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KRATON PERFORMANCE POLYMERS, INC. - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations.(Edgar Glimpses Via Acquire Media NewsEdge) INTRODUCTION You should read the following discussion of our financial condition and results of operations with our audited consolidated financial statements and related notes thereto included in our Annual Report on Form 10-K as of and for the year ended December 31, 2013. This discussion contains forward-looking statements and involves numerous risks, assumptions and uncertainties, including, but not limited to, the risk factors discussed in the "Risk Factors" section of our most recent Form 10-K, as well as in "Factors Affecting Our Results of Operations" and elsewhere in this Form 10-Q. Actual results may differ materially from those contained in any forward-looking statements. OVERVIEW We are a leading global producer of styrenic block copolymers ("SBCs") and other engineered polymers. We market our products under the Kraton®, CariflexTM and NEXARTM brands. SBCs are highly-engineered synthetic elastomers, which we invented and commercialized almost 50 years ago, that enhance the performance of numerous end use products by imparting greater flexibility, resilience, strength, durability and processability. Our polymers are typically formulated or compounded with other products to achieve improved, customer-specific performance characteristics in a variety of applications. We seek to maximize the value of our product portfolio by emphasizing complex or specialized polymers and innovations that yield higher margins than less differentiated products. We sometimes refer to these complex or specialized polymers or innovations as being more "differentiated." Our products are found in many everyday applications, including personal care products, such as disposable diapers, and in the rubberized grips of toothbrushes, razor blades and power tools. Our products are also used to impart tack and shear properties in a wide variety of adhesive products and to impart characteristics such as, flexibility and durability in sealants and corrosion resistance in coatings. Our paving and roofing applications provide durability, extending road and roof life. We also produce Cariflex isoprene rubber and isoprene rubber latex. Our Cariflex products are highly-engineered, non-SBC synthetic substitutes for natural rubber and natural rubber latex. Our Cariflex products, which have not been found to contain the proteins present in natural rubber latex and are, therefore, not known to cause allergies, are used in applications such as surgical gloves and condoms. We believe the versatility of Cariflex provides opportunities for new, high margin applications. We have a portfolio of innovations at various stages of development and commercialization, including - polyvinyl chloride alternatives for wire and cable, and medical applications; - polymers and compounds for soft skin and coated fabric applications for transportation and consumer markets; - highly-modified asphalt ("HiMA") for high-performance paving applications; - NEXAR family of membrane polymers for water filtration, heating, ventilation, air conditioning and breathable fabrics; and - synthetic cement formulations and polymers used for viscosity modification in oilfield applications. Our products are manufactured along the following primary product lines based upon polymer chemistry and process technologies: - un-hydrogenated SBCs ("USBCs"); - hydrogenated SBCs ("HSBCs"); - Cariflex isoprene rubber ("IR") and isoprene rubber latex ("IRL"); and - compounds. 40 -------------------------------------------------------------------------------- The majority of worldwide SBC production is dedicated to USBCs, which are primarily used in paving and roofing, in adhesives, sealants and coatings, and in footwear applications. HSBCs, which are significantly more complex and capital-intensive to manufacture than USBCs, are primarily used in more differentiated applications, such as soft touch and flexible materials, personal hygiene products, medical products, automotive components, and certain adhesives and sealant applications. Three months ended Nine months ended September 30, September 30, Product Line Revenue: 2014 2013 2014 2013 USBCs 55.8 % 58.9 % 55.0 % 58.1 % HSBCs 29.4 % 30.2 % 31.8 % 31.1 % Cariflex 12.5 % 8.6 % 11.0 % 8.4 % Compounds 2.2 % 2.2 % 2.2 % 2.3 % Other 0.1 % 0.1 % 0.0 % 0.1 % Three months ended Nine months ended September 30, September 30, End Use Markets: 2014 2013 2014 2013 Advanced Materials 23.3 % 24.8 % 25.0 % 26.8 % Adhesives, Sealants and Coatings 37.3 % 36.0 % 38.8 % 37.5 % Paving and Roofing 26.8 % 30.5 % 25.2 % 27.2 % Cariflex 12.5 % 8.6 % 11.0 % 8.4 % Other 0.1 % 0.1 % 0.0 % 0.1 % 2014 Third Quarter Financial Overview - Sales volume was 80.7 kilotons in the third quarter of 2014 compared to 83.5 kilotons in the third quarter of 2013. - Revenue was $319.0 million in the third quarter of 2014 compared to $327.1 million in the third quarter of 2013. - Gross profit was $63.8 million in the third quarter of 2014 compared to $47.5 million in the third quarter of 2013. Adjusted gross profit (non-GAAP) was $64.7 million in the third quarter of 2014 compared to $71.7 million in the third quarter of 2013. - Adjusted EBITDA (non-GAAP) was $39.4 million in the third quarter of 2014 compared to $44.8 million in the third quarter of 2013. - Net income attributable to Kraton was $16.6 million or $0.50 per diluted share in the third quarter of 2014 compared to a net loss of $(5.6) million or $(0.17) per diluted share in the third quarter of 2013. Diluted earnings per share were impacted by items that are discussed further in Net income attributable to Kraton. 