Quaker Chemical Corp
NYSE:KWR
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Quaker Chemical Corp
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Greetings, and welcome to the Quaker Chemical Corporation Second Quarter 2018 Results Conference Call. A brief question-and-answer session will follow the formal presentation. [Operator Instructions]. As a reminder, this conference is being recorded.
It is now my pleasure to introduce your host, Michael Barry, Chairman, Chief Executive Officer and President for Quaker Chemical Corporation. Mr. Barry, you may begin.
Thank you, Don. Good morning, everyone. Joining me today are Mary Hall, our CFO; and Robert Traub, our General Counsel. After my comments, Mary will provide the details around the financials, and then we'll address any questions that you may have. We also have slides for the conference call. You can find them in the Investor Relations section of our website at www.quakerchem.com.
I'll start off now with some remarks about the second quarter. I'm pleased we have delivered a strong quarter, despite some market challenges. The quarter's impressive results were largely driven by two major themes. The first being sales increases and the second was gross margins improvement.
Let me start with the margins. Since mid-2016, we have been in a generally rising raw material cost environment, and as we have discussed in the past with raw materials, there's a lag effect between changes in our raw material costs and adjustments to our product pricing. On the last conference call, our expectation was that we would be catching up on this lag effect with our price increases and our gross margin will continue to increase in the second quarter, and I’m happy to report it did.
While raw materials continue to rise sequentially from the first quarter, our price increases were enough to more than turn the tide leading to our gross margin expansion. However, we are continuing to see raw material cost increases in the third quarter which we are addressing with additional price increases where necessary. How exactly this all plays out in the second half of the year is hard to predict in a precise manner, but our best estimate that our gross margins will be in the low to mid 36%. And going forward, we still expect our gross margins to get back to our targeted 37% once raw material increases subside.
Now let me move on to sales, our sales increased 10% versus prior year with 5% of this increase coming from strong volume growth and 2% from foreign exchange. The remaining growth of revenue of 3% was primarily driven by price increases. Let me now give you some additional color on our region’s performance. Our biggest segment, North America showed a sales increase of 8%, with volume growth and price increases both being about 4 percentages.
Our European or EMEA region showed a 10% increase with price increases largely driving a 3% increase in sales and the rest being driven by exchange rates. In our Asia Pacific region, our sales increased 16% largely driven by 10% higher volumes. To note some of this volume growth was higher than normal due to timing of shipments hitting this quarter versus other quarters. However, even considering this timing we continue to see good growth in China. The remaining revenue growth in Asia Pacific of 6% was largely driven by foreign exchange rates and higher prices and product mix.
And for the eight quarter in a row, we are happy to report that South America showed solid revenue growth. The 5% growth in South America sales was due primarily to volume growth as well as price increases totaling 23%, which more than offset a negative exchange rate impact of 18%. One way to see our market gains is to look at our overall organic product volume growth in the quarter and compare that to the underlying production growth in our base markets.
Our overall volume growth was 5% as compared to the underlying growth in our base markets which we estimate at approximately 3%. We believe the spread of approximately 2% is indicative of our share gains and is due to our commitment to our customer intimacy model. Specifically, we put our customer needs first as our top priority providing a strong service and business solutions. I believe this approach continues to differentiate us in the marketplace.
So in summary for the quarter, despite the continued challenges we faced with higher raw material cost, we were able to grow our adjusted EBITDA by 15% and our non-GAAP earnings by 26%. In a nutshell, we were able to do this by growing in our base markets, taking share in the marketplace, increasing our gross margins and continuing to leverage our SG&A. And we’re also seeing an increase in our earnings per share due to favorable impacts from the US tax reforms, which was the primary reason why our non-GAAP earnings growth of 26% exceeded adjusted EBITDA growth of 15%.
I’d now like to make a few remarks about our combination with Houghton International. Nothing has really changed since July 9thpress release. We continue to be in constructive discussion with both the FTC and the European Commission as well as with potential buyers of the product lines, we anticipate we’ll need to be divested.
