Quaker Chemical Corp Q3 FY2020 Earnings Call

Greetings. Welcome to Quaker Houghton Third Quarter 2020 Investor Call. At this time, all participants are in a listen-only mode. A question-and-answer session will follow the formal presentation. Please note this conference is being recorded. I will now turn the conference over to Michael Barry, Chairman, CEO, and President. Thank you. You may begin.

Good morning, everyone. Joining me today are Mary Hall, our CFO; Robert Traub, our General Counsel; and Shane Hostetter, our Head of Finance and Chief Accounting Officer. We have slides for our conference call. You can find them in the Investor Relations section of our website at www.quakerhoughton.com. A great deal has changed in the world in 2020 with the COVID-19 pandemic. For us, our top priority is and has been to protect the health and safety of our employees and our customers, while ensuring our business continuity to meet our customers' requirements. All of our 34 plants around the world are operating, and we are satisfying all of our customer needs. I am very proud of what the Quaker Houghton team has done to continue servicing our customers, as well to continue our integration efforts, which are going well. We are pleased with our results for the third quarter when considering we were coming from such a weak second quarter. Overall, our sales were up sequentially 28% from the second quarter and down 5% from the third quarter of last year on a pro forma basis. Let me now give you a little more flavor on what we experienced by segment or region. First, as we look sequentially, the Americas saw the largest quarterly net sales improvement as sales grew 48% sequentially, driven primarily by stronger volumes. A similar story I heard in Asia Pacific, EMEA, and our Global Specialty Businesses, where volume improvement drove net sales increases of 24%, 21%, and 16% respectively compared to the second quarter. So we saw good sequential improvement in all business segments. Another way to indicate this sequential quarterly sales trend is to look at what happened in our three main customer industry groups on a global basis. Metalworking increased the most and grew 39% sequentially from the second quarter, due primarily to automotive OEMs and related suppliers coming back from the prolonged shutdowns or significantly reduced production rates in the second quarter due to COVID. Our other industry groups of metals and Global Specialty Businesses also increased and showed growth of 21% and 16% respectively. I hope these different cuts of our significant sequential sales increases help provide insight into what was happening in the quarter. Overall, our sequential volumes were up 27%, but our pro forma volumes were still down versus last year by approximately 10%, when excluding the positive impact of Norman Hay, which we acquired last October. This approximately 10% decline was felt in all regions and segments. However, Asia Pacific was less impacted since China actually showed modest year-over-year growth. I also want to point out that we did continue to take market share despite the weakness in our end markets as our continued analysis shows that we have total organic sales growth due to net share gains of approximately 2% in this quarter versus the third quarter of last year. I am very pleased to see this strong rebound from last quarter, but we're certainly not all the way back. As we said previously, we estimate it will take at least two more years for our markets to fully return, and some markets like aerospace, which make up about 3% of our sales, will take more time than that. However, we expect our sales to rebound more quickly due to our projected continued market share gains, as well as our potential smaller bolt-on acquisitions in the future that we may make. Concerning gross margins for the third quarter, they were up significantly compared to both the second quarter and for last year. The sequential increase is primarily due to higher volumes and its impact on the fixed portion of our manufacturing costs. The increase from last year was primarily due to the realization of our manufacturing and raw material cost synergy savings. This pandemic and its impacts have been similar in many ways to what we went through in late 2008. Just like then, we took fast action to save costs in numerous ways. Essentially, all discretionary expenses have been eliminated, we stopped new hires where possible, some positions were furloughed, and our planned capital expenditures have been cut by over 30%. And very importantly, we reviewed our integration and synergy plans in light of this situation and took additional actions as well as accelerated other synergies where possible. This has led to additional cost synergies as we have increased our guidance on synergy achievement again this quarter. For 2020, our current estimate is $58 million of cost synergies achieved versus our earlier estimate of $53 million. Also, the total synergies we estimate we will achieve in 2021 have been raised from $65 million to $75 million, with 2022 reaching $80 million. In this quarter, we achieved $17 million in synergies, and we expect sequential improvement during our future quarters. So overall, we are pleased with the quarter, given the environment in which we were operating, and we did see significant sequential improvement in our sales, gross margins, and adjusted EBITDA. Also, our cash flow is very strong and our net debt decreased by 7% or $58 million. The positive cash flow nature of our business during severe downturns is something we have discussed with investors in the past, and we're now seeing its positive impacts again in these tough times. Looking ahead, we anticipate that throughout the next year or two, our markets will show gradual sequential improvement. However, it's hard to predict that improvement by quarter, given the continued uncertainty in our operating environment. For the fourth quarter, we expect our adjusted EBITDA to be in the ballpark of the third quarter, and for the full year, we expect our adjusted EBITDA to exceed $215 million. Overall, our higher expected synergies, additional cost-saving actions, and improvement in our product margins and our cash flow management are expected to continue to help us during this period of time when our markets are down versus pre-COVID levels. As we look forward to 2021, we expect our adjusted EBITDA to increase by over 20% as we continue our integration savings, take market share in the marketplace, and benefit from an expected gradual rebound in demand. In closing, I want to thank all of our colleagues at Quaker Houghton, whose dedication and expertise help to create value for our customers and shareholders and differentiate us in the marketplace. I am so proud of how our team has performed in servicing our customers, meeting their needs, and successfully continuing with our integration execution, which is both critical and difficult for us this year. People are everything in our business and by far our most valuable asset, and ensuring their safety and well-being is and will continue to be a top priority for us. I'm proud of and very happy with our Quaker Houghton team and what we have and will be able to accomplish for our customers and investors both now and going forward. And that concludes my prepared remarks. I'll now hand it over to Mary so that she can review some of the key financials for you for the quarter.