41 -------------------------------------------------------------------------------- RESULTS OF OPERATIONS Factors Affecting Our Results of Operations Raw Materials. We use butadiene, styrene and isoprene as our primary raw materials in manufacturing our products, and our results of operations are directly affected by the cost of these raw materials. On a FIFO basis, these monomers together represented approximately $135.1 million and $158.4 million or 53.0% and 56.6% of our total cost of goods sold for the three months ended September 30, 2014 and 2013, respectively, and approximately $393.7 million and $477.4 million or 51.7% and 57.2% of our total cost of goods sold for the nine months ended September 30, 2014 and 2013, respectively. Since the cost of our three primary raw materials comprise a significant amount of our total cost of goods sold, our selling prices for our products and therefore our total revenue are impacted by movements in our raw material costs, as well as the cost of other inputs. The cost of these monomers has generally correlated with changes in energy prices and is generally influenced by supply and demand factors, and prices for natural and synthetic rubber. Average purchase prices for butadiene and isoprene decreased during the three months ended September 30, 2014 compared to the three months ended June 30, 2014, whereas average purchase prices for styrene were relatively flat. Average purchase prices for butadiene increased during the three months ended September 30, 2014 compared to the three months ended September 30, 2013, whereas average purchase prices for styrene were relatively flat and average purchase prices for isoprene decreased. Average purchase prices for these monomers decreased during the nine months ended September 30, 2014 compared to the nine months ended September 30, 2013. We use the first-in, first-out (FIFO) basis of accounting for inventory and cost of goods sold and therefore gross profit. In periods of raw material price volatility, reported results under FIFO will differ from what the results would have been if cost of goods sold were based on estimated current replacement cost ("ECRC"). Specifically, in periods of rising raw material costs, reported gross profit will be higher under FIFO than under ECRC. Conversely, in periods of declining raw material costs, reported gross profit will be lower under FIFO than under ECRC. In recognition of the fact that the cost of raw materials affects our results of operations and the comparability of our results of operations we provide the spread between FIFO and ECRC. - In the three months ended September 30, 2014, reported results under FIFO were lower than results would have been on an ECRC basis by $1.8 million; and - In the nine months ended September 30, 2014, reported results under FIFO were higher than results would have been on an ECRC basis by $6.5 million; and - In the three and nine months ended September 30, 2013, reported results under FIFO were lower than results would have been on an ECRC basis by $20.7 million and $23.5 million, respectively. International Operations and Currency Fluctuations. We operate a geographically diverse business, serving customers in over 60 countries from five manufacturing facilities on four continents. Although we sell and manufacture our products in many countries, our sales and production costs are mainly denominated in U.S. dollars, Euro, Japanese Yen and Brazilian Real. From time to time, we use hedging strategies to reduce our exposure to currency fluctuations. We generated our revenue from customers located in the following regions. Three months ended Nine months ended September 30, September 30, Revenue by Geography: 2014 2013 2014 2013 Americas 37.7 % 38.9 % 39.4 % 39.8 % Europe, Middle East and Africa 37.0 % 41.0 % 36.9 % 39.2 % Asia Pacific 25.3 % 20.1 % 23.7 % 21.0 % Our financial results are subject to gains and losses on currency translations, which occur when the financial statements of our foreign operations are translated into U.S. dollars. The financial statements of operations outside the United States where the local currency is considered to be the functional currency are translated into U.S. dollars using the exchange rate at each balance sheet date for assets and liabilities and the average exchange rate for each period for revenues, expenses, gains and losses and cash flows. The 42 -------------------------------------------------------------------------------- effect of translating the balance sheet into U.S. dollars is included as a component of accumulated other comprehensive income (loss). Any appreciation of the functional currencies against the U.S. dollar will increase the U.S. dollar equivalent of amounts of revenues, expenses, gains and losses and cash flows, and any depreciation of the functional currencies will decrease the U.S. dollar amounts reported. Our results of operations are also subject to currency transaction risk. We incur currency transaction risk when we enter into either a purchase or sale transaction using a currency other than the local currency of the transacting entity. The impact from currency fluctuations amounted to pre-tax losses of $1.0 million and $3.1 million for the three months ended September 30, 2014 and 2013, respectively, and pre-tax losses of $2.5 million and $5.0 million for the nine months ended September 30, 2014 and 2013, respectively. For the three months ended September 30, 2014 compared to the three months ended September 30, 2013, the primary driver for the decrease in our pre-tax currency losses was the change in foreign exchange rates between the Euro and U.S. Dollar and the Japanese Yen and U.S. Dollar. For the nine months ended September 30, 2014 compared to the nine months ended September 30, 2013, the primary driver for the decrease