UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
For the quarterly period ended June 30, 2017
or
For the transition period from to
Commission file number 1-13879
INNOSPEC INC.
(Exact name of registrant as specified in its charter)
Registrant’s telephone number, including area code: (303) 792 5554
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes ☒ No ☐
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes ☒ No ☐
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company, or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer”, “smaller reporting company” and “emerging growth company” in Rule 12b-2 of the Exchange Act.
If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial standards provided pursuant to Section 13(a) of the Exchange Act. ☐
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ☐ No ☒
Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.
Common Stock, par value $0.01
TABLE OF CONTENTS
PART I
Item 1
Item 2
Item 3
Item 4
PART II
Item 1A
Item 5
Item 6
SIGNATURES
2
CAUTIONARY STATEMENT RELATIVE TO FORWARD-LOOKING STATEMENTS
This Form 10-Q contains certain “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995. All statements other than statements of historical facts included or incorporated herein may constitute forward-looking statements. Such forward-looking statements include statements (covered by words like “expects,” “estimates,” “anticipates,” “may,” “believes,” “feels” or similar words or expressions, for example) which relate to earnings, growth potential, operating performance, events or developments that we expect or anticipate will or may occur in the future. Although forward-looking statements are believed by management to be reasonable when made, they are subject to certain risks, uncertainties and assumptions, and our actual performance or results may differ materially from these forward-looking statements. Additional information regarding risks, uncertainties and assumptions relating to Innospec and affecting our business operations and prospects are described in Innospec’s Annual Report on Form 10-K for the year ended December 31, 2016 and other reports filed with the U.S. Securities and Exchange Commission. You are urged to review our discussion of risks and uncertainties that could cause actual results to differ from forward-looking statements under the heading “Risk Factors” in such reports. Innospec undertakes no obligation to publicly update or revise any forward-looking statements, whether as a result of new information, future events or otherwise.
3
PART I FINANCIAL INFORMATION
INNOSPEC INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME
(Unaudited)
Net sales
Cost of goods sold
Gross profit
Operating expenses:
Selling, general and administrative
Research and development
Adjustment to fair value of contingent consideration
Loss on disposal of subsidiary
Foreign exchange loss on liquidation of subsidiary
Total operating expenses
Operating income
Other net income
Interest expense, net
Income before income taxes
Income taxes
Net income
Earnings per share:
Basic
Diluted
Weighted average shares outstanding (in thousands):
The accompanying notes are an integral part of these unaudited interim consolidated financial statements.
4
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
Other comprehensive income:
Changes in cumulative translation adjustment, net of tax of $(0.7) million, $(1.2) million, $(0.8) million and $(0.8) million, respectively
Changes in unrealized gains on derivative instruments, net of tax of $0.1 million, $0.0 million, $0.0 million and $0.0 million, respectively
Amortization of prior service credit, net of tax of $0.0 million, $0.0 million, $0.1 million and $0.1 million, respectively
Amortization of actuarial net losses, net of tax of $(0.3) million, $(0.1) million, $(0.5) million and $(0.3) million, respectively
Total other comprehensive income/(loss)
Total comprehensive income
5
CONSOLIDATED BALANCE SHEETS
(in millions, except share and per share data)
Current assets:
Cash and cash equivalents
Trade and other accounts receivable (less allowances of $4.3 million and $4.7 million respectively)
Inventories (less allowances of $9.7 million and $8.6 million respectively):
Finished goods
Raw materials
Total inventories
Prepaid expenses
Prepaid income taxes
Total current assets
Property, plant and equipment:
Gross cost
Less accumulated depreciation
Net property, plant and equipment
Goodwill
Other intangible assets
Deferred tax assets
Pension asset
Other non-current assets
Total assets
6
CONSOLIDATED BALANCE SHEETS—(Continued)
Current liabilities:
Accounts payable
Accrued liabilities
Current portion of long term debt
Current portion of finance leases
Current portion of plant closure provisions
Current portion of accrued income taxes
Current portion of acquisition-related contingent consideration
Current portion of deferred income
Total current liabilities
Long-term debt, net of current portion
Finance leases, net of current portion
Plant closure provisions, net of current portion
Unrecognized tax benefits
Deferred tax liabilities
Pension liabilities
Deferred income, net of current portion
Other non-current liabilities
Total liabilities
Equity:
Common stock, $0.01 par value, authorized 40,000,000 shares, issued 29,554,500 shares
Additional paid-in capital
Treasury stock (5,417,857 and 5,483,341 shares at cost, respectively)
Retained earnings
Accumulated other comprehensive loss
Total Innospec stockholders’ equity
Non-controlling interest
Total equity
Total liabilities and equity
7
CONSOLIDATED STATEMENTS OF CASH FLOWS
(in millions)
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization
Deferred taxes
Cash contributions to defined benefit pension plans
Non-cash movements on defined benefit pension plans
Stock option compensation
Changes in assets and liabilities, net of effects of acquired and divested companies:
Trade and other accounts receivable
Inventories
Accounts payable and accrued liabilities
Accrued income taxes
Plant closure provisions
Other non-current assets and liabilities
Net cash (used in)/provided by operating activities
Cash Flows from Investing Activities
Capital expenditures
Business combinations, net of cash acquired
Sale of short-term investments
Net cash used in investing activities
Cash Flows from Financing Activities
Proceeds from revolving credit facility
Repayments of revolving credit facility
Repayments of finance leases
Payment for acquisition-related contingent consideration
Dividend paid
Issue of treasury stock
Repurchase of common stock
Net cash used in financing activities
Effect of foreign currency exchange rate changes on cash
Net change in cash and cash equivalents
Cash and cash equivalents at beginning of period
Cash and cash equivalents at end of period
8
Amortization of deferred finance costs of $0.3 million (2016 – $0.2 million) are included in depreciation and amortization in the consolidated statement of cash flow but in interest expense in the consolidated statement of income.
