Cabot Corporation (CBT) Q3 2017 Earnings Report, Transcript and Summary

Good day, ladies and gentlemen and welcome to the Q3 2017 Cabot Earnings Conference Call. At this time, all participants are in a listen-only mode. [Operator Instructions] As a reminder, this conference call is being recorded. I would now like to introduce your host for today’s conference, Mr. Steve Delahunt, Vice President, Treasurer and Investor Relations. Please go ahead.

Good afternoon. I would like to welcome you to the Cabot Corporation earnings teleconference. Last night, we released results for our third quarter of fiscal year 2017, copies of which are posted in the Investor Relations section of our website. For those on our mailing list, you received a press release by e-mail. If you are not on our mailing list and are interested in receiving this information in the future, please contact Investor Relations. The slide deck that accompanies this call is also available in the Investor Relations portion of our website and will be available in conjunction with the replay of the call. During this conference call, we will make forward-looking statements about our expected future operational and financial performance. Each forward-looking statement is subject to risks and uncertainties that could cause actual results to differ materially from those projected in such statement. Additional information regarding these factors appears under the heading forward-looking statements in the press release we issued last night and these factors are discussed more fully in the reports we filed with the Securities and Exchange Commission, particularly our Annual Report on Form 10-K for the fiscal year ended September 30, 2016. In order to provide greater transparency regarding our operating performance, we refer to certain non-GAAP financial measures that involve adjustments to GAAP results. Any non-GAAP financial measures presented should not be considered to be an alternative to financial measures required by GAAP. Any non-GAAP financial measures referenced on this call are reconciled to the most directly comparable GAAP financial measure in a table at the end of our earnings release issued last night and available in the Investors section of our website. I will now turn the call over to Sean Keohane, who will discuss the key highlights of the company’s performance, Eddie Cordeiro, who will review the business segment and corporate financial details. Following this, Sean will provide closing comments and open the floor to questions. Sean?

Thank you, Steve. Good afternoon, ladies and gentlemen. This quarter, we achieved solid operating results despite some unique challenges. The Reinforcement Materials segment continued to deliver strong operating results, with 46% growth in EBIT on a year-over-year basis driven by benefits from contract and spot pricing and favorable product mix. The Performance Chemicals segment experienced a more challenging quarter due to lower margins from higher feedstock costs compared to last year and the impact of unplanned downtime on volumes and costs. Results in Purification Solutions were weaker compared to last year due to lower volumes and pricing in mercury removal as well as the impact of a plant disruption at one of our facilities. Partially offsetting these headwinds was volume growth in the environmental and specialty applications of this business. The Specialty Fluids segment had a solid quarter, but EBIT decreased $6 million compared to the prior year quarter during which the business experienced a particularly high level of project activity. We had a reduction in our operating tax rates largely from a change in the geographic mix of business earnings. This benefit was largely offset by FX losses in the emerging market currencies in a negative LIFO adjustment. We generated strong cash flows from operating activities totaling $132 million during the quarter. Consistent with our capital allocation strategy, we continue to reinvest in our businesses and return cash to shareholders. We invested $41 million in capital expenditures in the quarter, while returning cash to shareholders through $19 million of dividends and repurchasing 250,000 shares for $13 million. On the strategic front this quarter, we continue to execute our strategy to advance in our core. To that end, we announced our plan to invest in a new fumed silica plant in Carrolton, Kentucky. The new manufacturing facility will extend our existing long-term relationship with the Dow Corning division of Dow Chemical. And we expect the plant to be operational by 2020. We also recently celebrated the groundbreaking of our new fumed silica manufacturing facility in Wuhai, China which we announced in September of 2016. These projects will allow us to continue to meet the growing market demand for our high-performance fumed silica. In addition, we will be able to improve supply and manufacturing efficiencies while achieving environmental and safety benefits through these over-the-fence relationships. We are excited to add both the Wuhai and Carrolton plants to our global manufacturing network and are confident these investments will further strengthen our leading global position in the fumed metal oxides market. Overall, I am very pleased with the progress we have made in advancing the corporate strategy and I am confident in our ability to deliver attractive and sustained total shareholder return based on the combination of EPS growth and cash return to shareholders. I will now turn it over to Eddie to discuss the financial results of the quarter in more detail. Eddie?

