Ferro Corporation
Q2 2017 Earnings Call Transcript

Published: 29 Jul 2017

[Operator:]

Good morning. Thank you for joining the Ferro Corporation 2017 Second Quarter Earnings Conference Call. An archived replay of this teleconference will be available through the Investor Information section at ferro.com later today and will be available for approximately 7 days. During the presentation, all participants will be in a listen-only mode. After that, we will conduct a question-and-answer session. [Operator Instructions] I would now like to turn the call over to Mr. Kevin Cornelius Grant, Manager, Head of Investor Relations for Ferro Corporation.

[Kevin Cornelius Grant:]

Thank you, operator. Good morning to everyone participating in the call, and thank you for joining us. This morning, we'll be reviewing Ferro's financial results for the second quarter ended June 30, 2017. As a reminder, the news release and conference call presentation deck are available on the Investor Relations section of our website. I'm joined today by Peter Thomas, our Chairman and CEO; and Ben Schlater, Vice President and Chief Financial Officer. After our comments this morning, we'll be happy to take your questions. I'd like to remind everyone that some of the comments we are making today are forward-looking statements and are based on our view of the world and our businesses as we see them today. Of course, circumstances can change. Please refer to the forward-looking statement disclosure in our earnings release and presentation. Today's call will contain various operating results on both the reported and adjusted basis. Those identified as adjusted exclude certain onetime items and charges. Description of these non-GAAP financial measures and reconciliations are included in the earnings release and the presentation deck. It is now my pleasure to turn the call over to Peter.

[Peter Thomas:]