We have recast certain 2016 amounts to conform to new accounting standards.
9
CONSOLIDATED STATEMENT OF EQUITY
Balance at December 31, 2016
Changes in cumulative translation adjustment, net of tax
Treasury stock reissued
Treasury stock repurchased
Amortization of prior service credit, net of tax
Amortization of actuarial net losses, net of tax
Balance at June 30, 2017
10
NOTES TO THE UNAUDITED INTERIM CONSOLIDATED FINANCIAL STATEMENTS
NOTE 1 – BASIS OF PRESENTATION
The accompanying unaudited interim consolidated financial statements have been prepared in accordance with generally accepted accounting principles in the United States of America for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X under the Securities Exchange Act of 1934. Accordingly, they do not include all the information and notes necessary for a comprehensive presentation of financial position, results of operations and cash flows.
It is our opinion, however, that all adjustments (consisting of normal, recurring adjustments, unless otherwise disclosed) have been made which are necessary for the financial statements to be fairly stated. These financial statements should be read in conjunction with the consolidated financial statements and notes thereto included in the Company’s Annual Report on Form 10-K filed on February 15, 2017.
The results for the interim period covered by this report are not necessarily indicative of the results to be expected for the full year.
When we use the terms “Innospec,” “the Corporation,” “the Company,” “Registrant,” “we,” “us” and “our,” we are referring to Innospec Inc. and its consolidated subsidiaries unless otherwise indicated or the context otherwise requires.
NOTE 2 – SEGMENT REPORTING
The Company reports its financial performance based on the four reportable segments Fuel Specialties, Performance Chemicals, Oilfield Services and Octane Additives.
11
The Fuel Specialties, Performance Chemicals and Oilfield Services segments operate in markets where we actively seek growth opportunities although their ultimate customers are different. The Octane Additives segment is expected to decline in the near future as our one remaining refinery customer transitions to unleaded fuel.
The Company evaluates the performance of its segments based on operating income. The following tables analyze sales and other financial information by the Company’s reportable segments:
Net Sales:
Refinery and Performance
Other
Fuel Specialties
Personal Care
Home Care
Performance Chemicals
Oilfield Services
Octane Additives
Net sales:
Gross profit:
Operating income:
Pension credit
Corporate costs
Total operating income
12
The pension credit relates to the United Kingdom defined benefit pension plan which is closed to future service accrual. The charges related to our other much smaller pension arrangements in the U.S. and overseas are included in the segment and income statement captions consistent with the related employees’ costs.
The following table presents a summary of the depreciation and amortization charges incurred by the Company’s reportable segments:
Depreciation:
Corporate
Amortization:
NOTE 3 – EARNINGS PER SHARE
Basic earnings per share is based on the weighted average number of common shares outstanding during the period. Diluted earnings per share includes the effect of options that are dilutive and outstanding during the period. Per share amounts are computed as follows:
Numerator (in millions):
Net income available to common stockholders
Denominator (in thousands):
Weighted average common shares outstanding
Dilutive effect of stock options and awards
Denominator for diluted earnings per share
Net income per share, basic:
Net income per share, diluted:
13
In the three and six months ended June 30, 2017, the average number of anti-dilutive options excluded from the calculation of diluted earnings per share were 18,843 and 18,843, respectively (three and six months ended June 30, 2016 – 471 and 471 respectively).
NOTE 4 – GOODWILL
The following table summarizes goodwill at the balance sheet dates:
Gross cost (1)
Accumulated impairment losses
Net book amount
Acquisition of Huntsman European Differentiated Surfactants Business
On December 30, 2016 the Company acquired the European Differentiated Surfactants business (“Huntsman”) from Huntsman Investments (Netherlands) B.V.. We purchased the business for total consideration of $199.2 million subject to working capital adjustments.
The measurement period for the valuation of assets acquired and liabilities assumed ends as soon as information on the facts and circumstances that existed as of the acquisition dates become available but does not exceed twelve months. During the three months ended March 31, 2017, we have reviewed the fair values of assets acquired and liabilities assumed in the acquisition of Huntsman, resulting in a $39.3 million increase in assets acquired and a corresponding decrease in goodwill. The following table summarizes the calculations of the total purchase price and the provisional allocation of the purchase price to assets and liabilities assumed for the business:
Fixed assets
Other net assets acquired
Purchase price, net of cash acquired
The final purchase price, including working capital adjustments, and fair value review of assets and liabilities acquired has not been finalized as at June 30, 2017.
Huntsman, and the associated goodwill and other intangible assets, are included within our Performance Chemicals segment for management and reporting purposes. There is currently no goodwill amortizable for tax purposes.
14
NOTE 5 – OTHER INTANGIBLE ASSETS
The following table summarizes the other intangible assets movement year on year:
Gross cost at January 1
Acquisitions
Exchange effect
Gross cost at June 30
Accumulated amortization at January 1
Amortization expense
Accumulated amortization at June 30
Net book amount at June 30
Acquisitions in the year relate to the allocation of goodwill from the Huntsman acquisition based on our provisional assessment of the fair value of the other intangible assets acquired. These intangible assets relate to customer relationships.
