Quaker Chemical Corp (KWR) 2017 Q4 法說會逐字稿

Greetings, and welcome to the Quaker Chemical Corporation Fourth Quarter and Full Year 2017 Results Conference. (Operator Instructions) As a reminder, this conference is being recorded.

It is now my pleasure to introduce your host, Michael Barry, Chairman, CEO and President. Thank you. You may begin.

Thank you, Donna. Good morning, everyone. Joining me today are Mary Hall, our CFO; and Robert Traub, our General Counsel.

After my comments, Mary will provide the details around the financials, and then we will address any questions that you may have. We also have slides for our conference call. You can find them in the Investor Relations section of our website at www.quakerchem.com.

I'll now start it off with some remarks about the fourth quarter. I am pleased we have delivered another good quarter despite some market challenges. The quarter's results were largely driven by 2 major factors: the first were very strong sales; and the second, lower-than-expected gross margins.

Let me start with the margins. Since mid-2016, we have been in a generally rising raw material cost environment. And as we've discussed in the past, with raw materials, there is a lag effect between changes in our raw material costs and the adjustments to our product pricing. On the last conference call, our expectation was that gross margins would begin to increase in Q4, but instead, they were even with Q3 primarily due to raw materials being higher than our expectations. The good news is that we do expect our gross margins to trend upward over the next few quarters and expect that during most of 2018, our gross margins will be around 36%.

While we see raw materials continuing to increase, especially in the first part of the year, we also have pricing initiatives in place where necessary to offset the raw material cost increases as well. While we continue to experience more of this lag effect we have talked about in the past, we are making good progress, and that is the reason for our higher margin expectations. So we do expect the margins to continue to increase, but the exact timing of when we will reach our goal of 37% is hard to predict.

So now let me move on to sales. I am very pleased with the strong revenue and volume growth we have achieved in both the fourth quarter and the full year. Let me now give you some additional information at the regional level for the quarter. Our biggest segment, North America, showed a sales increase of 5% due primarily to the Lubricor acquisition last year as well as price increases. Our European or EMEA region showed a 17% increase, 8% of which was due to foreign exchange, while the rest was due to a combination of good volume growth and higher pricing.

In our Asia Pacific region, our volumes were very strong, driving essentially the entire sales increase of 11%. And for the 6th quarter in a row, we're happy to report that South America showed good revenue growth. The 24% growth in South America was due primarily to volume growth as well as price increases.

One way to look at our market share gains is to look at the overall organic product volume growth in the quarter of 5% and compare that to the underlying production growth in our base markets of global steel and auto, which we estimate grew at approximately half this amount. We believe this spread of over 2% is indicative of our share gains and is due to our commitment to our customer intimacy model. Specifically, we put our customers' needs first as our top priority, providing them with strong service and business solutions. I believe this approach continues to differentiate us in the marketplace.

In addition, we continue to invest in many other initiatives in our existing business lines and in each of our regions that will extend our competitive advantage and help us gain further share, which includes growing our recently acquired technologies around the globe. As I mentioned in the past, using baseball analogies, I see each of these initiatives as singles, and our goal is to hit many singles to produce multiple runs, and thereby show continuous growth even in challenging market conditions.

One item worth mentioning that I believe is worth a number of singles was our recent purchase of our partner's interest in our India JV. We now have 100% ownership of our India business, which we believe will have strong inherent growth characteristics in our base markets for the foreseeable future.

So in summary for the quarter, despite the challenges we face with lower-than-anticipated gross margins, we were able to grow our adjusted EBITDA by 15%. In a nutshell, we were able to do this by growing in our base markets, taking share in the marketplace and continuing to leverage our SG&A.

I would now like to make a few remarks about our combination with Houghton International. Since our announcement last April, we have been proceeding down numerous paths to close the deal. The one path that largely determines the timing of the close is the regulatory review process. Today, we have received approval from China and Australia. The U.S. FTC and the European Commission are still in the process of their reviews, and we do expect to divest a small number of product lines, but the current expected revenues are consistent with our original expectations. As we've said in the past, we're excited about this combination as it will essentially double the size of the company and enable continued above-market growth for good cross-selling opportunities and provide at least $45 million in cost synergies. Overall, we currently expect the regulatory reviews will be completed and our closing will occur in the first half of 2018.

