Quaker Chemical Corp (KWR) 2003 Q2 法說會逐字稿

Good morning and welcome to the Quaker Chemical Corporation sponsored second quarter earning results conference call. At this time all participants have been placed on a listen-only mode and floor will be open for questions and comments following the presentation. I would now like to turn the floor over to your host, Mr. Ronald J. Naples, Chairman and Chief Executive Officer. Sir, the floor is yours.

Thanks very much and welcome everybody, thanks for joining us on a July white morning, and thanks in particularly for joining us on a Friday morning in July. Although if the weather is where you are anywhere like it is here in Philadelphia it's just as well to be inside. So I hope you're doing better than us in that regard. In any case, as we've done in the past, we're going to cover the second quarter briefly, and then we'll be taking any questions that you have about our performance or anything that's on your mind. Mike Barry will present along with me, our Chief Financial Officer, and Joe Bauer, our President, is also here to help answer any questions.

I'd like to talk briefly about the second quarter of course, but more important I want to highlight some of the long-term steps we took in the quarter concerning acquisitions and in particular our expanded CMS effort because really, and in the terms of the long run, those are the things which are going to really be the key factors. As the press release points out, we beat the second quarter by -- or last year's second quarter by 1 cent in this year's quarter results. Our bogie is always to beat the prior year, so we made that one but it is actually below our expectations for ourselves. And we got to that result in a different way than we expected because the deeper we got into the quarter the more important -- the more apparent it was that the demand was having a hard time with prior year comparisons, and also margins weren't what we had hoped for. On both these questions, demand and margins, Michael has a little more to say.

But just as kind of a top line, the point is on margins in particular that raw materials again were the culprit as they were in the last quarter. We were also hurt by mix, both product mix as well as geographic mix. That was also true last quarter I should point out. And the way that hurts really is in our -- some of our traditional strongest margin areas such as for instance business in Europe, we had weaker comparisons in the second quarter, so that hurt us a bit. It's important to note, though, as you think about our profitability and our margins that the gross margin you see on our income statement is not driven by these factors alone because, as the press release points out, and as we tried to prepare for last quarter, the addition of the CMS business that we won a few months ago had an impact on those margins. So, the reported gross margin is affected by that. And if you strip out the effect of the CMS business, which Mike will go over with you, you'll see that margins do come down, but they're not down the kind of break that's noted in the income statement itself.

So, and the bottom line is that we managed to deliver the quarter in terms of an increase over prior year through management of other parts of the income statement. Sales, as the press release points out, were a record for a quarter, that's including the CMS sales. If you take out the CMS sales, it's still a record for the quarter. Of course those -- still a quarterly record at sales of almost 77 million. And of course that's helped to acquisition then these days a favorable exchange which is a pleasant turnaround for us from what we were facing for the last six or seven years. If you look around the world in terms of demand, we really have a mixed bag. Among both geographies and our businesses and how it splits out between steel and metalworking.

In sheet steel we see New York and the U.S. are having the hardest comparisons. We've noted that the large steel makers are carefully watching how they're using their capacity so that they don't overproduce the demand requirements. They're obviously paying a little more attention to protecting their pricing than has been traditional in that business. In the long run that's probably good, but it does hurt us a bit in the short-term. Asia and particularly China has been doing relatively well, there's pretty strong demand growth there. It's pretty strong demand growth for us in these markets and it's reflective of the steel manufacturing growth there. And South America is in the same boat. So if you look at them overall, Europe and the U.S. are having a hard time with prior year comparisons in terms of our business and also in terms of their production with prior year. Asia and South America are moving along pretty well.

China is a particularly strong market in Asia. And it had a notable impact on the steel markets in the second quarter. China continues to be a net importer of raw sheet steel. So that helps in terms of demand from around the world. One of the difficulty of the second quarter is that the import quotas in China have already been filled really late first, early second quarter, so you didn't have that impetus in the market. New quotas are coming available, but there's still question marks about the inventory situation there and precisely what production markets will be helped. But the bottom line, China is a pretty good driver in the steel business still. Metalworking around the world we see that auto production demand is down both in the U.S. and Europe. And for us that's true also. In Asia, and in South America, our demand is doing okay and Asia does not have much of an impact on the metalworking business but South America has been rolling along okay. So as I said, between steel and metalworking and the geographic mix it's really a mixed bag.