Product rights
Brand names
Technology
Customer relationships
Non-compete agreements
Marketing related
Internally developed software
Total
NOTE 6 – PENSION PLANS
The Company maintains a defined benefit pension plan (the “Plan”) covering a number of its current and former employees in the United Kingdom, although it does also have other much smaller pension arrangements in the U.S. and overseas. The Plan is closed to future service accrual but has a large number of deferred and current pensioners.
Plan net pension credit/(charge):
Service cost
Interest cost on projected benefit obligation
Expected return on plan assets
Amortization of prior service credit
Amortization of actuarial net losses
15
The amortization of prior service credit and actuarial net losses is a reclassification out of accumulated other comprehensive loss into selling, general and administrative expenses.
The Company also maintains an unfunded defined benefit pension plan covering a number of its current and former employees in Germany (the “German plan”). The German plan is closed to new entrants and has no assets. The net pension charge for the German plan for the three and six months ended June 30, 2017 was $0.2 million and $0.4 million, respectively (three and six months ended June 30, 2016—$0.2 million and $0.4 million, respectively).
As at June 30, 2017, our Performance Chemicals segment has pension obligations in its European businesses with a liability of $4.5 million (December 31, 2016—$4.1 million).
NOTE 7 – INCOME TAXES
A roll-forward of unrecognized tax benefits and associated accrued interest and penalties is as follows:
Opening balance at January 1, 2017
Adjustment for prior period tax positions
Closing balance at June 30, 2017
Current
Non-current
All of the unrecognized tax benefits, interest and penalties would impact our effective tax rate if recognized.
We recognize accrued interest and penalties associated with uncertain tax positions as part of income taxes in our consolidated statements of income.
The Company or one of its subsidiaries files income tax returns with the U.S. federal government, and various state and foreign jurisdictions. As previously disclosed, one of the Company’s U.S. subsidiaries is currently subject to a state tax examination in respect of 2012 through to 2014 inclusive. The Company and its U.S. subsidiaries received notification in May 2017, of a federal income tax examination by the IRS for 2015. The Company currently anticipates that adjustments, if any, arising out of these tax audits would not result in a material change to the Company’s financial position as at June 30, 2017.
The Company and its U.S. subsidiaries remain open to examination by the IRS for years 2013 onwards. The Company’s subsidiaries in foreign tax jurisdictions are open to examination including France (2013 onwards), Germany (2015 onwards), Switzerland (2015 onwards) and the United Kingdom (2015 onwards).
The Company is in a position to control whether or not to repatriate foreign earnings and we currently do not expect to make a repatriation in the foreseeable future. No taxes have been provided for on the unremitted earnings of our overseas subsidiaries as any tax basis differences relating to investments in these overseas subsidiaries are considered to be indefinite in duration. The amount of unremitted earnings at December 31, 2016 was approximately $788 million. If these earnings are remitted, additional taxes could result after offsetting foreign income taxes paid although the calculation of the additional taxes is not practicable to compute at this time.
16
NOTE 8 – LONG-TERM DEBT
Long-term debt consists of the following:
Revolving credit facility
Term loan
Deferred finance costs
Due within one year
Due after one year
NOTE 9 – PLANT CLOSURE PROVISIONS
The liability for estimated closure costs of Innospec’s manufacturing facilities includes costs for decontamination and environmental remediation activities (“remediation”). The principal site giving rise to remediation liabilities is the manufacturing site at Ellesmere Port in the United Kingdom. There are also remediation liabilities on a much smaller scale in respect of our other manufacturing sites in the U.S. and Europe.
Movements in the provisions are summarized as follows:
Total at January 1
Charge for the period
Utilized in the period
Total at June 30
Amounts due within one year refer to provisions where expenditure is expected to arise within one year of the balance sheet date.
17
NOTE 10 – FAIR VALUE MEASUREMENTS
The following table presents the carrying amount and fair values of the Company’s assets and liabilities measured on a recurring basis:
Assets
Non-derivatives:
Derivatives (Level 1 measurement):
Other non-current assets:
Interest rate swaps
Liabilities
Long-term debt (including current portion)
Finance leases (including current portion)
Other non-current liabilities:
Foreign currency forward exchange contracts
Non-financial liabilities (Level 3 measurement):
Stock equivalent units
The following methods and assumptions were used to estimate the fair values of financial instruments:
Cash and cash equivalents: The carrying amount approximates fair value because of the short-term maturities of such instruments.
Long-term debt and finance leases: Long-term debt principally comprises the term loan and revolving credit facility, which are shown net of deferred finance costs that have been capitalized. The fair value of long-term debt approximates to the carrying value, as the discounting to its present value is offset by the payments under the interest rate swaps. Finance leases relate to certain fixed assets in our oilfield services business. The carrying amount of finance leases approximates to the fair value.
Derivatives: The fair value of derivatives relating to interest rate swaps and foreign currency forward exchange contracts are derived from current settlement prices and comparable contracts using current assumptions. Interest rate swaps relate to contracts taken out to hedge interest rate risk on a portion of our long-term debt. Foreign currency forward exchange contracts primarily relate to contracts entered into to hedge future known transactions or hedge balance sheet net cash positions. The movements in the carrying amounts and fair values of these contracts are largely due to changes in exchange rates against the U.S. dollar and changes in U.S. LIBOR.
