Greetings. Welcome to Ingevity's Second Quarter Earnings Call and Webcast. At this time, all participants are in a listen only mode. [Operator Instructions] Please note this conference is being recorded. 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's 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 would encourage you to download this file so you can follow along on the call.

You can find it by visiting ir.ingevity.com under Events and Presentations. For participants who are logged into our webcast, the slides should be visible in the online viewing pane and also available to download. On Slide number 2 of that deck you will see our disclaimer that today’s 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 are included in our earnings release and can be found on the investor section of our website.

Our agenda is on Slide 3. With me today, as always, are 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 Michael 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 Q & A. With that, I will 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 will turn with me to Slide number 4, you will 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% when compared to the previous year's quarter.

For the first time, we had the benefit of a full quarter of revenue from our newly acquired Engineered Polymers product line, formed through the acquisition of the Capa caprolactone business, Perstorp Holding AB.

Secondly, we saw very strong increase in shipments of our Performance Material segments, automotive products accelerated significantly by a step change in orders in China, as automakers increased compliance with national China 6 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 in adjusted EBITDA and 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 top line 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 to 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 MO all along. And as a result, we posted year-over-year quarterly adjusted EBITDA margin increases in 12 of the 13 quarters since our spin.

Now, if you will turn with me to Slide number 5, 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, agriculture chemicals, lubricants, and others were down about $17 million or 14%.

On top of the ongoing secular decline and demand for printing inks, our results reflect the decision we made in the second half of 2018 to walk away from some printing ink business in Europe based on suboptimal margins.

To be clear, however, we remain committed to providing excellent products and technical service to printing ink 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, the U.S 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're 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 precipitation in the U.S., 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 Evotherm warm mix asphalt technology. However, North American sales growth was offset by sales decreases overseas, particularly in Brazil, as the government there's enforcing strict austerity measures, and in Turkey.

In the Performance Chemical 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 a weaker demand in industrial applications such as seals, gaskets, and mining screens. Polyol sales in Asia grew, driven by polyurethane film applications were offset by lower thermoplastic sales in hot melt and shoe adhesive applications.

In North America, growth in polyols and thermoplastics for bioplastics were offset by lower monomer sales. 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' demand was stronger than that from 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 were price and mix improvements across the board and the team's tight control of cost. We are continuing, as we have over the past three years, to transform this segment toward more specialty applications.

While Capa 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've not traditionally participated in.

We launched a new low color, low odor resin called Altatac, that appeals to a new set of adhesives customers, and we achieved initial commercial sales of a new rosin-based product that 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 6, 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 6 regulatory standard, which calls for evaporative mission canisters equivalent to those for U.S EPA Tier 2.

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 9 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 6 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's patented U.S Tier 3 and LEV III gasoline vapor emission solutions, particularly our honeycomb scrubber products in the U.S 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 in the European Union, as the industry implements the Euro 6d standard.

As a reminder, the Euro EU 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 Zhuhai, 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% in this year's 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 a given quarter.

Further, it remains our expectation that the 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 providing leading-edge solutions that meet these regulatory demands.

At this point, I will turn the call over to John Fortson, 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. Good morning, everyone. Turning to Slide 7, 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 SG&A line on the income statement. SG&A is up from last year, primarily reflecting the additional cost, both cash and noncash associated with the Capa caprolactone acquisition as well as increased legal expenses.

Our core SG&A, excluding legal expenses of $4 million and amortization of $7.1 million included in SG&A from the acquisitions was down 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 Capa 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 industrial revenue bond barring 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 30 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 remain available from our Board authorized share repurchase programs. Diluted adjusted earnings per share on the quarter was $1.36, which is a 22.5% increase from the second quarter of last year.

As of June 30, Ingevity had 41.8 million basic shares outstanding and 42.2 million diluted shares outstanding. Turning to Slide 8. Our net debt at the end of the quarter was $1,267.7 million. Our net debt to EBITDA was 3.23x at the end of the quarter after peaking last quarter at 3.4x after the Capa acquisition.

Working capital increased this quarter due to the inclusion of our Engineered Polymers accounts as well as the ramp-up in 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 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 9, you will find information on our outlook for the rest of the year. We are maintaining our guidance across all metrics.