Our intent is to have an investor call after the closing and provide an updated view of the new company as well as our expected synergies. So I believe 2018 will be another good year for Quaker. We expect to close the combination with Houghton, see gross margin improvement and get the benefits of tax reform. In addition, we expect to see growth in our end markets in most regions of the world, and we expect to continue to grow above the market as we have done historically through our growth initiatives and market share gains.

In closing, I want to thank all of our associates, whose dedication and expertise helps to create value for our customers and shareholders and differentiate Quaker in the marketplace. People are everything in our business, and by far, our most valuable asset. I'm very happy with our Quaker team and continue to be excited about the upcoming combination with the Houghton International team.

And now, I'll turn it over to Mary Hall, our CFO, so that she can provide you with more details behind the financials. Once Mary has completed her comments on the financials for the quarter, we will address any questions that you may have. Mary?

Thanks, Mike, and good morning, all. Before I begin, let me remind you that comments made during this call will include forward-looking statements. These statements are based on current expectations, estimates, projections and assumptions that are subject to risks and uncertainties, which may cause actual results to differ materially. For a discussion of these risks, please review the cautionary statements regarding forward-looking statements included in our earnings release and the risk factors included in our 2017 Form 10-K filed with the SEC. These are available on our website.

Turning to our results. As you all know, Mike likes baseball analogies, so I thought I would use one myself. To quote Yogi Berra, "It's deja vu all over again." Once again, Quaker delivered a strong performance in the quarter and for the full year, driven by significant increases in volume, primarily organic volume. While we continue to experience challenges in our gross margin as raw material costs were higher than we expected, we were able to offset this with continued market share gain, benefits from our past acquisitions, improvements in SG&A from our cost discipline, and most importantly, our relentless focus on serving our customers.

As I lead us into the financial summary, please note that Quaker provides certain information, including non-GAAP earnings per diluted share and adjusted EBITDA in an effort to provide shareholders with better visibility into Quaker's core operations.

Excluding certain onetime items, which we believe do not reflect our core operations. Reconciliations are provided in Charts 10 through 12 of this investor deck, and they are also in yesterday's earnings release and the Form 10-K filed yesterday.

So now if you please look at Charts 4 and 5 together as I highlight our financial performance. Quaker reported a 1% increase in non-GAAP earnings per diluted share in Q4 to $1.27 and a 9% increase for the full year to $5.01 versus analyst consensus of $1.25 for the quarter and $5.00 for the full year. We achieved these results on strong volumes and good cost discipline despite an erosion of gross margin due to rising raw material costs. Our adjusted EBITDA of $29.6 million for the quarter was up 15% versus Q4 last year, and our full year adjusted EBITDA of $115.2 million was up 8% versus prior year. Both are records for Quaker.

The strong volume drove net sales increases of 10% for both the quarter and the year. Unlike the previous several years, FX was less of a factor in 2017, impacting Q4 and the full year by 3% and 1%, respectively. Appreciation of the euro versus the U.S. dollar was the primary driver for the positive FX impact on results, as the euro started 2017 at 1.05 to the dollar and ended the year at 1.20 to the dollar, a 14% appreciation.

Our gross margin declined about 1.4% Q4 to Q4 last year to 35.1% due primarily to rising raw material costs, which also impacted our full year gross margin, which declined about 2% to 35.5%. We began to see margin improvement toward the end of the year and expect gross margin to be in the 36% area for most of 2018, with our target still in the 37% area, although timing of that is hard to predict.

Quaker continued to show good cost discipline as we leveraged our infrastructure to support the strong top line growth, helping to offset the gross margin decline. Note that our GAAP operating income includes combination-related expenses of approximately $30 million for the year.

