in Q1 '17. I don't know if customers are buying ahead of price increases or what exactly drove that -- the strong result last year. But if you could just provide a little bit of color on that, I think, could be helpful.

[Rahim Suleman, Executive VP & CFO]

Yes. I think that's right, Mark. And I think that there's -- it's difficult to provide exact specificity. But when we look at our biggest customers and the biggest patterns that we would have seen year-over-year, we would have seen an abnormally high purchase rate in Q1 2017. So I think that there was an element of that. And then it's odd if I tell you that the element that we saw in Q1 '18 is a belief that 1 or 2 of our Japanese customers looked at their inventory levels and wanted to get some adjustment into there. But again, neither of those 2 are statements of long-term demand because we think that the long-term demand remains strong. But I think that there is a little bit of that dynamic where we were surprised on 1 product in Q1 '17 and we were surprised on a different product actually in Q1 '18.

[Mark Neville, Analyst]

So the inventory adjustment was this year or last year, the Japanese customer?

[Rahim Suleman, Executive VP & CFO]

I think that there was a build process in place in 2017, and in one product anyway, we can see a reduced demand in Q1 '18 that we don't believe -- and I say we don't believe -- in discussion with our customer, we don't think is a sustainable change in long-term demand. It was hitting their year-end and rightsizing their inventory for year-end for them.

[Mark Neville, Analyst]

Okay. And maybe if I can, just one last one on Magnequench on profitability of your margin. If I'm just looking at rare earth prices, I mean, it looks like input costs would come up a bit. Maybe your ASPs come down a bit. But I think, Rahim, too, some comments you made, or was it -- or Geoff, that the sort of level of profitability, where you're at now shouldn't be a meaningful stepdown. And maybe I misinterpreted that, but just comments on that.

[Rahim Suleman, Executive VP & CFO]

Well, I think Q1 '18 was healthy. So I mean, I think that what I said was always try to focus on the longer term and try to capture kind of the 2017 average and think that through as well. So some of it will be sustainable, good guys that go through in any quarter. And some of it will be -- there will be some adjustments of price as we go forward as well.

[Mark Neville, Analyst]

Okay. And again, just given the movement in the rare earth prices, it looks like costs have come up a bit. And again, presumably, prices down a little bit in Q2?

[Rahim Suleman, Executive VP & CFO]

Yes.

[Operator]

[Operator Instructions] There are no further questions at this time. I will turn the call back over to the presenters.

[Geoffrey R. Bedford, President, CEO & Director]

Great. Well, thank you very much for joining the quarter -- the call, and we look forward to talking to you next quarter. Thank you very much.

[Operator]

This concludes today's conference call. You may now disconnect.