Quaker Chemical Corp Q1 FY2021 Earnings Call

Greetings and welcome to Quaker Houghton's First Quarter Earnings Release Conference Call. At this time, all participants are in a listen-only mode. A question-and-answer session will follow the formal presentation. As a reminder this conference is being recorded. I would now like to turn the conference over to your host, Mr. Michael Barry, Chairman CEO and President.

Good morning, everyone. Joining me today are Shane Hostetter, our CFO; Robert Traub; our General Counsel; and David Will, our Global Controller. 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 over the past year 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 plants around the world are operating, and we are continuing to meet our customer needs despite the increasingly challenging conditions caused by COVID, as well as the current year global supply chain pressures that have impacted raw material availability. I'm very proud of what the Quaker Houghton team has done to continue to service our customers as well as continue with our integration. We are very pleased with our strong first quarter results. Overall, our sales were sequentially up 11% compared to the fourth quarter with all regions and segments showing revenue growth. This was primarily driven by higher volumes as our business continues to come back from the negative impact that COVID-19 had on our end markets. The sequential increase was broad-based with all segments and regions growing between 9% and 12%. I also think it is interesting to look at our revenue changes from the first quarter of 2020, which is just when COVID-19 was starting to impact us. A year ago, we primarily saw the COVID impact in China, and you can see this impact in our current quarter Asia Pacific sales growth of 31%. EMEA and our global specialty businesses also showed strong growth and were up 14% and 12%, respectively, from a year ago. The Americas were relatively flat in sales from a year ago if you exclude the two recent small acquisitions that we made. Overall, we anticipate sequential sales growth to play out in the first quarter. But we were surprised by how strong our sales volumes ended up being as we simply just did not expect to see this level of growth so soon in 2021. Some of this growth may be due to our customers replenishing their products in the supply chain and some pre-buying of our products, but it is really difficult to precisely say this was a major impact. I also want to point out that our ability to gain new pieces of business and take market share also contributed to our performance as our analysis shows that we had total organic sales growth due to net share gains of approximately 3% in the first quarter of this year versus the first quarter of 2020. So we continue to feel good about our ability to deliver on our historical performance of consistently growing 2% to 4% above the market due to share gains. And looking forward, we continue to feel good about these levels and share gains given the opportunities we have recently won or are actively working on. While higher than expected sales were a positive for us in the quarter, a clear negative was the continued increase in our raw material costs. While we knew raw materials were increasing the last time we talked, the increases have continued longer and at a higher level than we expected. Overall, our cost of raw materials have increased over 20% since the end of last year. There is tremendous stress on the supply chain of our raw materials and logistics. Further, the availability of raw materials has impacted us at times. But I'm proud to say that we've navigated through this so far and have ensured that all our customer businesses continued to operate. The increase in raw material costs did put downward pressure on our gross margins in the first quarter, and this downward pressure will continue into the second quarter just given the sheer magnitude and duration of additional increases and the lag effect we experienced between the time the raw material cost increase and the time we have to fully implement price increases to offset that. So overall we are pleased with the quarter given the environment we're operating in and saw a strong sequential improvement in our sales and adjusted EBITDA from the fourth quarter. Synergy achievement also was a factor in our results as we achieved $18 million in the current quarter compared to $10 million last year. Relative to liquidity, we did increase our net debt in the quarter due to the small acquisition in the steel market and an increase in our working capital due to the strong sales growth. However, our leverage ratio of net debt-to-adjusted EBITDA continued to improve from 3.2 times at the end of the year to 3.1 times to the end of the first quarter. And we currently expect to be below three times at the end of the second quarter. As we look forward to the second quarter, we expect short-term headwinds from higher raw material costs and some lower volume impacts due to some of the factors I mentioned earlier, as well as the automotive market continuing to have semiconductor shortages. I do see the second quarter as our lowest quarter of the year both in terms of gross margin and profitability. However, we do expect our margins to sequentially improve in the third and fourth quarters and return to where we expected them to be by the end of the year. As I think about our full year, we are continuing with our previous guidance, which is really a floor or the low end of our expected EBITDA. However, I am more optimistic on our year than I was a few months ago. While we may end up the year in the same place, we're slightly better based on our strong first quarter, the shape of our year's expected profitability trends has changed. Essentially we're seeing higher demand for the year but greater margin pressures in the near-term, which is expected to be largely offset by this higher demand. However, the margin pressures are expected to be short-term in nature once our price increases are fully implemented. So we currently expect to exit the year at better than expected demand for our products and our margins largely returning to our expected levels. So even though we expect to largely end up in a similar or slightly better place as our previous expectations, I feel better about this scenario than the already positive one I had envisioned a few months ago. We will have a step change in our profitability, essentially complete our integration, continue to grow above the market by taking share, and reach our targeted net debt to adjusted EBITDA leverage of 2.5. In closing, I want to thank all of our colleagues at Quaker Houghton whose dedication and expertise helps 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 given the current conditions we are facing this year. People are everything in our business, by far our most valuable asset. And ensuring their safety and well-being is and will continue to be a top priority for us. So I can't help but reemphasize my pride for 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 Shane so that he can review some of the key financials for you for the quarter.