The important point of all this that seems to come down for me comes down to that we're still in a very strong position in our markets. We've not lost that share overall, in fact we're building share over the years, and we're in a strong position in these markets that still have a lot of demand uncertainties around them and are affected by economic conditions. Indeed the vagaries of these markets and the demand patterns that we see over the years point to the importance of doing new things to continue our growth. Particularly in our own case given our self imposed demand for consistent performance in our business, and this in a very inconsistent world. So we have continued focus on adding to and spreading our business in areas and ways that give us the maximum chance of success by sticking with things we know. The real premium is on, one, building market share and deepening our penetration of customers. And two, getting into businesses and new markets in both our major businesses.

So the things that we've been focusing on over time, and in particular some of these things came to the surface more in the second quarter, are one, our internal efforts at market expansion, programs like tube and pipe, coatings, dry coat, these are market expanding efforts in different stages of development in the company, but all of them are focused on expanding our market reach, and all of them are based on internal development efforts. Second, is efforts we've made about deepening our customer penetration. CMS is an excellent example of that and, in fact, it's the prime way that we can get into our customers, learn more about them and give us more opportunities in them. And third is market share expansion and new market -- and the effort to get into new market segments through acquisition. Those are three things that will continue to affect our long-term and those are three things that have been going quite well for us and in which we have made a great deal of progress.

In the second quarter specifically we made strides, particularly in the latter two areas with customer penetration through CMS and through acquisitions. CMS is an important opportunity for us to build leadership in our markets worldwide, particularly in metalworking and it's an important opportunity for us to build product market share in networking. The bottom line of CMS is that it's a way to build our value to our customers. What that allows is we can build share. It provides us a window to our customers in a way nothing else does, because we are actually inside their businesses helping them to do better, learning about their needs, learning about the opportunities to develop new products, really becoming partners with them.

We talk a lot internally about creating value for our customers and becoming indispensable to their operations. Well, CMS is the way to do it. It's really a way to deliver on the value proposition that we have been building our business around. Right now, CMS is largely an automotive industry initiative. But the experience we have there will help us build this kind of activity in other sectors as the opportunity arises. Whether it becomes steel or whether it's in the industrial sector, what we learn and how we good we get at CMS will carry over into these other businesses.

And over time as our value becomes clear, we can use our global industry integration to serve global customers in a way our competitors can't, which is to say given our focus on a global organization and global knowledge and globally integrated operations, the better we get at CMS, the more important we will become to global customers and the more that will help us build our competitive position vis-a-vis our own competitors. So we think CMS is an important part of the growth in our businesses in terms of building market share, in terms of building partnership with customers and delivering value. It's a very strategically important business pillar on which we can build.

We've been in CMS for a while but, of course, the extent of CMS has increased dramatically, given some of our latest activity that we talked about regarding GM and other customers. So we're still in the process of learning to run that business in a new way, and that will give us some short-term challenges, but we have a great deal of confidence in the business for the long run.

The last area I wanted to mention, which I've already mentioned but wanted to talk about a bit more, was acquisitions. We made two acquisitions in the second quarter. We announced them in the second quarter. They were certainly small but they were indicative of our determination to find tight fits out there that bring something important to us, whether it be a good customer relationship or new technology or access to new customers or new market segments, and businesses that are tight enough fits that they can allow us to leverage their profits. And I believe both of those things or all of those factors fit into the second-quarter acquisitions. One was a small German cleaner business. We bought a business that allows us to expand our competitive position in steel in the cleaner business in Europe, something we had not made much of an impact in. It stacked us up a little better against one of our prime competitors there. It's more of a technology base than many other cleaner businesses, so we hope that's a business of which we can build value. And it fits excellently with our market access, since we're already in all these steel makers anyway.