Thanks, Kevin. Well, Ferro has delivered another strong quarter of performance. First and foremost, we are pleased to have generated our fourth consecutive quarter of strong organic volume and sales growth. Growth is coming from businesses across our entire portfolio. And in fact, all three reporting segments generated organic volume, sales and profit growth. We believe that Ferro is well positioned for both near-term and long-term growth. Our teams are focused on growth. And with the transformation of our portfolio that we have undertaken in recent years, they have businesses with which to achieve it as our performance in recent quarters demonstrates. From an organic growth perspective, our vitality index is currently at 20%. This means that 20% of our gross revenue is generated from products that have been launched within the last three years. That is a target we are happy to have achieved, and we expect to increase it as we move forward. And from an organic growth perspective, we are eager to add to the 11 acquisitions we made in recent years. There are exciting technologies and margin expansion opportunities associated with possible future transactions, and we're feeling quite positive about the range of optionality for future acquisitions. With growth now woven into the cultural fabric of our company, we begin to bring into focus the next phase in our strategy, which we call the Dynamic Innovation and Optimization phase. In this phase, we are intensifying the importance of continually innovating to achieve a higher level of growth through technology, leadership and operational efficiency. Our people have already been moving toward this way of thinking, and I'm convinced that as we sharpen our concentration on this innovation phase, we'll upgrade our business in ways that will deliver even stronger, sustainable performance over the long term. It's a very exciting time for the entire Ferro team with many opportunities in front of us as we continue the successful execution of our strategy. Now I'll review some of the results from the second quarter. Please note the non-GAAP numbers I'll refer to are on an adjusted basis using constant currency. All the comparisons are to the second quarter of 2016. During the quarter, we grew net sales by 19.6% to $348.6 million with organic sales increasing by 6.5% on a constant currency basis. Total volume increased 11.6% with organic volume increasing 8.2%. As I noted earlier, this is the fourth consecutive quarter of organic sales and volume growth. We increased gross profit by 14.1% to $110 million, compared to $96.4 million in the second quarter prior year. We've reduced gross profit margin of 31.1% despite the raw material pricing headwinds our industry experienced with adjusted gross profit margin coming in at 31.5%. We grew adjusted EBITDA by 17.8% to $64.3 million or 18.4% of net sales. And finally, we delivered GAAP earnings per diluted share of $0.25, an increase of 13.6%. And we delivered record adjusted EPS of $0.37. As you can see, it was another quarter of very good financial performance. Our strategy and our people delivered once again. On the basis of our performance in the first half of 2017 and the acquisition of Italian tile coatings producer SPC in the second quarter, we have updated our annual guidance. Although the strength in our business indicates we are tracking above the market, we are aware of potential headwinds in the second half. We have a high level of confidence that we will be able to achieve our full year guidance. Now before we get into segment performance for the quarter, please turn to the conference call presentation deck Slide 3, where you can see that second quarter sales increased to $348.6 million, up from $291.4 million in the prior year quarter. Slide 5 shows gross profit margin for the quarter affected by the raw material price increases we've discussed. Consolidated adjusted gross profit margin was consistent with our expectations, coming in at 31.5% for the second quarter. As you recall, we took measures to mitigate raw material price increases beginning fourth quarter of last year, including product price increases, more profitable product reformulations and other measures. Our current view is that pricing for many raw materials that we use reached the peak in the second quarter, and we expect stability over the rest of the year. Turning to Slide 8 in the conference call deck, you'll see the results for our Performance Colors and Glass, or PCG, which were very strong for the quarter. As we have discussed in prior quarters, PCG is the market-leading supplier of glass-based coatings for glass substrates. Our products add value in automotive, decoration and industrial and electronics applications. PCG serves technology-driven markets wherein product campaigns of life cycles have fluctuate as demand ramps up, levels off and winds down to an off-cycle period. Even if sales fluctuate, we can enhance customer relationships through our technology-driven R&D support for their product innovation needs. As technology for coatings and decoration advances, we see opportunities to attract customers with innovative technology and reinforce our market leadership. Net sales increased by 12.9% to $106.6 million, up from $94.4 million in the 2016 second quarter. Organic sales were relatively flat in the quarter. Gross profit was $40.4 million compared to the $36.1 million last year, and gross profit margin was 37.9%. Sales were higher in all geographic markets. Automotive, light vehicle sales in the U.S. were down in the second quarter, offset by increases in Europe and Asia Pacific. However, we remain the first choice for automotive customers with our lead-free enamel solutions. Our acquisition of ESL added to the sales gains of our electronics business in the U.S. We anticipate continued growth in next generation of electronic packaging technology, and we expect our electronics business to grow with it. I should add that we are very, very pleased with the performance of ESL since we acquired in the fourth quarter last year. And our decoration business continues to expand in all regions with additional container sales in the Americas, along with market share expansion in the Americas and Asia Pacific. Moving to Color Solutions, please turn to Slide 9. As a reminder, the Color Solutions segment was formerly called Pigments, Powders and Oxides. Color Solutions is a leader in production of high-value inorganic and organic pigments and color solutions for a variety of substrates and applications such as paints, plastics and construction materials by concrete, roofing and siding. This segment continues to perform extremely well. The platforms that we have acquired, such as Nubiola, a global manufacturer of inorganic pigments; and Cappelle, a global manufacturer of inorganic and organic pigments, are making significant contributions to our business. We are seeing excellent results from cross-selling activity into new customers and new markets. In Color Solutions, net sales for the quarter increased by 48.1% to $90.2 million. Sales and volumes increased in all geographic markets. Gross profit grew to $29 million, and gross margin improved to 32.1%. Organic sales increased 15% to $70 million, and margins came in at 33.8%. Results from Cappelle, which was acquired in October 2016, were not included in the prior year quarter. In the pigments space, we delivered double-digit growth in every region. We continue to introduce new products into the space in response to customer requests. In addition, we expanded our market share in the Americas and Asia Pacific during the quarter. Turning to our Surface Technology product line. We had another stellar quarter with sales growth of 29.8% driven by precision polishing sales for certain high-tech applications. Our surface polishing technology is a leading choice in this market, and we continue to deliver the highest quality products and services for our customers. Now let's turn to our third segment, Performance Coatings, on Slide 10. Performance Coatings is a leading supplier of glass-based coatings for metal substrates, which we sell through porcelain enamel business and decorative coatings for ceramic tile, which we sell through our Italian coatings business. Performance Coatings also performed well in the second quarter with double-digit growth in volumes and sales. Volume increased 10.8%, while net sales increased by 11.5% to $151.7 million. Gross profit was $40.9 million at a gross profit margin of 26.9%. In the U.S., porcelain enamel sales to appliance makers contributed to the increase in volumes. Sales and volumes increased significantly in Europe and in the Asia Pacific region. The second quarter includes sales from SPC, which we acquired early in the second quarter. SPC is a tile coatings manufacturer based in Italy that focuses on specialty products at the high end of the market, which reflects our overall strategy of providing higher-value products at the top end of the market. In tile coatings, we leverage our technology, market knowledge and customer relationships to drive growth and mitigate raw material costs through product reformulations. Because of our deep knowledge of coatings technology, we can reformulate our products such that they have equal or better functional performance, while reducing cost to our customers. We anticipate continued growth in our Performance Coatings business. So overall, another very good quarter. We are pleased with Ferro's performance, particularly given the external factors that have impacted our sector. Our global team is committed to delivering on our strategy. We've developed positive momentum. Our team is excited about it, and we intend to maintain it. And with that, I'll turn the call over to Ben for his comments on the quarter.