Stock equivalent units: The fair values of stock equivalent units are calculated at each balance sheet date using either the Black-Scholes or Monte Carlo method depending on the terms of each grant.
NOTE 11 – DERIVATIVE INSTRUMENTS AND RISK MANAGEMENT
The Company enters into various foreign currency forward exchange contracts to minimize currency exchange rate exposure from expected future cash flows. As at June 30, 2017 the contracts have maturity dates of up to eighteen months at the date of inception. These foreign currency forward exchange contracts have not been designated as hedging instruments, and their impact on the income statement for the first six months of 2017 was a loss of $0.6 million (first six months of 2016: gain of $3.0 million).
18
The Company enters into interest rate swaps to minimize interest rate exposure related to a part of our borrowing requirements. These interest rate swaps have been designated as hedging instruments, and their impact on accumulated other comprehensive loss for the first six months of 2017 was a gain of $0.0 million (first six months of 2016: $0.0 million).
NOTE 12 – COMMITMENTS AND CONTINGENCIES
Legal matters
While we are involved from time to time in claims and legal proceedings that result from, and are incidental to, the conduct of our business including business and commercial litigation, employee and product liability claims, there are no material pending legal proceedings to which the Company or any of its subsidiaries is a party, or of which any of their property is subject. It is possible, however, that an adverse resolution of an unexpectedly large number of such individual claims or proceedings could in the aggregate have a material adverse effect on the results of operations for a particular year or quarter.
Guarantees
The Company and certain of the Company’s consolidated subsidiaries are contingently liable for certain obligations of affiliated companies primarily in the form of guarantees of debt and performance under contracts entered into as a normal business practice. This includes guarantees of non-U.S. excise taxes and customs duties. As at June 30, 2017, such guarantees which are not recognized as liabilities in the consolidated financial statements amounted to $5.7 million.
Under the terms of the guarantee arrangements, generally the Company would be required to perform should the affiliated company fail to fulfil its obligations under the arrangements. In some cases, the guarantee arrangements have recourse provisions that would enable the Company to recover any payments made under the terms of the guarantees from securities held of the guaranteed parties’ assets.
The Company and its affiliates have numerous long-term sales and purchase commitments in their various business activities, which are expected to be fulfilled with no adverse consequences material to the Company.
NOTE 13 – STOCK-BASED COMPENSATION PLANS
The Company grants stock options and stock equivalent units (“SEUs”) from time to time as a long-term performance incentive. In certain cases the grants are subject to performance conditions such as the Company’s stock price. Where performance conditions apply the Monte Carlo simulation model is used to determine the fair values. Otherwise the Black-Scholes model is used to determine the fair values.
19
Stock option plans
The following table summarizes the transactions of the Company’s stock option plans for the six months ended June 30, 2017:
Outstanding at December 31, 2016
Granted - at discount
- at market value
Exercised
Forfeited
Outstanding at June 30, 2017
At June 30, 2017, there were 44,543 stock options that were exercisable, of which 9,421 had performance conditions attached.
The stock option compensation cost for the first six months of 2017 was $2.2 million (2016 – $1.9 million). The total intrinsic value of options exercised in the first six months of 2017 was $2.0 million (2016 – $1.6 million).
The total compensation cost related to non-vested stock options not yet recognized at June 30, 2017 was $7.9 million and this cost is expected to be recognized over the weighted-average period of 2.21 years.
The following table summarizes the transactions of the Company’s SEUs for the six months ended June 30, 2017:
At June 30, 2017 there were 54,509 SEUs that are exercisable, of which 49,141 had performance conditions attached.
The charges for SEUs are spread over the life of the award subject to a revaluation to fair value each quarter. The revaluation may result in a charge or a credit to the income statement in the quarter dependent upon our share price and other performance criteria.
The SEU compensation cost for the first six months of 2017 was $2.5 million (2016 – $0.0 million). The total intrinsic value of SEUs exercised in the first six months of 2017 was $1.1 million (2016 - $1.2 million).
The weighted-average remaining vesting period of non-vested SEUs is 2.14 years.
20
NOTE 14 – RECLASSIFICATIONS OUT OF ACCUMULATED OTHER COMPREHENSIVE LOSS
Reclassifications out of accumulated other comprehensive loss for the first six months of 2017 were:
Details about AOCL Components
Affected Line Item in the
Statement where
Net Income is Presented
Foreign currency translation items:
Liquidation of subsidiary
Defined benefit pension plan items:
Total reclassifications
(1) These items are included in the computation of net periodic pension cost. See Note 6 of the Notes to the Consolidated Financial Statements for additional information.
Changes in accumulated other comprehensive loss for the first six months of 2017, net of tax, were:
Other comprehensive income before reclassifications
Amounts reclassified from AOCL
Total other comprehensive income
NOTE 15 – RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS
In March 2017, the FASB issued ASU 2017-07, Compensation—Retirement Benefits (Topic 715): Improving the Presentation of Net Periodic Pension Cost and Net Periodic Postretirement Benefit Cost. ASU 2017-07 requires companies to present the service cost component of net benefit cost in the same line items in which they report compensation cost. Companies will present all other components of net benefit cost outside operating income, if this subtotal is presented. The new standard is effective for annual periods beginning after December 15, 2017, including interim periods within those fiscal years. The Company has not yet determined the effect of the standard on its ongoing financial reporting.