Thank you, Mike. And good morning all. Before I begin, let me remind you that comments made during this call include forward-looking statements, which 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 in our 2019 Form 10-K filed with the SEC. These are available on our website. Please also note that we continue to update our risk factors in our Form 10-Q to address the evolving COVID-19-related issues, and these risk factors should be reviewed along with those in our 2019 Form 10-K. In our press release and in this presentation, we provided certain information, including non-GAAP earnings per diluted share, non-GAAP operating income, and adjusted EBITDA as well as certain pro forma items in an effort to provide shareholders with better visibility into the company's core operations, excluding certain items, which we believe do not reflect our core operating performance. Reconciliations are provided in the appendix of this investor deck. In this review, our comparison periods show actual and non-GAAP results, as well as pro forma sales and pro forma adjusted EBITDA as if we had been combined with Houghton throughout the periods presented. Remember that we closed the Combination on August 1, 2019, so our actual reported and non-GAAP Q3 2019 results include only two months of Houghton. Please see slides six through ten now, while I review some highlights. As Mike noted, we saw sales rebound of $367 million in the third quarter, up 28% from $286 million in Q2, but still down 5% from pro forma Q3 2019 sales of $386 million, due primarily to lower volumes as a result of COVID-19. Our gross margin of 38.2% is up significantly from our gross margin of 34% in Q2 and 32.3% in Q3 of last year, which we estimate would have been about 35.5%, excluding a purchase accounting adjustment. We also saw a benefit to our gross margin this quarter that we estimated at approximately 0.5%, which we attribute to price mix that we believe was unique to the quarter. You might remember on our last call that I commented that we expected the benefits of our procurement synergies and manufacturing optimization to be more visible as volumes pick up, and this is what you see coming through as part of our sequential improvement. In addition, our cost synergies in these areas continue to increase, as reflected in our updated cost synergy estimates. Our non-GAAP operating income of $43.2 million rebounded significantly from Q2's $11.2 million and is also up 25% from $34.5 million in Q3 of last year, primarily due to the addition of Houghton and Norman Hay and the benefits of realized cost synergies, partially offset by the negative impact of COVID-19. Similarly, our non-GAAP EPS of $1.56 is up significantly from Q2's $0.21, while it is flat to last year as a result of the additional shares issued at close of the Combination. Our effective tax rate in the current quarter was an expense of 8.1% versus a benefit of 27.6% in Q3 of last year. We've seen significant volatility in our quarterly effective tax rates due to COVID-19-related changes in profitability as well as continued updates to the 2017 tax law. Excluding the impact of all unusual items, we estimate that our Q3 effective tax rates would have been approximately 24% and 20% for 2020 and 2019, respectively. For the full year, we expect our effective tax rate, excluding all unusual items, will be in the range of 23% to 25%. As Mike mentioned earlier, we're pleased to see our adjusted EBITDA almost double to approximately $64 million in Q3 from the Q2 level of approximately $32 million and increased approximately 5% compared to our pro forma adjusted EBITDA of $61 million in Q3 of last year. This is due primarily to the benefits of our realized cost synergies in the quarter and the inclusion of Norman Hay, more than offsetting the negative impact of COVID-19. Another bright spot in the quarter was our cash flow. As we discussed in our last call, because our business is so asset light, with most of our investment in working capital versus property, plant, and equipment, when we experience a major downturn in volumes, we expect to see significant positive cash flow from releases in working capital. Indeed, we saw this in both Q2 and Q3 and are pleased to report that our year-to-date operating cash flow more than tripled versus last year to $112 million. In addition, our low capital intensity allows us flexibility with our capital spending, and consistent with our Q2 call, we're on pace to reduce our CapEx by more than 30% versus our original pre-COVID estimate. As a result of our strong cash flow, we were able to reduce net debt by $58 million, a 7% reduction from Q2. This improves our leverage ratio to 3.4 times from 3.7 times at the end of June, and our bank-calculated leverage at the end of Q3 was about 2.9 times versus our covenant maximum of 4.25 times. In short, our liquidity and leverage showed good improvement from already solid levels. In addition, as Mike noted, we further increased our estimates of expected Combination cost synergies from $53 million to $58 million in 2020, from $65 million to $75 million in 2021, and from $75 million to $80 million in 2022. In summary, our track record of navigating successfully through tough economic environments by gaining share, disciplined cost management, and generating good cash flow during major downturns all give us confidence in our ability to weather the current challenges. This strong core operating performance is further enhanced by the cost synergies we are realizing from the Combination, and we're seeing the meaningful impact of the synergies on our financial performance. In 2021, as Mike mentioned, we expect to see a greater than 20% increase in adjusted EBITDA. Finally, we believe the company is well positioned to leverage the expected upswing in business activity. Thank you all for your interest in Quaker Houghton, and now I will turn it back over to you, Mike.