Okay, thank you Sean. I will discuss the segment results beginning with Reinforcement Materials. During the third quarter of 2017, EBIT for Reinforcement Materials increased by $16 million as compared to the third quarter of 2016. The increase in EBIT was principally due to higher unit margins driven by favorable spot market pricing, especially in Asia, better product mix and the benefits of higher oil prices on our energy efficiency investments. Sequentially, volumes decreased by 1% due to reduced demand in the tire markets in china primarily due to customer pre-buying which occurred in the second quarter of fiscal 2017. EBIT decreased by $3 million compared to the second quarter of fiscal 2017 largely driven by the customer pre-buying and timely raw material purchases both of which occurred in the second quarter of fiscal 2017, but did not reoccur in the third quarter. Looking ahead, Reinforcement Materials will continue to benefit from overall strong market fundamentals, but we expect modestly higher fixed costs and a negative impact from inventory draw-downs in the fourth quarter as compared to the third quarter. Now, turning to Performance Chemicals, EBIT decreased by $13 million compared to the third quarter of fiscal 2016 due to higher feedstock costs and the impact of unplanned downtime on volumes and costs in specialty carbons and formulations. Overall, volumes for Performance Chemicals decreased 2% year-over-year, with volumes in specialty carbons and formulations down 3% partially offset by a 3% increase in metal oxides. Performance Chemicals EBIT decreased by $5 million compared to the second quarter of fiscal 2017 also primarily due to higher feedstock costs and the impact of unplanned downtime on volumes and costs in specialty carbons and formulations. Sequentially, volumes decreased by 9% in specialty carbons and formulations, which was partially offset by a 10% increase in volumes in metal oxides. EBIT margins in the Performance Chemicals segment were 20% for the third quarter of fiscal 2017, which is down 6 percentage points from the same period last year. The unplanned downtime that we experienced this quarter cost the business approximately $5 million of EBIT between the lost margin and additional maintenance expense. Normalizing for this loss, EBIT margins would have been 22% for the quarter. This, however, is still down from the peak margins of about 26% a year ago. To give you some context on the margin developments in the segment, our feedstock costs were at their lowest point in the third quarter 1 year ago, when oil dipped below $30 per barrel. Since then, our feedstock costs have slowly risen over the last 12 months driven by higher oil prices and specific forces affecting prices of the specialty carbons feedstock slate. We are currently in the midst of implementing price increases to recoup some of the loss margin and fund the necessary investments to fuel innovation and new capacity in order to serve our customers. Our target is to have them implemented during the fourth quarter and barring any substantial change in oil prices we are targeting EBIT margins in the 23% to 24% range for 2018. Over the long-term, we would consider this margin level to be strong and durable. Looking ahead to the fourth quarter, we expect end markets to remain strong with announced price increases taking hold during the quarter. Volumes and product mix should improve with the resolution of unplanned downtime. The third quarter fiscal 2017 EBIT in Purification Solutions decreased by $2 million compared to the third quarter of fiscal 2016 due to lower volumes and margins associated with the mercury removal business and higher maintenance costs associated with temporary plant disruption. The plant disruption and higher maintenance impacted segment EBIT by $3 million in the quarter. Purification Solutions EBIT decreased by $4 million compared to the second quarter of fiscal 2017 driven primarily by unfavorable product mix and higher fixed costs associated with the plant disruption and maintenance, partially offset by an increase in non-environmental and specialty volumes. In the last few months we have also seen an up-tick in competitive intensity in the North American powdered activated carbon market including mercury removal. Capacity in this market was overbuild with a much higher volume expectation for mercury removal than we are seeing. As the market continues to develop, this has resulted in significant price pressure. We believe prices are unsustainably low and our focus is on restoring margins before focusing on volumes. In the fourth quarter, we do expect the segment to benefit from seasonal volume growth and lower fixed costs. Looking out over the next year or so, we will be focusing on restoring margins and continuing to build our specialty business. In the medium-term we anticipate growth and the stabilization of the North America powder market and growth in the specialty applications. As a result the near-term EBIT expectation is more likely in the $2 million to $4 million per quarter on average with some seasonal variations between quarters. Third quarter fiscal 2017 EBIT in Specialty Fluids decreased by $6 million as compared to the third quarter of fiscal 2016 during which the business experienced a particularly high level of project activity. Sequentially Specialty Fluids EBIT increased $4 million compared to the second quarter of fiscal 2017 as we saw higher rental activity in Asia, Middle East and Africa and the North Sea. The higher activity was offset by a decrease in volumes in fine cesium chemicals, following the strong second quarter of fiscal 2017. Looking ahead, we expect a similar level of project activity in the EMEA region. I will now turn to corporate items. We ended the quarter with a cash balance of $198 million and our liquidity position remained strong at $1.2 billion. During the third quarter of fiscal 2017, cash flows from operating activities or source of cash of $132 million including a decrease in net working capital of $31 million. Capital expenditures for the third quarter of fiscal 2017 were $41 million. Discretionary free cash flow was $71 million of which we returned to our shareholders $19 million in dividends and $30 million in share repurchases. As we look at the full year we expect CapEx to be approximately $150 million. We recorded the tax provision of $16 million for the third quarter for an effective tax rate of 22%. This included a charge of $5 million from tax related to certain items. Excluding the impact of certain items on both operating income and the tax provision, the operating tax rate on continuing operations for the third quarter of fiscal 2017 was 21%, which also represents our current forecast for the year. Adjusted EPS in the third quarter also benefited from the rate catch-up to bring the operating rate down to 21% for the year. Offsetting this tax benefit were FX charges in our un-hedged emerging market currencies of Brazil, Argentina and China as well as the LIFO charge of $2 million due to rising feedstock costs at the end of the quarter. And I will now turn the call back over to Sean.