Thanks, Mike, and good morning everyone. Before I get into the results for the quarter, I want to remind everyone that comments made during this call may include forward-looking statements based on current expectations, which are subject to risks and uncertainties that could cause actual results to differ significantly. For more details on these risks, please look at the cautionary statements regarding forward-looking statements in our earnings release and our Form 10-Q filed with the SEC. Additionally, please reference our risk factors in our 2020 Form 10-K and our first quarter Form 10-Q for a discussion of risks that could affect our forward-looking statements. Mike and I will also refer to several non-GAAP measures during this call, which are consistent with the press release and call charts shared yesterday. Looking at our strong start to the year, the quarter shaped up as Mike summarized. Our performance was driven by record quarterly net sales, although this was partially offset by lower-than-expected gross margins due to higher raw material costs amid significant supply chain challenges. As I discuss our quarterly performance, please refer to slides six and seven in our call charts for further insights into our financials. Our record net sales of $429.8 million represent a 14% increase from the previous year, primarily driven by higher volumes, including a 3% contribution from acquisitions and a similar increase due to foreign exchange. This top line performance reflects a global effort, with each segment showing notable growth year-over-year. APAC's net sales increased by 31%, marking the largest growth compared to the previous year, largely due to the initial impacts of COVID on China in the first quarter of last year, while other segments were impacted in the following quarter. EMEA also exhibited strong net sales growth of 14%, reflecting a solid recovery from COVID-19. The Americas and GSB experienced net sales growth of 4% and 12%, mainly due to higher volumes, including the Coral acquisition in December, which helped to mitigate some market pressures, such as the semiconductor shortage. While net sales were a positive story for the quarter, we, like many of our peers and other manufacturers, are facing significant challenges with rising input costs due to global supply chain disruptions. Gross margins were 36.3% for the quarter compared to 35.4% last year. However, excluding one-time cost increases related to acquisitions, these would have been 36.6% and 35.5%. This 1% year-over-year improvement is largely due to successfully executing integration synergies, which helped offset the higher raw material costs incurred during the quarter. SG&A expenses increased by $5.6 million compared to the prior year quarter due to additional costs associated with our recent acquisition of Coral and higher SG&A related to foreign exchange, although these were partially offset by savings from integration synergies and reductions in travel and other areas due to COVID-19. The net result was strong adjusted EBITDA growth in the first quarter. Our adjusted EBITDA of $77.1 million grew by 28% year-over-year, leading to an 8% increase in our trailing 12-month adjusted EBITDA to $239 million. This performance was driven by increased operating earnings in each segment, benefiting from the global market recovery, acquisitions, and integration cost synergies contributing to a record adjusted EBITDA. From a tax perspective, we had an effective tax rate of 24.2% for the quarter compared to a benefit of 31.1% last year. Excluding one-time items in each period, our tax rates would have been fairly consistent at 25% for the current quarter versus 22% last year. We expect our effective tax rates for the second quarter and the full year to be in the range of 24.5% to 26.5%. Our net GAAP EPS of $2.11 increased by 53% compared to last year due to strong operating earnings and adjusted EBITDA, along with $3 million of lower interest expense from reduced borrowing rates, partially offset by a slight increase in tax expense. Regarding liquidity, our net debt of $749.6 million rose by $32 million in the quarter, primarily due to a $25 million acquisition of a tin-plating business for the steel market, $7.1 million in dividends, and $12.6 million in operating cash outflows. The company's main cash requirement this quarter was working capital. As sales and volumes increase dramatically, cash is required to meet daily operating needs, which will return to us as demand stabilizes. Despite the increase in net debt, the company improved its leverage ratio to 3.1 times as of the first quarter, down from 3.2 at the end of last year. We are committed to prudent capital allocation, prioritizing debt reduction while continuing to pay dividends and invest in strategically sound acquisitions, all while aiming to reduce leverage below our target level of 2.5 times by year-end. In summary, Quaker Houghton had a strong quarter that exceeded our expectations due to ongoing end-market recovery, increased demand, and significant market share gains. Looking ahead to the second quarter and the remainder of the year, we anticipate that our strong first quarter performance and improved volume demand will be somewhat offset as raw material cost increases take effect and we experience additional volume impacts from market variability, including the semiconductor shortage. However, we maintain our previous guidance that we expect to see an increase of more than 20% in adjusted EBITDA in 2021 compared to the $222 million achieved last year. That concludes my remarks. Thank you for your interest in Quaker Houghton. I will now turn it back to Michael.