In our Performance Chemical segment, given our market assessment and the first half performance, we are taking a conservative view. We expect revenues in 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 TOFA pricing is improved, the rosin pricing environment remains challenged. Sales growth in pavement technologies applications will remain somewhat weather dependent. The demand is there, infrastructure budgets are in place, state and municipalities are ready and willing to pave.

The question is simply can they get all of the paving work in 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 oilfield volumes to be flat to up slightly, consistent with first half performance. For Engineered Polymers, we expect that the business's geographic footprint 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 it 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 China 6 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 will be pulling through vehicles as they opt for China 6 compliance.

U.S Tier 3 LEV III implementation continues, and automakers are continuing to progress past the 80% level in the U.S and Canada. In the European market, carmakers will likely complete implementing the new Euro 6d standard in the quarter.

From a cost perspective, we will be cycling through higher cost product manufacturing during the ramp-up of the Zhuhai 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 will see we are maintaining our guidance for the year in sales of between $1.3 billion and $1.36 billion and adjusted EBITDA between $390 million 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 may be lighter. But when all is said and done, 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, but 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.

D&A for the year, adjusting for the Capa acquisition, will be the high 80s millions for the year, approximately $25 million for Capa 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 pavement, our overall performance this quarter reflects the benefits of our growth strategy and the more insulated nature of some of our markets.

As John has detailed, we remain committed to and confident in our guidance for the year. I appreciate the work and efforts of our 1,750 employees worldwide. They’re 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 will open-up the call to questions..

Thank you. [Operator Instructions] Our first question comes from Mike Sison with KeyBanc Capital Markets. Please state your question..

Hi, guys. Nice quarter. In terms of Performance Materials; another really strong quarter there in 2Q. You just noted that you felt '19 in terms of sales growth would be better.

Is that already done, meaning the better come in 2Q, or is the second half actually accelerating a little bit better than your expectations as well?.

Hi, Mike. This is Michael Wilson. I believe that the trends we've seen in the first half of 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 Capa.

The Engineered Materials business, the $34 million is -- 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 talk about the 2020 potential, that business as you really -- you have a year under your belt and probably have some new project potential wins going forward..

Yes, Mike, again, for Capa in the second quarter revenues were down versus the prior year comparison on a pro forma basis as we called out. As we 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 of 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. It's an applications area where we've talked about markets growing at 6% 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 our other business had been more insulated by a stronger U.S economy..

Great. Thank you..

Our next question comes from John McNulty with BMO Capital Markets. Please state your question..

Yes, thanks for taking my question. Clearly, the Performance Materials business continues to hum along and it seems like the volumes and revenues are maybe even higher than what you expected.

Does that get you through the inventory kind of nick that you were seeing in China faster than originally expected, and can we start to see the margins improve sequentially as we move into 3Q, or is that still more of a 4Q timeframe?.

I think in terms of cycling through all of the inventory, it's still going to be sometime in 4Q before we are 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 getting better in 2020, I guess if we have a similar kind of macro backdrop, I assume the 6% would be a little bit on the aggressive side.

But I guess 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 movement going around in terms of the competitive activity, particularly as a competitor had brought back capacity and as people look to kind of rebalance 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, is there anything you would 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 derivative side, both polyols and thermoplastics that we 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 Zaffino with Oppenheimer & Company. Please state your question..

Hi. Great. Thank you, guys. You know I just want to key in on the question on the 9x increase from historic levels in China. That's obviously more than the increase that you're seeing per vehicle. So what's driving that or what's basically 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 kind of 6 standard beginning in late last year.

But what you're seeing is a shift away from historically a powdered market to pelleted -- to pellets as the primary material in the canisters. So we're simply reporting on what we're seeing in terms of -- trying to give you some indication of the level of growth by looking at those pellet volume versus that historical average.

So I don't know I can answer the question for you precisely just based upon the content value that you're referencing..

Well, you can do some math too, Ian, right? I mean, at the end of the day there's a multiplier amount of carbon going into the canister, right, and it's got a higher price to it because you're using higher quality stuff, 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 9x stronger..

The share shift is probably the piece missing..

Yes..