Thanks Eddie. Looking across the segments, Reinforcement Materials remains well positioned for another strong quarter, notwithstanding modestly higher fixed costs and the negative impact from inventory drawdown. Europe, Middle East and Africa and Asia Pacific end markets remain strong and we continue to expect quarterly EBIT in the fourth quarter to be in the $45 million to $50 million range. Performance Chemicals did experience some challenges in the third quarter, but the end markets remain robust and we expect full year volume growth to be in the 4% to 5% range and in line with the market growth rates. We would anticipate profit levels returning more in line with previous quarters in the low $50 million range as the impact of downtime is now behind us. In the Purification Solutions segment, we expect to see stronger seasonal volumes and lower fixed costs during the fourth quarter and expect EBIT in the fourth quarter will be in the $3 million to $5 million range. Finally, the Specialty Fluids segment continues to make progress in the expansion into Asia, Middle East and Africa region, it is always the timing of projects in this business is difficult to forecast. We continued to drive our advancing the core strategy focused on 7% to 10% EPS growth over time and expect to be towards the high end of that range for the fiscal year 2017. We are maintaining discipline around our capital allocation framework, which balances reinvesting for growth in our core businesses and returning cash to shareholders. Thank you very much for joining us today. And I will now turn the call back over for our question-and-answer session.

Thank you. [Operator Instructions] And our first question comes from Kevin Hocevar from Northcoast Research. Your line is open.

Hey, good afternoon everybody.

Hi Kevin.

I am wondering if you could connect the dots a little bit with so Asia volumes were in Reinforcement Materials were down 7%, it sounds like pricing is really doing well, stop market pricing is doing really well particularly in Asia and I think you can kind of see that in the minority interest line there, I think a lot of joint ventures are in Asia and that number was just high as it’s been in quite some time, so I am wondering if you can help connect the dots, if volumes were down as much as they were and it seems like pricing and maybe you can elaborate on this maybe even getting stronger can you kind of help me connect the dots, how you are able to get solid spot pricing in kind of a soft volume environment and what’s your expectations for that going forward?

Yes. Sure Kevin. So I think let me just pullback for a second on China vis-à-vis, I think as we have discussed in previous calls what we are seeing in China is solid growth rates, albeit they are down from sort of the past 10 years or 15 years growth rates that I think the industry had seen, they have adjusted to growth rates that I think would be more in kind of 5% to 7% range and so that transition continues and not in consistent at all with sort of the macro story around China. As we look at the carbon black business there, we are seeing a long-term trend of I would call ratcheting of environmental enforcement and ultimately what would happens here is companies like Cabot have maybe environmental investments to meet the compliance standards that are on the books. I think are in a more advantage position as compared to some local competitors that may not have. So the enforcement regime I think continues and we are seeing that in carbon black and as I talk to a number of chemical company peers I think they are saying that same trend to happen, so that leveling of the playing field I think is a good thing. Now when that happens a few things play out. One I think you would start to see certain capacity get either curtailed or shutdown and there is definitely some of that happening and that that provides I think more price support to get prices up to the levels that we think they need to be at in the long run for this business. So we are certainly seeing that play out and we are pleased with the developments there. Now, in the quarter as you pointed out volumes were down. I think there were two things happening across the whole tire industry we definitely saw significant amount of pre-buying occur in calendar Q1 or our fiscal Q2. And a lot of the tire customers have already commented on this as they were out with price increases to deal with the pretty rapid run up in raw materials at that time. And so I think there was a fair bit of pre-buying across the whole chain. And some of that definitely played out in the volume picture in Q3. I think in addition to that, we have been very focused on managing the pricing in the marketplace and including China and in the quarter put more emphasis on that because we think the rebalancing is going on, it’s appropriate and supportive to do that. We still see the long run growth rates in China in that sort of 5% to 7% range and we would expect to get our share that over time, so no change in the long run direction there.

