Quaker Chemical Corp (KWR) 2007 Q3 法說會逐字稿

Greetings ladies and gentlemen and welcome to the Quaker Chemical Corporation's third quarter 2007 earnings conference call. At this time all participants are in a listen-only mode. A 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, Mr. Ronald J. Naples, Chairman and CEO for Quaker Chemical Corporation.

Thanks very much and welcome, everybody. We're pleased to have you here. Thanks for joining us. With me this afternoon is Mark Featherstone, our CFO, and as usual I will provide some introductory comments and Mark will provide more detail and then we will have a chance to answer any questions people may have.

In my comments I just want to hit some highlights and make a few general observations and I promise to be as brief as possible. I guess the top line of all this is that I believe we had an outstanding third quarter by almost any measure, whether it be sales, and in fact we had the highest quarterly sales ever, profits or cash. I typically like the numbers to speak for themselves but in this quarter there are a number of moving parts. EPS, were it to speak for itself, went from $0.32 last year to $0.31 this year. But as I said, there are moving parts and right on the face of the income statement you see one of those, a $3.3 million environmental charge. Adjusting for only that one moving part, and that's the only one I'm going to talk about, it's apparent that our operating income would have been up 24%. That brings our ongoing operating margin, if I can call it that, to about 5% for the quarter, continuing the progress that we've made in '07.

Sales were up a very strong, just about 21% for the quarter and 17% for the year so far. Indeed, that's considerably ahead of market growth. We are very pleased with such a strong sales increase and even more pleased that there are several important aspects embodied in that increase. That increase is led by volume growth of about 13% in the quarter, so it's real growth. And as you know, if you're achieving real growth it has a lot more promise than simply growth related to pricing, but that indicates how you're increasing your markets. It was broadly spread, in China, Europe, North America. We got leverage from this growth. Our sales were up 21% and our profits were operating at an ongoing operating margin, if you will, 24% indicates some of that.

We were helped by price increases. That recognizes our continuing effort to work with our customers to recognize the value we bring to them and to adjust to realities of raw material escalation, which we've certainly continued to see in crude oil but also have begun to see in animal fats and vegetables. These latter two increases are driven by other competing uses such as bio demand -- biodiesel fuel, high food demands and lower supplies. In any case that's a concern to add to our concerns about crude oil.

In the last quarterly call I pointed to these possibilities as in areas of perhaps increases, and we have seen them come to pass. But despite our raw material challenges, we have managed to maintain our gross margins through 2007. The third quarter gross margin is about where we have been in the earlier part of '07, and this we've maintained in the face of raw material pressures. I believe that this reflects the kind of customer conversations mentioned earlier, and are better processed to keep our pricing increases and customers more current on the pricing front. There is never a perfect match between the timing and size of a raw material increase and the pricing, but we are getting much better at that process.

There are two additional major points I'd like to make before I return to Mark for more detail. First, I'm pleased to say that we've generated over $19 million in cash in the third quarter. The bulk came through hard work on working capital, particularly receivables. Each quarter we've been talking about the work that we've been doing in this area, and I'm pleased to say in the third quarter it's begun to pay off, at least in part. Our sales are still growing handsomely and, of course, we have to finance that sales growth through working capital, and in the quarter we did have some catch-up positives, but I don't expect that we'll have this size of working capital improvement in every quarter. But we are in as good a shape as ever in terms of our working capital as a percentage of our sales. The overdues have been worked down at a very low percentage and we have robust processes in the company to keep ourselves current. So I believe we will be able to use our working capital very efficiently going forward.

The second general point I'd like to make is the environmental settlement in California mentioned a bit earlier and mentioned in our press release,and in fact outlined further in a press release about a week ago. This allowed to us clear the decks on an outstanding issue that's been with us for many years. Having putting this behind us eliminates uncertainty regarding where this whole thing was going, and also significant possible financial exposure. All of this flowed, from in most part in any case, from problems in our AC Products subsidiary out in California from the early 90s. In the mid 90s we began working on voluntary and, I might say, expensive efforts to mitigate the effects. And now we are able to put this behind us. That's a great result for the water district where we operate and for us.

That takes me to the last thought I'd like to leave you with before moving on to other areas. The net of all this I believe is that we are in as good a shape as we've been in in a long time. Our market position and our market shares are strong, especially in growing markets. You can see that in our real volume growth. We have strong stakes in major industrializing growth markets, India, China, Brazil. We have excellent and value-based positions with our customers. You can see that, I think, in our access for pricing discussions and it's made possible by our technology efforts. We have growing profitability. In fact, this year we should have our highest EBITDA ever. We are generating stronger cash flows, which means we will have a stronger balance sheet.