With respect to taxes, our Christmas surprise in the form of U.S. Tax Reform makes comparisons to prior periods a bit difficult. As we noted in our press release and Form 10-K, we took charges in the fourth quarter of about $17.8 million for the transition or toll tax on foreign undistributed earnings and profits, which we will pay out over 8 years and the charge of about $4.5 million for the revaluing of our deferred tax assets and liabilities to the new 21% corporate rate. We estimate that excluding the impact of tax reform and certain nondeductible combination expenses, our Q4 effective tax rate would have been approximately 29%. For 2018, our best estimate at this time is that our ETR for the year, excluding combination expenses, will be in the 23% to 25% range versus 27% to 29% without tax reform.

Overall, our strong operating performance drove solid operating cash flow of about $65 million, which is down from last year's $74 million due to approximately $26 million of cash outflows for combination-related expenses. You can see that our net cash on hand of about $90 million is up slightly from last year with no increase in debt, and yet both reflect the additional cash expenditures for combination expenses, our purchase of the outstanding 45% ownership of our India JV for about $32 million in the year and a 6% increase in dividends paid year-over-year.

As you can see, Quaker continues to deliver strong cash flow and use its cash and balance sheet prudently to grow the business. The next few charts give you some more history and context to certain of our key metrics. Chart 6 reflects volume trends and shows our 8th consecutive year of volume growth, which is up 7% in 2017.

Chart 7 shows our gross margin trends, and here you can see the year-over-year decline as raw material cost trended upward. As Mike indicated, we're beginning to see gross margin improve and expect to be in the 36% area for most of this year.

Chart 8 shows our continued climb in adjusted EBITDA as we ended the year with a record $115.2 million, up 8% year-over-year.

And finally, Chart 9 shows our continued discipline in managing the balance sheet, resulting in a strong net cash position of $23.1 million at year end.

In summary, despite the noise around us, Quaker continues to deliver on its operating model to drive solid financial performance for its shareholders. Looking into 2018, we expect auto to show positive growth globally even with the U.S. and most of Europe expected to be relatively flat to 2017, and for steel to show modest growth.

We continue to expect market share gains and our leveraging past acquisitions to drive above-market growth. In addition, we expect to close the Houghton combination in the first half of this year, roughly doubling the size of the company. In short, we expect another busy year, one that will be unique in the life of Quaker, but we expect to continue to deliver the good performance our shareholders expect of Quaker.

So thank you all for joining us and for your interest in Quaker. And now, I'll turn it back to you, Mike.

Thank you, Mary. At this stage, we'd like to address any questions from any participants on the conference call.

(Operator Instructions) Our first question is coming from Mike Harrison of Seaport Global Securities.

Mike, I was wondering if you could give us a little bit more color on the raw material picture? Are you having any issues with raw material availability, any shortages of key materials or are they just going up in price? And also are you seeing any regional differences in terms of the pace of raw material inflation?

Sure. On the first part of your question, there is not really availability issues at all with it. It's more around our expectations of something happening in the quarter. So like, for example, in the fourth quarter, there were hurricane events, crude was increasing, let's say, more than anticipated. So that just kind of means there is another round of price increases we have to kind of go through. So once these kind of things level out, stabilize when we get the pricing freeze into place, we'll get back to kind of where we need to be. We're just being in this environment really that has been kind of going up. You definitely do see regional differences, I think, some more challenges in the Asia Pacific region, but currency can play some roles in this as well. So there are some differences, but we just react as raw materials go up, and put price initiatives in place to offset them.

And as we're thinking about the price that you're going to need in order to be able to offset that and kind of get to the 36% that you're targeting for 2018, I mean, should we be modeling kind of a 1% to 2% pricing contribution for the year or could we see that number get more into the mid-single digits?

No. I think it's probably in the lower end of that, yes, not mid-single digits.

Okay. I'm curious on South America. Obviously, a very strong quarter and we've seen some improvements there, but it seems to be coming in fits and starts. Can you give any thoughts on kind of what you've seen as Q1 has unfolded, and we're in kind of a seasonally slower period in South America. Has that sustained or are we having a steady start again?

We won't comment too much on the first quarter for this, so -- kind of still early relatively speaking from a results perspective. But I would just say, in general things continue to do very well in South America. So from a volume perspective, we just continue to see more steel production and more auto production.