Thanks, Shane. We will now open it up for questions.

Thank you. Your first question comes from the line of Katherine Griffin with Deutsche Bank. Please proceed with your question.

Hi, good morning. Thanks for taking the question. So first, I just wanted to touch on the comment around potentially lower volumes in Q2. I think Shane you just mentioned some market variability related to the semiconductor shortage. And I was just wondering if you could provide a little bit more color on like what that market variability is and maybe how you expect volumes to trend by region in Q2?

Sure. It's hard for us to be precise on this because there are so many factors at play here. But we do feel there could have been some pre-buy in the first quarter and as well as some of our customers replenishing their supply chain products into it. And it's really hard to get at that. We really spend a lot of time trying to analyze that trying to understand that better. And for example, there were places I think of the United States in the steel industry and the auto industry, they're really running very hand to mouth right now. But in other places of the world, there could have been some other effects. So we think that overall there could be some volume impact due to that as well as the semiconductor shortage just continues to – continue on, at least for another quarter here. And so we think that will impact things as well. So it's hard for us to precisely tell on our volumes.

Okay. Thanks. And then just on the gross margins. If you could just talk a little bit more about how you expect to improve that in Q3 and Q4. I think it's, of course, price increases coming through but I'm curious if there's other actions that you're taking or could take in order to get to that previous gross margin guidance?

Sure. Yes, looking back at where we were in the third and fourth quarters of last year, we were really improving our gross margins through a lot of the synergies that we were achieving through the integration of the company. So we saw that. And now these large raw material price increases have come through. They started in the fourth quarter, more came through in the first quarter, and more coming through in the second quarter—very large increases even between March and April. What we have to do, and we are doing, is continuing to implement price increases in the marketplace. We've done those price increases in the first quarter, and we're going to have to do more and are doing more in the second quarter. So it's about catching up. We have this lag effect that we talked about, where there's a period of time between when our raw materials go up in cost and we can implement price increases in the marketplace to fully offset them. We believe we'll be successful in our price increases and that raw materials will begin to stabilize mid-year. Therefore, as these price increases get fully into effect, let's say towards the middle of the year, we will see sequential improvement between the second quarter to the third quarter and then third quarter to the fourth quarter.

Thanks very much.

Your next question comes from the line of Mike Harrison with Seaport Global Securities. Please proceed with your question.

Hi, good morning.

Good morning, Mike.