in our pre-tax currency losses compared to the nine months ended September 30, 2013 was the change in foreign exchange rates between the Brazilian Real and U.S. Dollar and the Japanese Yen and U.S. Dollar. Seasonality. Seasonal changes and weather conditions typically affect the Paving and Roofing end use market and generally result in higher sales volumes into this end use market in the second and third quarters of the calendar year compared to the first and fourth quarters of the calendar year. Our other end use markets tend to show relatively little seasonality. Recent Developments Share Repurchase Program. On October 27, 2014, Kraton's board of directors approved a share repurchase program through which the Company may repurchase outstanding shares of the Company's common stock having an aggregate purchase price of up to $50.0 million. Kraton intends to finance the share repurchase program through a combination of cash and debt. The Company plans to repurchase shares of its common stock over the next two years in the open market at prevailing market prices, through privately negotiated transactions, or through a trading program under Rule 10b5-1, subject to market and business conditions, applicable legal requirements and other considerations. Terminated Combination Agreement with SBC Business of LCY. On January 28, 2014, we executed a definitive agreement (the "Combination Agreement") to combine with the styrenic block copolymer ("SBC") operations of Taiwan-based LCY Chemical Corp. ("LCY"). The Combination Agreement called for LCY to contribute its SBC business in exchange for newly issued shares in the combined company, such that Kraton's stockholders and LCY would each own 50% of the outstanding shares of the combined enterprise. On June 30, 2014, Kraton notified LCY that its Board of Directors intended to withdraw its recommendation to Kraton's stockholders to approve the Combination Agreement unless the parties could agree upon mutually acceptable revised terms to the Combination Agreement. This notice cited the decline in operating results for LCY's SBC business in the first quarter of 2014 and a related decline in forecasted results thereafter, together with the decline in Kraton's stock price and negative reactions from Kraton's stockholders. Following Kraton's notification of its Board's intention to change its recommendation, the parties engaged in discussions to determine whether they could mutually agree to changes to the terms of the Combination Agreement that would enable the Kraton Board to continue to recommend that Kraton's stockholders approve the Combination Agreement. The parties engaged in numerous discussions subsequent to June 30, 2014 regarding possible revisions to the terms of the Combination Agreement. On July 31, 2014, an explosion occurred in a pipeline owned by LCY in Kaohsiung, Taiwan, causing substantial property damage and loss of life, and numerous governmental and private investigations and claims have been initiated and asserted against LCY. On August 4, 2014, LCY notified Kraton that it would no longer negotiate, and would not agree to, any revisions to the terms of the Combination Agreement. On August 6, 2014, the Kraton Board withdrew its recommendation that Kraton's stockholders approve the Combination Agreement. On August 8, 2014, Kraton received notice from LCY that LCY had exercised its right to terminate the Combination Agreement. The provisions of the Combination Agreement provide for Kraton to pay LCY a $25 million break-up fee upon a termination of the Combination Agreement following a withdrawal of the Kraton Board's recommendation, unless an LCY material adverse effect has occurred and is continuing at the time of the withdrawal of the Kraton Board's recommendation. In LCY's notice terminating the Combination Agreement, LCY requested payment of such $25 million termination fee. On October 6, 2014, LCY filed a lawsuit against Kraton in connection with Kraton's refusal to pay the $25 million termination fee. We believe that the impact upon LCY of the 43 -------------------------------------------------------------------------------- July 31, 2014 explosion in a gas pipeline in Kaohsiung, Taiwan constitutes an LCY material adverse effect as defined in the Combination Agreement, and Kraton has notified LCY that accordingly Kraton is not obligated to pay the termination fee. While the ultimate resolution of this matter cannot be predicted with certainty, we do not expect any material adverse effect upon our financial position, results of operations or cash flows from the ultimate outcome of this matter. KFPC loan agreement. On July 17, 2014, KFPC executed a syndicated loan agreement (the "KFPC Loan Agreement") in the amount of 5.5 billion New Taiwan Dollars ("NTD"), or $182.9 million (converted at the July 17, 2014 exchange rate), to provide additional funding to construct the HSBC facility in Taiwan and to provide funding for working capital requirements and/or general corporate purposes. The KFPC Loan Agreement is comprised of NTD 4.29 billion, or $142.7 million (converted at the July 17, 2014 exchange rate), to fund KFPC's capital expenditures, and NTD 1.21 billion, or $40.2 million (converted at the July 17, 2014 exchange rate), to fund working capital requirements and/or general corporate purposes. Obligations under the KFPC Loan Agreement are guaranteed 50% by Formosa Petrochemical Corporation and 50% by Kraton Polymers LLC. See Note 6. Long Term Debt, for further discussion of the KFPC Loan Agreement. Outlook With respect to raw material costs, following declines in butadiene contract prices in September and October, the Company currently expects a continued downward bias for the balance of the year. Based upon these recent raw material price trends, the Company