[Ben Schlater:]

Thank you, Peter. Good morning, everyone. As Peter said, Ferro delivered another quarter of strong results. Today, for the next few minutes, I'll review onetime adjustments for the quarter and provide an overview of the more meaningful expenses embedded within the SG&A and other income and expense lines. Finally, I'll touch on the components of our quarterly cash flow and cover our updated guidance for the year. There were a few nonrecurring items that were adjusted out of our second quarter results

[Kevin Cornelius Grant:]

Operator, we'll be happy to take the first question.

[Operator:]

Thank you. Ladies and gentlemen, we will now proceed to the question-and-answer session. [Operator Instructions] Our first question comes from the line of David Begleiter from Deutsche Bank.

[David Begleiter:]

Thank you. Good morning. Peter, very nice results. Just on the second half guidance and these headwinds you're talking about here, which ones are you most focused on or concerned about in terms of the impact on the business?

[Peter Thomas:]

David, well, thanks for the compliment, first. If you've been listening through our earnings season, and we see similar headwinds versus the sector. We would see things like auto maybe slowing down a bit, which we can discuss probably a little bit later. We would also maybe see commercial construction as it relates to our flat glass business. Actually globally, Europe has slowed down a bit, and so has the Middle East. We would see potentially continued raw material volatility with cobalt and lithium, although we do have plans to mitigate those potential increases through the course of the year. You've heard that emerging markets have been doing extremely well, and they have for us. The first half of the year our emerging markets have grown double digits. Although we expect them to continue to grow versus last year, maybe it'll be at a slower rate. So those are the handful of headwinds that we see, David. But to be very candid, since we really keep track of headwinds daily, we are quick to move to build mitigation plans to eliminate that impact. So we feel pretty good, like we've said, around the guidance for the balance of the year, but those are the handful of headwinds.

[David Begleiter:]

Very good. And just in Performance Colors and Glass, you did have, I guess, minus 1% volume mix in the quarter. I think you addressed the reasons why auto. Should that business volume mix perspective grow in the back half of the year or be flat or be down?

[Peter Thomas:]

From where we sit today, we don't see it really sliding any further than where it is. It will have – there will be an impact on auto, not so much in Europe and Asia Pacific. They're mostly in North Americas, as you're seeing elsewhere. But we do have some very interesting opportunities that will be positively impacting the business for the second half, and I'll just give you a little bit of a flavor without getting – giving away a lot of our technology secrets. But one of the big, exciting opportunities with ESL that complement our business has to deal with the competency around the increasing demand of sensors, electronic sensors for automobiles, for example. If you just go back a handful of years, there may have been in midrange luxury automobiles only about 10 sensors. Today, we're looking at 80 to 100. So as that technology evolves with automobiles that are parking themselves and lane assist and vibrating, not moving over into other lanes and stopping while you're in cruise control, all those features for those automobiles require sensors, and we are a market leader in that space. So we – hopefully, we'll see a pickup in that particular business in the second half of the year because of that.

[David Begleiter:]

Thank you very much.

[Operator:]

Thank you, sir and continuing on. Our next question comes from the line of Mike Sison with KeyBanc Capital Markets. Please proceed.

[Mike Sison:]

Hey, guys. Congrats on really nice quarter there. For Color Solutions, it really does seem like you're grooming a nice growth business. Can you maybe talk about what we should expect from that business longer term? What's driving it? And I guess it might slow down a little bit in the second half in terms of growth?

[Peter Thomas:]

Yes. We might not be in a position to say that. What I will suggest is, again, the cross-selling benefit of having those three franchises is absolutely phenomenal. That's number one. We continue to see opportunities that still are in – remain like an exciting activity for us. The second thing is because of the application overlay and we're addressing new markets that we weren't in prior to those two acquisitions, we're developing a range of new products, whether they are new Ultramarine-type products, anticorrosive products, heat-reflecting products, the pipeline of new products coming from those three businesses are doing a bit better than we had thought originally, and it's happening sooner. So the idea of, one, the cross-selling benefits, leveraging the technology applications, those pigment businesses have phenomenal technology and marketing people and the fact that we are selling at the high-end level with key customers will continue to make this business attractive for the balance of the year. And quite candidly, as we continue to add acquisitions through the course of the year potentially, we will continue to see this business build out nicely. I think last quarter, you asked a question how excited we were and how big this could be. And I think we did make a comment, maybe a little jokingly, but you can see the addressable market for this business for us the way we look at it of being well over $1 billion over time. So we remain very, very enthusiastic about the prospects of this business.

