Quaker Chemical Corp (KWR) 2008 Q2 法說會逐字稿

Greetings ladies and gentlemen, and welcome to the Quaker Chemical Corporation second quarter 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. Thank you, Mr. Naples, you may begin.

Thanks very much, and welcome everybody. Glad to have you here. As usual, Mark Featherstone and I are here and our typical process is as it has been that I'll provide an overview, and then Mark will provide some detail, and we will both be available for questions.

Also here today I want to point out is Mike Barry, currently our Senior VP North America and the Managing Director of that region. Mike was our CFO for six years, so some of you may know him, and certainly he's no stranger to these meetings, but he's here today with a different portfolio in mind. As you may know, we announced early in May that I'll step down as CEO in October. I'll keep the Chairmanship for awhile, but I will be turning over the top executive job. At the same time we announced that Mike will succeed me in that top executive job as CEO. I've been at this for 13 years with you, but the next time Quaker has one of these sessions, it's Mike you'll be hearing from. And I know since all of you have your mute buttons at this point in this conference, at least I'm spared all the sighs of relief.

I'm very pleased to have Mike succeed me. He's been a Quaker for 10 years, he's very well prepared in the terms of the assignments he's had from the CFO, to a global leader of our global metal working business, to now Managing Director of our North American operation, which is our largest operation. He's very accomplished in terms of what he's achieved here at Quaker, particularly in his recent North American role, where he's led a dramatic improvement in our business in North America. Which has made a very valuable incremental contribution to our corporate results over the last two or three years, I should note.

He's very knowledgeable about our business and our global positions and strategies. He's been part of our Global Management Executive Committee for his whole time here at Quaker, and has an important contributor to our strategic development. He has very strong ties to our organization, and he's steeped in our business, he's and steeped in our people. I think this will help him lead the organization, and by the same token I don't believe that he'll be trapped by the status quo, where he sees a need to shift strategy, or change action over time. So we're very pleased with this appointment, and we are glad to have Mike available to step in, and we think he's certainly ready to be an excellent CEO.

One other as suspect, I hope this makes available point to you about how we operate here at Quaker, and the value we place on the primary purpose we have here, which is to build an enduring economic enterprise, a guiding principal since I arrived here in 1995. I trust the fact that we were able to name such a well prepared successor, at the same time I announced my plans, speaks volumes about the seriousness with which we take the responsibility of building for the long-term, especially in a relatively strong company such as Quaker, with many competing and urgent demands, always tugging us, on our resources, our attention, and our time. We always focused on the long-term short term balance. Our willingness to invest in management development and succession, is an example of our long-term oriented investment, and is indicative of the long-term balance I'm talking about. Mike is living proof of our willingness to make this trade-off here at Quaker.

Another result of this long-term short-term balance is the kind of financial results we were able report for the second quarter. And indeed for the first six months. It was in many ways a remarkable quarter. These are, I'll put in quotes, interesting days for us. You know the issues, economic activity, demand uncertainties, financial market stability, soaring raw material prices. The quarter saw all of these elements in dramatic relief. the pace and level of raw material price escalation was eye popping. Way ahead of even the volatile activity of the last few years. Later on Mark will have a bit more to say about this. The auto industry demands and consequent production levels was challenged. Housing activity in the like were also problematic.

Yet, in the face of all of this, in the second quarter we were able to achieve sales up 15%, our profit after tax was up a modest 4%, and EPS were flat last year, $0.41 to $0.41. But I want to hasten to point out that these figures include about $0.12 per share charge in partial recognition of cost related to our CEO transition. So you can see that this was an excellent quarter, and we are proud of the quarter we were able deliver in these circumstances.

I should point out it's not just the second quarter. You know that we had a great first quarter. For six months our sales are up over 16%. And profits are a handsomely ahead of prior year, whether the CEO costs are included or not. The quarter is not an unqualified good news of course. Our gross margin percent is down but we are able to manage our way through to the bottom line, with for instance leverage on our SG&A spending, which helps our bottom line results show the kind of improvement we show this quarter.