now expects the fourth quarter 2014 results will reflect a negative spread between FIFO and ECRC of approximately $12.0 million, resulting in a full-year 2014 negative spread between FIFO and ECRC of approximately $5.5 million. Three Months Ended September 30, 2014 Compared to Three Months Ended September 30, 2013 Revenue Revenue was $319.0 million for the three months ended September 30, 2014 compared to $327.1 million for the three months ended September 30, 2013, a decrease of $8.1 million or 2.5%. Excluding the $1.5 million negative effect from currency movements, revenue declined $6.6 million, or 2.0%, with the decrease driven primarily by lower average selling prices associated with product mix, weakness in European paving and roofing markets and lower average raw material costs. Sales volumes declined 2.8 kilotons, or 3.4%, from 83.5 kilotons in the third quarter of 2013 to 80.7 kilotons in the third quarter of 2014. The decrease in total sales volume did not have a material impact on the period-over-period change in revenue, as the revenue impact from lower sales volume of USBC products was offset by the revenue contribution from increased sales volume in higher revenue per ton Cariflex products. With respect to revenue in each of our end use markets: - Advanced Materials revenue was $74.2 million for the three months ended September 30, 2014 compared to $81.2 million for the three months ended September 30, 2013. The $7.0 million or 8.6% revenue decline (a decline of $6.6 million or 8.2% excluding a $0.3 million negative effect from currency fluctuations) was largely due to lower average selling prices reflective of product and customer mix and a 3.4% decline in sales volumes. The decline in sales volume was primarily due to lower volume into personal care applications, partially offset by increased sales into other HSBC applications. The lower personal care sales volume reflects the market trend in which certain customers shifted from HSBC-based applications towards less differentiated and lower cost materials, including USBC-based solutions. While sales volume in the third quarter of 2014 into personal care applications was flat compared to the second quarter of 2014, indicating that the shift away from HSBC solutions in personal care has largely occurred, this shift amounted to a decline in sales volume in the third quarter of 2014 of approximately one kiloton compared to the third quarter of 2013. Innovation sales volume increased, with higher sales of HSBC innovation grades into medical and auto/industrial applications and increased sales of USBC-based innovation grades into personal care applications. - Adhesives, Sealants and Coatings revenue was $119.1 million for the three months ended September 30, 2014 compared to $117.6 million for the three months ended September 30, 2013, an increase of $1.5 million or 1.3% (an increase of $2.0 million or 1.7% excluding a $0.5 million negative effect from currency fluctuations). Sales volume increased by 5.0% primarily due to higher sales into pressure sensitive adhesives and industrial applications, which was partially offset by lower average selling prices, reflective of lower raw material costs, primarily isoprene. Innovation sales volume increased, led by increased sales into oil additive, protective film and oil gel applications. 44 -------------------------------------------------------------------------------- - Paving and Roofing revenue was $85.6 million for the three months ended September 30, 2014 compared to $99.7 million for the three months ended September 30, 2013. The $14.2 million or 14.2% revenue decline (a decline of $14.0 million or 14.1% excluding a $0.1 million negative effect from currency fluctuations) was principally due to lower sales volume in Europe in both paving and roofing applications compared to the third quarter of 2013. With respect to innovation, sales volume growth in HiMA sales continued, led by increased sales in Europe and South America. - CariflexTM revenue was $40.0 million for the three months ended September 30, 2014 compared to $28.2 million for the three months ended September 30, 2013. The $11.7 million or 41.5% revenue increase (an increase of $12.3 million or 43.4% excluding a $0.5 million negative effect from currency fluctuations) was the result of a 48.3% increase in sales volume, largely for medical glove applications, partially offset by the impact of customer mix on average selling prices. Cost of Goods Sold Cost of goods sold was $255.1 million for the three months ended September 30, 2014 compared to $279.7 million for the three months ended September 30, 2013. The $24.5 million, or 8.8%, decrease was primarily related to a period over period benefit of $18.8 million due to the spread between FIFO and ECRC and a $3.5 million reduction in turnaround costs associated with the third quarter 2013 MACT related production downtime. Gross Profit Gross profit was $63.8 million for the three months ended September 30, 2014 compared to $47.5 million for the three months ended September 30, 2013. Gross profit as a percentage of revenue was 20.0% and 14.5% for the three months ended September 30, 2014 and 2013, respectively. Operating Expenses - Research and Development. Research and development expenses were $7.4 million and 2.3% of revenue for each of the three month periods ended September 30, 2014 and 2013. - Selling, General and Administrative. Selling, general and administrative expenses were $16.4 million for the three months ended September 30, 2014 compared to $22.4 million for the three months ended September 30, 2013, a decrease of $6.1 million or 27.0%. The third quarter of 2014 included a $4.2 million benefit from a reduction in estimated transaction fees, and the third quarter of 2013 included $0.9 million