In February 2016, the FASB issued Accounting Standards Update (ASU) 2016-02, Revision to Lease Accounting, which amends ASC Topic 842, Leases. The ASU requires lessees to recognize a right-of-use asset and a lease liability for virtually all of their leases (other than leases that meet the definition
21
of a short-term lease). The new standard is effective for fiscal years beginning after December 15, 2018, including interim periods within those fiscal years. Early adoption is permitted. The new standard must be adopted using a modified retrospective transition, and provides for certain practical expedients. Transition will require application of the new guidance at the beginning of the earliest comparative period presented. The Company has not yet determined the effect of the standard on its ongoing financial reporting.
In May 2014, the FASB issued Accounting Standards Update (ASU) 2014-09, Revenue from Contracts with Customers ASC Topic 606, which amends the existing accounting standards for revenue recognition. ASU 2014-09 is based on principles that govern the recognition of revenue at an amount an entity expects to be entitled when products are transferred to customers. The original effective date for ASU 2014-09 was for annual and interim periods within those years beginning after December 15, 2016. In August 2015, the FASB issued ASU No. 2015-14, Revenue from Contracts with Customers – Deferral of the Effective Date, which defers the effective date of ASU 2014-09 for one year and permits early adoption as early as the original effective date of ASU 2014-09. The new revenue standard may be applied retrospectively to each prior period presented or retrospectively with the cumulative effect recognized as of the date of adoption. We expect to adopt the new revenue standard on January 1, 2018 and continue to evaluate whether we will adopt the standard retrospectively or as a cumulative effect adjustment. We expect to continue the evaluation, analysis and documentation of ASU 2014-09 (including those subsequently issued updates that clarify its positions) throughout most of this year as we work towards the implementation and finalize the impact the adoption will have on our consolidated financial statements.
NOTE 16 – RELATED PARTY TRANSACTIONS
Mr. Robert I. Paller has been a non-executive director of the Company since November 1, 2009. The Company has retained and continues to retain Smith, Gambrell & Russell, LLP (“SGR”), a law firm with which Mr. Paller holds a position. In the first six months of 2017 the Company incurred fees from SGR of $0.2 million (2016 – $0.4 million). As at June 30, 2017, the amount due to SGR from the Company was $0.0 million (December 31, 2016 – $0.0 million).
22
This discussion should be read in conjunction with our unaudited interim consolidated financial statements and the notes thereto.
CRITICAL ACCOUNTING ESTIMATES
The policies and estimates that the Company considers the most critical in terms of complexity and subjectivity of assessment are those related to business combinations, environmental liabilities, pensions, deferred tax and uncertain income tax positions, goodwill and property, plant and equipment and other intangible assets (net of amortization). These policies have been discussed in the Company’s 2016 Annual Report on Form 10-K.
RESULTS OF OPERATIONS
The following table provides operating income by reporting segment:
Foreign exchange loss on liquidation of Subsidiary
23
Three Months Ended June 30, 2017
The following table shows the change in components of operating income by reporting segment for the three months ended June 30, 2017:
(in millions, except ratios)
Gross margin (%):
Aggregate
24
Net sales: the table below details the components which comprise the year on year change in net sales spread across the markets in which we operate:
Change (%)
Volume
Price and product mix
Exchange rates
Volumes and price and product mix in the Americas were in line with the prior year. Volumes in EMEA and ASPAC decreased due to customer reformulation to our new technologies. Price and product mix in EMEA and ASPAC benefitted from increased sales of higher margin products from our continuing technology changes. AvTel volumes were lower than the prior year due to the normal variations in the timing of demand, partly offset by a favorable price and product mix. EMEA and ASPAC were adversely impacted by exchange rate movements year over year, driven by a weakening of the European Union euro and the British pound sterling against the U.S. dollar.
Gross margin: the year on year increase of 3.5 percentage points was driven by increased sales of higher margin products together with a favorable price and product mix. The effect of weaker exchange rates versus the U.S. dollar did not significantly impact gross margin.
Operating expenses: the year on year increase of $1.9 million was driven by a provision for agent commissions together with higher performance based personnel-related compensation.
Acquisition
Excluding the acquisition of Huntsman, increased Personal Care demand led to higher volumes in all our markets, partly offset by pricing pressures which adversely affected the price and product mix. EMEA and ASPAC were adversely impacted by exchange rate movements year over year, driven by a weakening of the European Union euro and the British pound sterling against the U.S. dollar. Sales growth from the acquisition of our Huntsman business at the end of 2016 has been excluded from the market analysis above and included as one variance for the segment total.
25
Gross margin: the year on year decrease of 15.4 percentage points was driven by the dilutive effect of the lower margins for our recently acquired European businesses together with some one-off events for an unplanned plant outage and raw materials purchasing and pricing issues.
Operating expenses: the year on year increase of $4.3 million is principally related to the acquisition of our Huntsman business.
Net sales: the year on year increase of $29.6 million was driven by continued improvement in customer activity, especially in completion. Overall volumes increased by 62 percent year on year, together with a favorable price and product mix of 2 percent.
Gross margin: the year on year decrease of 4.7 percentage points was driven by the mix of customer activity. When compared to the first quarter of 2017 the gross margin has remained steady.
Operating expenses: the year on year increase of $3.8 million was driven by higher selling and technical support expenses required to deliver the increase in customer demand.
Net sales: have increased by $7.1 million compared to the prior year, due to the phasing of orders from our one remaining refinery customer.
Gross margin: the year on year decrease of 6.4 percentage points was due to lower volumes of production in the current year leading to a higher manufacturing cost per tonne.