Our major uncertain contingency is behind us in the ACP environmental exposure. We have the right strategies to maintain our positions in our core markets and to build in our new markets. You can see that through our building success and in the CMS strategic initiative and in the moves we've made in mining and coatings. We have a strong management team and an organization that is seasoned and working well together toward common goals and I believe we have the right outlook and purpose in our company, focused on global competitiveness and responding to markets and our customers, as we call it, as a single worldwide company bringing our global resources to bear locally. I believe we have put ourselves in a very strong position. Now all of us here fully realize that nothing in this life is promised, and there are few lines that go straight up, but we feel better prepared than ever today to create our own future, and that I think is the best way to go into the future.

With that, I'll stop and I'll turn to Mark to provide a bit more detail on the quarter.

Thank you, Ron. Good afternoon, everyone.

As Ron indicated, we had some unusual items in the third quarter but overall had a quarter showing the continuation of the progress we've seen so far this year. I'll spend a few minutes focusing on the third quarter P&L and then we will go on to questions. Revenues for the third quarter compared with the same period last year were up 20.9% to $140.7 million. The gross was driven by volume growth, price improvement, as well as higher revenue related to the company's CMS channel. The volume was up 13% from last year, which includes higher CMS revenues from both new CMS programs and the renewals and renegotiations of several CMS contracts earlier in the year. Price improvement totaled about 3 percent of sales, and occurred broadly across all regions and market segments. Foreign exchange also increased revenues by about 5%, as the U.S. dollar weakened against most currencies. Volume growth was led by double-digit increases in our volumes in China and good growth in Europe and North America.

The market in the North American steel market continued to be somewhat mixed. Volumes were higher than the second quarter, which itself was an improvement over the first quarter of 2007. However, volumes remained below prior-year levels. And while the high levels of inventory in the steel service centers decreased during the quarter, overall demand for steel was somewhat weak and the improvement in the inventory situation did not translate into volumes recovered at the prior-year levels, and we expect this mixed picture to continue for the rest of the year. We also see some pockets of slowness in a few of our automotive customers but our sales, particularly through CMS, have increased due to contingent conversions of systems from competitor to Quaker products as well as other factors. For example, Quaker product sales through our North America Powertrain CMS channel have increased at double-digit rates on a year-to-date basis.

The higher sales prices reflects our continued efforts to work with our customers to deliver value, while also recognizing the impact of higher raw material costs. Overall raw material costs continued to remain significantly higher than last year, up about $6 million so far this year versus last year, with about a third of that occurring through the third quarter. As we have discussed before, we generally are able to recover most of raw material price increases through higher selling prices but there is a lag effect. However, so far this year we have been able to keep our margin percentages relatively stable compared with the first and second quarter.

Now as you you recall, during the second quarter we had a positive catch-up effect where pricing caught up to the proper raw material price increases and we recovered some margin. During the third quarter, the reverse occurred as prices for tallow and vegetable oil products increased, and we experienced somewhat of a lag effect while we worked with customers to recover those cost increases.

Turning to crude oil, despite the recent run up in crude oil prices to the $9-plus range, mineral oil prices have been relatively stable to date, although some price increases have been announced which would take effect later in the quarter. Now a lot of our mineral oils are tied to ICISLOR, which tends to be a little more stable index than West Texas Intermediates which is a more widely traded index. However, prices for vegetable oils and animal fats have escalated, due in part to increased demand related to biodiesel fuels and food. We continue to monitor these developments closely and have begun discussions with customers about the impact of these cost increases, but only limited pricing actions have become effective during the third quarter.

Looking ahead, we expect our China business to continue to do well. But as I mentioned previously, there were fewer steel mills opening in China in 2007 than in previous years. So this will cause a temporary dampening effect on our growth rate. However, as we look forward to 2008 several new steel mills in China are tentatively scheduled to open, and we believe we are well-positioned to capture a good share of that business. Of course these large steel mills tend to take some time to ramp up their production, as does their consumption of Quaker products. Traditionally, we talked about our success in steel in China but I also would like to point out our other business in China is actually growing at a faster rate than steel, although that's a much smaller base.