And then last question for me for now is on how -- it sounds like you're still waiting for the approvals in the key jurisdictions in the U.S. and EU. At this point, do you have any update on what might need to be divested? It sounds like you said that's still within what you had originally been anticipating, but just any color there would be appreciated.

Sure. I think we've mentioned in the past the areas that we felt would -- there have to be some remedies or divestitures around will be some product lines in the primary metals area. And that's what was our expectation going in and that's what's going to be coming out. So we'll have to do some divestitures in that -- in some of those areas. And really, the commenting on that is, there's really nothing negative in this regard. And like you said, it is not inconsistent from our original modeling or original expectations. It's just the process itself that is taking a little longer.

Our next question is coming from Jonathan Tanwanteng of CJS Securities.

Can you talk about the cash flow benefits of the U.S. Tax Reform, are they basically equivalent to the change in effective tax rate?

Well, we do expect some benefit to the tax rate will result in lower cash taxes, so there will be some benefit clearly there. And as I indicated, we do expect pretty meaningful benefit dropping our effective tax rate to that 23% to 25% area this year.

Okay. And can you remind us what proportion of Houghton revenue profits are in the U.S. and if they get the same level of tax benefit at all?

We expect that our NewCo, as I think about it, the combined company, will have similar -- end up in a similar tax place as what I have indicated for Quaker.

They have a little, as a percentage of business, a little less in the U.S. than we do. But as Mary said, our best estimate at this stage, we'll have an equivalent impact between the 2 companies from the U.S. Tax Reform.

Okay, great. And then, Mike, how much of the synergies you've talked about in that $45 million or better actually show up in the gross margin for the company few years down the line. What is the gross margin potential, I guess, of -- once you've integrated it assuming a more normalized environment for us?

Yes, John, yes, there is definitely a portion of it because when you're talking about part of the synergies, we're talking about are going to be in the procurement area, the raw material area as well as the manufacturing and supply chain and having a more efficient supply chain. So there will definitely be a portion in that. I think our intent, I guess, is when we announce the closing, we would then have a conference call, and we'll kind of walk through some of those benefits and the timing in more details at this. But at this stage, we're not ready to disclose all of that.

Okay, fair enough. And then just last one quickly, is it still possible for Houghton to close in Q1? Since you said first half instead of Q2, I was just wondering what the timing thoughts are around that.

Sure. I mean, it's possible, but the fact that we're sitting here on March 1, I would say it's more likely that it will be a second quarter event.

Our next question is coming from Edward Marshall of Sidoti & Company.

I just want to understand the theme of how, if I could for a second, the delay, have you had any particular correspondence with the regulators? I mean, what are they saying, how close do you think you are? And then likewise, you spent about, I guess, $30 million of combination-related cash expense this year. What's your estimate, I guess, as we move into the first half of 2018 for the total number of combination-related expenses?

Okay. On the contact with the regulators, yes, there's a lot of contact on a daily, weekly basis with it. We have a lot of respect for the regulators and the process they go through. There is no disagreements, it's just working through the process at this stage. So there is not a lot of gnashing of the teeth or a lot of disagreements. It's just a very detailed process you have to kind of go through and complete before you can close the transaction.

And regarding the expenses that you had a question around, Ed. So from the beginning of the year through and including close, we expect to spend another $30 million to $35 million. A lot of that is related to at close, paying the advisers, banks, et cetera. So that's $30 million to $35 million.

Additional is what you're saying.

Majority of which we would capitalize.

Okay. And you said that's additional to the $30 million that has been spent already.

Yes.

Okay. And then if I could, you touched on pricing already. I just kind of want you to elaborate on that a second. How are -- maybe the same type of question. How are pricing discussions going with customers? It sounds like they're receiving -- it's being well received, I guess, or maybe not as well as you would like, but I'm curious about are you -- do you expect in 2018 to continue to play catchup if raw materials continue to increase or will there be large step changes where you're trying to get ahead of it for a while, then the raws will catch up. I just kind of wanted to get your sense as to how that pricing kind of dynamic might work.