of transaction fees. Excluding transaction fees, selling general and administrative expenses would have been $20.6 million in the third quarter 2014 compared to $21.5 million in the third quarter 2013. Selling, general and administrative expenses were 5.1% and 6.9% of revenue for the three months ended September 30, 2014 and 2013, respectively, or 6.5% and 6.6%, respectively, excluding transaction fees. - Depreciation and Amortization. Depreciation and amortization was $16.6 million for the three months ended September 30, 2014 compared to $15.8 million for the three months ended September 30, 2013, an increase of $0.7 million or 4.7%. Interest expense, net Interest expense, net was $6.1 million for the three months ended September 30, 2014 compared to $5.7 million for the three months ended September 30, 2013, an increase of $0.4 million or 6.2%. Income tax expense Income tax expense was $1.1 million and $2.0 million for the three months ended September 30, 2014 and 2013, respectively. Our effective tax rate was 6.4% and (52.8%) for the three months ended September 30, 2014 and 2013, respectively. Our effective tax rates differed from the U.S. corporate statutory tax rate of 35.0%, primarily due to the mix of pre-tax income or loss earned in certain jurisdictions and changes in our valuation allowance. We record a valuation allowance when it is more likely than not that some portion, or all, of our deferred tax assets will not be realized. As of September 30, 2014 and December 31, 2013, a valuation allowance of $85.4 million and $90.0 million, respectively, has been provided for net operating loss carryforwards and other deferred tax assets. We decreased our valuation allowance by $4.4 million for the three months ended September 30, 2014, of which $2.5 million represents utilization of net operating losses in the current period and $1.9 million relates to the assessment of our ability to utilize net operating losses in future periods. We increased 45 -------------------------------------------------------------------------------- our valuation allowance by $3.6 million for the three months ended September 30, 2013, of which $3.5 million represents current period net operating losses and $0.1 million represents changes in other comprehensive income (loss). Excluding the change in our valuation allowance, our effective tax rate would have been a 31.7% expense and a 38.3% benefit for the three months ended September 30, 2014 and 2013, respectively. Our pre-tax income is generated in a number of jurisdictions and is subject to a number of different effective tax rates that are significantly lower than the U.S. corporate statutory tax rate of 35.0%. For the three months ended September 30, 2014, we earned $12.3 million of pre-tax income in jurisdictions with an expected full year effective tax rate of 9.8%. For the three months ended September 30, 2013, we earned $1.1 million of pre-tax income in jurisdictions with an expected full year effective tax rate of 9.6%. Net income (loss) attributable to Kraton Net income attributable to Kraton was $16.6 million or $0.50 per diluted share for the three months ended September 30, 2014, an increase of $22.2 million compared to a net loss of $(5.6) million or $(0.17) per diluted share for the three months ended September 30, 2013. Net income for the three months ended September 30, 2014 was positively impacted by the following items, net of tax: - A reduction in the accrual for fees related to the terminated Combination Agreement with LCY of $4.2 million or $0.13 per diluted share - A reduction in our income tax valuation allowance of $1.9 million or $0.06 per diluted share related to the assessment of our ability to utilize net operating losses in future periods - An insurance recovery related to the production downtime at our Belpre, Ohio, facility of $1.0 million or $0.03 per diluted share In addition, net income for the three months ended September 30, 2014 was negatively impacted by the following items, net of tax: - Start-up charges related to the joint venture with FPCC of $0.2 million or $0.01 per diluted share - Negative spread between FIFO and ECRC of $1.8 million or $0.06 per diluted share Net loss for the three months ended September 30, 2013 was negatively impacted by the following items, net of tax: - Transaction and acquisition related costs of $0.9 million or $0.03 per diluted share - Production downtime related to MACT legislation of $3.5 million or $0.11 per diluted share - Negative spread between FIFO and ECRC of $20.7 million or $0.63 per diluted share 46 -------------------------------------------------------------------------------- Nine Months Ended September 30, 2014 Compared to Nine Months Ended September 30, 2013 Revenue Revenue was $954.4 million for the nine months ended September 30, 2014 compared to $1,001.8 million for the nine months ended September 30, 2013, a decrease of $47.4 million or 4.7% with $46.9 million of the decline attributable to lower average selling prices associated with lower average raw material costs. Sales volumes declined 5.7 kilotons, or 2.4%, from 239.2 kilotons in the nine months ended September 30, 2013 to 233.4 kilotons in the nine months ended September 30, 2014. The decrease in total sales volume did not have a material impact on the period-over-period change in revenue, as the revenue impact from lower sales volume of USBC products was offset by the revenue contribution from increased sales volume in higher revenue per ton Cariflex products. With respect to revenue in each of our end use markets: - Advanced Materials revenue was $238.6 million for the nine months ended September 30, 2014 compared to $268.9 million for the nine months ended September 30, 2013. The $30.3 million or 11.3% revenue decline (a decline of $31.6 million or 11.7% excluding a $1.3 million positive effect from currency fluctuations) was largely due to a 6.3% decline in sales volumes and, to a lesser extent, lower average selling prices reflective of lower raw material costs, primarily butadiene. The decline in sales volume was primarily due to lower volume into personal care applications, partially offset by sales into HSBC-based PVC replacement products, specifically into highly-differentiated grades such as medical and wire and cable applications. The lower personal care sales volume reflects the market trend in which certain customers shifted from HSBC-based applications towards less differentiated and lower cost materials, including USBC-based solutions. While sales volume into personal care applications in the third quarter of 2014 compared to the second quarter of 2014 was flat, indicating that the shift away from HSBC solutions in personal care has largely occurred, this shift amounted to a decline in sales volume of approximately three kilotons for the nine months ended September 30, 2014 compared to the nine months ended September 30, 2013. Innovation sales volume increased, with higher sales volume growth into consumer and automotive and industrial applications. - Adhesives, Sealants and Coatings revenue was $370.5 million for the nine months ended September 30, 2014 compared to $375.1 million for the nine months ended September 30, 2013, a decline of $4.6 million, or 1.2% revenue decline (a decline of $4.4 million or 1.2% excluding a $0.2 million negative effect from currency fluctuations). This decrease was primarily due to lower average selling prices, reflective of lower raw material costs partially offset by a 2.4% increase in sales volumes. The increase in sales volumes was primarily due to higher sales into lubricant additive, printing plate and sealants and caulk applications partially offset by lower sales into nonwovens and pressure sensitive adhesive applications. - Paving and Roofing revenue was $240.4 million for the nine months ended September 30, 2014 compared to $272.3 million for the nine months ended September 30, 2013. The $31.9 million or 11.7% revenue decline (a decline of $33.5 million or 12.3% excluding a $1.7 million positive effect from currency fluctuations) was principally due to a 7.4% reduction in sales volumes and, to a lesser extent, lower average selling prices driven by lower butadiene costs. The decline in sales volume was primarily due to lower paving volume in Europe, and, to a lesser extent, Asia Pacific. With respect to innovation, growth in HiMA sales continued, led by increased sales in Europe and South America. - CariflexTM revenue was $104.6 million for the nine months ended September 30, 2014 compared to $84.5 million for the nine months ended September 30, 2013. The $20.1 million or 23.7% revenue increase (an increase of $19.8 million or 23.4% excluding a $0.2 million positive effect from currency fluctuations) was primarily due to a 28.0% increase in sales volumes, largely for medical glove applications, and, to a lesser extent, increase sales volume in the medical stoppers and condom markets. This growth was partially offset by lower average selling prices, primarily due to lower isoprene costs and sales mix. Cost of Goods Sold Cost of goods sold was $761.4 million for the nine months ended September 30, 2014 compared to $834.5 million for the nine months ended September 30, 2013. The $73.1 million, or 8.8%, decrease was primarily driven by a $74.7 million reduction in raw material costs which includes a period over period benefit of $30.0 million due to the spread between FIFO and ECRC. In addition, cost of goods sold declined $3.5 million due to the absence of turnaround costs associated with the third quarter 2013 MACT related 47 -------------------------------------------------------------------------------- production downtime, lower sales volumes, and favorable manufacturing absorption. Partially offsetting these decreases are $11.4 million of costs associated with the weather-related production downtime at our Belpre, Ohio, facility and an operating disruption from a small fire at our Berre, France, facility in the first quarter of 2014, foreign currency fluctuations of $4.9 million, and increases in other manufacturing costs. Gross Profit Gross profit was $193.0 million for the nine months ended September 30, 2014 compared to $167.2 million for the nine months ended September 30, 2013. Gross profit as a percentage of revenue was 20.2% and 16.7% for the nine months ended September 30, 2014 and 2013, respectively. Operating Expenses - Research and Development. Research and development expenses were $23.7 million for the nine months ended September 30, 2014 compared to $23.8 million for the nine months ended September 30, 2013, a decrease of $0.1 million or 0.2%. Research and development expenses were 2.5% and 2.4% of revenue for the nine months ended September 30, 2014 and 2013, respectively. - Selling, General and Administrative. Selling, general and administrative expenses were $78.9 million for the nine months ended September 30, 2014 compared to $73.5 million for the nine months ended September 30, 2013, an increase of $5.3 million or 7.2% primarily due to a $6.8 million increase in professional fees related to the terminated Combination Agreement with LCY and $0.6 million in costs related to production downtime at our Belpre, Ohio, facility. These increases were partially offset by a $0.7 million decrease in information technology costs and a $0.7 million decrease in costs related to our joint venture company, KFPC. Selling, general and administrative expenses were 8.3% and 7.3% of revenue for the nine months ended September 30, 2014 and 2013, respectively. - Depreciation and