So it's very small, but we think it gives us an interesting base to build on. The acquisition we announced just last week was an Italian metal working business, the heart of which is a geographic expansion in metal working in the Italian market specifically, but also with some complementary technology and some technology synergies that should help us exploit new market segments in other parts of the world as well. So we think that we get benefit from both of these acquisitions, both financially and business wise, and that's an important part of our moving ahead.

So the net of all this is that we remain as committed as ever to current performance. We've talked a lot in our company about consistent performance being a priority, and we stay focused on that. But in the face of that, we're increasingly building our long-term promise. It's always a challenge for a business to find the right balance, the right mix of long-term and short-term, and we hope we have found that balance by staying committed to current performance as we've been investing for the long-term. I wish our markets were stronger right now, but wherever they stand, I believe we're in a good position to compete effectively there. And as important, we're building -- our long-term business building balance is strong and getting stronger. I think in the second quarter, you saw the addition to that face for the future. With that, I'll stop and turn to Mike, and he can cover a bit more of the detail for you.

Thanks, Ron. Good morning everyone. I'd like to discuss some of the components of the P&L for the second quarter in more detail. As usual, I'll start with sales. Revenues for the second quarter compared with the same period last year were up 20% to a record $83.5 million. There were some significant swings in some of the major revenue components, and I'd like to review these components now. First of all, the new CMS contract revenues represented 10 percentage points of the growth. Currency translation primarily due to the stronger euro increased sales by 6%, as the average euro rate was 1.14 this quarter compared 0.92 during the second quarter of last year.

So you can see that the new CMS contracts and the change of currency accounted for 16 percentage points of the 20% of growth. Acquisitions also had an impact as the timing of the 2002 acquisitions of Epmar and a controlling interest in our South African joint venture accounted for 3 percentage points of the growth. Product volumes of our businesses without including the acquisition and the new CMS contracts were down 5%, primarily due to weaker demand in our steel business. And price and mix effects accounted for 6 percentage points of the revenue growth, although approximately half of this increase is due to higher prices in Brazil which were necessary to recover some of the currency impact on raw materials.

As I usually do, I'd like to now give some revenue data on a segment basis. As you may recall, we had segmented business into three areas, metal working process chemicals, coatings, and other chemical products. Metal working process chemicals are products used as lubricants for various heavy industrial and manufacturing applications, and make up approximately 90% of our sales revenue. Reported revenues in the second quarter compared with 2002 were up 22%. I'd like to break down the major drivers of this 22% growth in the segment. Again, the new CMS contracts accounted for half of the revenue growth or 11 percentage points. Currency accounted for 7 percentage points of the growth, and the timing of the purchase of a controlling interest in our South African (indiscernible) accounted for 3 percentage points of the revenue growth. So these 3 items accounted for 21 percentage points of the 22% growth in this segment. The other 1% of the growth in this segment was made of some large swings in our regional businesses. For example, our U.S. business was down 10% without the new CMS contracts, and our European business was down 1% on a local currency basis.

However, offsetting these declines was an 11% increase in our Asia-Pacific business and a 45% increase in our South American business, with much of this increase due to higher prices needed to somewhat offset the currency impact on raw materials. So while our global base business was close to flat, you can see there were some major regional growth differences as the U.S. and Europe declined and Asia-Pacific and Brazil grew.

Our second business segment is coatings, which makes up approximately 8% of our sales and contains products that provide temporary and permanent coatings for metal and concrete products. Revenues for this segment were up 8% in the second quarter of 2003, compared to last year, primarily due to the timing of our acquisition of Epmar. However, base revenues declined by approximately 8%, primarily due to lower maskant sales to the aerospace industry as a result of lower aircraft builds.

And our small business segment represented approximately 2% called other chemical products. Sales were up 27% versus the second quarter of 2002. This segment was higher primarily due to our Q2 technologies joint venture which produces sulfur removal products for industrial gas streams.