Thank you, Mary. We'll now open it up for questions.

Thank you. Our first question is from Mike Harrison with Seaport Global Securities. Please proceed.

Hi, good morning.

Good morning, Mike.

Good morning.

Congratulations on a nice quarter, and I hope they're counting your ballots as we speak.

I think they are.

I was wondering if you can talk a little bit about what's driving the confidence in your 2021 EBITDA outlook. Obviously, you increased the synergy assumptions and that's contributing, but what are you assuming around the rate of recovery in some of your key markets, and I guess, what are your thoughts on the potential impact of the second COVID wave?

It's difficult to predict exactly how a second wave of COVID and the current lockdowns in Europe will affect us. Our expectation for a 20% or more increase is based on a gradual improvement in our markets from where we are today. We also anticipate continuing to gain market share, which typically adds around 2%. However, we are hopeful that we won't experience a drop as severe as we did in the second quarter of this year. If we see steady improvements in our markets and continue to achieve synergies, we believe this will positively influence our results. Of course, if another COVID outbreak leads to widespread lockdowns that exceed current forecasts for orders and steel, that could alter our outlook. This assessment is based on our best estimates currently available.

All right. And then, wanted to ask about the steel business, we've seen a little bit of consolidation with Cleveland Cliffs and AK Steel as well as ArcelorMittal's U.S. assets. Can you talk about what that consolidation means for your steel business?

Both of those customers are very significant customers to us. In some ways, switching - probably we'll switch our largest customer from being ArcelorMittal to the AK Steel Group or the closed group. So - but essentially we don't expect to see any difference. We have very strong relationships with those customers and we don't anticipate any impact on our business because of that.