Another indicator of our strength, even with sales leaping ahead, and accounts receivable growing, and raw material costs soaring, and dividend being paid, we are generating real cash. Second quarter showed that in spades, with the net debt down considerably, and at its lowest level in several years. The point is that we are dramatically out growing and outperforming our markets.

We've been doing that through building market share, even as our markets turn tough, doing it through delivering more for our customers, even as we face the realities of rising costs and prices everywhere. Doing it through our global market portfolio, and the emphasis we put over the last few years on building market position in the so-called brick countries, in particular. These are countries in which the middle class is growing, with the consequent increase in demand for consumer durables which creates demands for our products and services. The long and short of it is, we are in the right places at the right time, and we are in the right places as a leader in virtually all of these markets, and many of our businesses, except perhaps Russia where our position is increasingly growing. So we have a very good base on which to build, that's helped us not only perform in the short term but will help us perform in the long-term.

These attributes are made particularly powerful by the culture we've developed in our country, about how to uniquely serve-- in our company, I'm sorry-- about how to uniquely serve our customers, and by the unique competitive position we've carved out for ourselves. These flow from three fundamental premises. What we actually call here internally and talk about a lot, imperatives. Three fundamental imperatives. One is to sell value, not just our products, and that is, what we can we do for you with our services, Mr. Customer, and with our knowledge and experience. Two is to operate as a globally integrated whole. That is to be a truly global single worldwide company, not just a collection of operations around the world. And three, is to harness our global knowledge and learning. The thing our real business is knowledge. What we really sell is our knowledge. That knowledge is not owned anywhere in the company, and we work hard at trying to make sure that knowledge is available for competitive advantage everywhere in the company.

These motions are captured in our destination, it's something that we discussed before and I will now take time to read analogy although it's only two powerful sentences for us, but it's destination is captured in all of our corporate publications, and it's a ubiquitous reference for us internally as we talk about our tasks, and what we do to achieve our success. In other words, it's constant touch stone and compass for us, as we look to the future. Put all together this is a powerful competitive stance for us. The culture inculcated from this, will serve us well for a long time, regardless of the tactical shifts we have to make, and even strategic shifts we have to make along the way. Indeed we are a small company, but we are a very global company. We are a global company for a company of any size, but we are remarkably global for a company of our size. With our global reach, our global geographic portfolio, our global way of operating, our mix of businesses, our market leadership positions, our growing positions in new businesses, an organization of people focused on success.

In the face of an uncertain world with market and cross vagaries, we believe we are in as good a place as we can be, to continue our performance progress, not only for the rest of the year, although we certainly think that's true, but indeed well into the future. We've come a long way with sales well north of $500,000 and growing, with EBITDA at all time highs and growing, and with market cap well through the $300 million level and we hope growing, and we believe there's much more to come. I hope this reinforces for you, a sense of not only what we've done, but how we've done it, and the fundamental premises that underlie what we've accomplished, as well as a promise for the future, as we take these attributes into that future. With that I will stop and turn the session over to Mark where he can fill you in on some details, and then later in the session we will both be available for question, Mark?

Thank you, Ron. Good afternoon everyone. While reported EPS of $0.41 per diluted share is the same as the previous year, this includes a $0.12 per diluted share charge related to CEO transition, which I will discuss further later. I will now spend the next few minutes focusing on the second quarter P&L, and then we will go on to questions.

As Ron mentioned, revenues for the second quarter compared with the same period last year were up 15% to $158.2 million. The growth was driven by volume growth in Asia Pacific and South America, pricing improvement, as well as higher revenue related to the company's CMS channel. The higher CMS revenue is both from new CMS programs, and the renewals and restructuring of several CMS contracts in 2007. Foreign exchange also increased revenues by approximately 8% as the US dollar weakened against most major currencies.

Regarding volume, overall volume for the quarter was up modestly. Asia Pacific volume grew again by double digits, and South America was also higher, which more than offset declines in North America and Europe. In North America, both fuel, metal work, and volumes, were lower than the prior year. Steel volume was essentially flat with the first quarter, but behind last year's second quarter. The weaker dollar continues to help the mid field imports, and also posted customer export activity, which has helped to offset lower steel demands for consumer durables, including autos, and housing related demands such as appliances. Our sales to the auto sector were also lower, despite continued share gains and conversions at CMS sites.