We intend to present a remedy to both commissions in the third quarter and we expect approval and the close of the combination to be in the fourth quarter. Overall the magnitude of the divested product lines continues to be approximately 3% or less of the combined revenue with the companies which is consistent with our original expectations. This additional time allows us to finalize the process with both the regulators and the potential buyers.
I believe the end result will be a remedy which meets the needs of the market, the regulatory authorities and the new combination. And as we said in the past, we are excited about this combination as it will essentially double the size of the company, it enables continued above market growth through good cross-selling opportunities and provides at least $45 million in cross synergies.
Our intent is to have an investor call after the closing and to provide an updated view of the new company, as well as our expected synergies. To recap, I believe 2018 will be another good year for Quaker. We expect to close the combination of Houghton to year-over-year gross margin improvement and realize benefits from the US tax reform. In addition, we expect to have good growth in our end markets in most regions of the world and we expect to continue to grow above the market as we’ve done historically through our growth initiatives and market share gains.
In closing, I want to thank all of our associates whose dedication and expertise helps to create value for our customers and shareholders and differentiate Quaker in the market place. People are everything in our business and by far for our most valuable asset. I’m very happy with our Quaker team and continue to be excited about the upcoming combination with the Houghton International team.
And now I’ll turn it over to Mary Hall, our CFO, so that she can provide you with details behind the financials. Once Mary has completed her comments on the financials for the quarter, we’ll address any questions that you may have. Mary?
Thank you, Mike, and good morning all. Before I begin, please remember that comments made during this call include forward-looking statements which are based on current expectations, estimates, projections, and assumptions that are subject to risks and uncertainties which may cause actual results to differ materially. For a discussion of these risks, please review the cautionary statements regarding forward-looking statements included in our earnings release and the Risk Factors included in our 2017 Form 10-K filed with the SEC. These are available on our website.
Please refer now to Chart 4 and 5 as I review our financial performance. Quaker reported a 26% increase in non-GAAP earnings per share to $1.56 as a result of strong operating performance across the company. In a similar scene to Q1 of this year, strong sales growth and good cost control were key drivers of performance and in this quarter we also saw gross margin improve both sequentially and year-over-year. All these factors combined resulted in a very strong quarter.
Our net sales increased 10% to about $222 million compared to Q2 last year, with organic volume growth of 5% leading the way and our pricing initiatives driving selling price and mixed improvements of 3%. In addition, the generally weaker US dollar year-over-year benefitted our topline by about 2% with a major being the euro which appreciated 8% versus the dollar from 1.1 in Q2 2017 to 1.19 in Q2 2018.
Our gross margin of 36.5% is up 8/10 of a percent versus last year’s 35.7% and is also up sequentially over Q1 35.6%. This is a second quarter of sequential gross margin improvement. In addition Quaker continued to share good cost discipline as we further leveraged our operating cost to support our strong topline growth. Note that our GAAP operating income and operating margin reflect 4.3 million of Houghton related expenses.
If we look at the ratio of SG&A to sales on chart 5, the Q2 ratio of 24.4% compares favorably to 24.7% in Q2 of last year, and together with our gross margin increase drove improved operating income and operating margin. Our lower effective tax rate in the current quarter of 1t6.8% versus last year’s 26.2% was another contributor to the strong earnings performance.
In the current quarter, we adjusted our estimate of the [total] tax on unrepatriated earnings related to US tax reform that we booked in Q4 of 2017. The adjustment reduced our current quarter taxes by $1.2 million and this combined with the lower statutory rate in the US of 21% versus 35% last year resulted in a relative low Q2 effective tax rate.
For the full year, we continue to expect that our effective tax rate will be between 23% and 25% excluding the impact of Houghton combination related cost and any current year adjustments to the US tax reform charge that we booked in Q4 of 2017. As a result of our strong operating performance, adjusted EBITDA was up 15% year-over-year, operating cash flow is down a big year-over-year as we invested in working capital to support the 10% increase in sales. Our liquidity and balance sheet remained strong with a net cash position of 26.1 million at June 30.
Turning to chart 6, here you can see the continued growth in volume, which is all organic volume growth for the quarter. In chart 7, we see the sequential and year-over-year increases in gross margin that I described earlier. As Mike mentioned, we see raw materials continuing to increase and now expect gross margin to be in the low to mid 36% area for the rest of the year.
