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Quaker Chemical Corporation (NYSE:KWR)

Q2 2008 Earnings Call Transcript

July 31, 2008 3:30 am ET

Executives

Ron Naples – Chairman and CEO

Mark Featherstone – CFO

Analysts

Robert Felice – Gabelli & Co.

Daniel Rizzo – Sidoti & Co.

Operator

Greetings ladies and gentlemen and welcome to the Quaker Chemical Corporation’s second quarter earnings conference call. (Operator instructions)

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.

Ron Naples

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’ll both be available for questions. Also here today I want to point out is Mike Barry, currently our Senior Vice President 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 is no stranger to these meetings. But he is here today actually with a different portfolio in mind. As you may know, we announced early in May that I will step down as CEO on October. I’ll keep the Chairmanship for a while but I will be turning over to the top executive job. At the same time, we announced that Mike will succeed me in that top executive job as CEO.

So, I’ve been at this for about 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 on at this point in the conference, at least I’m spared all the signs of relief.

But I am very pleased to have Mike succeed me. He has been at Quaker for ten years. He is very well prepared in terms of the range of assignments he has had from 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 is very accomplished in terms of what he has achieved here at Quaker particularly in his recent North American role where he has 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 is very knowledgeable of our business and our global positions and strategies. He has been part of our global management executive committee for his whole time here at Quaker and has been an important contributor to our strategic development. He’s got very strong ties to our organization, and he speaks on our business and he speaks on 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 are very pleased with his appointment and we are glad to have Mike available to step in, and we think he is certainly ready to be an excellent CEO.

One other aspect, I hope this makes a valuable 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 principle 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 small company such as Quaker, with many competing and urgent demands always tugging on us, on our resources, our attention, and our time.

We have always focused hard 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 tradeoff here at Quaker.

Another result of this long-term, short-term balance is the kind of financial result we were able to report for the second quarter, and indeed for the first six months. There wasn’t many ways for remarkable quarter. These are “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 the consequent product levels was challenged. Housing activity and 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 earnings per share were flat with last year, $0.41 to $0.41. But I want to hasten to point out that these figures include about $0.12 a share charge in partial recognition of cost related to our CEO transition. So you can see that this was an excellent quarter, and we’re proud of the quarter we were able to deliver in these circumstances.

And I should point out that 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 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 have showed 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 to its lowest level in several years. The point is that we are dramatically outgrowing and outperforming our markets. We are doing this 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’ve put over the last few years on building a market position in the so-called BRIC countries in particular.

These are countries in which the middle class is growing with the consequent increase in demand for consumer durables, which creates demand 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 in 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 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 have developed in our country about how to uniquely serve – in our company, 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 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 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 trying to make sure that knowledge is available for competitive advantage everywhere in the company. These notions are captured in our destination, it is something that we’ve discussed before and I will not take time to read it now even though it's only two I think powerful senses for us. But as 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 have to do to achieve success. In other words, it’s constant touchstone and compass for us as we look to the future.

Put all together, this is a powerful completive 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 global company for a company of any size but 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, and organization of people focused on success, in the face of an uncertain world of market (inaudible) vagaries we believe we're 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 $0.5 million 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 is much more to come.

I hope this reenforces 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, and as well as the promise for the future as we take these attributes into that future.

With that, I'll stop and turn the session over to Mark, where he can fill you on some details and then later in the session, we'll both be available for questions. Mark?

Mark Featherstone

Thank you, Ron. Good afternoon everyone. While our reported EPS of $0.41 per diluted share is the same as the previous year, this includes $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’ll go on to questions.

As Ron mentioned, revenues for the second quarter compared with the same period of 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 has also increased revenues by approximately 8% as the US dollar weakens against both 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 that offset declines in North America and Europe.

In North America, both steel and metal working 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 limit steel imports and also boosted customer export activity which has helped to offset lower steel demand for our consumer durables including autos, as well as housing related demands such as appliances.

