Quaker Chemical Corp (KWR) 2006 Q2 法說會逐字稿

Greetings ladies and gentlemen. Welcome to the Quaker Chemical Corporation second quarter 2006 earnings conference call.

[OPERATOR INSTRUCTIONS]. It is now my pleasure to introduce your host, Mr. Ronald Naples, Chairman and Chief Executive Officer of Quaker Chemical. Thank you, Mr. Naples. You may begin.

Thanks very much and good afternoon, everybody and welcome and thanks for being here. In attendance with me today as well as Neal Murphy our CFO. Our process this afternoon will be typically as it is. I will say a few things, Neal will cover in more detail, and then we'll have time tore questions. We will try to keep our comments brief.

You've seen the press release by now and it tells the story. $0.30 quarter which we feel is a good quarter as our first quarter of this year at $0.26 and especially against our second quarter of '05 at $0.18. Our sales in the quarter were our highest ever for a quarter, up almost 11%. In fact, it includes -- the quarter includes our two highest sales months ever.

We're really pleased it was a good solid quarter. It begins to show that we're on the way back from the volatile environmental shifts of the past couple years and the impact they've had on the business and it allows us to demonstrate we're beginning to realize the promise of many of the Management actions we've taken over the same time with pretty unblinking view of the facts as they were confronting us. Market actions and some of the growth commitment that we've put in place where China is concerned, our internal responses, so it is great to have a quarter that is focused on building on our past steps even in a face of I must say no relief in our biggest challenge, raw materials, and I will say more about that in a moment, and two a quarter that delivers that helps us to point us in a way back to the financial performance that we've always had, and the financial performance we plan to rebuild.

So it was a quarter without the drama of reacting to big shifts and the financial noise of some of the past quarters. One piece of the drama that did apply, however, is that there was tho break from the raw material pressure that we've seen over the last couple years. In fact, it may have even exacerbated a bit. In the second quarter of '05, we saw average oil prices somewhere in the low 50's where second quarter of '06 our realized price was somewhere in the low 70's, pretty dramatic change.

It just adds to the tremendous challenge oil has been or more accurately the refined products we use that flow from oil have been to us over the past couple of years. Our recent financial results indicate that we have and we are dealing with a challenge working with our customers on pricing and contractual arrangements that seek to find a good mix of serving both our purposes but nevertheless recognizing our cost realities and two build our volumes through building share in some of our markets and penetrating new markets. We greatly appreciate the confidence of our customers in working with us to get this done, and we of course are staying focused on continue to go earn more business.

I talked a bit a moment ago about an undramatic quarter. It has been a long road for mid-2004 when oil prices began their wild ride and gross margins have been in the mid-30's range. Today with percentage margin stabilized although at a lower level, slightly over 30%, and at a time when we had seen margins slip below this level but now back up a bit even in the face of the tremendous kind of oil price difference between '05 and '06 I mentioned a moment ago. We're working to maintain these better stabilized margin levels without counting on any raw material cost relief. In fact, I think Neal will say a bit more about this later. We're internally focused on improving the dollar margin per unit of sales even as a significant gross percentage of gross margin improvement is hard to come by just by the dint of now the math works.

Of course below the line costs today and cost management is as key today as it has ever been. In the quarter, our gross margin dollars were up over 10%, but our operating income was up 75%. You can see the effect of trying to manage that combination below the line cost and gross margin dollars. We're staying vigilant on this even as we recognize we are in a high service business and we have to work to keep up the level of service to our customers and, two, that we need infrastructure expense investment in places such as China as we seek to build our market position that builds on top of the strengths we have there today.

As I reflect on getting to this quarter, I am struck that along the way, along the long ride here, we reacted externally and internally to broad range of dramatic changes. Our external world has seen unprecedented and raw material movement, both in terms of the size of the movement, oil in the mid-70s now, the speed with which it happened, the volatility we've seen and the duration of the change. Those of us who are old enough to remember the early 70's when we had the long gas lines also remember while the price change was dramatic, it only lasted a few months. That's a far cry from the two years we've seen recently with no end in sight.

We've also seen a world of demand in consistency in different places around the world, particularly in automotive markets. We've had to deal with a whole range of customer issues. As many of our own customers confronted their own challenges with market changes and with competition.

We responded externally with pricing efforts to reflect the cost realities we're seeing and the kind of relationship we want to build approximate our customers. We rethought some of the contractual relationships we entered into along the way particularly regarding CMS. We've undertaken a range of business development actions from extending into new markets and mining is an example of that, getting into new businesses and building our position in new businesses. Our business is an example of that and building share both in steel and metal working around the world and particularly in places like China.