Overall pricing was up about 5% from last year's second quarter. The higher sales prices reflect our continuing efforts to work with our customers to deliver value, while also recognizing the impact of higher raw material costs. Overall raw material costs were significantly higher than prior year levels. These costs escalations continue into third quarter as well, despite the recent decline in crude oil prices. Our current estimates are that raw material price increases in 2008, will be roughly equal to the total raw material increases of 2005, 2006, and 2006 combined. Now those of you who have attended our investor presentation in the past, have heard us refer to overcoming more than $40 million in raw material cost increases in the 2004, 2007 period. So that gives you an order of magnitude on the raw material cost increases we are facing this year.

As we have discussed before, we have been able to work with our customers to recover most of the increased raw material costs through higher selling prices. Although there usually is a lag effect in achieving this catch up effect. And while we achieve price increases in the second quarter, we haven't implemented additional price increases in the third quarter to recover higher costs.

Turning now to segments, I would like to give you a little more detail on the segment basis. As you recall, we segmented the businesses in three areas, metalworking process chemicals, coatings, and other chemical products. In our metalworking process chemical segment, which makes up 92% of our sales, revenues in second quarter are compared to 2007 were up 15% to $146.2 million; and operating income declined to $17.1 million. Sales in our coatings segment, which makes up about 7% of our sales, increased $900,000, or 9%, due to the higher chemical milling maskants sales for the aerospace industry. Operating income increased 14% to $2.6 million. In our smallest segment, which represents about 1% of sales, the sales were up $300,000.

Turning now to gross margin. Gross margin as a percentage of sales was 28.3% this quarter, which represented a decrease from the 31% from the second quarter of '07, and 29.5% in the first quarter of 2008. On the 2.7% percentage point decline in the reported gross margin percentage, more than half was due to the math of higher revenues and higher costs resulting in a smaller percentage. This represents a gross up effect related to raw materials, and the change in CMS contracts. The balance is due to a combination of mix effects, and under recovery in pricing of raw material increases.

To give you a better sense of the dramatic and unprecedented cost increases we've been facing, the cost of some of our key base oils and animal fats in the US are up more than 50% so far this year, with the bulk of this increase occurring in the second quarter, and continuing into the third quarter. And while costs are also up in other regions the weakness in the US dollar has helped dampen some of these cost increases. In addition some international markets have moved up more gradually than US markets. However, costs in those regions are also up significantly.

I should also note that the recent drop in crude oil prices back into the $120 to $130 range, has not yet been reflected in our raw material costs. While the net shortfall in gross margin dollar recovery was higher than in the first quarter because of the numeric escalation I just discussed, pricing actions are going into effect in the third quarter to address this, with further pricing actions currently in progress. I'd also note, that despite the escalation of raw material costs just discussed, gross margin dollars for the second quarter were up approximately 5%, or more than $2 million for the quarter.

Turning now to SG&A. SG&A as a percent of sales was 23.5% of sales for the quarter, compared to 25.7% in the second quarter of 2007. And compared to a full year 2007 SG&A rate of 25.6%. In absolute terms, SG&A for the quarter was up about 5%, or $1.7 million. With higher foreign exchange rates accounting for about $2.5 million of the increase. The increases related to growth initiatives, as well as normal inflationary increases, were more than offset by lower legal environmental costs, and lower incentive compensation costs.

Turning now to CEO transition costs, in connection with the announced retirement of Ronald J. Naples as Quaker's CEO on October 3, 2008, Quaker will recognize and incremental $5.8 million in expense over the next three years. $3.5million of this amount will be recognized in 2008, including $1.9 million or $0.12 per share in the second quarter of 2008. These costs have been separately identified on the face of our income statement, and are more fully detailed in the 8-K we filed on May 13, 2008.

Touching briefly on operating income, the operating income as a percentage of sales for the quarter, excluding the CEO transition cost, was slightly below last year's percentage, and we continue to target operating income as a percent of sales, of more than 5% for the full year. Other income higher in 2007, benefiting from the net arbitration award of approximately $1 million, related to litigation with one of the former owners of our Italian subsidiary. Unfortunately the award was subject to an almost 60% effective tax rate, so only about $0.04 dropped to the bottom line. The decrease in the interest expense over the second quarter of last year is reflected on lower average debt balances outstanding, benefiting from the strong second quarter cash flow, as well as lower average interest rates and higher interest income.