[Mike Sison:]

Right. Okay. Great. And then in terms of the second half earnings growth, I understand first quarter was a little bit of an anomaly, relative to '16. But maybe any particular reason the second half is growing a little bit less than the second quarter in terms of year-over-year growth?

[Peter Thomas:]

Yes. There are a couple of things. One, last year, the second half, really represented what we're defining as the newly merged companies. So we have stronger comps than we had in the prior two quarters. And the second thing is, again – and Mike, you know this because you joked with us about this before. For us, it's better for us to be approximately right than precisely wrong. So we've maintained an air of conservatism because of the potential headwinds that we've mentioned.

[Mike Sison:]

Got it. And then last one on Color Solutions. If you think about what type of other technologies or maybe market that would make sense for you to add via acquisition, what would that be as you look to – and maybe just an update on your acquisition pipeline?

[Peter Thomas:]

Okay. The first question is, as you know, we have two strategies – sub-strategies within the Color Solutions business. The first is a pure-play pigment horizontal type of a sub-strategy, where we have set out to acquire the highest and inorganic and organic pigments that have very market – very attractive market structures, which we have done. And there are a few others that I certainly can't name at this point. But rest assured that we are aware of them and having discussions in various ways. The second is the vertical piece, where we're actually adding value to the pigment by functionalizing it. So with a very unique combination of the high-end pigments that we have, we can do a lot of things. We can formulate them. We can particle engineer them, and we can create new types of pigments as we have already, particularly in the Ultramarine area, which we'll be rolling out here shortly. And we also then could take those combinations and move them into different physical forms. And this is what we call our vertical strategy, where we can make paste from them, slurries, solutions, dispersions and a range of other new types of product offerings. And that is what we defined as the vertical. That's a very fragmented space. We're very good in fragmented markets. We're the market leader in what we do now, and our expectation is that we're building the foundation to be the market leader in these fragmented vertical side. And we're very confident that we will take a very strong position in that space over the next 18 to 24 months.

[Mike Sison:]

Great. Thank you.

[Operator:]

Thank you, sir. And our next question comes from the line of Rosemarie Morbelli with Gabelli & Company.

[Rosemarie Morbelli:]

Thank you. Good morning, everyone. And I’ll add my congratulations to others. Peter, you are now going into a new phase. Could you give us a little more detail as to what you expect from this current phase?

[Peter Thomas:]

Yes. And thank you for asking the question because we're very, very excited about introducing the phase. Many of you that are on the call, if you put it together, we were kind of introducing it over the last two calls. And so finally, we felt it'd be prudent for us to bring it out, considering that we now believe that we've really successfully have run through our reenergized growth phase, which is Phase three. But let's start with what happened to the company, Rosemarie. I mean, basically, what we've said is the new company has emerged from our first three phases. And there are three important components of that emergence. One was that we are much more focused and better positioned than we were. We have greater growth potential and optionality, and we have a much stronger technology position. So if you take those three pieces and you say we want to leverage those moving forward to address the shareholders' concerns around is it sustainable, can you do more? Well, the answer to that is yes. We've created a dynamic environment, which for us means a continuance of what we've done but at a higher performance level. Now having said that, if we look into our Dynamic Innovation and Optimization phase, you should think of it in terms of principal characteristics. So when you look at that next phase for us, we would view it as a self-renewing or higher-growth, sustainable business model. We'll retain our customer-tailored, asset-light specialty orientation. We'll be a technology leader in target spaces where we're innovating and not falling. And you may be hearing more about that shortly. We have a much larger addressable market. When we started down our journey, we had an addressable market back in 2012 of $3.2 billion. Today, it's about $8.5 billion. And our expectation here moving out is that we can create an even broader addressable market of over $10 billion. Why is that important? Because as a market leader in a $3 billion market with 45% to 50% market share, a lot of folks were concerned about our ability to grow. So the way you change that is broaden your addressable market with technology while maintaining a leadership position, albeit at lower percentages. So we have a lot of headspace to grow. We have built a wider lens of growth options for the business. What do we mean by that? Well with the acquisitions and the cross-fertilization of applications, our inorganic pipeline with the addition of the 11 acquisitions has now swelled up to about 200 from 175. And what you'll find is our organic opportunities of the platforms that we fund have moved from about 65 to over 80. And then when you look at the next four years where we talk about $600 million of new program sales, that has basically swelled up to about $800 million. So the dynamics of the business around a wider lens of opportunity on every strategic decision we've made is working to that end. What we've also done and looked at with this phase is that we're much better positioned behind major macro and sector growth drivers. And what does that mean? Well, if we have a power alley around digital competency and we know substrates, know colors, what you'll find is that we will now be introducing advanced technology positions. Whether we are licensing things or whether we are acquiring emerging, proven technologies that are patent protected, you're going to see that dynamic take hold here over the near term. Also, what we want to do to keep the dynamic element moving is that we're going to selectively extend on the value chain. And this gets back to our vertical strategy with our Color Solutions. Then of course, because of growth, you know as well as I do, it's very easy to get drunk with acquisitions and growth and you start leaking money all over the place. Well, that certainly won't happen in this phase because it has its own identity. We're going to continuously optimize our cost structure and asset footprint, which is part of the optimization program we introduced a couple of quarters ago. Then what's really important now is that we need more scale to support our reinvestment in our core businesses and are targeting growth. So the – as we look at continually investing $150 million a year of invested capital in the business, there are some maybe a bit larger opportunities that we'll start to consider once we feel – as we continue to feel good about the momentum we've created. So those are the key characteristics of what we're defining as dynamic innovation and optimization. How do they sound to you?