Operating expenses: the year on year decrease of $0.3 million was due to a reduction in the provisions for doubtful debts together with continuing cost efficiencies.
Other Income Statement Captions
Pension credit: is non-cash, and was a $1.0 million net credit in 2017 compared to a $1.7 million net credit in 2016 primarily due to higher amortization of actuarial losses.
Corporate costs: the year on year decrease of $0.3 million was driven by lower legal, professional and other expenses primarily due to $1.0 million of acquisition-related expenses in the prior year; partly offset by $0.5 million higher costs related to the corporate activities required to support our Huntsman acquisition; together with the benefit of the weaker British pound sterling against the U.S. dollar for our Ellesmere Port cost base.
Loss on disposal of subsidiary: the loss of $1.0 million in the quarter relates to an indemnity claim in relation to residual testing in the Aroma Chemicals business which was sold in 2015.
Adjustment to fair value of contingent consideration: in the comparative period there was a contingent consideration credit of $2.4 million related to a previous acquisition.
Other net income: other net income of $2.1 million related to $2.2 million of gains on translation of net assets denominated in non-functional currencies mainly in our European businesses, partly offset by losses of $0.1 million on foreign currency forward exchange contracts. In the prior year, other net income of $8.5 million primarily related to $7.0 million of gains on translation of assets and liabilities denominated in non-functional currencies in our European businesses, together with gains of $1.5 million on foreign currency forward exchange contracts.
26
Interest expense, net: was $2.0 million in 2017 compared to $0.7 million in 2016, driven by the additional term loan related to our Huntsman acquisition, increased working capital requirements in the first half of 2017 leading to higher borrowing with our credit facility and the recent rise in LIBOR impacting our credit facility interest.
Income taxes: The effective tax rate was 25.0% and 20.6% in the second quarter of 2017 and 2016, respectively. The adjusted effective tax rate, once adjusted for the items set out in the following table was 26.0% in 2017 compared with 20.5% in 2016. The 5.5% increase in the adjusted effective tax rate was primarily due to the second quarter of 2017 benefiting, to a lesser extent, from the positive impact of taxable profits in different geographical locations as compared to the second quarter of 2016. The Company believes that this adjusted effective tax rate, a non-GAAP financial measure, provides useful information to investors and may assist them in evaluating the Company’s underlying performance and identifying operating trends. In addition, management uses this non-GAAP financial measure to evaluate the performance of the Company’s operations and for planning and forecasting in subsequent periods.
The following table shows a reconciliation of the GAAP effective tax rate to the adjusted effective tax rate:
Tax on adjustment to fair value of contingent consideration
Tax on stock compensation
Adjustment of income tax positions
GAAP effective tax rate
Adjusted effective tax rate
27
Six Months Ended June 30, 2017
The following table shows the change in components of operating income by reporting segment for the six months ended June 30, 2017:
28
Volumes in the Americas were higher as a result of increased demand following a slower than normal end to 2016. Volumes in EMEA and ASPAC decreased due to customer reformulation to our new technologies. Price and product mix in the Americas was adversely impacted by increased sales of lower margin products. Price and product mix in EMEA and ASPAC benefited from increased sales of higher margin products. AvTel volumes were lower than the prior year due to the normal variations in the timing of demand, with a slight improvement in product mix. EMEA was adversely impacted by exchange rate movements year over year, driven by a weakening of the European Union euro and the British pound sterling against the U.S. dollar.
Gross margin: the year on year increase of 3.0 percentage points was driven by increased sales of higher margin products together with a favorable price and product mix. The effect of weaker exchange rates versus the U.S. dollar did not significantly impact gross margin.
Operating expenses: the year on year increase of $3.1 million was driven by a provision for agent commissions, together with higher performance based personnel-related compensation and increased accruals for share-based compensation due to the relative performance of the Innospec share price compared to the comparative period.
Excluding the acquisition of Huntsman, increased Personal Care demand led to higher volumes in all our markets. Price and product mix was adversely affected by pricing pressures in the Americas and ASPAC while EMEA benefitted from strongly favorable price and product mix in the first quarter. EMEA and ASPAC were adversely impacted by exchange rate movements year over year, driven by a weakening of the European Union euro and the British pound sterling against the U.S. dollar. Sales growth from the acquisition of our Huntsman business at the end of 2016 has been excluded from the market analysis above and included as one variance for the segment total.
29
Gross margin: the year on year decrease of 14.5 percentage points was driven by the dilutive effect of the lower margins for our recently acquired European businesses together with some one-off events for an unplanned plant outage and raw materials purchasing and pricing issues in the second quarter.
Operating expenses: the year on year increase of $8.6 million is principally related to the acquisition of our Huntsman business.
Net sales: the year on year increase of $59.9 million was due to an increase in customer demand for all our product lines following the increase in customer activity in the latter part of 2016 as oil prices increased. Overall volumes increased by 86 percent year on year, partly offset by an adverse price and product mix of 13 percent.
Gross margin: remained unchanged year on year reflecting the current mix of customer activity.
Operating expenses: the year on year increase of $9.1 million was driven by higher selling and technical support expenses required to deliver the increase in customer demand.
Net sales: have decreased by $3.8 million compared to the prior year, due to the phasing of orders from our one remaining refinery customer.
Gross margin: the year on year decrease of 12.2 percentage points was due to lower volumes of production in the current year leading to a higher manufacturing cost per tonne.
Operating expenses: the year on year decrease of $0.4 million was due to a reduction in the provisions for doubtful debts together with continuing cost efficiencies.