Got it, great. And I think you have a couple of price increase announcements in the market you talked about your specially carbon blacks, I think that price increase I believe took effect at the end of June and then you also had Europe rubber black increase, I think €50 to €80 a ton effective middle of June so and I believe that that affects the spot market particularly, so on the rubber one could you rewind us what percent of Europe is spot market and could you give an update on how you think these price increases are doing both at the Europe rubber one and the specialty carbons one?

Sure. So you are right we are in the market with the price increases in Europe for reinforcement materials. The spot market as we have commented in the past is in the zone of 20% of that market, so it is still a heavily contracted market, but that being said there is some gap to the spot market and so this is really a continuation of the trend that we have been commenting on where we are seeing Europe has pretty good fundamentals. The growth rates are pretty strong in Europe. I think European PMI just hit a 10 year high and so I think that is going through in terms of overall activity in Europe, so demand levels are up. And then on the supply side things have become, more supportive there. There were certainly some competitor capacity take outs that have occurred over the last – over the last year. And we have seen that that is supporting things as well. And so we are in the market with price increases here. And I think those are appropriate given that set of circumstances and given that overall the cost of continuing to support our customers in this industry continues to go up. So I think that has to happen and as things play out there I would expect that we would have success. In specialty carbons you referenced that one as well, so we are out with price increases here and maybe I will just pull back a little bit on this one as well, because there is a lot going on here in terms of the margin progression over the last couple of years. And I think in Eddie’s comments he talked about the impact that we had this quarter of the outage and if you normalize for that where our EBITD margins would have been. Those are still off the peak, it was – that was hit a year ago. Now at that time we were certainly benefiting from a dip in oil and feedstock prices, but since then that time those have risen. And so as a result we are in the market raising prices to recoup some of that lost margin and also fund some of the necessary investments to serve our customers growth plans here. Now these will play out over the course of Q4 because the way things work in this business is there is less sort of contracted business in the sense the way you would be familiar with tire, but there are various arrangements and ability to address pricing ranges across customers in terms of timing. So I would think about this playing out over the course of Q4 and trying to set us up for 2018 and as Eddie commented we have got a target margin level that we think is the right level in terms of being not only a very strong level, but also a durable long-term level, so that’s where we are on the specialty carbons price increase.

Okay, great. Thank you very much.

Thank you. Our next question comes from Mike Sison from KeyBanc. Your line is open.

Hi guys. When you think about performance chemicals you are going to have good volume growth this year and EBIT is going to be down, so it sounds like the momentum in volume could sustain potentially into ‘18, what do you think needs to happen to get earnings growth of that volume as we head into ‘18?

Yes. So I think we have been pleased with the volume progression in the business and it is certainly our expectation that we will grow at market rates in this segment. And if you look at the basket of applications and you look at the growth rates of each of those they sort of roll up into this 4% to 5% range, so that’s certainly our expectation. Now, this year, we have had some headwinds as we have talked about compared to 2016 the single biggest one that we have been dealing with is on oil. And so I think it is important that we have success in the marketplace in terms of getting a pricing up and those margin levels into that target range, because I think in order to fund the growth investments for innovation and new capacity to serve our customers that’s the level that we need to be at. So I think that’s kind of the first order business. I mean I start I guess by adding back the one-time issue that we had this quarter for about $5 million. I think the underlying rate is more in that low-50s range at the starting point. So with that starting point step two is moving the prices up and then with that plus the market growth we would expect in our continued efforts to generate new products for our customers, that’s kind of the model for how we grow the EBIT in this business and make its contribution to our overall 7% to 10% target.