Okay, good, good, good. And then just touching on margins here, two parts of it. On the oilfield side you said you were selling more specialty.

Does that mean we should expect higher margins there? And then also just on the chemical business, in general, with all the initiatives that you're now putting in, is there a new target on the chemical side for margins or what should we be expecting there? Thanks..

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 in what we do. We are actually tailoring product formulations for specific customers. You think about drilling muds, they're very complex mixtures of chemicals and everybody has got a different formulation.

So by working to meet a specific customer's need, we can provide a more tailored product. I think that gives us sort of stickiness with the customer, but it 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've indicated that in performance chemicals that our sort of target between now and 2022 is to drive margins in that business to the mid 20s EBITDA margins on a sustainable basis. We haven't given any guidance beyond that to this point..

And just remember, Ian, that's an annualized number, right? I mean, as you know, Q1 and Q4 are different from our Q2, Q3's because of the impact of the paving in those quarters, right? So trying to get to mid 20's 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 6 vehicles. If you could elaborate on that comment.

And also where do you see automobile inventories in China today?.

Let me take the first one and I will pass the second one to Ed Woodcock to comment. But the preference for China 6 vehicles is that the Chinese consumers are more savvy about regulatory packages probably than say consumers for U.S vehicles.

And the reason for that is, is that China has a history of allowing 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 with a lot of China 5 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 was absolutely correct on that. We feel that they've cleared through the China 5 inventory with the discounts that they've given in the marketplace. And what this does is now it frees up opportunity for the OEMs to basically produce -- refill the dealer lots with China 6 vehicles.

So we expect now that that inventory is cleared, we're going to see more product, more demand for our products as they're starting to produce and fill the dealer lots with China 6 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 Capa acquisition versus improved TOFA pricing or increased derivatization..

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 Capa, the improvement in 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 repeatedly talked about, the printing ink business that we began moving away from in the second half of last year. Obviously, 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 one last thing would be the improvement specifically in pricing in pavement as well as the benefit of mix in pavement, driven by the strong Evotherm sales in North America in the quarter..

Thanks. And lastly, a pine chemical competitor disclosed that they're taking less CTO from a supplier.

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 pulp processes, in particularly craft pulp from softwoods.

And because of lower demands in paper board and packaging materials, those pulp manufacturers are producing less pulp. So CTO has been less available or abundant, but it's a very strategic raw material for us. We plan carefully throughout our network of suppliers on an annual basis. And we are 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, that it's kind of helped balance that CTO supply and demand dynamic..

Thank you..

Our next question comes from Jon Tanwanteng with CJS Securities. Please state your question..

Good morning. Thank you for taking my questions.

Could you first provide some color on how much asphalt business or pavement business was 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 it's not insubstantial and I think to John's point, the encouraging part of all this is, is that the funding is there, the project is there, our customers are ready to do the paving. It's just they've got to have the ability to do it.

And as we know, there's a paving season that can be pushed so far into the fall, depending on weather and 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 to lay new pavement. That seems like a pretty big deal.

Can you talk about the adjustable market opportunity there to growth rates and how soon that could impact your P&L?.

Yes, so especially around the Indulin product that allows 100% of the roadbed to be recycled using 100% of the aggregate, using fresh asphalt and the Indulin 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 as singles versus homeruns. And then pavement, 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?.

Yes, I wouldn't really be in a position to provide kind of specific market opportunity, but the objective of the customers choosing free recycle content is very strong. And that has been an area, especially in our Evotherm technology and throughout our pavement business, that we have focused on.

So this is yet another, I'd say, a tool in our toolkit to make sure that we can take full advantage of that trend in the marketplace..

Okay, great. And then just on the materials side, you mentioned the drag for maintenance and higher inventory cost and legal expenses. I wanted to focus a little bit more on the legal expense in particular.

Are they increasing beyond your expectations, has anything changed there? Is there any update you can provide on the defense of your products in the market?.

Now, Jon, 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 cost to defend our intellectual property could run us for the full-year in the range of $10 million to $15 million. That's not insignificant to the Performance Material segment.

