INNOSPEC INC. quarterly report, Q3 FY2019

Business context and reporting period

Innospec Inc. filed this unaudited Form 10-Q for the quarter and nine months ended September 30, 2019. It reports four segments: Fuel Specialties, Performance Chemicals, Oilfield Services and Octane Additives. Unless noted otherwise, amounts are in U.S. dollars.

Financial performance and liquidity

• Revenue rose 2% in Q3 and 4% year to date. Gross margin was 32.0% in Q3 (30.6% prior year) and 31.0% year to date (29.4%). Operating margin was 10.3% in Q3 and 9.4% year to date.
• Q3 effective tax rate was 20.4%, versus 32.2%; nine-month rate was 24.3%, versus 27.9%. Management attributed the lower adjusted rates primarily to a greater share of profits in lower-tax jurisdictions.
• Nine-month operating cash flow was $103.2m, compared with $35.1m. Capital expenditures were $22.6m; cash dividends were $12.2m. Cash declined to $110.3m from $123.1m at year-end 2018.
• At September 30, debt outstanding on the revolving facility was $132.5m; finance lease liabilities were $1.8m. Cash exceeded facility debt by $22.2m. Current assets were $673.3m and current liabilities $296.7m.
• The company replaced its prior borrowings with a new $250m revolving facility maturing September 2023, with an option to request a one-year extension and an accordion of up to $125m. Reported long-term debt, net of financing costs, was $131.2m.

Material changes versus prior comparable period

• Oilfield Services was the strongest growth driver: Q3 sales rose 17% to $121.4m and nine-month sales rose 23% to $358.1m, with higher operating income in both periods.
• Fuel Specialties sales increased 7% in Q3 and 5% year to date; operating income also increased. Management cited volume growth and improved sales mix, partly offset by expenses including higher provisions and performance-based compensation.
• Performance Chemicals sales fell 13% in Q3 and 10% year to date. Management cited a customer bringing some volume in-house, foreign exchange and unfavorable product mix in some regions, although segment gross margins improved year over year.
• Octane Additives sales declined 29% in Q3 and 57% year to date as the remaining refinery customer continued its transition to unleaded fuel. The segment recorded a nine-month gross loss of $0.1m and operating loss of $1.9m.
• Nine-month SG&A increased to $214.9m from $197.8m, and R&D to $27.0m from $25.1m. The prior-year period included a $4.8m restructuring charge; none was recorded in 2019.
• Operating cash flow improved substantially year over year, which management attributed to working-capital control and timing of tax payments. Receivables increased $16.8m, largely with Oilfield Services sales; inventory increased $3.4m.

Outlook, commentary, risks and unusual items

• No specific consolidated earnings or revenue guidance is provided in the filing. Management said inventory was built ahead of expected high demand in the fourth quarter. It expects Octane Additives sales to continue declining as the sole customer transitions to unleaded fuel.
• A June 27, 2019 network security incident disrupted access to certain systems and data. Most affected systems and data had been restored, but recovery work continued; the full financial impact and insurance recovery remained under assessment. The company said the incident had not materially affected results through September 30.
• Management concluded disclosure controls were ineffective as of September 30 because the cyber incident exposed a material weakness in IT infrastructure controls. Additional procedures were performed to validate reported results, and remediation was underway; the weakness had not yet been fully remediated.
• Plant closure provisions totaled $49.2m, including $45.3m non-current, principally associated with remediation at the Ellesmere Port, U.K. site.
• Unrecognized tax benefits, interest and penalties totaled $14.9m; the filing states the full amount would affect the effective tax rate if recognized. Italian tax audits include periods 2011–2014; the 2014 audit was at an information-gathering stage. The company also noted a potential U.S. tax adjustment related to the Tax Cuts and Jobs Act.
• Guarantees not recognized as liabilities totaled $4.7m. The company reported no material pending legal proceedings, while noting that numerous individual adverse claims could be material in aggregate.
• U.K. withdrawal from the E.U. remained a risk; the filing noted an extension of the exit deadline to January 31, 2020. Adoption of the new lease standard materially increased reported assets and liabilities, without affecting the income statement; operating lease liabilities are not treated as debt by the company.

Important facts for investors to verify

• Whether the cyber incident’s ultimate costs, business effects and insurance coverage are material, and whether the disclosed IT-control material weakness is remediated.
• Whether Oilfield Services growth and margins can be sustained, and whether Performance Chemicals’ lost customer volume and weaker sales recover.
• The pace and financial effect of the remaining Octane Additives customer’s transition to unleaded fuel.
• Working-capital quality, particularly receivables and inventory trends, given higher sales and the reported increase in days sales outstanding in several segments.
• Developments in Italian and U.S. tax matters, plant remediation estimates, and U.K./E.U. political developments.
• Facility terms, borrowing levels and covenant headroom under the replacement revolving credit agreement; the filing text does not provide a clear covenant-headroom value.