Great. And then when you think about 7% and 10% target, I know it’s not specifically an annualized year, but if you were to hit that goal in 2018 what type of earnings growth would you need in Reinforcement Materials to get there?

Well, I think in Reinforcement Materials as you know a lot depends on how our annual contracts go and that’s something that will certainly play out over the balance of this year. So a little bit difficult to project that at this stage, I think normally a little bit later in the year we will be in a position to comment a little bit more on that, but in order to drive our overall company performance in that range, we need contribution from all businesses and certainly reinforcement and performance chemicals being the two biggest, those would need to be growing in and around that range in order to make it as a company, so that would certainly be the way we would think about it Mike.

And then one, just curious as you think about Reinforcement Materials, industry clearly tightened up as you told us in the last year or so that enabled pricing to finally head in the right direction, any thoughts maybe by region how the industry looks heading into your fiscal ‘18?

Yes. So no real change compared to what we have talked about over the last quarter, so I would say it’s still pretty consistent, but let me just maybe do a real quick walk around the major regions and what’s happening. I will start with Europe because I commented on it earlier, but I think that remains strong given the demand picture as well as the tightening of supply and demand that we have been commenting on. So I would say no change there and continued momentum. North America remains stable, although I think we have not seen the growth here that the market fundamentals would suggest. And I think it’s not just ask but if you look at the tire companies as well and I believe we are heading into a period where tire imports have leveled off in terms of their penetration. And with new capacity investments coming on-stream over the coming period I think North America will return to growth rates in that sort of 2% to 3% range that one would expect over time. Again I don’t think the industry has seen that yet, but our view is that is what will happen here. Now, it’s interesting that one of our competitors just recently announced that they are planning to idle some capacity, so I think that’s – I think recognition of the fact that with the growth having been fairly modest in North America in the recent period that things probably need to tighten a little bit more in order to get pricing to the levels that it needs to be at to support investments in the industry, so that’s kind of North America. South America is growing, but I think the political uncertainty remains real question here. China, I have talked about I think there is good growth here. Now, we are well positioned with a significant tranche of capacity and with the market tightening as we see environmental enforcement ratchet it. I think that that will continue to be a strong spot for us. And then South Asia I think continues as well its growth trajectory quite a bit of imported tires in places like North America do come from South Asia, so we would expect good solid demand growth there. So I think the real question Mark here is how things play out in North America and I think this transition into what we believe is the longer term growth rate in North America. But it has not yet materialized, but I think signs are as I talk to folks in the industry that that is coming.

Great. I appreciate the color.

Thank you. Our next question comes from David Begleiter from Deutsche Bank. Your line is open.

Thank you. Good afternoon.

Hi Dave.

Hi there. Sean you mentioned that in Purification Solutions prices are below normal below with same levels, what do you think normalized prices should in this business and longer term what is potential this business to from EBITDA or margin perspective, we are taking it back to assuming competitive intensity does to become a little more disciplined here?

Yes. So certainly in the last few months we have definitely seen an up-tick in the competitive intensity. And I think it’s related to the fact that the industry overbuilt with a much higher volume expectation as the mercury removal application was with developing certainly we are not seeing the growth rates that were expected and underpin a lot of those investments. And so as a result I think when you see this happening in industry, people tend to try to fill up plans first and pricing moves in the wrong direction. And it’s our view that it’s not at sustainable levels right now. And so our focus needs to be on trying to restore margins before where we are chasing. We are chasing volumes in this business. So we will have to see how that plays out over the near-term. As I think about the business David, I think it’s sort of in the near-term and in the medium-term. In the near-term we are going to have to really focus on restoring those margins and trying to establish a level if pricing for our business that gives a solid return and allows us to reinvest. And then in the medium-term assuming that we can get some stabilization there that combined with growth in our specialty applications should allow for this business to make its contribution to our overall company targets of 7% to 10% over time. I think the growth rates are there to support that. I think the specialty investments that we are making to build that part of the portfolio support that and it’s really a question of does pricing in the powdered market in North America stabilized and move in the right direction.

Very good and so just on fumed silica, you are building two plants right now in the U.S. and China, what’s the growth rate of this industry and what do these two plants do for your capacity and are you actually gaining share with this capacity?