[Rosemarie Morbelli:]

Sounds pretty good. So I guess we are looking at manufacturing plants, consolidations and most likely, an additional acquisition in the smallish size between now and the end of the year. And when you look at bigger opportunities in terms of inorganic, is that two years out, would you say?

[Peter Thomas:]

As you know, we've mentioned before, every day we look at things that are larger. And I think it's just a matter of timing and what's in the queue for us to meet our objectives around rounding out our technology portfolio. So we constantly look at things of that scale, but maybe they just might not make sense relative to how we view our technology position moving forward. But certainly, anything is possible when you have a lot of optionality. And that's basically where we are.

[Rosemarie Morbelli:]

And following up on this, Peter, how much leverage are you willing to take for a large acquisition?

[Peter Thomas:]

We're pretty disciplined around what we've been doing. But right now, as we've mentioned before with the positive momentum and the outlook that we have moving forward, I think the organization and our board is very pleased with what we're doing. And if we see something that's very compelling and we can delever quickly, we're still looking. And maybe 4, 4.25 might make sense as long as we can delever pretty quickly like within 18 to 24 months.

[Rosemarie Morbelli:]

Okay. And lastly, if I may. On the organic volume of 8.2% in the second quarter, are you – what are we looking at in terms of sustainable volume growth given the environment and not only for the second half of this year but going out in a few years? What do you think you can do?

[Peter Thomas:]

Here's how I'll answer that, but you can extrapolate. I think it's good for you to think this through. There's been a paradigm shift in the business. We've had four quarters of organic growth, both in revenue and volume. If you believe in the Dynamic Inorganic – Innovation and Optimization phase that I just mentioned, our expectation is it would be that we'll continue with an elevated performance versus the past. That's just where we're headed, and we like it. The organization loves it. We have the culture that's thriving on it, and nobody wants to go backwards. So when you have that type of momentum, there's no reason why we can't continue to deliver what we have committed to, which would be our market growth rate as Ferro where we participate plus 1% to 2%.

[Rosemarie Morbelli:]

Okay. Thank you very much.

[Operator:]

Thank you. And our next question comes from the line of Dmitry Silversteyn with Longbow Research.

[Dmitry Silversteyn:]

Good morning, gentlemen. Let me add my congratulations to another strong quarter. A couple of questions. First of all, just to follow up on Rosemarie's questions regarding this latest phase of the – of your initiative. Should we be expecting any more sort of incremental investments and costs going up in the short term as you build out your sales or marketing departments or invest more in R&D and kind of – not really blue sky projects but maybe longer-term payoff projects? How should we think about your – probably more in SG&A investments changing with this phase?