Now I'll move on to gross margin. Gross margin as a percentage of sales declined from 41.7% for the second quarter of 2002 to 34.7%. As we mentioned previously, the company's new CMS contracts have caused different relationships between margins and revenues than in the past. At the majority of our current CMS sites, the company effectively acts as an agent and reports revenue and costs from these sales on a net sales or pass-through basis. The new CMS contracts have a different structure which results in the company recognizing in reported revenue to gross revenue received from the CMS site customer, and then cost of goods sold to third-party product purchases. These additional revenues and costs will substantially offset each other in the short-term since the company has very little of its own product converted as of yet at these sites.

The negative impact of gross margin for the second quarter related to the new CMS contracts is approximately 3 percentage points. In the second half of the year, we will see the full impact of the new CMS contracts, and we expect the negative impact on a gross margin percentage basis to be approximately 4 to 5 percentage points. The remaining decline in the second quarter gross margin percentage of approximately 4 percentage points is due to increased raw material cost, as well as some product and regional sales mix. On a full-year basis, we continue to expect overall raw material cost to be higher in 2003 versus 2002, due in part to the continued high oil prices. However, we also expect raw material prices to be somewhat more favorable in the second half of the year versus the first half of the year.

The net result of all these factors is that we expect our gross margin percentage to improve in the second half of the year. Excluding the impact of the new CMS contracts, we project the gross margins to be near 40% which is where we were in the second half of 2002.

Moving down to P&L, I'll now discuss our SG&A and other expenses. Reported SG&A of 23.2 million is essentially flat with the 23.3 million last year. Increases from foreign exchange rates and the timing of the company's acquisitions in 2002 were offset by reduced incentive compensation expense and cost containment efforts throughout the company. As previously disclosed, we do expect higher SG&A cost for the full year, partially due to increases related to our pension insurance and (indiscernible) implementation.

The other income category variance is primarily due to a 300,000 positive P&L impact related to a $2.4 million priority cash distribution from the company's real estate joint venture. Net interest expense is higher than the prior year for the second quarter, primarily due to lower interest income from the company's international affiliates. For example, last year we had more cash in our Brazilian entity, which was earning interest at nearly 20%. We made a decision at midyear to bring back this money due to the potential for the real to weaken, which it did, so it was a good decision. But this is the result of a decrease in our interest income.

Our effective tax rate for the second quarter of 2003 was 31%, to bring our year-to-date effective tax rate to 32%, down from the 33% in the first quarter. The decrease in the effective tax rate on the first to second quarter is primarily due to our favorable settlement of outstanding tax audits and appeal issues related to several Florence (ph) subs. We currently anticipate our effective tax will be 32% for the full year of 2003. Of course, many external and internal factors can impact this, and we will continue to revise this number as the year progresses if necessary.

Continuing down the P&L, minority interest was higher for the second quarter of 2003 compared with the same period last year, primarily due to the purchase of a controlling interest in our South African joint venture. And equity income is lower for the second quarter compared to last year, primarily due to weaker performance from our Venezuelan venture and the consolidation of our South African joint venture, but partially offset by approved results from our real estate joint venture.

Now I'd like to make a couple comments concerning our balance sheet. Many of the line items on the balance sheet have been impacted by the stronger euro. This would be a common theme if I were to go up and down the balance sheet and explain each account. Concerning our leverage, our debt to capital ratio remains strong at 27% at the end of June compared to 26% at the end of March, 25% at the end of 2002 and 34% at the end of June of last year. As we mentioned in our press release, we increased our available credit lines since the end of March from 25 million to 50 million currently. The 50 million is made up of $30 million committed and $20 million uncommitted. At the end of June, we had approximately 17 million outstanding under the credit lines.

We have increased our credit availability by bringing in additional banks in order to increase the number of banking relationships, which we feel would be valuable long-term for the company. In addition, the additional liquidity would be ready as we continue to look for tight-fit acquisitions as we have done four times over the past 16 months. On our cash-flow statement, I wanted to point out that we received 4.2 million in priority distributions from our real estate joint venture in the first half of the year. In the second half we also expect to see an additional distribution of about $225,000. Also, there is a significant decrease in cash related to increased accounts receivables. The increase to accounts receivable are primarily due to the start-up of the company's new CMS contracts, as well as increased sales volume quarter over quarter.