Chart 8 shows our continued and consistent positive trend and adjusted EBITDA as we further leverage our operating cost while growing the company. Also the current trailing 12 months adjusted EBITDA with 122 million is a record. Chart 9 shows our cash and debt balances and highlights our strong balance sheet and good liquidity with a net cash position of 26.1 million as I mentioned earlier.
In summary, Quaker continues to consistently deliver good earnings in cash flow despite various market challenges. We expect 2018 to be another good year for Quaker as we focus on delivering value to our shareholders and closing the Houghton combination.
Thank you all for your interest in Quaker, and now I will turn it back over to you Mike.
Thank you, Mary. At this stage, we’d like to address any questions from any participants on the conference call.
[Operator Instructions] our first question comes from Laurence Alexander of Jefferies. Please proceed with your question.
Laurence Alexander
A couple of questions, first just looking at eyeballing chart 6, it looks like there’s a pattern of Q3 being seasonally stronger than Q2. Are you seeing anything in terms of your end market, and I guess I’m thinking particularly in Europe that would sequentially make that more difficult. And then I guess the second question is just with the Houghton acquisitions were pending, have you seen any indication of talents leaving Houghton either resume’s crossing your door accidentally or second hand or any other kind of indications of issues with the retention.
Michael Barry
On the first question around volumes and the quarterly the third quarter may be somewhat higher than the second quarter. Similarly that’s been the case historically. You know it’s not necessarily the case all the time because you can get in to these timing issues with shipments. We’ve seen some of that this past quarter with both Europe being in on direction and Asia Pacific being in another direction. So there’s nothing fundamentally though that happens in the business that we see would been a major discontinuities in our volume.
On the second question, on the Houghton retention, yeah. So from the Houghton retention perspective, no the key personnel and certainly that we want to have on the Houghton team continues to be with them and engaged.
Our next question comes from Edward Marshall of Sidoti & Company. Please proceed with your question.
Edward Marshall
I wanted to ask, you touched on inflation, I wanted to ask about situations and maybe there’s any pre-booked purchase from Asia Pacific that might drop off the significant year-over-year [role] in that particular region?
Michael Barry
There has been some pre-buy that we try to do for cases like this. So in general, if your question is kind of how does the tariff situation impact Quaker, I think one thing to keep in mind is, Quaker generally produces its products locally and uses local raw materials, that’s why we have so many blending facilities around the world. However there are circumstances where there are some specialty type raw materials where we have to buy from China or the US which are used in products throughout the world.
We have identified all these items that would have tariffs on them and we’re in the process of taking steps to mitigate their impact. These steps generally include buying the raw materials from another country if possible where we’re formulating our finished product to reduce or eliminate the tariff related raw material or raising the price on our finished products. In fact we constantly face circumstances all the time like this within the normal course of doing business with raw materials, it’s just one that’s more obviously tariff related.
So I don’t really see this differently in any way, and even if we couldn’t mitigate any of the effects of the tariff, we currently estimate that the impact to our gross margins would be at most a decrease of 0.3%. But I do think we will mitigate most or all of it and I don’t see this as an issue that will have a significant or adverse impact on results. So I hope this will give you a little more context.
Edward Marshall
And I notice that you broke out the market data with each segment in the quarter, and we’ll appreciate the clarity. And my question I guess aside from anything maybe regulatory was there anything that we should read into with the consolidation of the two businesses that might have given us a better luck and maybe that’s why you started breaking that down to 2Q I’m just curious?
Michael Barry
We’ve always been breaking at the regional performance historically, so that has nothing to do with that.
Edward Marshall
I meant that it looks like there’s primary metals, metal work (inaudible) within the each individual international segment now data in the quarter for this is just three months and the six month release. We could follow-up later that’s fine. And then the total investment it to happen now including all the fees associated with regulatory or professional fees. Do you kind of have a ball number as to the additional cost that we’re based on that you incurred with the delay of the transaction?