I would now like to give some data on a segment basis. As you recall, we segment our business into three areas. First, metalworking process chemicals. Second, coatings. And third, other chemical products. In our metalworking process chemicals segment,which makes up 92% of our sales, revenue in the third quarter compared with '06 was up 21% to $129.9 million and operating income improved 18% to $18.8 million. In our coatings segment, which makes up about 7% of sales, sales were up 16% or $1.4 million, due to higher temporary and permanent coating sales, and also operating income increased slightly to $2.2 million. Our small segment, which represents 1% of sales, is called "other chemical products." Sales were up $400,000 and operating income was also up slightly.

Turning now to gross margin, gross margin as a percent of sales was 30.7% this quarter, which represents a slight decrease from the 31.6%, where services decreased from the 31.6% from the third quarter of last year while very close to the first two quarters of 2007, and that's despite escalations in animal fats and vegetable oil prices. Although there was continued escalation of raw material costs over the previous year, gross margin in dollar terms was up about 17% or more than $6 million for the quarter, due to the combination of volume growth, price recovery actions, as well as stronger performance in our CMS channel, where we continued to add new sites which have offset site closures. We also started up a few new CMS sites during the quarter, and are scheduled to start up a few more sites in the fourth quarter as well. For the most part, the CMS sites that have closed have tended to be smaller sites, while the sites we have gained have tended to be larger operations.

I should also note that three strikes at GM during the third quarter and at Chrysler during the fourth quarter did not have a meaningful impact on our operations. We expect to have some product conversion opportunities at our new CMS cites gained, as that's one of our selection criteria when we decide to go into the bidding process. However, these product conversion opportunities generally do not occur immediately upon gaining a CMS site. While we expect production reductions and plant closures at some CMS sites in North America, we expect product sales and service opportunities at new CMS sites, both in North America and other regions to help offset any profit loss from volume reductions at existing sites.

Moving on to SG&A and other expenses. As a percentage of sales, SG&A was 26% of sales for the quarter this year versus 27% last year. This compares to a full-year 2006 SG&A percent of sales of 26.3%. Of course, this included both litigation and remediation expenses related to the AC Products environmental litigation, now settled, and that totaled $600,000 during the quarter. In addition there were bankruptcy and strategic initiatives charges of $1.2 million. On a pro forma basis, if we add back the bankruptcy and strategic initiatives charges noted above as well as the environmental settlements, SG&A as a percent of sales during the quarter would have been 25.2%. In absolute terms, SG&A for the quarter was up about 16%, or $5.1 million. Higher foreign exchange rates accounted for about a quarter of this increase. The bankruptcy and strategic initiative charges represented another quarter of the increase. We also continued to invest in future growth opportunities such as China, and product initiatives such as mining and coatings, and also had higher commissions on the 20% plus growth in sales we experienced and, of course, we also had some normal inflationary increases as well.

Looking at other income, other income is lower than 2006, primarily as a result of the distribution received from our former real estate joint venture in the prior year quarter, and a net increase in interest expense over last year is reflective of higher average debt balances outstanding, as well as higher interest rates. The third quarter tax rate this year benefit from a change in mix of income levels towards lower tax jurisdictions, as well as the tax incentives related to our new facility in China. The tax benefit in the third quarter includes a $700,000 refund of taxes paid in China, as a result of Quaker's increased investment. The 2006 quarter included a similar $400,000 refund. In addition, as discussed in our press release, the third quarter 2007 included a non-cash, out-of-period, tax benefit adjustment of $1 million related to certain deferred tax items. For the fourth quarter, we expect our tax rate to be well below the second quarter rate of almost 35% but above our third quarter tax rate.

Turning now to our balance sheet and cash flows, our net debt has decreased from December 2006 primarily due to higher earnings and the significant working capital reductions Ron noted. The company's net debt to total capital ratio was 36% at September 2007 compared with 40% at December 2006. During the quarter we also successfully extended the maturity of our existing committed credit facility from 2010 to 2012 and increased the facility's size from $100 to $125 million.

Now over the last few quarterly conference calls, there have been a few questions on working capital and cash flows, so I wanted to spend another minute in this area. First, as Ron noted, we experienced an overall improvement of cash flows of $19 million during the quarter, including $12 million in the working capital area, and we are pleased with our progress during the quarter. As we indicated in our earlier conference calls, the first quarter historically is our weakest cash flow quarter and cash flow tends to improve as the year progresses. In addition, our ongoing efforts to improve working capital paid significant dividends this quarter.