Yes. So in fumed silica market goes into a pretty diverse set of applications, the single biggest one would be silicones, but it goes into adhesives and toners and coatings and a number of others. If you look at the basket of applications it is around that sort of global 4% to 5% range and I think the others that play in the value chains feel similarly about the growth rates there. So that’s sort of our expectation. I think each investment is a little bit different. The China investment we now are the largest fumed silica producer in China and this investment is going to continue to fuel the growth here. And we think the growth rates will be quite strong in China across the set of applications. And in fumed silica, it’s all about having the right strategic projects and right strategic partnerships, these sort of fence line partnerships that I referenced. And that is in fact the case here. So this will allow us to grow at the market growth rates, probably over time stretch our share position a bit in China. So that’s all about a continuation of that and stretching our number one position in China out over time. The investment in Carrollton is a continuation of our long-term partnership with Dow Corning division of Dow. We have a plant, a fence line plant with them in Midland, Michigan. We also have one in Barry, Wales with them. And this one in Carrollton, Kentucky is the fence line with their primary siloxane or silicone monomer plant in Kentucky. And so this one over time allows us to continue growing in North America, but I also try to realize some efficiencies because a fence line plant typically has better overall efficiencies in terms of movement flows of material coming by pipe rather than by rail car has environmental benefits, so sort of logistics environmental overall efficiency benefits are big part of why this one makes sense and then over time continuing to feed growth in North America.

Thank you very much.

Thank you. Our next question comes from Jim Sheehan from SunTrust. Your line is open.

Thank you. Can you talk about the impact that announcements by tire OEMs may have on your business in the next quarter or two quarters, I understand that they expect volumes in North America to be much lower than previously forecast?

Yes. Hey Jim. So the tire guys have been coming out with their own quarterly announcements recently. I think the story remains pretty consistent where they did see that front half of the year is a bit stronger than back of the year in part because of some of this pre-buying that occurred in the channels to try to get ahead of price increases to recover run up in raw material. So I think that view as we talk to customers is pretty consistent and that in the end when 2017 is over that probably would have been a little better growth rate in the first half than in the second half. I think we are seeing mix stories across the customer base. I think Goodyear had a more difficult period and released I think as I look at Michelin. I think they are seeing that back part of year will begin to strengthen. And they are seeing a cross certain applications in particular mining and agricultural segments, they are important segment those both beginning to come to life again, so that’s a positive. So I think it will – might be a little bit choppy as we see how things play out for them. But I think the overall growth rates remain in line here.

Great. And in Performance Chemicals, the price to raw materials, you are raising prices in this segment, when do you think that you will be fully caught up to raw materials?

Well, so I think where we are out right now and as I have said we will be increasing and implementing those price increases during Q4. So there will be some benefit in Q4, but I think it’s really about how we set up for 2018. Now I think the question of recovering raw material run up is a tricky one in the sense that and that’s why we try to provide some color around overall expected margin levels, because certainly last year we benefited from a decline in oil, especially relatively short period where it dips right down into sort of the $3 a barrel range for a short period of time. As we think about the long-term margin structure for this business, we think across Performance Chemicals something in this 23% to 24% EBIT margin level is the right level. That would represent a very strong margin level if you look back over the long-term history of the business, but one that we think would be durable, absent any significant moves in oil from where we are today. So, that’s our target and what we are going after.

Great. And I think you have talked in the past about the potential for a replacement cycle in China, can you talk about when you think that might occur, when the inflection point might occur for you and why is Cabot better positioned to benefit from that than your competitors?

Yes. So, in the past, when we have talked about this, what I am referring to is in China there has been a significant build-out all the car park. And so if you look at the ratio in China of tires that are tied to OE sales or new cars versus replacement, you see a higher proportion of OE in China, because the car park is getting built out. In a mature market, the car park only grows modestly and then you have got the replacement. So, the ratio is a little bit different and mature versus China market. And so we will certainly see that play out over time as the car park starts to mature and its growth rate slows a bit and the replacement cycle kicks in. If your think about, it takes roughly 5 years to hit the replacement cycle, 4 to 5 years of a car and you think about how much the car park is growing in China over the last 4 to 5 years, where a lot of cars that haven’t yet hit that replacement cycle. And certainly, this is our view that the replacement market will become more supportive and I think the customers see it that way as well. Some of our leading global customers have focused very much on the high value segments, the larger diameter rim sizes. They have seen a lot of growth in those cars at the OE level in China. And our plan for over the next few years, a bump in the replacement cycle from that. In terms of why we are well positioned here, in terms of any of the global players in China we are far and away the largest. We have on the order of 500,000 tons of capacity in China. And so I think from a market position, we are best placed. We have been in China since the late 1980. So we have established ourselves in the industry and across China as the leader in this industry and having made all of the environmental investments that are ultimately beginning to pay off now as China values enforcement than environmental quality more, I think that positions us well. And then our efforts to continue to work with customers around innovation that’s been I think well developed and recognize over the long period. I think that combination of factors distinguishes us and is not so easy to copy.