We've also committed to investing in the operating strength we have where we think that we have opportunity, and of course one of the main areas there is China. Internally we've reorganized to lineup better with the market challenges and customer relationship issues that we wanted to deal with and to establish better financial accountable. We've taken dramatic restructuring actions including stack reductions including change the the way we work in some areas to help us make better progress on cost control.

Looking ahead, I look back on a first and second quarter that indicate promise, that show that we've begun to dig our way back from the doldrums but also looking ahead I climb it is premature to say we're around the corner and the world will be more hospitable to us in the future than it has been in the past couple of years. We're still -- there is still much in our environment that will make demands of us. I also believe that we are as well positioned today as ever to manage in the world as we find it and that we're planning stay focused on steady progress.

With that, I will turn it over to Neal, and he can give you more detail on the quarter.

Thank you, Ron, and good afternoon, everyone, and welcome. As Ron mentioned, we announced record quarter sales of $118.7 million and diluted earnings per share of $0.30. This compares to sales of $107 million and diluted earnings per share of $0.18 for the second quarter of 2005. The improvement in net income versus the second quarter of last year was really driven by volume growth, pricing actions, strong performance from our CMS channel, and SG&A cost control.

Second quarter revenues were also 8.1% higher than the first quarter of this year and net income has improved from the first quarter by 18%; 3 million from 2.5 million. I will spend the next couple of minutes focusing on the second quarter and we'll then open the floor for questions. Revenues for the second quarter compared with the same period last year were up 11%. Revenue growth would have been 10%, but for foreign exchange movement which had a $1.1 million or 1% positive effect on revenues. Revenue growth was driven by a combination of volume and pricing improvement with the bulk of the volume growth occurring in the United States and China and the pricing improvement broadly across all of our regions and market segments.

The positive foreign exchange impact on revenue was due to a stronger Brazilian real, higher prices reflect continuing efforts to work with our customers to recover high raw material costs, and strong volume growth with low double digit increases in our volumes in both Asia, North America, flows from a combination of continued growth and demand in these markets as well as increased market penetration, particularly in Asia where as Ron mentioned we continue to expand our operations.

Sales in the steel sector were generally strong across all regions. Pockets of softness in sales in the automotive sector in parts of Europe and South America offset the steel growth in those regions. In contrast to this time last year, when we were quite concerned about softening demand and excess inventory at various points within the steel supply chain, global demand has been strong this year and steel prices have generally been firm and inventory levels are at more normal levels as compared to history. There has recently been a bit of slippage in steel prices in China with resulting concerns about possible supply demand imbalance later in the year, but we have not seen any impact of that as yet in our business.

I would like to now give some revenue data on a segment basis as you may recall. We segment our business into three areas, metal working process chemicals, coatings, and other chemical products. Our largest segment, making up 92% of our sales is metal working process chemicals, which includes products used as lubricants for various heavy industrial and manufacturing applications. Reported revenues in this segment for the first quarter compared with the first quarter of 2005 were up 11%. Growth in sales in this segment is largely reflective of pricing actions, strong volume growth in the U.S. and Asia, and some positive impacts from foreign exchange.

Our second business is coatings, which makes up approximately 7% of our sales and contains products that provide temporary and permanent coatings. Sales for this segment increased $1.9 million or 28% due in large part to higher chemical milling masking sales to the aerospace industry which has had an recent increase in the aircraft build rate. In our smallest segment representing approximately 1% of total sales called other chemical products, sales were down $0.8 million. This small segment has a limited customer base with an erratic order pattern, resulting in fluctuations in quarterly sales levels.

Return to gross margin. Gross margin is a percentage of sales of 30.4% this quarter was an improvement over the first quarter of 29.6%, and slightly below the 30.6% from the second quarter of 2005. Our persistence on a pricing front has enables some degree of margin stability despite dramatic escalation in raw material costs over the past year and continuing into the second quarter.

As Ron mentioned, gross margin in dollar terms was up more than 10% or $3.4 million on the strength of improved volume and stronger performance from our CMS channel. In CMS, we've improved the terms and conditions of key contracts, we've generated internal processes efficiencies, and we've gained higher Quaker product sales through this channel.

While the second quarter shows stability both with the first quarter of 2006 and with the second quarter of last year in terms of margins, it is still the low levels from the not too distant past, and I would like to try to provide many perspective on this. Our gross margin in late 2003 and early 2004 immediately prior to the commencement of the continuous raw material price spiral that we're experiencing hovered in the 33 to 35% range, and while our pricing efforts over the past two years have enabled us to substantially offset the dramatic spike in raw material cost during this same period, we have not ben able to restore margins to the levels achieved immediately prior to this continuous period of raw material escalation.