So, in summary, we made 36 cents per diluted share for the quarter and 69 cents per diluted share that year-to-date. For the full year, our current projections are that we will slightly exceed last year earnings of $1.51 per diluted share with the third and fourth quarters earnings level being approximately equal. That concludes my prepared remarks.

Thanks, Mike. Now we'll turn to any questions that you all may have.

The floor is now open for questions. (CALLER INSTRUCTIONS) Christopher Cook, please state your affiliation.

Susquehanna Financial. Good morning. A couple of questions. First on the CMS business, you've been having some success. Can you provide some indication for us in terms of the total %age by the end of this year of what that business will represent in terms of revenue?

It's approximately going to be about 13% of our revenue. So our revenue -- let me put it a different way -- would be 13% higher approximately if we had not done the new CMS contract.

How aggressively are you pursuing this, and do you expect any additional wins this year or early next year?

Joe, do you want to talk about that?

There are a couple contracts, Chris, that we are currently negotiating, but it's too early to really predict exactly whether we will be able to acquire those are not. But as Ron indicated in his opening remarks, we continue to focus on this because we do think it's strategically important from a positioning point of view with our strategic customers. But at this time, I don't really feel comfortable making any kind of predictions, but there are other customers that we are looking at where we're bidding on CMS contract.

Let me just add to that, Christ, that obviously we can't always predict whether we'll win or not, but what we are doing is being -- let me put it this way -- aggressively selective about the business that we go after. Because as far as we're concerned, not all CMS is created equal. It's important to have the right customer relationships in the right facilities so that you have the kind of opportunities to improve the business and grow the product business. If you can't get those things, we think it probably doesn't make a lot of sense to be doing it. So we think it's important that we grow the CMS business, but we want to be, A, selective about where we do it and how we do it, and B, we also want to be mindful of the capacity we have to do the business so that we don't get too far ahead of ourselves and be in a position where we've overwhelmed our own capacity to deliver. So I guess the net of all that is yes, we're out there looking for new business, we are going to be bidding on new business. But we're trying to do it in as planful and as controlled a way as we think makes sense to make sure that we are successful with what we're doing.

Very good. In terms of how business has been progressing throughout the quarter, did you notice any change month to month throughout the quarter and maybe even into July here?

I think as a general comment, I think in my own comments I said that the deeper we got into the quarter, the tougher the demand comparisons became. I wouldn't say that was dramatic, but kind of at the margins it seemed to me to get a little tougher the further we got into the quarter.

Would you say that's continuing right now?

I'd say it's kind of going along. It's hard to read right now. A, it's earlier. We don't really have the numbers for July yet, of course. Some of the early indications are that parts have been good end parts remain about like they were, not any softer but about like they were. Of course, it's compounded in the summer by slower production for shutdowns and that kind of thing. So it's -- I hate to give you a big maybe, Chris. Let me put it this way, I don't know we've seen a lot of change from what we observed as the second quarter was ending.

Very good. Thanks a lot.

Robert Kosowsky.

Sidoti & Co. Hi, guys. I'm just curious as to what are some of the factors that led to the product mix decline. Are you seeing some customers asking for like price concessions on some of your fluids, or are they looking for less value-added products?

I think a lot of it, Bob, is really due to regional mixes. As I mentioned in my comments, we do see Asia being higher, South America being higher, and Europe being down a little bit, U.S. being down. So in those regions and some of the businesses we have in those regions might have had higher margin business. But a lot of it tends to be on a regional basis. A lot of the decline we saw, I think, quarter to quarter was really due to raw materials. Raw materials at the point where they were in the second quarter of last year is really at a low point probably in the past two years. The second quarter of this year is really kind of a high point in the past two years. So a lot of that variation is raw materials. We really haven't seen price erosion in our markets.

As part of the pension fund contribution so far, how much have you guys contributed year-to-date, and are there any thoughts on 2004, or is it still too early to tell?

So far it's about half a million, and for the full year it's going to be about a million and a half. For next year, we project it to be roughly about a million or so.

