Quaker Chemical Corp (KWR) 2008 Q3 法說會逐字稿

Greetings, ladies and gentlemen, and welcome to the Quaker Chemical Corporation third quarter earnings conference call. At this time, all participants are in a listen only mode. A brief question and-answer session will be following the formal presentation. (OPERATOR INSTRUCTIONS) As a reminder, this conference is being recorded. It is now my pleasure to introduce your host, Mr. Michael Barry, Chief Executive Officer and President for Quaker Chemical. Thank you Mr. Barry, you may begin.

Thank you. Good afternoon, everyone. This is my first conference call as CEO and President of Quaker, and it certainly has been an eventful three weeks since I entered my new role on October 4. Joining me today is Mark Featherstone, our Chief Financial Officer and Jeff Benoliel, our General Counsel and newly appointed Head of Global strategy. Mark will give us more detail around the financials, and then we will address any questions that you may have, but I'd like to start off now with some remarks about the third quarter and what we are currently seeing in our marketplace. Overall, it was a good third quarter, but that is really only part of the story given the global event of the past few weeks. As we enter the third quarter, margin recovery was our main challenge, however, as we exited the quarter, our challenge was shifted to the volume or demand side of our business.

So let me start first with some remarks about our margin recovery efforts. Raw materials continue to increase significantly in the third quarter. Year-to-date, our raw material thoughts are up 11% with over half of this increase being in the third quarter. And just as a point of reference, we will see more increases in our raw material costs this year than the previous three years combined, so it has been a top priority for us to recover our margins in such a volatile environment. Now, crude oil pricing did start to significantly decline during the third quarter, but our raw material costs did not see any significant improvement. So there has been a delay or lag effect between crude oil and the kind of raw materials we purchased as each of the different types of raw materials we purchased have their own supply/demand characteristics. We also put in place price increases in our products across all product lines and in all regions during the quarter to help us offset the very large raw material costs we were experiencing. As we enter the first quarter in 2009, we expect margins to continue to recover due to the fact that most of our necessary price increases either are in place or will be implemented by the beginning of 2009 and our input costs are normalizing.

So while we feel good about the progress we are making on margins, our latest challenge is with the demand side for our products and we really started to feel this in the third quarter as we saw slower than typical demand in China, Europe, and the US. China was down from our expectations, but still higher than last year primarily due to the Olympics, which resulted in lower customer demand and shipment restrictions. In Europe, we began to see a decline in both automotive and steel markets and in the US, we continued to see the decline in the automotive markets and that's been ongoing for awhile. However, we also began to see a slowdown in North American steel markets which had been decent prior to this quarter primarily due to the weak dollar and its positive impact on steel imports and exports. Then as the third quarter was ending, we saw the credit crunch and global stock market declines hit us in early October and our large steel and automotive customers began to announce significant production reductions for the fourth quarter, especially in the US and Europe, although China and South America are also seeing some softening.

So what are we doing about this situation? Of course, we are actively monitoring and constantly evaluating the situation. There is still a great deal of uncertainty on the magnitude and the duration of the production declines. In our 2009 planning, we are actively working on -- which we are actively working on, we are looking at a whole range of demand scenarios and what our responses would be so that we will react in a timely fashion as we get more clarity around this global economic situation. The bottom line is that we continue to focus on the long term, but we also will manage the short-term realities that we are facing. So let's now talk about some of the positive things we are seeing in our business. One, we expect to see margin recovery as I discussed earlier. In the past year, we have seen declines in our margins and we expect this trend to turnaround for the reasons I stated earlier. Two, we are excited about new business opportunities we are getting in our businesses such as steel, tube and pipe, mining and metal working. We are also making progress in our product conversions in our CMS business, especially with the new contracts we picked up over the past year. So we do expect to expand our market share in our markets. Three, we have very promising growth initiatives in our coatings product line and I believe that coatings can show significant growth for Quaker over the next several years. And four, we still expect to see good growth opportunities in the brick countries, Brazil, Russia, India, and China. We are well positioned in each of these countries and have growth initiatives in place.