Maybe if I could take a little bit of a different tack on the raw material impact you're expecting in Q2. Consensus EBITDA numbers for Q1 were kind of in the, call it $60 million realm and you guys came in at $77 million. Is Q2 from an EBITDA perspective maybe tracking toward that $60 million number that we had been modeling, if we keep in mind the inflationary impact and maybe some of the other puts and takes you're thinking about?

Yes. We don't give too specific guidance on that. But I would just say that we do feel that it will be the lowest quarter of the year for the reasons we talked about, both margin and down on volume somewhat. We had said this when we had our call last at the end of last quarter, and we had thought that our first quarter was going to be the lowest quarter of the year. And that's, of course, why our analysts took our guidance on that. It was really just this higher demand that came through in the quarter than we expected, and now the whole raw materials situation has changed that. So yes, it's definitely changed the shape of how our EBITDA is going to transpire for the quarters this year.

All right and maybe a little bit more color on the specific raw materials, where you're seeing an impact. You mentioned that overall you've seen things increase about 20% since year-end. I think, if we look at crude-based materials, base oil has gone up pretty substantially–probably more than that 20% number. But can you talk about what you're seeing in your plant-based and animal-based raws and maybe you also give us some rough idea of how much of your raw material spend is in those three buckets, crude-based, plant-based, and animal-based?

Sure. One thing I would say is that all of our raw material groups for the most part really have gone up. It's not just constrained to one area. They all have gone up, which has put tremendous pressure on our supply chain costs—freight, drums, that kind of thing. Just the whole supply chain is facing increases. As for the exact percentages, I don't have the precise numbers in front of me, but certainly between animal fats, vegetable fats and oils, and the base oils that come from crude, they definitely comprise a significant part of our raw material spend. There's also a whole host of other chemicals that are used in additives, but pretty much across the board, everything has increased.

All right. And then, if I can sneak one more in here, looking at the primary metals business as compared to the metalworking business, it seems like metals is kind of lagging if I just look at the year-on-year growth rates for each of your segments. Is that typically what you would expect to see coming out of the cycle like this? Is that the metalworking business recovery is taking place more real-time and then it pulls steel and aluminum with it on more of a lag?

Not - like last year I know we saw some pretty strong growth coming out of COVID for our metals business, and there was more of a lag at that time in metalworking. So maybe this is just catching up, or there’s some other factors, but I don't think of it that way. I think all of them are fairly consistent and have been showing good growth relative to what we see in the external markets for these businesses.

All right. Thanks very much.

Thanks, Mike.

Your next question comes from the line of Laurence Alexander with Jefferies.

Good morning. It's Dan Rizzo on for Laurence. How's everyone doing?

Good morning, Dan.

Good morning. So you mentioned – obviously, we talked extensively about raw material costs. So I was just wondering, obviously, labor and shipping costs are also an issue. I was wondering to what extent and, as important, how difficult it is to pass on those costs? Because people expect costs to go higher, but I was just wondering with the others if that's more of a conversation with your customers.

It hasn't. It's not – I would say the next biggest impact for us besides raw material costs has been the cost of drums, freight costs, and so forth. And we consider those in the same kind of conversation as raw materials. So when we're having conversations with our customers around price increases, we will include those in those conversations as well.

Okay. And then were there any temporary costs you took out this year in response to COVID that are coming back this year that we should kind of be cognizant of?

Well, certainly, we did a lot less travel last year due to COVID and the circumstances around it. So far this year, there hasn't been too much more of that kind of travel. In fact, the comparisons suggest we probably did more travel in the first quarter of last year compared to this year. As this year progresses and we start to open up more, there can be more travel, but certainly we still have many places around the world that are pretty locked down right now, such as Brazil and India. We're still dealing with some restrictions in the U.S. and Europe as well. The only place currently back to normal is China. So overall, I would say that as we trend through the year, we will start to see some of those travel costs return, but certainly not to the levels we had in 2019.

Okay. And then just a final question. So, obviously, the U.S. and Europe are recovering, while India is going through a serious problem right now. I was wondering if that has any effect on your production in that region and to what extent?