Okay. One other additional question, I'm just kind of curious as to how many -- as far as the chemical management contracts, how many people are actually down in the plants? And have you added any people to kind of help with this process, and do you guys expect to hire some more people to be in the plants?

We've got a major hiring effort underway, because when you do the CMS you actually go into the plant and you manage our chemicals, is what it comes down to; from ordering inventory to controlling application to making sure it's clean. So it's a total management process. I guess -- what would you say is the increased headcount, Joe?

For the power train plants that we just took on, we hired roughly 50 additional people to support those.

I guess as you guys pick up incremental contracts, you might be picking up additional people as needed?

Absolutely, because you need the people to do the work, and that's the way you can deliver value to your customers.

One thing on the CMS, the benchmarking is a key issue with us, so the people in the plants are gauging exactly how we are doing against the benchmarks that we established for the plants. So, as Ron said, we are selective in our choices of where we go after CMS contracts based on the opportunities we see to provide additional value to the customer as well as to ourselves.

Thank you, guys. I'll get back in the queue.

Thanks, Bob.

Robert Pefetch (ph).

This is Greg Mokosko (ph). Could you talk a little bit about the metal working area. You mentioned that it was down 10% in the United States and Europe. Would you say that there is any impact from CMS on those areas, and the point being that CMS is an interest area for customers and is it having an impact on the existing metal working business?

That's a pretty big question. I don't think CMS per se is having an impact on the existing metal working business. What it is is a way to deliver -- A, to ship our share of that business, and B, a different way to deliver the value to the customer. In fact, we expect our business will grow through CMS, not decline. Naturally, we would be disappointed if we were declining our product -- if our product business were declining through CMS. And the whole intent of this is to build our market share with these customers. I'm not sure that gets at the heart of your question. Did we miss it?

No. Again, is the marketing and talking with customers, etc., does that make them perhaps rethink about what they're doing and in terms of just making decisions say for new contract or expanded service in the existing business, just have an impact on what's there? Or is it really purely economic, the year-over-year decline without CMS?

Oh, yes, if you're talking about our specific market situation. I don't think the decline has any relationship to the fact that we're doing CMS business. I think we're looking at market conditions. I'm sorry I missed that.

With respect to the steel business, you mentioned that because of capacity, etc., and that does make sense. Just to help me better understand, how much of the steel rolling business would be -- the steel business would be with regard to mini mills versus integrated? I'm assuming most of it is with integrateds, but give me some color on the mini mill side of the business.

Well, you're right that most of this is integrated mill business. I think the mini mill business is growing and probably mostly in the United States. If you look overseas, particularly in Asia, the business is really still dominated by integrated mills. In fact, in our business which is high-quality rolled sheet, the integrated mills are still where the game is played because, in most cases, the mini mills don't meet the quality levels to supply, say, the automotive guys. So I don't have off the top of my head the specific breakout of that business. Do you have a sense of that, Joe?

No, but I would say that it is very small, the mini mills that we have any business with. I know less than 10%.

Yes, I'd say over 95% of our business is with integrated.

In fact, one of the acquisitions we made last year was -- one of the motivations for an acquisition we made last year of United Lubricants was improved position with the mini wells, because obviously that set up a piece of business that we want to make sure that we're there serving their needs and finding ways that we can increasingly serve those needs. But we're a cold-rolled sheet where high-quality sheet is concerned. It's still really an integrated mill game.

Have you benefited -- is there any benefit for some of the re-openings that are being talked about, the old LH businesses, I guess?

LTV.

LTV, excuse me.

Yes, we certainly hope so. It creates more market demand and creates more capacity that we can be part of filling, and you can bet we'll be out there competing for that business.

Thanks very much.

Thanks for joining us.

(CALLER INSTRUCTIONS) Mr. Naples, there appear to be no further questions at this time.

Thanks for joining us everyone. We certainly appreciate your interest and I wish you all a pleasant rest of the summer. We will be talking again in the fall. Thanks for joining us.

Thank you, that does conclude today's teleconference. Please disconnect your lines at this time and have a wonderful weekend.