Mary Hall
Let me take that one and see if I can provide some clarity to that. So, we’ve spend just looking at 2018, if you look at the year-to-date numbers we’ve spent or booked roughly $10 million year-to-date and we said that we expect through and including close to spend another $30 million to $35 million. The bulk of that amount is actually due and due an ad close between 25 million and 30 million of that number. So if you think about the 10 million spend or booked year-to-date and then what should or run rate be for the rest of the year until we close in Q4, we estimate roughly 2 million a quarter. So some of the cost obviously that we incurred in the first half of the year, we do not expect to repeat.
Edward Marshall
And then finally has Houghton limited any investment in Quaker’s traditional business whether it’s from working on organic or inorganic opportunities?
Michael Barry
How are we winning it – have connection problem here a little bit. But nothing of all, we’re continuing to do business as normal and continue to invest as we need to, to keep the business growing very well organically.
Our next question comes from Mike Harrison of Seaport Global. Please proceed with your question.
Mike Harrison
Just to clarify the comments in Asia, you mentioned that there was some unusual component to the volume and I think the question related to tariffs was, are any of your customers doing any pre-buying in Asia-Pacific in order to make purchases ahead of tariffs being implemented. Is that’s what’s going on there or could you maybe give more details on the unusual strength there.
Michael Barry
I would just say, no we don’t believe there’s any pre-buying due to tariffs in China. I think we feel pretty good about that. I did mention though that we did see some kind of unusual, some timing issues with some shipments in this quarter or second quarter versus being in other quarters, and that could be – sometimes we split businesses at different plant locations with other suppliers during the year and sometimes I can hit one quarter versus the other. So there’s some of that. But even if you take that kind of out, which we estimate might be around 3% of that volume growth, you still have very strong 7% volume growth in Asia Pacific, which we believe is true growth that we’re getting in that region.
And then we’re kind of seeing the opposite effect a little bit in Europe. Europe was relatively flat, but there were some timing issues with shipments there or trials and there was also a piece of business that we gave up there that was due to profitability and credit issues. But if you strip out these timing things and these unusual things that there we would had good growth as well from a volume perspective.
So overall we are very pleased with the growth throughout the company, although you can see these quarter-to-quarter effects within a specific region.
Mike Harrison
And then was also just hoping to have a little bit of a conversation regarding pricing. I know that a portion of your sales are indexed to raw material costs or have some kind of a contractual pass through. Can you discuss that, is that pretty balance by region or is there region where more or less of your customers are indexed and then how does the indexing work. Is it just a key raw materials or is it the total cost of raws that you’re able to pass through to customers.
Michael Barry
We try to indices that mimic the entire cost of the customer from a product pricing perspective. Generally the ones we have are with larger customers. We estimate it might be in that 20%-25% of sales range that we have these kinds of contracts. And most of those contracts tend to fit, fall within North America and EMEA, but we do have impacts everywhere around the world with this type of (inaudible).
Mike Harrison
And then in addition to price increases are there other actions that you can take to overcome the inflation that you’re seeing in raw material costs and presumably freight costs as well? Are you able to shift customers to higher value products that may be better margin for you, but increase the values of the customer, are you reformulating certain products because of raw materials, taking cost actions, what other things can you do besides pricing?
Michael Barry
Yeah, I think those are two good apples, we’re always trying to obviously generate new and improved products that can add value to the customers and add to our value and margins as well. And then like you said, reformulation is always something that we’re looking at. We have these, for example, somethings historically we’ve done, but we’re doing in a lot of different cases. It’s where some products might take a palm oil, some products might take a coconut oil dependent upon what happens in the pricing of those markets can really skew the pricing and impact the pricing to a certain customer. Some customers’ will we can approach and say, if you’re able to take this product and have a substitute to this product, you know we can either keep the prices same or mitigate the amount of increase we have to have and then it becomes a customer discussion. So we kind of work with our customers all the time, it’s certainly part of our fabric where we are constantly doing a lot of other things to try to minimize the price we pay for raw materials and the cost of our products.
Our next question comes from Jon Tanwanteng of CJS Securities. Please proceed with your question.
Jon Tanwanteng
If I’m reading last quarters’ outlook correctly, you had expected around 36% gross margins for the year. So you’re seeing low to mid 36 is now even with some additional tariffs and FX and improved headwinds. So you’re essentially breaking that outlook, first is that correct and second is that based on the established pricing we have out there or there further increases in the pipe of your customers?