So the key question will be, how much of the production reductions are in automotive and steel markets will be offset by the positives I've just mentioned? And it's hard to say at this point given the near term uncertainty we are seeing in our customer demands, although the reductions we are seeing today are significant, which are approximately 15% to 30% down in steel production in the US and Europe. So given what we know today, we do expect our results for the fourth quarter to not show the strength of our previous quarters this year; however,once again, I want to emphasize that we're confident in Quaker's future and we will continue to manage these short term realities that we are facing.

I also want to mention some items about our strong financial position. We finished our quarter with good operating cash flow and a strong balance sheet as our net debt level is at its lowest point since the second quarter of 2005. Also, our consolidated leverage ratio is strong and is now under 2. In addition, we believe we have good liquidity with over $50 million in borrowing capacity under our primary credit facility and we feel confident with the current financial strength of our banking group. So in summary, we had a good third quarter and while the near future will present some challenges for us, we are confident that our strategy, strong management team, leading market positions, good growth opportunities, and solid balance sheet will bode well for the future of our shareholders, customers and employees. And now I'll turn it over to Mark Featherstone, our Chief Financial Officer, so that he can provide you with details behind our financials, and after that, we will address any questions you have. Mark?

Thank you, Mike. Good afternoon, everyone. Reported EPS of $0.41 per diluted share was significantly higher than the $0.31 EPS that we reported for the third quarter last year. However, both periods included some unusual items including the $0.10 per diluted share charge related to the CEO transition and this years results while last years period included a charge related to the settlement of environmental litigation as well as some other items. I'll spend the next few minutes focusing on third quarter P&L and then we'll go on to questions.

Revenues for the third quarter compared with the prior period were up 13% to $159 million. The growth was driven primarily by pricing improvements and foreign exchange rate translation as well as volume growth in Asia Pacific and South America. Foreign exchange increased revenue by approximately 5% as the US dollar was weaker against most currencies, primarily the euro and the real. Regarding volume, overall volume for the quarter was down about 6%. Volumes in Asia Pacific and South America were higher; however, these gains were more than offset by declines in North America and Europe. In North America, both steel and metal working volumes were lower than the prior year stemming from softening of demand and consumer durables including automobile. Volume from both steel and metal working were lower than -- in the second quarter as well. Our sales to the automotive markets were also lower due to the lower customer productions despite continued share gains and conversions at CMS sites. Overall pricing mix was up about 14% from last year's third quarter. The higher sales prices reflect our continuing efforts to work with 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 and peaked in the third quarter. And despite the recent decline in crude oil prices, as Mike mentioned, our raw material costs remain largely unchanged.

As we've discussed before, we've 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. And while the second quarter was negatively impacted by a significant lag due to the sharp run up in raw material costs, price increases in the third quarter helped offset cost increases in the second and third quarter, and in certain areas we are taking additional actions in the fourth quarter to recover higher costs.

Turning now to our segments. I'd like to provide some data on our segment basis. As you'll recall, we segmented the businesses in three areas: Metal working process chemicals, coatings, and other chemical products. In our metal working process chemical segment which makes up 93% of our sales, revenues in the third quarter compared to 2007 were up 14% to $148 million, and operating income increased to $19.6 million which is a 4% increase. Sales in our coatings segment which makes up about 6% of our sales increased $300,000 or 3% due to higher chemical milling maskants sold to the aerospace industry and operating income increased 12% to $2.4 million. And in our smallest business segment representing 1% of sales, sales were up $100,000.