Wanted to ask about the Americas business, it really seems like the margin performance there was a lot stronger than what we were anticipating and obviously a massive improvement on a year-over-year basis. Can you give maybe a little bit more color about what drove that margin strength, particularly in the Americas?

The Americas, we have, I would say a disproportionate amount of raw material savings. Our raw material savings that we're achieving are disproportionate and more of it in the Americas than in other regions or business segments. So that's one aspect. We also had - we're doing our manufacturing consolidations. We've been pretty conservative or ensuring that we don't disrupt supply. So we have taken these shutdowns and while we plan properly and transition materials before we shut down a certain plant. Most of those shutdowns happened in the first wave of manufacturing consolidation, really happened in late in the second quarter, and of course in the Americas, we saw some of that too, but that's really everywhere around the world basically. But when you add those two impacts together, I think it's - you just see - tend to see more of it in the gross margin area in the Americas and other places.

All right. And then last question for me for now is just a clarification on the EBITDA guidance. You're talking that Q4 EBITDA should look similar to Q3, which was $64 million. By my math, that would put you above $220 million for the full year and you're guiding to more than $215 million. I'm aware that $220 million is more than $215 million, but just wondering should we be looking for Q4 to be more like high 50s than the $64 million you did in Q3? Or do you feel like it exceeds $64 million?

I think our mindset reflects a cautious approach, especially considering the current uncertainties in the marketplace. For instance, we are experiencing lockdowns in Europe, and it remains unclear how this might affect things like seasonal trends at the end of the year. It's possible that customers may reduce operations, but we don't have definite answers yet. This situation highlights the overall uncertainty we face, but we are trying to provide a range for potential outcomes.

Understood. All right, thanks very much.

Thank you, Mike.

Our next question is from Laurence Alexander with Jefferies. Please proceed.

Hey, guys. It's Dan Rizzo on for Laurence. How are you?

Good. Good morning, Dan.

Good morning, Dan.

Have you guys identified any Houghton revenue synergies yet and I missed it? I mean, is there any - kind of any - anything out there on that?

Yes, we are getting synergies. We haven't really pointed them out or quantified them per se, but when I do say that we are getting net market share gains of 2% this quarter versus like say the third quarter of last year, part of that is due to the cost synergies that we're achieving — not the cost synergies, the sales synergies that we're achieving due to the Combination.

Okay. That's helpful. And then on the cost synergies and temporary cost reductions, I was wondering how much of the temporary cost reductions will be coming back next year and when and how much that will be offsetting or how that will offset the synergies you're looking for from Houghton and just from general productivity?

Sure. That's a great question. A lot of it will likely depend on how quickly COVID resolves. Currently, it is quite challenging for us to travel frequently. We anticipate, particularly in the second half of the year, that we will hopefully return to a more normal situation next year. Some things will come back, and we are optimistic about that. When I mentioned our EBITDA being over 20% next year, that considers not only the additional synergies but also some extra costs that will return as we hopefully transition back to a more typical business environment.

If I would just - hey, Dan, let me chime in there if I could just add to that. So when we talk about increasing the cost synergy estimate, that is only what we view as permanent costs included in that. So — and any temporary cost reductions, as Mike mentioned, we've attempted to factor into the overall adjusted EBITDA guidance.

Okay. All right. Thank you very much.

Thanks, Dan.

Our next question is from Jon Tanwanteng with CJS Securities. Please proceed.

Hi, good morning and congratulations on the quarter.

Thanks. Good morning, Jon.

Good morning. I may have missed this, but I was wondering did you give any specific color on real-time demand in October and then heading into November as these cases spike and lockdown come in and if you've given any specific cushion for yourselves in the guidance for Q4 and maybe early next year as we run through the course of this.

I think we did not specifically comment on October. Things are progressing as we expected. As I mentioned in response to the previous question, the wildcard isn't necessarily October or November; it's more likely to be a December issue. I believe our guidance indicates a range, suggesting that one part of December could be weaker, closer to the $215 million figure we discussed. However, if things continue to progress normally, it could be higher than that.