Michael Barry
We’ve been consistently doing price increases for the past couple of years. So it’s been constant process just because raw materials are continuing to go up and it looks like that’s not going to stop in the near future. Trying to predict gross margins can be tough, there are so many factors that impact it, so all over the place, raw materials being one of them. So, we believe what we have been saying and continue to say is relatively consistent with our previous guidance, so we don’t see it as a change in guidance per say.
Jon Tanwanteng
And then just secondly, on the impact of the tariffs, not so much on the margin perspective, but the shifting of revenues from region-to-region, are you seeing that at all and where would you expect to see gains and losses?
Michael Barry
Well we would expect, for example, with the tariffs on steel that you would see an increase in production in the US and maybe a decrease in production in other places around the world. As we said in the past, in some ways we’re indifferent to that because we generally have consistent market share and steel industry everywhere around the world, so we’re somewhat indifferent to where product is – the steel is being made. But in this case I would expect given the tariffs that the US which is already seen some modest increases in steel production and steel capacity utilization this year, we would expect most of the benefit or the change being in that region, but it could be offset in other locations that we normally come in to the US in the past.
Jon Tanwanteng
Does it make a different on an after tax basis at all?
Michael Barry
Not, marginally. It depends where it comes from. At China we have a very attractive tax rate as well. So there’s not a big difference what we see in China versus what we see in United States.
Our next question comes from Liam Burke of FBR Capital. Please proceed with your question.
Liam Burke
Mike you’ve got a value proposition for the steel production and so price increases generally you’re able to get through, it’s just a matter of time. On the other hand you’ve been able to consistently add share. Do you see a point where price increases may hurt your efforts to maintain those share gains that you’ve been having over the last several years.
Michael Barry
I feel a lot of the price increases is to really just be recovering what’s going on from a raw material perspective. So it’s really just trying to maintain the profitability level that we have with a certain product customer and a certain product line. As you know, we’re taking EVA approach to evaluating the business and we feel that by doing that, just keeping at what we consider the current values and just adjusted for raw materials that we can continue to do that, achieve our return that above our cost of capital and also continue to take share in the market place.
Liam Burke
And on the primary metals, steel production volumes will pretty much drive the business, that’s easy to track. On the metal working side, how is that business going, it’s not as clear what the underlying – I mean how easy it is to track the underlying drivers, but you’re still seeing healthy metal working markets?
Michael Barry
Yeah, our two major market, certainly one of those is a major market in metal working because there are so many parts of it that you ensure selling through a producer and there’s a lot of components to that too. So you always have – auto is always going to be good and auto is doing very well this year globally. Of course we care about global and its doing well.
Another market that I would point out is, tubing pipe that we’re in. We saw both coatings as well as lubricants and rust preventatives and certainly in the tubing pipe market and once we are going off that that’s helping us as well. So I think we’re seeing, in general it’s been a pretty good situation and then almost all the base markets that we’re participating in pretty broadly around the world.
Our next question comes from Mike Gyure with Janney. Please proceed with your question.
Mike Gyure
Can you maybe touch – I guess your forward strategy looking to the acquisitions realizing the Houghton expected to close here on the fourth quarter. Just how you’re looking at the market, are you looking at more domestic, you are looking at more international or how do you view the market for potential sellers out there?
Michael Barry
Yes, it’s our intent to view with our acquisition strategy. What we said certainly is once we complete the combination with Houghton then our first priority certainly is to pay down our debt to at least to the 2.5 times EBITDA level, that’s one of our big focuses. But in the meantime as we still feel we can do what we call these little bolt-on type of acquisitions. Once we hit this other milestone after two years of the combination we can then look at larger ones. So as far as what areas we look in, I think we were looking in a whole host of areas, but it’s not a regional or a country specific strategy because we are pretty much everywhere we need to be around the world. So it’s really where we find we can do a bolt-on that add a new product line or bring a certain technology that we have. We’ve done a lot of those in the past. It’s just kind of caught in as well as ones that are more direct competitors as well. They can be somewhat regional nature or they can be global in nature. So, we have a pretty nice list of potential opportunities that we constantly evaluate.