Turning to gross margins. Gross margin as a percentage of sales was 29.2% this quarter which represented a decrease from the 30.7% from the third quarter of 2007, but is an increase from the 28.3% in the second quarter of 2008. The 1.5 percentage point decline in reported gross margin from the third quarter of '07 was primarily due to the math of higher revenues and higher costs resulting in a higher smaller percentage. This represents a growth of effect related to raw materials and a change in CMS contrast. I would also like to note that despite the escalation in the raw material cost previously discussed, gross margin dollars from the quarter were up about 8% or more than $3 million for the quarter.

Turning to SG&a. SG&A as a percentage of sales was 24% of sales for the quarter versus 26% of sales in the third quarter of 2007 and a full year 2007 SG&A percentage of 25.6%. In absolute terms, SG&A for the quarter was up about 4.6% or $1.7 million with higher foreign exchange rates accounting for almost all of the increase. Increases related to growth initiatives as well as normal inflationary increases were more than offset by lower legal and environmental costs.

Now, turning to CEO transition costs, in connection with the retirement of Ronald Naples as Quaker's CEO on October 3 , Quaker is recognizing an incremental $5.8 million in expense over the next three years. $3.5 million of this was recognized in '08 including $1.6 million or $0.10 in the third quarter. Now these costs have been separately identified on the face of the income statement and are more fully detailed in the 8-K we filed on May 13, 2008.

Other income was lower than 2007 due to foreign exchange losses in the current year quarter versus gains in the prior year quarter, and interest expense is down over the third quarter of 2007 due to lower average debt balances outstanding benefiting from the strong cash flows we've experienced and lower interest rates as well as higher interest income. Our effective tax rate in the third quarter was 17.6% as a result of FIN48 tax reserves falling off due to auto settlements and statutory expirations. As we've previously discussed, we expect to continue to experience volatility on a quarterly basis due to both FIN48 and potential changes in income mix, and if you'll recall, the prior year quarter included a $700,000 rebate related to our increased investment in China as well as a non-cash out of period tax benefit of $1 million dollars related to certain preferred tax items.

Turning to the balance sheet and our cash flows, the company's net debt to total capital ratio decreased to 27% at September 30, 2008 compared with 36% at September 2007 and 32% at December 31, 2007. I'd also like to comment on a few other financial matters. As of September 30, under our primary credit facility, more than $50 million or almost half of the credit facility remains unused and available, and this credit facility matures in 2012. We also have a number of other local credit facilities which our subsidiaries fax us on a periodic basis. I'd also like to note that the financing for our Middletown, Ohio expansion is also in place. In addition to the $10 million IRB which we closed on earlier this year, we have also closed on a number of leasing commitments and also have arranged low interest state loan which closed earlier this month. On our consolidated leverage ratio at September 30, 2008, was under 2 times debt, while our maximum permitted leverage ratio is 3.5 times, so we have sufficient borrowing capacity, and that concludes my prepared

Thanks, Mark. And at this point, we would like to address questions from any of the participants on this conference call.

Thank you. (OPERATOR INSTRUCTIONS) Our first question comes from the line of Robert Felice with Gabelli & Company. You may ask your question.

Hey, guys. A couple of quick questions. I guess first, on an absolute basis, how much of your raw materials increased year-to-date? You mentioned a percentage number but just wanted to get my hands around the absolute number.

Yes, I think we mentioned in our last phone call, Rob, that we expected about a $40 million increase in raw materials for the full year 08, I think through the third quarter of around $25 million or so.

And you still expect that $40 million number?

-- $40 million number.

Okay. And what's the magnitude of your price cost gap?

We made some progress through the third quarter, but we still have some GAAP carrying over from the second quarter.

Okay. And we're finally starting to see base oil prices and other prices tick down, although they haven't obviously dropped as fast as crude has. Just wondering, as those costs start to decline, do you anticipate holding on to your price despite the weak demand environment?