During our first two quarterly conference calls, we discussed a number of specific issues impacting working capital, particularly the start up of our new plant in China and a delay in receiving VAT invoicing approval. This delayed our cash collections. This collections delay was caught up in the third quarter, and we have worked down the safety stock that we established as part of the start-up of our new plant in China and the shutdown of an older facility. In addition, we were able to work with a customer to address issues in the customer's payment systems, which were causing payments to us to be delayed. The resolution of these three issues represented the majority of the working capital improvement during the quarter. However, our base working capital also showed improvement as well, which we were especially pleased with given the strong sales we experienced during the quarter.

On an operating cash flow basis, the third quarter was strongly positive after being negative in the first quarter and slightly positive in the second quarter, and we will continue to focus on improving our working capital and our cash flow generation.

That concludes my prepared remarks.

Okay. Thanks, Mark. At this stage, I will turn to any questions you all may have.

Thank you.

(OPERATOR INSTRUCTIONS)

Our first question is coming from Robert Felice with Gabelli & Company. Please state your question.

Hi, guys, how are you? Congratulations on a nice quarter. I guess first question, if I look at gross margin beginning fourth quarter of 2006, it expanded year over year but they've been expanding at a decelerating rate. I would imagine that's due to raw material cost increases. So I guess the first question, could you confirm that? And then secondly, as we look to the fourth quarter would you expect this trend to continue and result in year-over-year gross margin compression, or do you think some of the pricing from some of the renegotiated CMS business will likely offset raw material cost pressure? Just some color and guidance on fourth quarter margins?

Your first premise is correct, Robert, that the increase in raw materials has been a factor for us, there's just no question. In fact raws is just on -- given the effect of pricing, are up we estimate somewhere in the neighborhood of $6 million so far this year. But we are fighting the good fight with the prices and our customers have been willing to work with us, primarily I think because we are able to talk to them about a situation in which we can create more value for them. So we've been able to maintain the gross margins we had as the year started out. I think the likelihood that we will make a lot more progress on those gross margins in the fourth quarter is not high. I don't expect them to deteriorate but I don't expect that we'll get back to the gross margin at which we finished '06, mainly because there is still escalating raw material price effects out there. In fact what it -- oil is up to $96, $97 these days, I haven't seen what happened to it today, but it certainly was that when we started the day. And, of course, the timing of getting your price increases always seems to be a day late and a dollar short compared to the raw material increases we experience.

Of course we don't want to base all the price increasing just on raw materials because we do think we deliver value for our customers and that's always a part of our discussion. But the reality is the kind of robustness of raw material cost increases has been a challenge for us and I think it will continue to be, although I do think we will do well enough to keep it from eating into our gross margins very much.

So basically what you're saying is, it will be down year over year but hopefully flat sequentially.

Yes, we think that's probably a pretty good odds of that.

Yes, we had some pricing initiatives that took place late in the third quarter and early in the fourth quarter which should help offset some of the raw material prices that went up in the third quarter.

I think year to year it will be down.

Okay. And then just stepping back as we look out to '08, as you mentioned, Ron, oil is well above $90 per barrel but we haven't yet see $90 per barrel translate into higher base oil prices, higher mineral oil prices. And I would imagine that if it does stay above $90 these folks are being squeezed, so I would imagine you will see some escalation in raw material costs. So as you look out into '08, given pricing as a mechanism to offset that, do you think you'll be able to sustain operating income margins at '07 levels in '08?

We are doing the '08 planning now so I don't want to leap too far ahead on that and tell you something that we don't know for sure. But I should say as a general matter we are -- we feel strong that we can't put ourselves in a position to allow the raw materials to get too far ahead of us here. That's been a premise of our practices lately and it's been a premise of our discussion with our customers and that's going to stay as a constant focus for us. Because the challenge is there, but everyone faces those challenges. It's not true that base oils or mineral oils haven't moved up. They have moved up a little bit recently and it's only a matter of time before some of these crude oil price increases get folded into that. But as I said earlier we've about been in as a position as we've ever been to make sure that we take care of our side of this equation as we go into next year. I don't want to overstate because we haven't done all the planning for next year.

But it sounds like your hope would be to -- not to see any margin deterioration heading into '08?

Absolutely. Our goal is always going to be to try to improve that operating margin and we want to try to do that in whatever environment we face.

Okay, and then flipping gears to the tax rate, just a couple of quick questions around that. Even if I exclude some of the one-time benefits this quarter, the tax rate is really quite low. And I'm kind of wondering first, is that sustainable and what we should expect going forward? And then, secondly, what resulted in the reduction?