So far we've managed to balance both COVID-19 and raw material shortages—it's really challenged us at times in our plants to meet our customer requirements. But so far, we've been able to do that. We work very closely with our customers, and we've been able to satisfy their needs. So far, we are doing fine in that area.

Thank you very much.

Thanks, Dan.

Your next question comes from the line of Jon Tanwanteng with CJS Securities. Please proceed with your question.

Good morning. This is Brendan Popson on for Jon. Just want to ask real quick on you just alluded to it, but just the impact on your business from COVID in areas like Brazil and India.

Sure. It certainly has impacted us from the perspective of how challenging it has been at times when some of our employees have come down with COVID. But it hasn't impacted us to the extent that we have not been able to perform and where we've shut down customers or missed any major issues in that regard.

Okay. Great. And then any update on the CEO search?

No, the search continues as planned. We expect to conclude it sometime as we get closer to the end of the year, but right now that search is ongoing.

Okay. Great. And then just the last for me. Just how to think about your appetite for M&A today and the pipeline you're seeing out there?

Yes. Good question. We made two small acquisitions, one in December and one in February this year. We continue to look at smaller acquisitions. There are several out there that we're evaluating and hoping to complete some of those this year, but until something is done, it's hard to say. From an M&A perspective, while we won't look at anything substantial at this stage because we want to get our debt levels down to where our net debt-to-EBITDA is below the 2.5 times mark, we will continue to search for smaller opportunities in the meantime.

Okay. Thank you.

Thank you.

Your next question comes from Steve O'Hara with Sidoti. Please proceed with your question.

Hi. Good morning. Thanks for taking my question.

Good morning, Steve.

Just going back to your customer inventory replenishment or higher than expected purchases in the quarter, I can't recall, but were you guys talking about inventory replenishment and the idea that you thought that your customer inventories were low at the end of the year last year?

No, we weren't.

Okay. I mean, if these inventories are being used to replenish supply chains down the line, I could guess this is something that could keep rolling as that process takes time. Or I mean, I guess I'm thinking that maybe that could keep orders higher than expected for longer if that's the case, but maybe I’m not conceptualizing it correctly.

Yes. I know you're asking and I think we have the same questions that you have. We don't have really great visibility on that because sometimes there's a disconnect between what we see in external factors and what our customers are actually doing. So it's hard for us to say in this regard. It's certainly possible. I do believe that, for example, in the U.S. everything is very tight right now in the auto and steel industries. This should keep it steady longer, but there are also places around the world where other factors in supply chain replenishment could be in play. We think there's some value to it, but we're uncertain if it is a significant amount or not.

Okay. And then just going back to the commentary about Q2. Was there maybe an aspect that I missed, but in terms of revenue growth, are you expecting a dip sequentially in revenue, or is it more in the operating income because of cost pressures?

It's definitely going to be in the operating cost pressures. We think our volumes will be somewhat down from the first quarter. Again, it's hard to accurately predict based on the reasons we just discussed. We are also getting price increases as well. So our raw prices will be higher in the second quarter versus the first quarter, which will be somewhat positive for revenue. However, our margins will be down because costs keep escalating at a much higher rate. So hopefully that provides some clarity on the variables we are seeing.

Yes. No, that's helpful. And then, I mean, throughout your pricing, is it typically an indexed process where it's fairly visible to customers where you'd say this went up by this, this went up by that, and here's what it is, and it's going to start the next day? Is it other industries that really push customers to accept these and it's more of a negotiation as opposed to a formula?

Sure. We definitely have some contracts with major customers that are more index-based that adjust every three months based on raw materials. But I would say the majority of our business relies on negotiated pricing. When raw materials go up, we continually have to have another conversation to update customers and escalate prices again, which we justify based on the rising costs.

Okay. And then—sorry, last one. Assuming there was some inventory replenishment that took place in the quarter, I mean how long does that typically last for a customer? Are they able to kind of store three months worth of product? And assuming economic activity continues to improve globally, I mean is that—while you expect Q2 to be lower and then trend throughout the year, how long do you think that could depress volumes going forward if that was a big factor in the first quarter?