Well, I think we target to get a certain margin from our customers and of course, as we went up in prices with our customers, we work with them to try to reach a certain margin level that we need to have an acceptable profitability level. And in a lot of cases, we're just getting to that point where we still haven't reached that point so as things begin to change, we get our price increases in place, raw materials begin to come down. Once we get to a certain point and we exceed that profitability level, we will be working with our customers to adjust pricing downwards. So I'd say for the most part, we still haven't gotten to our our margins need to be as a whole as a company so we still expect to see margin expansion going forward, but then once we get to a point where we feel they're at the right place given everything considered, then we will expect to see some declines probably going in our pricing.

Okay, and on a consolidated basis what would you say is that target op income margin at the appropriate level?

One of the things I kind of struggle with, is I know when you're looking at our P&L and looking at gross margin percentages and things like that, and operating percentages, we tend to, at a macro level, look at things more on a margin per kilogram level with our customers and what kind of margin we need to get an acceptable rate of return or EVA with a customer, so we do this on a customer by customer basis, so it's hard for me to kind of say at a macro level where we would be on something that you'd be looking at on a gross margin percentage. Mark, I don't know if you have any --?

I think that's right, and I think to add to Mike's earlier comment, one of the things we're finding also is while raw materials may decrease in the US as base oil prices drop, in Europe and other areas, the rapid strengthening of the dollar has caused absolute prices in euro terms to continue to increase into the fourth quarter as well. So that's part of the area we'll be looking to further increase prices to recover margin.

Okay, and I guess going back to the margin point, if either quantitatively or qualitatively you could help me get my hands around the absolute level of operating income improvement you'd expect before you get to a more normalized per kilogram or per customer margin level, what would that be?

I don't want to even throw out a number to you because again, I don't have that right in front of me, but I think the other thing that you have to think about, Robert, is that at the same time we're getting, we will see higher margins if we recover our -- continue our margin recovery here in the fourth quarter. But at the same time our volumes are going to be down, so what is the affect of that as I mentioned in my comments is that it's really hard to say. The volume effect can be significant, but so is our margin recovery, and it really depends upon the net effect of those two and given the uncertainty that we're seeing in our customer base right now with these production/reductions, it's hard for us to really give a clear view on the fourth quarter.

Okay, and I guess just to clarify what you said before on the fourth quarter, do you expect the level of year-over-year growth to slow, or do you expect to show a year-over-year decline in the fourth quarter?

Well, certainly from a volume perspective, it will be down year-over-year from what we know today. Now, revenue, when you throw in the price increases and revenue stuff from CMS contracts, again, I don't have that off the top of my head but overall, again, we expect to see the fourth quarter to be the least strong quarter with the least amount of strength of any quarter this year.

And from an earnings perspective, year-over-year improvement or is that a stretch?

We're not forecasting anything more about the fourth quarter than really just what I said.

Okay, I'll hop back in queue.

Sure.

Thank you.

Thank you. Our next question comes from the line of Liam Burcke with Janney Montgomery Scott.

Thank you. Mike, you talked about in the press release partially on the cost side, or Mark did on the pass through versus the gross receipts. In general, how did the business perform during the quarter?

The CMS business?

Yes.

The CMS business in general has been a pretty stable business for us and continues to perform very well. We get profit in different ways from our CMS business. We get it from fees that we charge our customer for managing the business, and that's relatively stable. We also get through our products that we sell to this customers and there, it's kind of a double-edged story. We've actually made significant progress and continue to sell and get more of our share of products into our customer base, but at the same time, the automotive customer base is declining pretty rapidly in the United States. The US economy this year, auto production is way down, as you know. It has been historically over 60 million vehicles a year, and this year it's going to be under 14 million vehicles, so -- and our customer base has certainly felt that quite a bit, so we haven't seen the full brunt of that because of these conversions, so from a product perspective, it's down, from a service perspective, it's been pretty good.

The other thing I'd just add to that as well is some of our contracts have indexes related to it ,so the full extent of raw material prices have not yet been reflected on index, just based on where the index meet that. So that's hurt us a little bit in the fourth quarter, but we expect to get that back in the fourth quarter or '09.