Mary Hall
And let me just add there to. The focus is in that metal working space where going forward where it continues even post our Houghton combination to be a highly fragmented space. So, we continue to believe we’re natural consolidator in that larger metal working market and that would really be the focus of our future acquisitions.
Our next question comes from Garo Norian of Palisade Capital Management. Please proceed with your question.
Garo Norian
Just wanting to understand some potential back half of the year items, is currency likely to switch to become a headwind from a tailwind in to the first half of the year?
Mary Hall
It’s certainly looking like that, that’s a possibility. The dollar has shown some strength here in the last couple of months and we’re continuing to track that but do believe that versus what we saw in the first half of the year that that could be a bit more of a headwind.
Garo Norian
And then secondly, with the Houghton combination to try to make it a little bit more logical, I guess for me. In the event it closed beautifully on September 30, so you had it for a full fourth quarter. Would it be accretive or dilutive in the first quarter or three months so to speak of ownership?
Michael Barry
I don’t want to get in to a specific circumstance around that, the guidance we’ve given around that Garo is that we definitely believe in the first full year that this will be accretive. It’s hard to say if we have it for a week or a quarter or exactly --.
Garo Norian
Understood. I appreciate it, that’s just going to be a messy fourth quarter.
Our final question is a follow-up from Mike Harrison of Seaport Global. Please proceed with your question.
Mike Harrison
Wondering if you saw any impact in your North American automotive business? There were some supplier disruptions that I guess impacted a couple of major production facilities?
Michael Barry
No we had a very good quarter in North America. No issues.
Mike Harrison
Just wondered, you mentioned that the expectation would be as tariffs are implemented that you would see better production in the US and better utilization from those steel customers in the US. Can you talk a little bit about how improving utilization rates in steel mill help your business? Is it just the higher volumes or do you see them upgrade the products they’re using or use more – a broader range of products as well, I guess conversely when utilization declines, is that just a volume impact or do you see some shifts in product usage as well?
Michael Barry
At a high level I tend to view this more as just a volume. Our product gets consumed per ton of steel produced. So if they produce more tons, they’ll consumer of our products. But there certainly can be circumstances when you start to get tight in capacity utilization that somebody would need a product that has higher capabilities to allow and to produce extra capacity. So something like that’s possible, but I would think in the kind of stage we’re in now talking about capacity utilization in the mid-70s and in the steel industry I don’t view that as a major issues, albeit just more of the volume that would impact that we would pick up from additional ones and of course we would have an offsetting impact with (inaudible) steel is not being produced somewhere else around the world.
Mike Harrison
And then the last one from me is just in terms of the raw material basket, you’ve talked in the past about kind of mineral plant and animal components of raw materials. Can you talk a little bit about, may be some details on what you’re seeing in each of those three thesis and what the outlook is, maybe what you’re most concerned about right now?
Mary Hall
Let me take a stab at that Mike. I think as you accurately pointed out, we’ve got the three biggies that we talked about, the mineral oil, vegetables oils, animal fats. Let’s say the one we are most concerned about most directly seeing rising raw material costs are those most directly related to crude which are the mineral oils.
What we said is overtime the vegetable oil and animal fats tend to track over time with the mineral oil just because of substitutability and bio-diesel and the like. But I think it’s the mineral oil trends that are as you said perhaps most aligned at this point in time. The vegetable oil for the time being actually seem to be behaving pretty well. But again those are points in time versus over time. So, does that help answer your question?
Ladies and gentlemen, we’ve reached the end of our question-and-answer session. I would like to turn the call back to management for closing remarks.
Given that there are no other questions we’ll end the conference call now. And I want to thank you for your interest today. We are pleased with our results in the second quarter and we continue to be confident in the future of Quaker Chemical. Our next conference call for the third quarter of 2018 will be in late October or in early November. And if you have any questions in the meantime please feel free to contact Mary or myself. Thanks again for your interest in Quaker Chemical.
This concludes todays’ conference. You may disconnect your lines at this time. Thank you for your participation.