The effective tax rate in second quarter was 32.7%, compared to 34.7% in second quarter of last year. With the high tax, on the net arbitration award I had mentioned earlier being offset by a tax rebate in China. For the full year 2008, we will continue to benefit from the tax holiday in China, and currently expect a full year tax rate in the low 30 percentile. However, we also expect to continue to experience volatility on a quarterly basis due to FIN 48 and potential changes in income mix.

Turning to the balance sheet. Our net debt has increased from 2007 due to strong-- has decreased from 2007, due to the strong cash generation, and good working capital improvement during the quarter. Our net debt to capital ratio decreased to 28% at June 30, 2008, compared to 42% at June 30, 2007, and 32% at December 31, 2007. And that concludes my prepared remarks.

Okay, Mark, thank you very much. And at this stage we will turn to any questions that you may all have.

(OPERATOR INSTRUCTIONS). Our first question is coming from Robert Felice, from Gabelli & Company. Please state your question.

Hello guys, just a couple of quick questions. First, what was the magnitude of your second quarter raw material cost increases, and how much pricing did you get? So, in other words, I'm curious to get my hands around the delta between the two, the price cost gap?

Mark, why don't you-- do you have the figures on that?

Yes, for the first half of this year we are looking at higher costs compared to last year in the range of $12 million to $13 million. And the under recovery was probably between $1 million and $2 million. As we discussed we are looking for-- we've already implemented price increases to get that back in the third quarter. However, because raw material prices continue to escalate in the third quarter, we are looking at additional price increases as well beyond that.

We think, though, that going into the second half of the year, that we should be able to see a little more gross margin recovery, than we've seen, in terms of the percentage, than the kind of decline you've seen in the first half of the year.

Well, you mentioned a cumulative $40 million of cost increases that you'll experience this year, and you received $12 million or $13 million of that so far. So you've got $27 million or $28 million left. Do you have pricing in place enough to fully offset that? And to also cover the $1 million or $2 million delta from the first half? Or will you need to go out in the market with additional pricing?

I'm sorry, Ron. But we do have a lot of price increases that went into effect July 1, and some more going into effect on August 1. But we are going back for additional price increases, because as I mentioned we have raw materials continue to escalate into the third quarter as well.

I think the point here is that S40 million that we talked about, that of course is, we can't know that number specifically. That's based on projections, given what we know have come, already come down the track and what we expect to come down the track further. Of course we have to stay responsive to the markets as they actually develop. But all of our regions are working hard on making sure that we are able to keep our margins in good shape, even in the face of these increases. So as Mark said, we've got increases that we planned in the last quarter, that are going into effect, early in the third quarter, and we will be implementing other increases to try to do our best to stay ahead of the kind of escalation that we see coming.

It's always built around working with our customers to fine the right way to get this done. We are serious about the notion, the question here is the kind of value we can deliver to our customers, and we really focus hard on trying to make sure that's understood in our customers.

Do you feel comfortable at this juncture that you will be able to fully cover your raw material cost by the end of the year, or do you think there is going to be some gap?

Our expectation is that we should be at least able to, we should be able to recover some of the gross margin fall off, the gross margin percent fall off that we've seen in the first half of the year.

Then I guess if I look at the operating income by segment, it implies that your unallocated expenses are trending lower on a year over year basis for the quarter, and similar in the first quarter as well. So I'm curious to know what's driving the decline there, and maybe you can give us just some rough guidance for the full year.

You say unallocated, you mean indirect?

Yes.

I think Mark--

Yes, I think as I mentioned in my remarks, we had lower legal and environmental costs, and also lower incentive compensation costs, this year compared to last. That's what's driven the cost lower so far this year, and we'd like to see incentive comp come back, but we'll see how it goes, but the government and legal we expect to be lower this year for the full year, than last year.

So I would expect that unallocated amount to be similar to the from the second half to the first half, or will it trend up? Just trying to get my hands around that.