Pension credit: is non-cash, and was a $2.1 million net credit in 2017 compared to a $3.5 million net credit in 2016 primarily due to higher amortization of actuarial losses.
Corporate costs: the year on year increase of $0.2 million related to $1.1 million higher costs related to the corporate activities required to support our Huntsman acquisition; partly offset by lower legal, professional and other expenses due to $1.0 million of acquisition-related expenses in the prior year; together with the benefit of the weaker British pound sterling against the U.S. dollar for our Ellesmere Port cost base.
Loss on disposal of subsidiary: the loss of $1.0 million relates to an indemnity claim in relation to residual testing in the Aroma Chemicals business which was sold in 2015.
Foreign exchange loss on liquidation of subsidiary: the $1.8 million loss relates to the reclassification of historic foreign exchange translations of net assets from accumulated other comprehensive losses, for our captive insurance company which was liquidated in the first quarter of 2017.
30
Adjustment to fair value of contingent consideration: in the comparative period there was a contingent consideration credit of $4.0 million related to a previous acquisition.
Other net income: other net income of $1.1 million related to $1.7 million of gains on translation of net assets denominated in non-functional currencies mainly in our European businesses, partly offset by losses of $0.6 million on foreign currency forward exchange contracts. In the prior year, other net income of $8.2 million primarily related to $5.2 million of gains on translation of assets and liabilities denominated in non-functional currencies in our European businesses, together with gains of $3.0 million on foreign currency forward exchange contracts.
Interest expense, net: was $4.2 million in 2017 compared to $1.5 million in 2016, driven by the additional term loan related to the acquisition of Huntsman and the recent rise in LIBOR impacting our revolving credit facility borrowing.
Income taxes: The effective tax rate was 25.3% and 21.5% in the first six months of 2017 and 2016, respectively. The adjusted effective tax rate, once adjusted for the items set out in the following table, was 25.3% in the first six months of 2017 compared with 20.3% in the first six months of 2016. The 5.0% increase in the adjusted effective tax rate was primarily due to the first six months of 2017 benefiting to a lesser extent from the positive impact of taxable profits in different geographical locations as compared to the first six months of 2016. The Company believes that this adjusted effective tax rate, a non-GAAP financial measure, provides useful information to investors and may assist them in evaluating the Company’s underlying performance and identifying operating trends. In addition, management uses this non-GAAP financial measure internally to evaluate the performance of the Company’s operations and for planning and forecasting in subsequent periods.
Adjustment to fair value acquisition accounting
Adjustment for stock compensation
Tax on adjustment to fair value acquisition accounting
Adjustment of income tax provision
31
LIQUIDITY AND FINANCIAL CONDITION
Working Capital
The Company believes that adjusted working capital, a non-GAAP financial measure, (defined by the Company as trade and other accounts receivable, inventories, prepaid expenses, accounts payable and accrued liabilities rather than total current assets less total current liabilities) provides useful information to investors in evaluating the Company’s underlying performance and identifying operating trends. Management uses this non-GAAP financial measure internally to allocate resources and evaluate the performance of the Company’s operations. Items excluded from working capital in the adjusted working capital calculation are listed in the table below and represent factors which do not fluctuate in line with the day to day working capital needs of the business.
Working capital
Less cash and cash equivalents
Less prepaid income taxes
Add back current portion of accrued income taxes
Add back current portion of long-term debt
Add back current portion of finance leases
Add back current portion of plant closure provisions
Add back current portion of acquisition-related contingent consideration
Add back current portion of deferred income
Adjusted working capital
During the first six months of 2017 our working capital increased by $33.5 million, while our adjusted working capital has increased by $84.3 million. The Huntsman acquisition accounted for approximately $43 million of these movements which included an initial one-off working capital funding requirement post acquisition, together with the timing of customer receipts and key supplier payments in the second quarter of 2017. The remaining movements are being driven by increased inventories and accounts receivables across our businesses in line with the current demand from customers.
We had an $87.2 million increase in trade and other accounts receivable primarily related to a $56.8 million increase for the Huntsman acquisition trade receivables in our Performance Chemicals segment and from the timing of sales in our other segments. Days’ sales outstanding in our Fuel Specialties segment increased from 45 days to 55 days; increased in our Performance Chemicals segment from 55 days to 68 days; and decreased from 54 days to 52 in our Oilfield Services segment.
We had a $43.8 million increase in inventories, which is related to increases in all our segments to align with the timing of demand from customers. Days’ sales in inventory in our Fuel Specialties segment increased from 84 days to 116 days; decreased in our Performance Chemicals segment from 94 days to 57 days; and increased from 72 to 80 days in our Oilfield Services segment.
Prepaid expenses decreased by $1.2 million from $6.2 million to $5.0 million due to the expensing of prepaid costs in the year.
32
We had a $45.5 million increase in accounts payable and accrued liabilities primarily related to a $22.6 million increase for the Huntsman acquisition accounts payable in our Performance Chemicals segment and a $15.4 million increase in accounts payable for our Oilfield Services segment driven by increased customer activity. Creditor days in our Fuel Specialties segment increased from 28 days to 38 days; in our Performance Chemicals segment increased from 32 days to 41 days; and increased from 32 days to 53 days in our Oilfield Services segment.
Operating Cash Flows
We have used cash in operating activities of $10.9 million in the first six months of 2017 compared to generating cash of $57.1 million in the first six months of 2016. The year over year change in cash from operating activities is primarily due to the working capital requirements of our recently acquired Huntsman business, increased customer activity in our Oilfield Services segment, the timing of shipments in our Octane Additives segment and the payment of long-term incentive performance compensation.