[Peter Thomas:]

Yes. Thanks for asking that. And this is what the Phase 4 is all about with the Dynamic Innovation and Optimization. The fact that with the acquisitions and the staffing we have we really don't have to hire SG&A to accomplish our objectives because we'll keep adding talent from the acquisitions. In fact, the operating leverage you're starting to see, I think, was 16.5% versus 17 plus. And if we continue with the organic growth trajectory, by the math, it'll go down, and we just don’t have to add. And again, we've added an average of four to five deals a year. We are still committed to spending $150 million. We'll have people and – which brings me to another point, if you don’t mind that I mention it. I think it's very important. One of the reason and one of the big reasons why this organization is delivering is the culture that we've created here. And we – I really want to speak to this because you may not know this, but 42% of our population is new since the end of 2013. And what's important to note about that is with each of the acquisitions they were targeted for specific technology and marketing and sales competencies. And each of those companies were very entrepreneurial and innovation focused. So we brought a lot of talent in those areas. Ferro, as a whole, had a wonderful and unmatched manufacturing acumen, S&OP process and a lot of systems. And when you have the 58% of a corporation that was Ferro, the people that have survived our transformation, that coupled with the new employees, you have a phenomenal situation going on here. I – everyone jokes about Drucker and about culture eats strategy for breakfast. But I can tell you, I'm a believer after 44 years. And what he said after the book is if you have the right culture and you manage it as you're progressing through transitions and revitalizations and you hire the right people, you acquire the right people and you get the culture moving, then you end up with a momentum that we have. So it's really important to note that, again, 42% of Ferro's population is new. And if you want to hear another interesting dynamic

[Dmitry Silversteyn:]

That's very good granularity. I appreciate it. Just to follow up a little bit on kind of individual business demand. We've been reading a whole bunch of articles about a lot more people staying in their homes and doing more remodeling and doing more large-project remodeling like kitchens and baths, which is not necessarily good for paint business perhaps but should be good for tile business. So at least in North America, are you seeing the benefit of that in your tile demand? Or is it still primarily driven by what's going on in Europe and Middle East regions?

[Peter Thomas:]

Yes. Thanks for asking that. Our North American tile business is, again, at double-digit growth. And a lot of it has to deal with the decorative nature that the North American people, if you will, like. Plain tiles were not very attractive in the old days. But with the advent of digital applications and with our technology, we can make tile look like anything that's natural. Boy, I'll tell you the demand for that, particularly renovation in higher-end homes, is absolutely phenomenal. And of course you know, Dimitry, when you were here visiting with us, our strategy for the tile business is focusing on the high end as well as making sure that we have the lowest cost structure in the world, which is what we have. But more importantly, on the asset-light, heavy-touch model that we've engaged in, the fastest-growing market for high-end tiles would be the northern part of Europe and North America in terms of really high end. And we've positioned ourselves to be the leader in those areas with the low-cost structure. And where it comes to emerging markets that are getting out of the base level of tile and into something that's more sophisticated because the discretionary spend is better, we're seeing that in Egypt and our exports to Saudi and the Emirates and Turkey as well as in Vietnam, Bangladesh, Myanmar and some others. So anywhere where there's a high end and a lot of demand, we're positioned nicely. And where the emerging taste differential takes place in those emerging markets, we are introducing the higher-end products there as well. And that's why you see the Performance Coatings business in both revenue and volume were close to double digits.

[Dmitry Silversteyn:]

Excellent. And then kind of putting it all together and what you've said previously about the markets, I just want to go back to Mike's question perhaps. Your guidance for the second – your annual guidance of 12% to 13% revenue given what you've done in the first half suggests more like 9% to 10% growth in the second half of the year. By my calculation, the deals that you've done should add north of 10% in revenue. So am I reading too much into it? Or are you suggesting that organic growth for your business is going to be basically flattish going against tougher comps in the second half of the year?

[Peter Thomas:]

No. It's not going to be flat. Again, if you think about the past where how performed with our quarters in terms of percent growth through the year, what we have said is the new Ferro will have a similar sine curve, but it's going to be tighter. And we had really good comps last year, so we had 7% growth. I'll round up first quarter, second quarter, 7%. Last year third quarter, we had 3%, then the fourth quarter. Those quarters were a bit of an anomaly for a range of reasons we mentioned with some wrap – ramp-up of some new technology related to military and aerospace types of applications. But we're not flat. We're suggesting mainly with headwinds 1.5% to 2%. Again, this is based on the idea that we see some headwinds. And we're just being cautious that if those headwinds do happen, we're still going to deliver what we're telling you we're going to deliver. Again, I wasn't joking. We would rather be approximately right than precisely wrong at this point because we have just too much going for us here.

[Dmitry Silversteyn:]

Got it, Peter. Thank you very much.