Raw material escalations have resulted in an increase in annual cost of goods sold of 30 to $35 million over this two-year period, so that we've increased our cost of goods sold by $35 million on an annual basis, and we've been -- we accompanied this by associated increases in selling prices. The magnitude of this increase, though, has altered the relationship between gross margin and sales by approximately 2.5 percentage points.

In other words, even if we fully recovered raw material costs through pricing actions, the sheer magnitude of these cost escalations drives our gross percentage margin down -- our gross margin percentage down by approximately 2.5 percentage points as compared to the late 2003 early 2004 levels. Thus while we're achieving substantial raw material cost recovery in our selling prices, gross margin recovery is elusive and this continued environment of high raw material costs.

We continued our ongoing pricing efforts to improve margins as an important part of our every day business activities. Any substantial forward gross margin percentage movement, however, will likely be driven by a substantial movement in raw material costs.

We move down the P&L to SG&A. Reported SG&A of $29.8 million this quarter is $0.7 million higher than the second quarter of last year. SG&A as a percentage of sales has been reduced to 25.1% for the quarter as compared to 27.2% in the second quarter of 2005. Cost savings from restructuring efforts completed in 2005 are on pace with expectations, and they substantially offset increased spending and higher growth areas such as China as well as higher variable compensation, inflation, and other increases.

We continue to believe that SG&A for the full year will be similar to the full year 2005 in absolute dollar terms. The decrease in other income was the result of larger foreign exchange gains in 2005 versus 2006. The increase in net interest expense over the second quarter of 2005 is reflective of higher average debt balances outstanding during the second quarter and also higher rates. Our interest rates have moved upward by about 2.5 percentage points over the last year.

Our tax rate, the effective tax rate for the second quarter is 39.3% versus 32.5% for the same quarter last year. Many external and internal factors impact this rate. The most significant of which is shifting income levels amongst various taxing jurisdictions. We continue to explore opportunities to reduce our effective rate, and we currently anticipate that the second quarter effective tax rate will be the high point for the year.

Continuing down the P&L, equity income is essentially flat. The minority interest with lower for the second quarter of '06 compared with the same period last year primarily due to reduced business activity and profitability in the Company's minority affiliates. From the balance sheet, the Company's net debt has increased from December 2005 primarily to fund working capital needs associated with growth initiatives as well as the restructuring actions taken in the fourth quarter of 2005 but paid for in 2006. The Company's net debt to capital ratio was 39% at June 30, 2006, very much in line with the 40% at March 31, 2006, and above the 35% of net debt to total capital level at the end of 2005. That concludes my prepared remarks.

Thanks, Neil. At this stage we would like to take any questions that people may have. I will turn it back over to our AT&T person.

[OPERATOR INSTRUCTIONS]. Our first question is coming from Robert Felice of Gabelli & Company.

Hi, gentlemen, just have a couple questions if I may. Hoping you could shed some color as to the improvement in the CMS business. I would imagine it has something to do with the negotiations on contracts that got greater pricing over the last couple of months. Can you shed some color on that?

Neal, do you want to?

Sure. Certainly we had we've been in the CMS business now for many years, and we moved into a different model in the middle of 2003, so we've really moved up the learning curve in terms of just internal process efficiencies and managing the whole business. Certainly, there were some CMS contracts that had terms that weren't acceptable to us, and we worked with our customers to improve those terms, but we've also used the main strategy behind CMS was a channel to market, and it has been a very successful channel to market for us, and we have been able to move more and more Quaker product through that channel. It is a combination of a few things and certainly improved terms and conditions on certain contracts are a part of that.

Okay. Could you perhaps quantify the impact that its had year-over-year, I guess on the operating income line?

We don't really look at CMS as a separate segment or anything like that, so we don't disclose that as a separate profitability item.

Okay. And then forgive me, I am not recalling offhand, but could you remind me how much you anticipate your restructuring will save in 2006 on the SG&A line versus '05 and then where specifically if you can highlight where some of that cost improvement is coming from?