Got it. That's helpful. And then a question for Mary, you've thrown out the kind of cash, it's kind of a function of your business model. I'm just wondering if any of that reverses out as the business recovers, you have to put more into working capital. How should we think about cash flow going forward with that as a context?

Sure. And typical working capital dynamics and sales continue to pick up. Obviously, the receivables will follow, but we're also showing good inventory management and overall good working capital management. So when we look at that on a percent of sales basis, again, we will continue to manage that prudently. And while we would expect not true that as the business really begins to pick up that we'll be investing in working capital as opposed to releasing cash from working capital, we would still expect to see good positive cash flow as earnings pick up corresponding to the sales and volume pickup.

Okay, fair enough. And then last one for Mike, you've been delivering on these higher and higher synergies roughly about every six months or so. I mean where are they all coming from? Is that low-grade or runouts, should we be expecting more as you dive deeper into the business, especially if you can travel more between locations and business tick back up?

Initially, there were two main factors at play. In the beginning, we couldn't fully identify the raw material and supply chain synergies during our planning due to the need to operate in a clean room environment. However, we later realized these synergies would be greater once we started executing. Recently, we've accelerated the implementation of our synergies. For instance, if we consider our current figures, $17 million this quarter would translate into an annual run rate of $68 million. This indicates that we're moving faster than anticipated. Additionally, during the COVID situation, which began around March and April, we reassessed several aspects and adjusted our approach based on what we learned during the first nine months of the Combination. This combination of factors has led us to increase our synergies.

Okay. And we do have a follow-up from Mike Harrison with Seaport Global Securities. Please go ahead.

Hi. I have a couple of questions regarding your end markets. Could you provide more details about your aerospace exposure? I know you have the chemical milling maskants business in Global Specialty, but are there other products or regions that you consider to be part of the aerospace sector? Additionally, is all of it commercial, or do you also have some military or business jet exposure? Finally, what portion of that is related to maintenance versus new aircraft production?

So yeah, most of what we do is new rather than maintenance, and you're right, the maskants business is a significant part of it for new aircraft builds. However, we are also involved in metalworking fluids that are primarily used in the production of NIM aircraft in the U.S. and Europe. Overall, all those areas have been impacted. Currently, aerospace accounts for about 3% of our sales, and we don't anticipate much potential increase in that market for a while. I mentioned that other markets will likely recover over the next one to two years, but it will take considerably longer for aerospace to improve. This gives you an idea of the scale. What we're experiencing right now is likely at the bottom of that market.

All right. And then over on the tube and pipe business, is that something that just remains weak until oil and gas activity improves? Or have you seen some pick up there?

Yeah. We have - it's been weak and probably - and I would say it's weaker now than it was in the past certainly just because of the overall situation, but we have seen some positives in the business as well recently, but we're certainly closer to our low point at this point, given where oil is.

All right. And then last, wanted to ask about the canning business. We're hearing that there are shortages and a lot of those can producers are running flat out to meet demand, they're talking about adding capacity. Are there things that you're doing to help those customers run harder? Does it mean that they're using higher-end products from you guys? Or are they just using more of them, if they're running at a 100% capacity?

Yeah. I think, in general, of course, what our products try to do is make our customers' processes more efficient and productive. So — but I would say, in general, I don't know if there's been any major changes in that, I think we've seen benefits in our business over the past couple of years. We've been taking share in that business because of our products and our customers are operating pretty much flat out at this point. So I agree with your assessment on that. And I think it's just going to be a matter of time as they try to put on more capacity over time and that should help our business as well.

All right, thanks very much.

Thanks, Mike.

We have reached the end of our question-and-answer session. I would like to turn the conference back over to management for closing remarks.

Okay. Given there are no other questions, we will end our conference call now, and I want to thank all of you for your interest today. Our next conference call for the fourth quarter will be in late February or early March of 2021. And if you have any questions in the meantime, please feel free to reach out to Mary or myself. Thanks again for your interest in Quaker Houghton.

Thank you. This does conclude today's conference. And thank you for your participation. Have a wonderful day.