Amortization. Depreciation and amortization was $49.6 million for the nine months ended September 30, 2014 compared to $46.7 million for the nine months ended September 30, 2013, an increase of $3.0 million or 6.4% largely due to capital expenditures. Interest expense, net Interest expense, net was $18.7 million for the nine months ended September 30, 2014 compared to $24.9 million for the nine months ended September 30, 2013, a decrease of $6.3 million or 25.2%. The decrease was primarily due to charges aggregating $5.8 million incurred in connection with our March 2013 refinancing and to lower outstanding indebtedness. Income tax expense Income tax expense was $3.4 million and $4.4 million for the nine months ended September 30, 2014 and 2013, respectively. Our effective tax rate was 15.2% and (329.5%) for the nine months ended September 30, 2014 and 2013, respectively. Our effective tax rates differed from the U.S. corporate statutory tax rate of 35.0%, primarily due to the mix of pre-tax income or loss earned in certain jurisdictions and changes in our valuation allowance. We record a valuation allowance when it is more likely than not that some portion, or all, of our deferred tax assets will not be realized. As of September 30, 2014 and December 31, 2013, a valuation allowance of $85.4 million and $90.0 million, respectively, has been provided for net operating loss carryforwards and other deferred tax assets. We decreased our valuation allowance by $4.6 million for the nine months ended September 30, 2014, of which $2.7 million represents utilization of net operating losses in the current period and $1.9 million relates to the assessment of our ability to utilize net operating losses in future periods. We increased our valuation allowance by $7.9 million for the nine months ended September 30, 2013, of which $8.0 million represents current period net operating losses, partially offset by $0.1 million which represents changes in other comprehensive income (loss). Excluding the change in our valuation allowance, our effective tax rate would have been a 35.8% expense and a 276.9% benefit for the nine months ended September 30, 2014 and 2013, respectively. 48 -------------------------------------------------------------------------------- Our pre-tax income is generated in a number of jurisdictions and is subject to a number of different effective tax rates that are significantly lower than the U.S. corporate statutory tax rate of 35.0%. For the nine months ended September 30, 2014, we earned $16.4 million of pre-tax income in jurisdictions with an expected full year effective tax rate of 9.8%. For the nine months ended September 30, 2013, we earned $17.1 million of pre-tax income in jurisdictions with an expected full year effective tax rate of 9.6%. Net income (loss) attributable to Kraton Net income attributable to Kraton was $19.8 million or $0.60 per diluted share for the nine months ended September 30, 2014, an increase of $25.4 million compared to a net loss of $(5.5) million or $(0.17) per diluted share for the nine months ended September 30, 2013. Net income for the nine months ended September 30, 2014 was negatively impacted by the following items, net of tax: - Restructuring and other charges of $0.5 million or $0.02 per diluted share - Fees related to the terminated Combination Agreement with LCY of $8.8 million or $0.27 per diluted share - Production downtime at our Belpre, Ohio, and Berre, France, facilities of $12.0 million, net of a $1.0 million insurance recovery, or $0.36 per diluted share - Start-up charges related to the joint venture with FPCC of $0.6 million or $0.02 per diluted share In addition, net income for the nine months ended September 30, 2014 was positively impacted by the following items, net of tax: - A reduction in our income tax valuation allowance of $1.9 million or $0.06 per diluted share related to the assessment of our ability to utilize net operating losses in future periods - Positive spread between FIFO and ECRC of $6.4 million or $0.19 per diluted share Net loss for the nine months ended September 30, 2013 was negatively impacted by the following items, net of tax: - Restructuring and other charges of $0.2 million or $0.01 per diluted share - Transaction and acquisition related costs of $2.1 million or $0.06 per diluted share - Write-off of debt issuance costs associated with the credit facility refinancing of $5.1 million or $0.15 per diluted share - Settlement of interest rate swap associated with the credit facility refinancing of $0.7 million or $0.02 per diluted share - Production downtime related to MACT legislation of $3.5 million or $0.11 per diluted share - Negative spread between FIFO and ECRC of $23.5 million or $0.72 per diluted share Critical Accounting Policies For a discussion of our critical accounting policies and estimates that require the use of significant estimates and judgments, see "Management's Discussion and Analysis of Financial Condition and Results of Operations-Critical Accounting Policies" in our Annual Report on Form 10-K for the year ended December 31, 2013. 