Well, part of it, we talked about this in the previous quarters, was this adoption of FIN 48 is going to add some volatility to our tax rate, and compared to the second quarter, the third quarter was favorable. So that was -- that was part of it. I think when we look forward to the fourth quarter, I think we are looking at a tax rate that's certainly higher than the third quarter but probably somewhere around the 30% range or so. And, of course, our mix of income can be a factor as well. As you know we are currently on a tax holiday in China , in addition to getting that tax rebate for prior periods as well. So the mix of income among jurisdictions can also impact that tax rate quite a

Okay. Going forward, what should we kind of model as a reasonable tax rate?

I'd say low 30s.

Low 30s. So 31, 32%, is kind of sustainable?

For the next year or so. I mean our tax holiday in China doesn't last forever, so it kind of gradually fades out after a couple of years.

Okay, fair enough. Thanks for taking my questions. I'll hop back in queue.

Thank you.

Our next question comes from Patrick Flavin with Flavin Blake & Company. Please ask your question.

Good morning gents, or good afternoon.

And to you, Patrick. Sometimes the afternoon does feel like the morning.

Particularly if you've been looking at the stock market recently. I want to congratulate you on your cash generation efforts and your working capital efforts and, Ron, I think you're right, I think the company is in the best shape it's been in since I've known it, and you've got yourself a bona fide growth engine here. What mystifies me is the valuation on the company. And you're now being, -- you've got a market capitalization of a little over $200 million, call it 220, and you've got revenues in excess of a $500,000,000 a year. You're growing at 20% albeit some of that is currency and some of that is expense pass through, and it looks to me like you're valued at 8 times EBITDA, maybe 8 up to 9, call it 8 and change. Is this, -- is it a lack of knowledge of the company that is not causing the valuation to be affected materially, Ron, in your opinion?

Well, I think there's a number of things probably but you're probably as well informed in this area as I am. Are you still there?

Yes.

I don't know if anybody else is there but at least we can talk. The reality is, of course, we agree that we are undervalued. I guess those of us who are on this side of the table always think we are undervalued. I think another reality is that there some rotation to larger cap companies and that hasn't helped us in the recent past two months because our stock price has come down a little bit from where it was previously. We should have record EBITDA this year. I hope that will help our valuation. We are making an effort to get out into the marketplace, have been and are continuing to make an effort to get out into the marketplace to tell our story, and to try to get people interested in our story. And I think if you put together our commitment to a dividend level that we think is fair for people and that provides a solid return for them and our commitment to growth, and our commitment to running the company better and being in the right markets with the right strategies, I agree with you, Patrick, as you might expect, but I think we are a pretty good long-term investment and our mission now is to try to get that story out there. I think we are hurt by the fact, and I think you know this as well as I do, that we are not a high visibility company, that we are in a business that tends to not be too high visibility, and that we are a small company in this business, but in terms of being a independent public company we are the only game in town, really. Also we have relatively modest trading volumes and so we are trying to get out there to tell the story so that we can try to affect all those considerations that would help the company's valuation.

Well, I encourage you to do that because particularly with your very successful CMS activity, you are a gating agent for larger chemical companies in terms of accessing very large customers. And I would just hate to see you get munched away with valuations that are inappropriate. So I think if you do get out there and tell the story, it's going to have a therapeutic effect.

Thank you, and as I said we are doing that. As a matter of fact I will be in Chicago, Mark and I will be in Chicago next week at a couple -- at a financial presentation program, and we've been calling on individual investors, institutional investors, and we are going to continue to do that because we do think we have a good story to tell, and I think it's a story that's based on facts and it's based on delivered results, which is always the best kind of story to tell than just simply based on promise.

Thank you and keep generating the cash.

Thanks, we are working on that.

(OPERATOR INSTRUCTIONS) Thank you. There are no further questions at this time. I would like to turn the floor back over to management for any closing comments.

Thank you. I won't make any long closing comments, except to thank everybody for their interest and I trust that we can continue report these kind of results to you. That's certainly our desire and it's our expectation. And we are going to continue to work on the valuation question that Patrick raised, and I hope when we get together in a few months to discuss our year end and our fourth quarter, we will be able to tell a good story in that regard. Thanks, everybody. Have a nice fall. Good bye.

Ladies and gentlemen, this does conclude today's teleconference. You may disconnect your lines at this time. Thank you for your participation.