Same kind of neighborhood.

So it should benefit you in the back half of the year?

Yes.

We expect to continue to get leverage on SG&A spending. That's, when you've got your topside margins getting squeezed, you have to get the benefit elsewhere, and I think one of the things that the growth in revenues has allowed us to do, is to take more of these to the bottom line, that's one of the reasons we work so hard in getting that top line up.

Great. Thanks for taking my questions.

You're welcome.

(OPERATOR INSTRUCTIONS). Our next question is coming from Daniel Rizzo, with Sidoti & Company. Please state your question.

Hello, guys. You mentioned that you fully reduced debt by $14 million for the quarter. Is that something that's going to be a focus going forward with your free cash, getting the debt level lower, or are you comfortable with where it is? What's the story with that?

We are not focused on a targeted debt level. We want to use our cash the most effective way we can find. We want to preserve it for acquisitions, if we can. We do think that probably our cash levels in the second quarter, are probably as good as we are going to see them during the year, because there will be other demands coming down the road, increases in working capital, that kind of thing, but we still expect the year to be a pretty solid year from a cash standpoint.

The thing that's going to happen in the second half, Dan, is we announced the expansion of our Middletown facility, and we will have a lot of CapEx on that occurring in the second half. And we've actually closed on an IRB in the second quarter that incur expense with that will fund about half of that expansion, and when we talk about the net debt we are excluding that construction fund balance from the net debt calculation.

Okay. And just given the environment that we are in with raws up, and sometimes softening end markets, do you see more possible acquisition opportunities, some weakened competitors that you might be able to take over, or anything like that?

We are always anxious to make acquisitions that we think are important complements to what we do. I think the important part to any acquisition we make, is that it has to contribute something to our market position, or to our technology position. So we don't want to simply add-- there are weaker competitors out there, but were not really interested in simply adding low margin business, because a regional competitor for instance is having a hard time.

As I said we want to find an acquisition opportunity that will be meaningful to us in terms of size, that helps us to bulk up the businesses we have now and it's something that we are doing, that's important to us on the metal working side or the steel side, and also brings us some opportunity to build on our technology, or to combine our technologies to develop other products, that we think have promise for us.

Okay. All right. Thanks, guys.

You're welcome.

We have a follow-up question coming from Robert Felice, with Gabelli & Company.

Hello guys, just another quick question. Do you have a metric in place that you use to track, or follow how quickly or how much progress you're making converting your CMS business to Quaker product?

Absolutely. I mean that's an important competitive opportunity for us. And it's also, we think, an important opportunity for our CMS customers. So we track that very closely.

And what metric is that or rather-- is that something you consider publishing on an ongoing basis with your earnings report?

No. It's not something that we think is-- we think it's something proprietary and important to us in terms of how we compete in CMS, and would be good information for our competitors to have, and we would just as soon not talk about that publicly. You should know that when we look at competing for a piece of CMS business, the economic value-added of that piece of business is a very rigorous exercise for us, and what we can expect to use in terms of Quaker's products in those accounts, is an important aspect of that. But the bottom line is always what delivers the best result for the customer, not simply are they our products.

Well, I guess if we were to look back and track your conversion rate historically, since you started the CMS business what would it look like?

You are trying to get us to give you a number here.

Or a trend.

I'll put it this way. The CMS business has been very successful for us, we've chosen accounts carefully in terms of the business we want to compete on, the economic value added analysis we've done in choosing those accounts, builds in conversion opportunities. And so far, we've had most of what we'd planned on, in those analyses, happen. So I think that what you should take away from this, is we've been successful in serving our customers better, in these accounts where we think there is an opportunity.

Okay, that's helpful.

If there are any other questions, we are at your disposal.

Okay, I'll assume there are no other questions, so I just thank you all for your interest. We're of course focused on delivering the best second half we can deliver, we have a tremendous amount of confidence in what we can get done. So, I was going to say I'll look for to seeing you-- talking to you again in the quarter, but that won't happen. But I will look forward to listening to what Mike has to say on the quarter. And I hope that all of you have a good summer. What's left of it, thanks for your interest. Goodbye.