[Operator:]

Thank you. Our next question comes from the line of Mike Harrison with Seaport Global Securities.

[Mike Harrison:]

Hi, good morning.

[Peter Thomas:]

Hey, Mike.

[Ben Schlater:]

Hi, Mike.

[Mike Harrison:]

You mentioned in the past that you had a number of levers that you pulled during the first quarter in response to raw material cost increases. Was wondering if you can give some additional details on those actions that you've taken. And in particular, what actions can you see ongoing benefits from? I'm kind of thinking that pricing actions or reformulations probably are stickier and longer term, and then maybe some more temporary things might be pre-buying of lower-cost raw materials or surcharges that you can't hang on to forever. So I'm really just trying to get a sense if there's another shoe to drop in terms of the raw materials and have we delayed some of the impact there?

[Peter Thomas:]

No. Thanks for the question. As we mentioned in the first quarter, we – when we first heard of raw materials in last fall, our teams got together pretty quickly and built out about 6 buckets of mitigation activities. And they all had certain types of values, and some were short term, some were long term. And there was an overlap and cascading of the impact that offset the types of increases as they were coming in. As you know, in the first quarter, because of pre-buys, productivity initiatives, reformulation, price increases, running extra volume through, seeing new opportunities and just base manufacturing efficiency, they were all available to us. And we just said, "Look, we're going to pull all them instead of cascading of them. We're just going to yank everything." And what happened was we were very effective in the first quarter with them building into the business. And again, I think we were even more effective in the second quarter than we thought. But we're going to be focusing more going forward on continued reformulation; price increases in two ways, which I'll mention in a second; and the continuation of manufacturing efficiencies. Ferro is very competent in lean initiatives and best practices around manufacturing. So with the 11 acquisitions, we're accelerating our manufacturing acumen in a way that will drive support cost at the COGS level. And as it relates to price increases, we have price increases out there that, as we've mentioned, will carry us through to the balance of the year in a way that will mitigate what's left. But we're also implementing what we are defining as strategic price increases where we feel where we've delivered a lot of value in the marketplace that it's probably prudent for us to raise prices in some of our strategic application areas where we believe we should be paid more. And all of those activities are coming together here in the second half in a way that we feel pretty comfortable mitigate whatever is left. But we do see some volatility in cobalt, lithium and – but we believe we can manage those.

[Mike Harrison:]

Great. And then if I'm looking at your slide deck, Slide 7 shows free cash flow conversion. Can you remind us why that's falling? And do you have maybe some opportunities to improve working capital performance over the next several quarters?

[BenSchlater:]

Mike, it's Ben. Yes. So from a cash conversion perspective, it just reflects the seasonality of the business through the first sort of half of the year. The comparison points are obviously year-end points where the cash conversion is maximized. If you look at the guidance for a full year, we'll be at or better than 2016 on a full year basis. So really what you're seeing is sort of the ramp-up in working capital from an inventory perspective based on some of the things that we talked about as well as from the acquisitions. So it's seasonality for the most part.

[Mike Harrison:]

And then just looking at the Performance Colors and Glass business, are there additional new products that are in the pipeline there? I think you kind of mentioned that in automotive you're seeing some potential weakness, but you also have some lead-free products that are exciting. Are we at a point where we're lapping the new products and there's not much more in the pipeline? Or is there still more to come?

[Peter Thomas:]

There's still more to come, Mike. There are a lot of opportunity in that business. As I mentioned, right now that pipeline for new products on accumulative basis moving out over the next couple of years is probably somewhere between $200 million and $250 million of what we'll call gross new program sales, which would include cannibalized and actual new products. So having something that's almost 50% of what that business is, is a pretty good vitality index. So we feel really, really – continue to feel really good about PCG as well as the other businesses. We have a wonderful organic pipeline that's delivering. As we've mentioned before, our vitality index is at 20%. We expect about $220 million coming in this year with a gross margin of 34% versus the aggregate of where we are today at 31.5%. And it's been like that for the past couple of years, and that's one of the reasons why our gross margins were up is because the pipeline is widening.

[Mike Harrison:]

All right. And then last question for me is related to the Dynamic Innovation and Optimization strategy. Just looking at that optimization word, clearly that's an area that you guys have executed pretty well on, at least the legacy Ferro portion of the business. Was just wondering if you can talk a little bit about what inning we're in as we look at capturing the cost synergies of the acquisitions that you've done over the past couple of years. Are there any metrics that you can share about the progress you've made and about the opportunity going forward on cost synergies?