Yes.

Okay, and on the Middletown Ohio project, year-over-year capital expenditures up. I presume that's the expansion of that plant. In terms of percentage completion, how far are you along on that project?

Well we broke ground in the third quarter, so we're looking to finish that the third quarter of next year, so we're still in the early stages but as I mentioned before, the financing for that is all set up.

Okay, and then one last related question. Mark, your capital expenditure for the full year, general -- can you share some general guidelines?

Yes, I think our Middletown spending will accelerate a little bit in the fourth quarter compared to the third, but our base run rate of other CapEx should be roughly the same. I think we've had about -- somewhere between $2.5 million to $3 million of CapEx in Middletown so far this year, so I think if you back that off of our year-to-date and project that forward and say Middle town will probably be about the same in the fourth quarter as it has been from the -- so far this year.

Great. Thank you very much.

Thank you. Our next question comes from again from the line of Mr. Robert Felice of Gabelli & Company. Your line is now open.

Hey guys, just one or two follow-ups. Obviously, there's a lot of structural change taking place within the automotive industry, potential for some pretty big consolidation. As you think about the changes that are taking place there, how is Quaker positioned to deal with it, and how do you think about the risks associated with potential customers consolidating?

Well, certainly, we have very large positions with both General Motors and Chrysler, and we would expect to continue to have those positions as they end up hooking together. We've been, I think by their own admissions, a very significant part of cost reductions for them, so I think they're very happy about us as a supplier to them of services and products, so I don't expect any negative reaction from that perspective. Over time, we have been living with just the general decline in the auto industry in the US, but we expect to continue to try to expand in the auto industries elsewhere around the world, especially in Asia, India and so fourth as things expand in different parts of the world. So I would -- I don't see -- I just see the continuing trends that we have been experiencing to take place. We are, for example, we are becoming more and more active in Mexico where there's more and more opportunities for -- as the auto guys, Chrysler, GM tend to expand their operations in Mexico and we expect to have more of a service presence down there and get more of that business going forward. So it's just really -- I see a shifting around the world of where these opportunities will take place.

Okay, that's helpful and then I guess lastly, to your corporate unallocated expense for the year is running below last years level. Could you provide any guidance as to what that will be for the fourth quarter for the full year?

Overall, I'd say it will probably continue on the same kind of trend year-to-date. I think last year was a little higher. We had some environmental costs that were included in there, and we also had some higher incentive compensation costs last year, if you look at the year-to-date '07 versus 08, so we're not seeing those kinds of things for 2008.

Okay, so similar to the third quarter level, let's say?

Similar.

Okay. Thanks for taking my questions.

Sure.

You're welcome.

Thank you. Our next question comes from the line of Mr. Daniel Rizzo with Sidoti & Company.

Hi, guys, one quick follow-up question. In terms of your sales to the auto industry, do you sell into the Japanese automakers or into Japan at all?

No, not to a great extent. We have very minor sales. Certainly, it's an area we want to focus on more and it is an initiative for us, but it isn't a big part of our business today, and that's primarily due to a lot of the Japanese OEMs tend to buy from Japanese companies today, but we're hoping that through different mechanisms that we're working with, including enhanced technology products that we provide including the kind of service programs that we provide that over time, we will be able to penetrate more of the Japanese OEMs.

All right, thanks, guys.

(OPERATOR INSTRUCTIONS) One more moment, please, while we poll for any more questions. Thank you, but there appear to be no more questions at this time. I'd like to turn the floor back to management for closing comments.

Great. Thank you. Okay, so I'd like to thank all of you for your interest today. While these are challenging times, we will get through them and we will continue to prosper as a company. Our next conference call for the fourth quarter results will be at the end of February, and if you have any questions in the meantime, please feel free to contact Mark Featherstone or myself. Thanks again for your interest in Quaker Chemical. Goodbye.