I think in terms of the statuses of litigation, there's unfortunately not a whole lot new to report. The legal system seems to move at a glacial pace. 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 then also recover our legal fees, but that's all very speculative at this point in terms of how it's going to play out. It's just not a lot of new information..

Okay, great. Thank you. One last one, if I could. The comment here on Capa in the second half, you expected 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 still be negative, but they will be less negative, clearly, than what we saw in Q2. This was probably the worst of those comparisons and we do expect 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, it sounds like in the U.S you are expecting some benefit from sequential -- incremental sequential adoption of Tier 3.

So what's a good way to think about it? You're maybe now at 75% or so and going to 80%? Like, how would you describe it?.

No, Paretosh, I would say that as of now U.S automakers are probably at least 80% compliant at or slightly above that threshold. And again, the next regulatory step-up isn't to the 2020 model year vehicles -- or 2022 model year vehicles, which would come out mid 2021.

But as we've talked about 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 see it to be sort of a gradual march toward a 100% compliance.

And the way I would anticipate that rolling out from this point forward is every time an automaker goes in to refresh a model year platform, they're likely to go ahead and make it compliant with U.S Tier 3 requirements..

It's difficult, Paretosh, to get it down quarter-to-quarter, but I mean I think of it as somewhat linear, right? I mean we're sitting here at sort of 80% now and you got two years to get to the next one, think of it as sort of a linear step-up every quarter. That's about the best we can give you guys in terms of guidance on it..

Thanks. Yes, no, that's helpful. And then the follow-up. You flagged some -- I believe you flagged some weakness in Brazil and Turkey in the construction or the pavement business.

So how big are these two countries as a percentage of that business?.

Well, if I think about our pavement business overall, it's about 75% that is U.S North America-based, U.S and Canada. So the rest of the world is about 25%. As it turns out, we had tough comparisons for those two countries last year. In the case of Brazil, they were leading up to an election.

There was a lot of pavement activity, infrastructure activity going on. And with the election and a new administration and now austerity measures, they kind of turned that spigot 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 in other developed economies. 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 a backdrop of we want to continue to grow our pavement additives business outside the U.S. We see a value proposition there in other countries that's analogous many times to the U.S.

So we want to continue to grow in those markets, but they are less consistent than the U.S market for sure..

Understood. And if I could ask just one last one as kind of a big picture one.

Beyond these regulatory changes that are in place in U.S., China, and Europe, like what else are you seeing, anything to flag?.

Well, again, we have major initiatives being adopted, you know U.S., Canada, Europe and China right now. One that has been named that is not yet started is Brazil, which aims to go to the Tier 2 standard by 2025. And there's a published ramp-up schedule that we have for that, that I think we've had in some of our presentation materials.

But I think beyond that, Paretosh, the important point is to recognize a couple of things. First, while Europe is taking a step with Euro 6d from one day of parking capture to two day of parking capture, they're still well behind where the U.S is now and even China, that's moved to a Tier 2 standard. China at Tier 2 is still lagging the U.S standard.

So, we know there's work under way 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 1970's, early 1980's evaporative emission standards.

So, it seems inevitable to us that there will be further adoption in the future. Additional countries and tighter regulations in those that have already moved, but those rules haven't yet been promulgated or enacted into law. So we just can't talk with specificity about it now.

But we certainly don't subscribe to the theory that some have that once this current wave of adoption is done, that this is somehow going to revert to the SAR rate for internal combustion engines globally. We expect to continue to see strong regulatory adoption-fueled growth well into the future..

Great. Thanks guys..

Our next question comes from Chris Kapsch with Loop Capital Markets. Please state your question..

Yes, good morning, guys. So I had a question among Performance Chemical segment. You made a formal comment about some of those products or applications being sent into the industrial economy.

I'm just curious if there's a way to characterize that as being skewed more towards TOR-based products or derivatives or TOFA products or derivatives? And the reason I asked is, obviously, the percentages of those products that you get from refining TTO are fixed by nature, basically.

So, I'm wondering if there's an imbalance in the economic sensitivity to the demand there? Is it enough to influence your intended refinery operating rates in order to optimize the margins that you're targeting?.

That’s a great -- it'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.