Thank you, Sean.

Thank you. Our next question comes from Laurence Alexander from Jefferies. Your line is open.

Hi, guys. Dan Rizzo on for Laurence. How are you? A - Sean Keohane Hi, Dan.

Hi. You mentioned the fence-line plants and how they are more efficient. I was just wondering when you build a new plant like in Kentucky, is there like a certain number of years in contract or a minimum required purchase before you agree to do that or is it kind of more of a market function?

Yes. So, let me try to describe Dan in general how these fumed silica fence line plants work at a general level. So, one of the most strategic and important things in the fumed silica market is having access to feedstock and so that typically happens through these types of arrangements, where feedstock from fumed silica is either a stream that comes out of the silicones production process or out of the polycrystalline silicon production process. And it’s most efficient to establish a fence line relationship where those material feedstocks flow in a pipe over to the fumed silica producer and there are other various exchanges of flows of materials and utilities and things like that, that are shared at the fence line. So that’s why you typically see this fence line structure. Now, most of these partners in the case of Dow Corning as well as our partner in China, they are silicones producers. And so they have a certain amount of offtake from the plants of the fumed silica that they use in their compounds. So, they formulate finished silicone compounds that have fumed silica incorporated in them. So, there is a certain amount of sellback to them and then a certain amount of the fumed silica that is produced goes into what we call the merchant market or the other applications that we have in fumed silica beyond silicones. And there is quite a long list of adhesives and toners and coatings and others that we call the merchant market. So, that’s typically how these things work.

Okay, thank you. That was actually very helpful. And then you mentioned that specialty applications in Purification Solutions, is providing some offsets to some of the lumpiness from the mercury removal business. I was just wondering how meaningful it was at this point and if it’s going to be something you are focused on to grow out going forward?

Yes. So, in terms of our strategy, we are intensely focused on building out the set of specialty applications in the Purification Solutions business. And I think we are having good progress here. We have seen progress in certain new applications, for example, in biogas which is a relatively new application in activated carbon. And of course, we are working to develop new products to grow our position in the automotive application for vapor capture and fuel lines of cars, etcetera. So, it’s a range across pharma, catalyst, automotive, biogas that we think in the long run is the place that we should be focusing our effort and where Cabot and our innovation capability is best matched up. Now, those things take a little longer. And so I think about those as sort of medium-term pay offs. We have been working at it over the last couple of years and would expect over the next few years that those start to have a more material contribution. And coupled with that, we need to continue our focus as I commented earlier around the North American powdered market, including mercury removal of trying to get margins to a more sustainable level there, but the longer term certainly is the focus on growing out the specialty portfolio.

Thank you very much.

Thank you. Our next question comes from Chris Kapsch from Aegis Capital. Your line is open.

Yes, a few follow-ups. In Purification Solutions since you are just talking about that, you mentioned another bout of intensifying competitive pressure? And then on the forward look there, you talked about stabilization or the hope for stabilization. Just curious, I mean notwithstanding your development of those specialty applications, what needs to happen for the industry to behave less intensely on the competitive landscape? I mean, is there anything that you foresee happening? I don’t know if it’s going to be any step change in demand in mercury removal, but what else can happen to help stabilize the current situation in the industry? Thanks.

Sure. Thanks, Chris. I think an important question. So, as I said, our focus right now is on restoring the margins, because we don’t feel that pricing is at a sustainable level given the costs and investment that are necessary to support the business. So, in the near-term, we have actually in cases been ceding volumes in some recent bids, where we viewed pricing wasn’t at a sustainable long-term level. We of course then are always looking at our cost structure to evaluate options and I think we need to do that as we see where pricing levels go, do they stabilize, move up or go in a different direction. And then ultimately, I mean, as we focus on margin and in this case, certain cases, ceding some volume, as others’ capacity fills up, pricing levels should begin to move up so we have, I think more sustainable levels for the long-term. And I think this is important, I mean, certainly seeing a sharp demand uptick would be helpful here, because most of this capacity addition that has come on was in anticipation of that, but we are not banking on something like that happening and trying to do the right things to have a solid long-term sustainable business.