So we kind of already said this, once price is stabilized, it's like -- basically there is a 3 to 6 months lag. So if prices go up, it takes 3 to 6 months to go. And, of course, the opposite happens on the way down. So on a stable environment -- once you get stabilized for a while, it's going to reach its natural course. I think one of the things that has happened over the past several quarters now is that just has continued to increase. So we're kind of continue to be in this mode. We generally don't overshoot on prices with our customers anticipating higher things. We want to be fair for our customers, and as we see price increases, then we make adjustments with them accordingly. So it's really just a timing thing. So if things stabilize from this moment on, then you'll be looking 3 to 6 months out having -- go back to the margins that we kind of expect to have. So it's just a matter of how things continue to progress from here on out. And one thing I know I found over time is what we've been told or what people have forecast that hasn't been true. It's been -- we thought things were going to be stable for a while, and then certain events happen, crude goes up, hurricanes happen or whatever.

Right. And so are you saying that -- are you saying you start to see you're already into that 3 to 6 months' lag and that you've seen the raws kind of stabilize. I don't think that's what you're saying, but is that what you're saying?

I'm saying, we've been doing price increases for many, many quarters now. It's just that the raw materials keep coming up more. So we're kind of in that cycle. So what's happened -- price increases are fine, and we are getting them where we need them. It's just really the continuation of the raw materials progressing upwards.

And is this simple just kind of be -- maybe I can answer this question, but is it simple as saying, hey, our gross margin should be 37%. Take the difference between the 37% and the 35% the one you reported and say, hey that's the drive from pricing or is there other things in that number that I need to think about?

On a quarterly basis, there can be other things in that gross margin number because there is manufacturing in there and there can be swings in different things and so forth. But when you look at it over, let's say, a course of a few quarters and so forth, those type of things wash out I kind of think and it's -- really that differences could be really explained by more the raw materials and the pricing that we need in our products.

Our next question is coming from Laurence Alexander of Jefferies.

This is Daniel on for Laurence. In the press release, you mentioned mix issues being somewhat of a thing in the fourth quarter. I was just wondering if you can provide some color on that. I mean, is there certain region or certain end market where mix is kind of decreasing?

Well, one of the things with Asia Pacific, in particular, we can have some mix issues where, as various businesses ebb and flow there. Mining is one I think about in China as an example. That has been gradually picking up over time. And that can tend to be a little lower in margins, and that can influence it. And so within any certain quarter, you can have certain mix issues when you look at it generally in the full year, it's not too bad.

Okay. And then in just -- you mentioned that auto is flat in U.S., flat in EMEA, and improving elsewhere, can you just give regional trends on steel?

Regional trends on steel. It was, I'd say, in general, when I think of 2017 was a pretty good year for the steel industry. It's really one of the first times we saw almost kind of everywhere having decent steel production growth all at one time. So I think we're seeing pretty good, in general, increases across the board throughout the whole world. There is not, I would say, one area that is just tremendously growing. You kind of see things in both North America, EMEA with pretty decent steel growth. And China, China is the one that's the harder one to kind of get your hands on because when you look at the data, and most of the data comes out of the World Steel Association, they have even admitted it's probably somewhat overinflated when you look at China because the data itself doesn't naturally count some of the smaller inefficient mills. And when they have shut down and they weren't in the baseline, let's say, to the prior period and some of that is shifting to the larger mills, which is in the data they collect, it kind of overinflates a little bit. So but overall, I would say from our perspective, we are seeing pretty constant growth in all places with steel and -- in all parts of the world, and we expect steel to be, as Mary said, a pretty good market again this coming year, maybe not quite the same amount of growth, but generally good growth for steel.

Our next question is coming from Liam Burke of B. Riley FBR.

Mike, you had lower gross margins this quarter, but your adjusted operating margins were higher year-over-year. Could you give us some color as to how you are managing that SG&A line?

I will chime in here, Liam. Again, we just continue to be very disciplined in managing our costs. So we've said all along that one of the benefits in the combination with Houghton will be increasing the size of the company and we've shown an ability as we do that as we grow revenues to continue to leverage that operating margin, and you're just seeing that play out kind of quarter-over-quarter for us.

Okay. And in the past you've made acquisitions. Some of those acquisitions you could leverage your existing sales channels or your relationships in the steel mills. Others you had to sort of build incremental distribution. Looking at the market share gains you have here, do you have the organization in place to handle both your current acquisitions and then potentially Houghton?