Yes. Most of our customers require frequent shipments. It’s more just-in-time type of purchasing. Generally, they hold a few weeks' worth of product—not months. They could hold somewhat more if needed. For example, they may increase their inventory if they need to produce a greater amount of cars or parts to replenish the supply chain. It's possible, but we don’t have complete visibility on it.

Okay. Thanks for the time.

Thank you.

Your next question is a follow-up from Mike Harrison with Seaport Global Securities. Please proceed with your question.

Hi. Just a couple more from me. First of all, the aerospace business obviously was impacted by the 737 MAX and then the sharp reduction in air travel. Any thoughts on the pace of recovery? It seems like the airlines are at least reporting that travel is starting to come back. Could aerospace be maybe a positive contributor as we start to lap some of the big declines from last year?

Yes. Good question. I mean certainly in the first quarter comparison to the first quarter last year, we were down. But as you said, things really bottomed out in the second and third quarter of last year. We are seeing more activity in aerospace on a sequential basis, and we are more encouraged regarding aerospace as we progress through the year, let's say in the second and third quarters compared to prior year comparisons. However, we feel it will take a few years before this sector fully recovers back to 2019 levels. But it is trending in the right direction now and will definitely be a positive.

All right. And then, over in the canning business, it sounds like there's just tons of capacity coming on stream. Are you winning more than your fair share of that new business? And can you maybe talk about how much of a tailwind the canning industry could be for you in the quarters to come?

The can business has performed well throughout the pandemic, and we have been taking market share. We've significantly grown our can business over the last two years by enlarging what both Quaker and Houghton had, combining that with the Coral acquisition last year, which strengthened our offering to customers and allowed us to secure new pieces of business in can.

All right. And then, last one for me is on the Asia Pacific business. The pricing there, or price/mix I guess, looks like it was down about 4%, even as volume recovered very nicely year-on-year and looks like maybe even some sequential volume improvement. So what is driving that price lower or the price/mix? And will we see that turn positive as you guys put price increases in place to counter the raw material inflation?

I would say, in general, our prices in Asia Pacific have been impacted by the considerable mix we have of different countries' pricing for our products. For example, India has been having a tougher time from the COVID perspective and from an overall business perspective, which has likely contributed to the price dip, as it tends to have lower pricing compared to other countries in the Asia Pacific region. Overall, we are implementing price increases everywhere, so it really is more about the mix.

And should we expect that to turn positive then later in the year?

So from a pricing standpoint, it generally depends upon the mix of our businesses. I believe overall, we should see sequential improvement in pricing aspects of revenue quarter-over-quarter, but margins may be more negatively impacted in the second quarter because of raw materials outpacing our pricing increases.

All right. Understood. Thanks very much.

Thank you, Mike.

Your next question comes from a follow-up from Steve O'Hara with Sidoti. Please proceed with your question.

Hi. Thanks for taking the follow up. Maybe just curious if you could talk about possible impacts from any infrastructure bill that might go through or how you think about that, either from direct or through your customers' businesses?

We would view it as a positive. We cannot quantify it at this time. However, increased industrial activity should translate into a positive for us.

Okay. And is there—in terms of maybe— I mean, the last proposal I think was much smaller. But I mean, do you have any idea of maybe what any boost you saw last time? And then, obviously, the sizes are much different, but I was just kind of curious if there's any recollection from last time.

Yes. It will help us, but I don't think it’s a major event. It really depends on the magnitude, as you mentioned. What's mainly beneficial is if there's a rise in cars being purchased, or more metal products are sold. So it’s too early to quantify that.

Okay. All right. Thanks. Appreciate the color.

Thanks, Steve.

Ladies and gentlemen, we have reached the end of the question-and-answer session. And I would like to turn the call back to Mr. Michael Barry for closing remarks.

Okay. Given there are no other questions, we will end the conference call now. Thank you all for your interest today. Our next conference call for the second quarter will be in late July or early August. If you have any questions in the meantime, please feel free to contact Shane or myself. Thanks again for your interest in Quaker Houghton.

Ladies and gentlemen, this concludes today's conference. You may disconnect your lines at this time. Thank you all for your participation.