And Sean that sort of inflection that you may play out, it sounds like something that could happen more over a year or two rather than a quarter or two. Is that a better way of thinking about it or over what sort of timeframe?

I would say that’s probably right, Chris. I would say that’s probably right.

Okay. And Sean, you referenced your – the competitor that’s idling capacity at the end of ‘17 in North America, in the context of them making that decision, they also mentioned that their view that at current pricing levels in rubber blacks didn’t adequately address the cost of maintaining the production capacity. And it kind of sounds a lot like the way you are framing up your specialty price increase that you felt like you need to deserve the certain margin level in order to support innovation and capacity investments. So, just wondering what’s your view about the rubber black side of it in terms of the domestic pricing given that you feel that way at least in the specialty side?

Yes. Well, I think I feel similarly. And I think the conclusion that was reached is a reasonable conclusion. And as we think about this business in North America, the costs are certainly going up to support customers in this industry, environmental costs, ultimately there will have to be capacity investments made and those things need to be on the back of good sustainable margins. Now, I also think that over the last few years, while we have seen good signals of long-term fundamentals in North America, we have not yet seen across the tire sector, the kind of growth that I think people in the value chain were expecting. So given that picture not entirely surprising that someone might view the need to take out some capacity and focus on getting pricing in the right ways and then with good health, then comes growth, but generally good sustainable health has to come first. So I am guessing that’s the logic behind that and well, I think that makes sense.

Okay. And if I could just follow-up on one more just on pricing and focused on this price increase you have on the table for the specialty business and you mentioned that the margins benefit last year from the low oil prices, feedstocks and then that as those feedstocks have increase that was the rationalization the price increase. Now, I am just wondering did you pass any of the feedstock costs along to customers this year, otherwise they assume it makes for a difficult conversation. And I guess the narrative has to be focused on this entitlement and the returns that you need in order to support growth innovation as you referred to in the business. So, just color around how those conversations are going? And then also just curious like what if the customer don’t agree, to characterize this business, how often can in the specialty business, can a customer just substitute away from you? Are you typically sole-sourced or is there often two different grades specked in? What’s the characterization of the applications in which you are selling into for the specialty business around that pricing conversation with customers? Thank you.

Yes. Well, I think the primary objective in the conversation that we are having with customers is about supporting them for the long-term. And I think supporting them for the long-term requires investments, both investment to innovate and investment in terms of both supply reliability and new capacity to serve that growth. And I think that’s first and foremost the reason why. Now, oil was an input factor here. It’s not the business isn’t driven on that, but it’s a very important input factor here and given the moves that we have seen not just in headline oil price, but also some of the specific feedstocks that we buy that have moved up even a bit faster than that. It’s something that just has to be managed for long-term health. And so I think this is the conversation that we are having with customers and again the primary objective here is around supporting their long-term growth and supporting the investments that are needed to innovate. You build a new fumed silica plant, for example, and you incur a lot of cost before that capacity even comes online and you start to get paid for it for example. I mean, I could go through a lot of examples of how companies like ours have to make investments in the chemical industry that are sort of longer way of investment. So, I think this is quite important and that’s the primary part of the conversation. In terms of the different applications across specialty carbons, there is a whole range of applications and there is a whole range of, I would say different situations from situations where in fact we are delivering such unique performance that we are sole-sourced all the way to the other end of the spectrum, where the application is more mature. There are multiple suppliers that are available. And so how things play out in terms of competition is a factor. And there is everything in between. But I think the forces that we are seeing both the need for investment to support our customers in this industry and the fact that feedstock costs have moved up, I don’t think those are Cabot unique – that’s not a unique Cabot set of circumstances. So, I would imagine people would be looking at the same picture.

Okay, thank you for the extra color.

Thank you. And I am showing no further questions from our phone lines, I would now like to turn the conference over to Sean Keohane for any closing remarks.

Okay. Thank you, everyone for joining us this quarter and look forward to talking again next quarter and thanks for your support for Cabot. Take care.

Ladies and gentlemen, thank you for participating in today’s conference. This does conclude the program and you may all disconnect. Everyone have a wonderful day.