49 -------------------------------------------------------------------------------- EBITDA, Adjusted EBITDA, and Adjusted Gross Profit We consider EBITDA, Adjusted EBITDA and Adjusted Gross Profit to be important supplemental measures of our performance and believe they are frequently used by investors, securities analysts and other interested parties in the evaluation of our performance including period-to-period comparisons and/or that of other companies in our industry. In addition, management uses these measures to evaluate operating performance, and our incentive compensation plan bases incentive compensation payments on our Adjusted EBITDA performance, along with other factors. EBITDA, Adjusted EBITDA and Adjusted Gross Profit have limitations as analytical tools and in some cases can vary substantially from other measures of our performance. You should not consider any of them in isolation, or as substitutes for analysis of our results under U.S. generally accepted accounting principles ("GAAP"). Three months ended Nine months ended September 30, September 30, 2014 2013 2014 2013 (In thousands) (In thousands) EBITDA (1) $ 40,090 $ 17,724 $ 90,693 $ 70,274 Adjusted EBITDA (2) $ 39,417 $ 44,754 $ 115,491 $ 105,905 Adjusted Gross Profit (2) $ 64,650 $ 71,689 $ 198,450 $ 194,272 (1) EBITDA represents net income before interest, taxes, depreciation and amortization. Limitations for EBITDA as an analytical tool include the following: - EBITDA does not reflect the significant interest expense on our debt; - EBITDA does not reflect the significant depreciation and amortization expense associated with our long-lived assets; - EBITDA included herein should not be used for purposes of assessing compliance or non-compliance with financial covenants under our debt agreements. The calculation of EBITDA in the debt agreements includes adjustments, such as extraordinary, non-recurring or one-time charges, proforma cost savings, certain non-cash items, turnaround costs, and other items included in the definition of EBITDA in the debt agreements; and - Other companies in our industry may calculate EBITDA differently than we do, limiting its usefulness as a comparative measure. (2) Adjusted EBITDA is EBITDA net of the impact of the spread between the FIFO basis of accounting and ECRC and net of the impact of a number of items we do not consider indicative of our ongoing operating performance. Adjusted Gross Profit is gross profit net of the impact of the spread between the FIFO basis of accounting and ECRC and net of the impact of a number of items we do not consider indicative of our ongoing operating performance. We explain how each adjustment is derived and why we believe it is helpful and appropriate in the reconciliation below. You are encouraged to evaluate each adjustment and the reasons we consider it appropriate for supplemental analysis. Although we report our financial results using the FIFO basis of accounting, as part of our pricing strategy, we measure our business performance using the ECRC of our inventory and cost of goods sold. We maintain our perpetual inventory in our global enterprise resource planning system, where the carrying value of our inventory is determined using FIFO. At the beginning of each month, we determine the estimated current cost of our raw materials for that particular month, and using the same perpetual inventory system that we use to manage inventory and therefore costs of goods sold under FIFO, we revalue our ending inventory to reflect the total cost of such inventory as if it was valued using the estimated current replacement cost. The result of this revaluation from FIFO creates the spread between FIFO and ECRC. With inventory valued under FIFO and ECRC, we then have the ability to report cost of goods sold and therefore EBITDA, Adjusted EBITDA, Gross Profit and Adjusted Gross Profit under both our FIFO convention and under estimated current replacement cost. As an analytical tool, Adjusted EBITDA is subject to the limitations applicable to EBITDA described above, as well as the following limitations: - due to volatility in raw material prices, Adjusted EBITDA may, and often does, vary substantially from EBITDA, net income and other performance measures, including net income calculated in accordance with US GAAP; and - Adjusted EBITDA may, and often will, vary significantly from EBITDA calculations under the terms of our debt agreements and should not be used for assessing compliance or non-compliance with financial covenants under our debt agreements. 50 -------------------------------------------------------------------------------- Because of these and other limitations, EBITDA and Adjusted EBITDA should not be considered as a measure of discretionary cash available to us to invest in the growth of our business. Our presentation of non-GAAP financial measures and the adjustments made therein should not be construed as an inference that our future results will be unaffected by unusual or non-recurring items, and in the future we may incur expenses or charges similar to the adjustments made in the presentation of our non-GAAP financial measures. As a measure of our performance, Adjusted Gross Profit is limited because it often varies substantially from gross profit calculated in accordance with US GAAP due to volatility in raw material prices. We compensate for these limitations by relying primarily on our GAAP results and using EBITDA, Adjusted EBITDA, and Adjusted Gross Profit only as supplemental measures. See our financial statements included elsewhere in this Form 10-Q. We reconcile Gross Profit to Adjusted Gross Profit as follows: Three months ended Nine months ended September 30, September 30, 2014 2013 2014 2013 (In thousands) (In thousands) Gross profit $ 63,824 $ 47,450 $ 192,977 $ 167,222 Add (deduct): Restructuring and other charges - 83 558 83 Production downtime (a) (990 ) 3,506 11,423 3,506 Spread between FIFO and ECRC 1,816 20,650 (6,508 ) 23,461 Adjusted gross profit $ 64,650 $ 71,689 $ 198,450 $ 194,272 (a) In 2014, production downtime at our Belpre, Ohio and Berre, France facilities. In 2013, this adjustment reflects the production downtime at our Belpre, Ohio facility, in preparation for the installation of natural gas boilers to replace the coal-burning boilers required by the MACT legislation. 51 -------------------------------------------------------------------------------- We reconcile consolidated net income to EBITDA and Adjusted EBITDA as follows: |