Our sales to the auto sector were also lower despite continued share gains and convergence 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 level. These cost escalations continue into the 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 2007 combined.

Now, those of you who have attended our investor presentations 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 in this catch-up effect. And while we achieved price increases in the second quarter, we have implemented additional price increases in the third quarter to recover higher cost.

Turning now to segments, I would like to give you a little more detail on a segment basis. As you recall, we segmented the business into three areas; metal working process chemicals, coatings, and other chemical products.

In our metal working process chemical segment, which makes up 92% of our sales, revenues in the second quarter compared to 2007 were up 15% to $146.2 million and operating income declined to $17.1 million.

Sales in our coating segment, which makes us about 7% of our sales increased $900,000 or 9% due to the higher chemical (inaudible) sales to the aerospace industry. Operating income increased 14% to $2.6 million. And our smallest segment, which represents about 1% of sales, 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 and 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 growth of effect [ph] 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 and raw material increases.

To give you a better sense of the dramatic and unprecedented cost increases we have been facing, the cost of some of our key base oils and animal fats in the US are up more than 50% since the start of 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 of 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 reasons 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 dramatic 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 will also note that despite the escalation of raw material costs just discussed, gross margin dollars in the second quarter were up approximately 5% or more than $2 million for the quarter.

Turning now to SG&A, SG&A as the percentage 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 range of 25.6%. In absolute terms, SG&A third quarter was up about 5% or $1.7 million, with higher foreign exchange rates accounting for about $2.5 million of the increase. Increases, related to growth initiatives as well as normal inflationary increases, were more than offset by lower legal and environmental costs, and lower incentive compensation costs.

Turning out 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 an incremental $5.8 million in expense over the next three years. $3.5 million amount will be recognized in 2008, including $1.9 million or $0.12 per share in the second quarter of 2008. These costs has been identified on the face of our income statements 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 costs, was slightly below last year’s percentage and we continued to target operating income as a percentage sales of more than5 % for the full year.

Other income was higher than 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 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 reflective of 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 the second quarter was 32.7% compared to 34.7% in the second quarter of last year, with a high tax on the net arbitration award I 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 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 – I mean, 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.

Ron Naples

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

Question-and-Answer Session

Operator

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

Robert Felice – Gabelli & Company

Hey 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 of the price cost gap.

Ron Naples

Mark, why don’t you give figures on that?

Mark Featherstone

Yes. For the first half of this year, we're looking at higher cost compared to last year in the range of $12 million or $13 million, and the under recovery was probably between $1 million and $2 million. And as we discussed, we're looking for – we have already implemented price increases to get that back in the third quarter. However, because raw material price has continued to escalate in the third quarter, we're looking at additional price increases as well beyond that.

Ron Naples

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 see, in terms of the percentage than the kind of decline you've seen in the first half of the year.

Robert Felice – Gabelli & Company

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 you need to go out in the market with additional price increase?

Mark Featherstone

As I mentioned, I'm sorry Ronald, I (inaudible) we do have a lot of price increases that went into effect July 1 and some more going into back 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.

Ron Naples

Yes. I think the point here is that $40 million that we've talked about, that of course is we can't know that number specifically yet. That's based on projections given what we know has already come down to track and we expect to come down the track further. Of course we have to stay responsive to the market as they actually develop. But all of our regions are working hard on making sure that we're 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 increase to try to do our best to stay ahead of the kind of escalation that we see coming. Of course, it's always built around working with our customers to find the right way to get this done, because we're serious about the notion of – the question here is the kind of value we can deliver to our customers and we will really focus hard trying to make sure that is understood in our customers.

Robert Felice – Gabelli & Company

So, do you feel comfortable at this juncture that you'll able to fully cover your raw material cost by the end of the year or do you think there's going to be some GAAP?

Ron Naples

Well, our expectation is that we should be able to recover some of the gross margin falloff, the gross margin percent falloff that we've seen in the first half of the year.