Cash
At June 30, 2017 and December 31, 2016 we had cash and cash equivalents of $48.8 million and $101.9 million, respectively, of which $35.6 million and $90.2 million, respectively, were held by non-U.S. subsidiaries principally in the United Kingdom. The Company is in a position to control whether or not to repatriate foreign earnings. We currently do not expect to make a repatriation in the foreseeable future and hence have not provided for future income taxes on the cash held by overseas subsidiaries. If circumstances were to change that would cause these earnings to be repatriated, an additional U.S. tax liability could be incurred, and we continue to monitor this position.
Debt
At June 30, 2017, the Company had $141.0 million of debt outstanding under the revolving credit facility, $110.0 million of debt outstanding on our term loan and $5.8 million of obligations under finance leases relating to certain fixed assets within our Oilfield Services segment. Total long-term debt at June 30, 2017 is reported net of deferred finance costs of $1.9 million (December 31, 2016 – $2.2 million).
At December 31, 2016, we had $161.0 million of debt outstanding under the revolving credit facility, $110.0 million of debt outstanding on our term loan and $4.5 million of obligations under finance leases relating to certain fixed assets within our Oilfield Services segment.
The Company has a revolving credit facility that provides for borrowing of up to $200.0 million through November 2020 and may be drawn down in full in the U.S. and the United Kingdom.
The Company uses floating rate debt to finance its global operations. The Company is subject to business risks inherent in non-U.S. activities, including political and economic uncertainty, import and export limitations, and market risk related to changes in interest rates and foreign currency exchange rates. The political and economic risks are mitigated by the stability of the major countries in which the Company’s largest operations are located. Credit limits, ongoing credit evaluation and account monitoring procedures are used to minimize bad debt risk. Collateral is not generally required.
33
From time to time, the Company uses derivatives, including interest rate swaps, commodity swaps and foreign currency forward exchange contracts, in the normal course of business to manage market risks. The derivatives used in hedging activities are considered risk management tools and are not used for trading purposes. In addition, the Company enters into derivative instruments with a diversified group of major financial institutions in order to manage the exposure to non-performance of such instruments. The Company’s objective in managing the exposure to changes in interest rates is to limit the impact of such changes on earnings and cash flows and to lower overall borrowing costs. The Company’s objective in managing the exposure to changes in foreign currency exchange rates is to reduce volatility on earnings and cash flows associated with such changes.
The Company offers fixed prices for some long-term sales contracts. As manufacturing and raw material costs are subject to variability the Company, from time to time, uses commodity swaps to hedge the cost of some raw materials thus reducing volatility on earnings and cash flows. The derivatives are considered risk management tools and are not used for trading purposes. The Company’s objective is to manage its exposure to fluctuating costs of raw materials.
The Company’s exposure to market risk has been discussed in the Company’s 2016 Annual Report on Form 10-K and there have been no significant changes since that time.
Evaluation of Disclosure Controls and Procedures
Based on an evaluation carried out as of the end of the period covered by this report, under the supervision and with the participation of our management, our Chief Executive Officer and our Chief Financial Officer concluded that the Company’s “disclosure controls and procedures” (as defined in Rules 13a-15(e) and15d-15(e) of the Securities Exchange Act of 1934) were effective as of June 30, 2017.
Changes in Internal Control over Financial Reporting
The Company is continuously seeking to improve the efficiency and effectiveness of its operations and of its internal control over financial reporting. This is intended to result in refinements to processes throughout the Company.
On December 30, 2016 we acquired the European Differentiated Surfactants business from Huntsman (“Huntsman”). We excluded the operations of Huntsman from the scope of our Sarbannes-Oxley Section 404 report on internal controls over financial reporting as of December 31, 2016. We are continuing the process of implementing our internal control structure over the acquired operations and expect that this effort will be completed in 2017.
There were no other changes to our internal control over financial reporting, which were identified in connection with the evaluation required by paragraph (d) of Rules 13a-15 and 15d-15 under the Securities Exchange Act of 1934, that occurred during the second quarter of 2017 that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.
34
PART II OTHER INFORMATION
Item 1 Legal Proceedings
While we are involved from time to time in claims and legal proceedings that result from, and are incidental to, the conduct of our business including business and commercial litigation, employee and product liability claims, there are no material pending legal proceedings to which the Company or any of its subsidiaries is a party, or of which any of their property is subject. It is possible, however, that an adverse resolution of an unexpectedly large number of such individual claims or proceedings could, in the aggregate, have a material adverse effect on results of operations for a particular year or quarter.
Information regarding risk factors that could have a material impact on our results of operations or financial condition are described under “Risk Factors” in Item 1A of Part 1 of our 2016 Form 10-K . In management’s view, there have been no material changes in the risk factors facing the Company since that time.
There have been no unregistered sales of equity securities.
On November 3, 2015 the Company announced that its board of directors has authorized a share repurchase program which targets to repurchase up to $90 million of common stock over the next three years.
During the three months ended June 30, 2017, no shares of our common stock were repurchased by the Company. There was $82.5 million remaining under the 2015 authorization as at June 30, 2017.
Repurchases of common stock are held as treasury shares unless reissued under equity compensation plans.
None.
Not applicable.
35
36
Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
/s/ PATRICK S. WILLIAMS
/s/ IAN P. CLEMINSON
37