Yeah. The estimate and it looks like it is coming to fruition was in the 8 to $10 million range, and it was really concentrated, Bob, in Europe and the United States, and very much across the board amongst both the staff support functions and the front line and research, so it was -- we really went through a functional analysis of each of the departments and looked where it was prudent to make reductions, so now as I think we've mentioned in the past, we've redeployed a lot of that cost into Asia, and with improved earnings this year, we've reinstated some of our performance compensation and we also have inflationary increases, so we're really looking year-over-year at similar levels of volume. The other big piece of this 8 to 10 million annual savings was curtailment of our U.S. pension plan, and so we'll see that, and we're seeing the benefit of that this year, and we'll see it for years to come.

Okay. And then you had commented during your prepared remarks on the revenue breakout of the segments. Do you happen to have the operating income numbers?

No, I don't have that. Let me see. Maybe I will try to get back to you before the end of the conference call on that, Bob.

That would be great. Thank you. And I don't have any further questions.

Thanks for your interest, Bob.

Thank you.

Our next question is coming from Patrick Flavin of Flavin, Blake, & Co.

Hello, Ron. Hello, Neal. Congratulations. It's been a long slog, man.

I know exactly what you mean. Hasn't escaped my attention.

In terms of the price increases going through, Ron, now that you've had the difficulty of particularly on the the CMS side trying to twist people's arms on contracts that are written, having gotten through initial price increases, is this a wave, is this something that will continue?

If you mean the attention to pricing needs, yes, of course it will continue. I think it is just the kind of world where that's one of the imperatives we will have to stay tuned to all the time. I am not sure exactly what you mean by a bow wave. I think we've completed the bulk of what we felt we had to get done. I think most of that is in place, may see a little bit more of it coming in the future in terms of things we've already done, but it is not the kind of thing we're ever going to be finished.

Understood. What I meant by bow wave was the difficulty is in getting it done the first time once you get it done the first time, it becomes established procedural most and easier to get done the second time. Do you see it being easier if prices continue to go up for all of your assorted supplies, do you see it as being more timely and easier to get further price increases.

I am sure our guys in the field would never attach easy to a price increase regardless of what the timing may be. The reality is that this has caused us to change the nature of our discussion with our customers, and it does cause us to focus very hard on the areas that like raw materials which really do have dramatic impacts, and while our commit at some time our customers is to help their profitability and want just charge them higher prices, I think there are more willing to listen to the realities of a company in our position that provides them a valuable service, and so in that sense it is easier the second time around, but in terms of willingness to accept price increases, I am sure you realize that's never going to be easy.

And, Ron, I am sorry, Neal, a quick question for you. Given the nor malt of the tax rate in the second quarter, can you give us an estimate of the tax rate for the year?

It is really going to depend on forward-looking factors, but I would say it will certainly be higher than last year, and it will be in the mid to high 30's as we look although it now. There are a few issue that is still need to be resolved between now and year end. It is hard to give up too much more precision than that.

Okay. Then on a normalized basis, forget about this year, looking forward, what would a normalized rate be for your company?

I would say in the mid 30s. I think the 32.5% of the past is probably a bit on the low side as we look at the shifting mix of our income amongst the different taxing jurisdictions and regions of the world. I would say it is frankly somewhere in between where we are in the second quarter and the historical levels of 32, 33%.

Okay. Thank you, gents. Good work, keep it up.

Thank you.

Thanks, Pat.

I did want to respond to the opening question from Bob Felice with respect to operating income in our various segments for the second quarter. Our metal working process chemical segment operating income is $15.7 million. Our coating segment operating income is $2.3 million, and in other chemical products our operating income is $0.2 million. If there is any further questions on that, Bob, you can get back on the call.

[Operator Instructions] Our next question is coming from [Dan Rizzo of Sidoti and Company.]

How are you guys doing.

Hey, Dan, how's it going?

I had one more. Could you break down in terms of the revenue increases how much of that was volume and how much was price increases over the past quarter?

It always gets a little confusing. You have price, mix, and things, but I would just give you a rough estimate, so if we had 11% revenue increase, 1% was from FX. The remaining 10% was pretty much equally split between volume and price.

Okay. Great. That's it. Thank you.

Okay.

[Operator Instructions] We show no further questions in the queue at this time.

Okay. Thanks, everybody. I appreciate your interest. It has been a pleasure for us to talk to you about what we see as a good quarter. I hope there are going to be a lot more of them in our future as they were always there in our past. I hope it is cooler for you wherever you happen to be than it is here in the Philadelphia area where it is bouncing against 100 degrees but it is cooler in the room when you can talk about a $0.30 quarter rather than talking about an $0.18 quarter and I look forward to talking to you again in a few months. Thank you for your interest.

This does conclude today eases teleconference. You may disconnect your lines at this time. Thank you for your participation.

Thanks a lot.