In other words, in order to supply one segment, one type of applications, we're not producing an excess of something else. We still maintain that operating model of basically running to TOR 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 TOFA book of business today, we're only derivatizing about 40% to 45% of our TOFA, whereas the percentage of rosin we're derivatizing is much higher than that.

But I think to your first point is when I look at the market applications, it is rosin that is being more impacted by these 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 if there are things like printing inks where we're seeing the softness.

So, Mike, have I gotten that right? Would you add to that?.

No, I think that's exactly correct, Michael. And you know it's been well-stated. The decline is -- has been in the ink side from both secular nature and some walk away of some very low margin business. And to a little bit lesser extent not choosing to support low margin export kind of merchants rosin. But everything else seems very much inline..

Well, just to follow-up, just based on what you said.

If your -- if the demand for the TOFA-based oilfield and paving applications are generally firm and there's some sensitivity to industrial weakness more on the TOR side, are we going to end up short TOFA if we run the refinery rates to meet TOR demand?.

No, because what we would do is sell less of the underivatized TOFA. As I said, we're only derivatizing 40% to 45% of it. So we would balance that out. It is true that because of current demand we're not operating our refineries at a 100% utilization. Again, we are going to keep those in balance with what we see as the demand side..

Okay. That's helpful. Thanks. And then just -- I don't know if you will parse this for us, but if you -- and I appreciate the comments. It's better to look at Performance Materials margins on an annual basis.

But if you look at the 440 bps year-over-year decline in this quarter, just curious how much in terms of -- order of magnitude, how much of that was attributable to the penalty associated with the higher cost inventories that are currently being shipped to China? I'm just trying to understand because if, in fact, we bleed off that inventory by fourth quarter, trying to get a sense for what the benefit 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 legal expenses as the second one and then higher 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 slightly higher than the other two in terms of its impact..

Okay. That's helpful. And then one last one. Just you mentioned no real update on the legal front.

So just to be clear, there has or has not been issued by the courts a preliminary injunction against defendants in terms of the alleged infringement either sampling or using infringing products?.

No, the preliminary junction that we filed against BASF 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 impacts the strength of our underlying claim..

Okay. Thank you..

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 BASF lawsuit, I mean are there others out there that are kind of similar in nature or I mean is this kind of the only main one?.

We have filed legal actions against one other company, which is MAHLE, which is a Tier 1 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's supposed to be ruled on by the end of the fourth quarter?.

November..

November..

Yes, that's the trial that we will use in the new year..

In the 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 it's something you've addressed in the past.

But if you could just remind us what's in place there, given just the headlines we've read elsewhere about issues with that subject?.

Yes, so just a couple things. First of all, recognize that the U.S and Canada are the only two markets that are on the U.S EPA Tier 3 California LEV III standard and use the honeycomb scrubber. 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 at a very different place.

Now, we do have a new patent, which we refer 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 patent is applicable in China, but only to the point that China moves to a regulatory standard that would require teaching..

Okay.

But the -- I guess, the intellectual property around the pellets themselves, how is that …?.

Those are not under patent. You know our sort of state-of-the-art product, the BWC15 or BAX 1500 has been off patent for close to a decade, maybe more. The issue there is one of knowhow. And despite it being off patent, no one has really been able to replicate the efficacy, the consistency and the absorptive characteristics of that product.

And particularly its ability to meet the life of vehicle use standard..

And I would, Dan, cite our -- which I know you've heard us talk about, our change in market share in China as they’ve moved from what is historically a BAX 1100 market into BAX 1500 is evidence of our efficacy and strength in 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 into the third quarter. Ultimately if there is, say, it's an early frost or just bad weather in the fall and in the winter, again, it just gets pushed into the next year. It's never lost sales.

It's just a matter of timing and delays it could take potentially over more than a year; correct?.

Yes, that's what happens. If they can't 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 priority stays in place. And some of that actually happened last year. Some projects that got let -- Texas was a great example for implementation last year.

They had hurricanes and other issues, didn't get done and that’s why the backlog coming into this year 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. So thank you everyone for your time and interest this morning. We remain very positive about our long-term business outlook and we look forward talking with you again next quarter.

Hope you have a great day..

Thank you. This concludes today's call. All parties may disconnect. Have a great day..