Yes, we do. I mean, the past acquisitions, all the people that we had to -- say, business development people we had to put different places around the world, they have been established, and we do have the resources in place to drive continued growth there. And as I -- again, using baseball analogies, we're still relatively in the early innings of that. So rolling out these new technologies. So we're very optimistic about that. And then, of course, when we have the combination with Houghton and that gets finalized, both companies will have the internal resources to be able to do the cross-selling synergies.

On the early innings, is it similar, I mean, are the products similar where you have a longer sales cycle here?

Yes, I mean, I wouldn't say it's going to be day 1, we come in and everything -- but it's going to be kind of the same thing. But the good news is, we have the channels in place to the customers. We have the people in place. We have the technologies. The one thing we won't have to do is hire people from different places around the world. So from that perspective, it's fine. As far as qualifying products with customers and so forth, we're going to still have to do that and that can take some time. At least we have all the infrastructure in place.

(Operator Instructions) Our next question is coming from Garo Norian of Palisade Capital Management.

First question was on the gross margin commentary around, let's say, 36% ballpark for this year, and still gunning for the 37% target. Is that kind of ex-Houghton comment or including Houghton and ultimately what's the right way of understanding it?

No. It's not. It's that -- when we are giving that kind of guidance at this point, that's Quaker only. So the structures and gross margins around Houghton, we'll get more into once the combination is done and then we'll -- as we have that conference call talk about what the new company looks like, and then we will give you more of a sense of okay what's the combined margins and prospects around that.

Great. Okay. And just on the raw materials and what you've been dealing with, is there anyway volume perhaps benefit as customers might want your help to reformulate things so that the costs net to them aren't going up so much?

Sure. One of the things we do with customers all the time is, we have a certain agreement that's going on, and we feel we can reformulate and give them the same performance using a lower cost raw material, we give them that option and sometimes they choose to take it and sometimes they don't or sometimes they may trial it. So that's kind of, over the course of history, a lot of things we constantly do with our customers.

Great. On the product volume chart that you guys include, just eyeballing it, it looks like through the quarters of 2016, it was kind of nice sequential growth and then through the quarters of 2017, it was a bit more flatfish. I guess, can you remind me what was driving '16? Or maybe just talk about why '17 didn't see the continuation of the kind of growth that '16 had seen?

Actually, I don't have too much detail off the top of my brain. I think some of that is acquisition impact, Garo. So as you know, we did a small Lubricor acquisition at end of November 2016, but that's really the only thing acquisition, for example, that's impacting that 2017 numbers, whereas in the prior year, end of '15 and going into '16, for example, we had Verkol acquisition and more significant acquisitions.

Our organic growth this year is 5%. So -- and that's really one of the highest periods. So 2017, I mean, has been a really good -- really strong year for just basic organic growth for the company.

That's what I was kind of trying to make sure I understood because my impression is that this year was actually one of the strongest years in the last few, but then just visually, it didn't seem to be consistent. And then just last question for me is, can you remind me, is there anything in the agreement with Houghton related to kind of a date where things need to close by or otherwise for some reason the deal doesn't go or I just -- usually I feel like there is some sort of end time in these types of agreements?

No. There is no date in which the agreement terminates. There is a provision in the agreement that once you reach the 1 year mark, you can take steps if you want to try to do things differently or get out. But certainly our intent is to continue on with this, it's going to add a lot of value for our shareholders, and certainly haven't heard anything from the other side of wanting to do anything different as well. So we're excited about this.

At this time, I'd like to turn the floor back over to management for any additional or closing comments.

Okay. Given there is no other questions, we will end our conference call now, and I want to thank all of you for your interest today. We are pleased with our results for the fourth quarter and full year, and we continue to be confident in the future of Quaker Chemical. Our next conference call for the first quarter of 2018 results will be in late April or early May. And if you have any questions in the meantime, please feel free to contact Mary or myself. Thanks, again, for your interest in Quaker Chemical.

Ladies and gentlemen, thank you for your participation. This concludes today's conference. You may disconnect your lines at this time, and have a wonderful day.