Robert Felice – Gabelli & Company

Okay. And 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 may be you can give us just some rough guidance for the full year.

Ron Naples

When you say unallocated, you mean indirect?

Robert Felice – Gabelli & Company

Yes.

Ron Naples

Mark?

Mark Featherstone

Yes. I think as I mentioned in my remarks, we have 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 do we like to see incentive come back? We will see how that goes, but the – so the environment and legal, we expect to be lower this year for the full year than last year.

Robert Felice – Gabelli & Company

So what I expect that unallocated amount to be similar in the second half to the first half or it will trend up, just trying to get my hands around that?

Ron Naples

Same kind of neighborhood.

Robert Felice – Gabelli & Company

Okay, so it should benefit you in the back half of the year?

Ron Naples

Yes.

Mark Featherstone

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

Robert Felice – Gabelli & Company

Okay, great. Thanks for taking my questions.

Ron Naples

You're welcome.

Operator

(Operator instructions) Our next question is coming from Daniel Rizzo with Sidoti & Company. Please state your question.

Daniel Rizzo – Sidoti & Company

Hi guys.

Ron Naples

Hi, Dan.

Daniel Rizzo – Sidoti & Company

You mentioned that you fully reduced debt by $40 million for the quarter, is that something that's going to be your focus going forward with your free cash. By getting the debt level lower, are you comfortable where it is, what's the story with that?

Mark Featherstone

Well, we are not focused on a targeted debt level and we want to use our cash the most effective way we can find and 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're gonna 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.

Ron Naples

The thing that's going to happen in the second half, Dan, is we've announce 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 (inaudible) in the second quarter double fund about half of that expansion. And when we talk about the net debt, we are excluding that. We are pulling that construction fund down from the net debt calculation.

Daniel Rizzo – Sidoti & Company

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

Ron Naples

Well, we are always anxious to make acquisitions that we think are important complements to what we do. But I think the important part of any acquisition we make is that has to contribute something to our market position and to our technology position. So we don’t want to simply add – I mean 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 something that were doing that's important to us in the metalworking 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.

Daniel Rizzo – Sidoti & Company

Okay, alright. Thanks guys.

Ron Naples

You're welcome.

Operator

We have a followup question coming from Robert Felice with Gabelli & Company.

Robert Felice – Gabelli & Company

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

Ron Naples

Yes, 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.

Robert Felice – Gabelli & Company

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

Ron Naples

No. It's not something that we think is something proprietary and important to us in terms of how we compete in CMS and would be good information for our competitors to have. We just soon not talk about that probably.

Robert Felice – Gabelli & Company

Okay.

Ron Naples

But you should know that when we look at competing for a piece of CMS business, the economic value add of that piece of business is a very rigorous exercise for us and what we expect to use in terms of Quakers 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 they are products.

Robert Felice – Gabelli & Company

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?

Ron Naples

I'm trying to get us to give you a number here.

Robert Felice – Gabelli & Company

Well – or a trend, just qualitatively.

Ron Naples

I think that would be CMS – well I'll put it this way. The CMS business has been very successful for us. We chose an account carefully in terms of the business we want to compete on. The economic value added analysis we've done in choosing our accounts builds in conversion opportunities. And so far we've made most of what we have planned on in those analyses happen. So I think that what you should take away from this is that we've been successful in serving our customer better with our products in these accounts where we think there's an opportunity.

Robert Felice – Gabelli & Company

Okay, that’s helpful.

Ron Naples

If there are any other questions, we would be – we are at your disposal. Okay, I'll assume there are no other questions, so I just thank you all for your interest. We are of course focused on delivering the best second half we can deliver. We have tremendous amount of confidence on what we can get done. So, I was going to say I look forward to seeing you talking again in the quarter, but that won't happen, but I look forward to listen with Mike has to say in a quarter, and I hope all of you have a good summer with (inaudible) of it. Thanks for the interest. Goodbye.

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