[Ben Schlater:]

Mike, it's Ben. Yes. I mean, I think we would still expect, obviously, synergies to come through on these acquisitions. Most of the synergies, I would say, from a cost perspective come within the first two or three years. So if you think about the acquisitions that we've done even late 2016, we'll continue to see synergies into 2017 and 2018. But I think the broader point around so that – the optimization piece of the strategy is sort of the ongoing focus on optimization throughout the business. It's not just the base business and not just the acquisitions but the base business as well. And it's – we would look for that to continue across all facets of the business, cost of sales, all the way through SG&A. And a lot of that – what that is, Mike, is as much of a focus on costs, it's really as much of a focus on creating efficiency in the business. So that while the business is growing, the cost structure grows at a much reduced rate. And that's really the focus of this piece of the strategy so that we can leverage the existing cost base through growth so that we can do more with sort of what we have. And that's going to leverage, obviously, the innovation piece. In order to do that, we'll have to invest in new technologies, new processes, new people, that sort of thing. So from that perspective, it's really about supporting the growth.

[Mike Harrison:]

All right. Thank you very much.

[Peter Thomas:]

Operator, we have time for one more question. Please.

[Operator:]

Thank you. And the next question comes from the line of Kevin Hocevar from Northcoast Research. Please proceed.

[Kevin Hocevar:]

Hey, good morning, everybody. And let me add my congratulations on nice swing on quarters here as well. Peter, you mentioned raw materials kind of volatile but kind of expectation for stable and I think you mentioned that in the back half of the year. So wondering if you could give some clarity. It looked like it was that raws were about a $9 million headwind to gross profits here in the second quarter. So does that mean you'd expect that to continue to be about a $9 million headwind per quarter? Or when you say stable, do you mean they'll be flattish sequentially, but we might be comping easier comps? So maybe the year-over-year impact isn't so – as bad. And then also, you mentioned pricing actions and other actions you've been taking. When do you expect that to – those to kind of neutralize and the net – kind of those actions versus raw materials to be neutral to earnings? By the fourth quarter or third quarter? Or what do you think?

[Ben Schlater:]

Kevin, it's Ben. So let me take the first part of your question. Yes. I think from a raw materials perspective, I think we will see sort of the peak in the second quarter. And I do think from a gross perspective that will be the height, and it will continue to sort of trail down from there. So to your point around comping quarter-over-quarter, I would expect that number to come down a little bit through the balance of the year as we see the year play out. And then we'll look now to sort of the second piece of your question. We'll look to reformulation and price increases to offset that in the balance of the year. And that's all contemplated in the gross margin guidance of 31.4% and – 31.4% to 31.9%. So from that perspective, I think we would expect more stability in Q3 and Q4 from a net perspective as it relates to raws.

[Kevin Hocevar:]

Got you. And then just a second – final question. When I look at the 10-Q, you grew volumes really – like really nicely in Color Solutions. It looked like it was an $8 million contributor to sales. But on the gross profit line, it only added about $0.5 million. So it seemed like the leverage on those volumes to gross profit dollars was relatively small. So wondering if you could explain that why the incremental margins on that volume was a little light. And would you expect that to improve going forward?

[Ben Schlater:]

Yes, we would. It's – I think you had a couple of things happen in the second quarter with respect to Color Solutions. Number one, you had – we did have, we sold some products out of our Nubiola business that were a slightly lower margin. And so that was sort of a onetime thing. We would not expect that – for that to continue in the second piece – in the second half, rather. And then the other thing, Kevin, when you're looking at those walks in the Q, the other thing that you ought to do, particularly for Color Solutions, you take that $0.5 million and then you really need to add it to sort of that other piece that comes through the walk because that's a lot of the volume absorption. So the fall-through from that was actually much better than that. It was closer to what we would expect to see with respect to that business' existing margins. But we did have sort of those onetime sales from the Nubiola byproducts that pushed it down a little bit, but we wouldn't expect that to continue in a significant way.

[Kevin Hocevar:]

Got you. It makes sense. Okay, thank you very much.

[Operator:]

We'll turn it now to the presenters for their concluding remarks. Thank you.

[Peter Thomas:]

We would like to thank everyone for joining us on the call today. We appreciate your interest in Ferro, and we look forward to discussing our results with you again next quarter. Have a great day, and best regards.

[Operator:]

Thank you, sir. Ladies and gentlemen, that does conclude the conference call for today. We thank you all for your participation and ask that you please disconnect your lines. Thank you once again. Have a great day.