Quaker Chemical Corporation
Q3 2008 Earnings Call Transcript

Published: 29 Oct 2008

[Operator:]

Greetings ladies and gentlemen and welcome to the Quaker Chemical Corporation third quarter earnings conference call. At this time all participants are in a listen-only mode. A brief question-and-answer session will be following the formal presentation. (Operator Instructions) It is now my pleasure to introduce your host Mr. Mike Barry, Chief Executive Officer and President for Quaker Chemical. Thank you Mr. Barry, you may begin.

[Mike Barry:]

Thank you. Good afternoon, everyone. This is my first conference call as CEO and President of Quaker and it certainly has been an eventful three weeks since I entered my new role on October 4. Joining me today is Mark Featherstone, our Chief Financial Officer; and Jeff Benoliel our General Counsel and newly appointed Head of Global Strategy. Mark will give us more detail around the financials and then we will address any questions that you may have, but I’d like to start off now with some remarks about the third quarter and what we are currently seeing in our marketplace. Overall, it was a good third quarter, but the data is really only part of the story given the global events of the past few weeks. As we enter the third quarter, margin recovery was our main challenge; however as we exited the quarter, our challenge was shifted to the volume or demand side of our business. So let me start first with some remarks about our margin recovery efforts. Raw materials continued to increase significantly in the third quarter. Year-to-date our raw material costs are up 11% with over half of this increase being in the third quarter and just as a point of reference we will see more increases in our raw material costs this year than the previous three years combined. So it has been a top priority for us to recover our margins in such a volatile environment. Now, crude oil pricing did start to significantly decline during the third quarter, but our raw material costs did not see any significant improvement. So there has been a delay or lag effect between crude oil and the kind of raw materials we purchased as each of the different types of raw materials we purchased have their own supply and demand characteristics. We also put in place price increases in our products across all product lines and in all regions during the quarter, to help us offset the very large raw material costs we were experiencing. As we enter the first quarter in 2009 we expect margins to continue to recover due to the fact that most of our necessary price increases either are in place or will be implemented by the beginning of 2009 and our input costs are normalizing. So while we feel good about the progress we are making on margins, our latest challenge is with the demand side of our products and we really started to feel this in the third quarter as we saw slower than typical demand in China, Europe and the US. China was down from our expectations but still higher than last year primarily due to the Olympics which resulted in lower customer demand and shipment restrictions. In Europe we began to see a decline in both automotive and steel markets and in the US, we continued to see the decline in the automotive markets and that’s been ongoing for a while; however we also began to see a slowdown in North American steel markets which had been decent prior to this quarter primarily due to the weak dollar and its positive impact on steel imports and exports. Then as the third quarter is ending we saw the credit crunch and global stock market declines hit us in early October and our large steel and automotive customers began to announce significant production reduction for the fourth quarter, especially in the US and Europe although China and South America are also seeing some softening. So what are we doing about this situation? Of course, we are actively monitoring and constantly evaluating the situation. There is still a great deal of uncertainty on the magnitude and the duration of the production declines. In our 2009 planning which we are actively working on, we are looking at a whole range of demand scenarios and what our responses would be so that we will react in a timely fashion as we get more clarity around this global economic situation. The bottom line is that we continue to focus on the long term, but we also will manage the short-term realities that we are facing. So let’s now talk about some of the positive things we are seeing in our business. One, we expect to see margin recovery as I discussed earlier. In the past year we have seen declines in our margins and we expect this trend to turnaround for the reasons I stated earlier. Two, we are excited about new business opportunities we are getting in our businesses such as steel, tube and pipe, mining and metal working. We are also making progress in our product conversions in our CMS business especially with the new contracts we picked up over the past year. So we do expect to expand our market share in our markets. Three, we have very promising growth initiatives in our coatings product line and I believe that coatings can show significant growth for Quaker over the next several years and four, we still expect to see good growth opportunities in the brick countries, Brazil, Russia, India and China. We are well positioned in each of these countries and have growth initiatives in place. So the key question will be, how much of the production reductions in the automotive and steel Markets will be offset by the positives I just mentioned and it’s hard to say at this point given the near term uncertainty we are seeing in our customer demands; although the reductions we are seeing today are significant, which are approximately 15% to 30% down in steel production in the US and Europe. So given what we know today, we do expect our results for the fourth quarter to not show the strength of our previous quarter this year; however once again I want to emphasize that we’re confident in Quaker’s future and we will continue to manage the short-term realities that we are facing. I also want to mention some items about our strong financial position. We finished our quarter with good operating cash flow and a strong balance sheet as our net debt level is at its lowest point since the second quarter of 2005. Also our consolidated leverage ratio is strong. In addition we believe we have good liquidity with our $50 million in borrowing capacity under our primary credit facility and we feel confident with the current financial strength of our banking group. So in summary, we had a good third quarter and while the near future will present some challenges for us, we are confident that our strategy, strong Management team, leading market position, good growth opportunity and solid balance sheet will bode well for the future of our shareholders, customers and employees. Now I’ll turn it over to Mark Featherstone, our Chief Financial Officer, so that he can provide you with details behind our financials and after that we will address any questions you have; Mark.

[Mark Featherstone:]

Thank you, Mike. Good afternoon, everyone. Reported EPS of $.41 per diluted share was significantly higher than the $0.31 EPS we reported for the third quarter last year; however, both periods included some unusual items including the $0.10 per diluted share charge related to the CEO transition in this years results while last years period included a charge related to the settlement of environmental litigation as well as some other items. I'll spend the next few minutes focusing on the third quarter P&L and then we’ll go on to questions. Revenues for the third quarter compared with the prior period were up 13% to $159 million. The growth was driven primarily by pricing improvements and foreign exchange rate translations as well as volume growth in Asia Pacific and South America. Foreign exchange increased revenues by approximately 5% as the US dollar was weaker against most currencies, primarily the euro and the riel. Regarding volume, overall volume for the quarter was down about 6%. Volumes in Asia Pacific and South America were higher; however, these gains were more than offset by declines in North America and Europe. In North America, both steel and metal working volumes were lower than the prior year stemming from softening of demand in consumer durables including automobile. Volumes from both steel and metalworking were lower in the second quarter as well. Our sales to the automotive markets were also lower due to the lower customer production despite continued share gains and conversions at CMS sites. Overall pricing mix was up above 14% from last years third quarter. The higher sales prices reflect our continuing efforts to work with customers to deliver value while also recognizing the impact of higher raw material costs. Overall raw material costs were significantly higher than prior year levels and peaked in the third quarter and despite the recent decline in crude oil prices, as Mike mentioned our raw material costs remain largely unchanged. As we’ve discussed before, we’ve been able to work with our customers to recover most of the increased raw material costs through higher selling prices, although there is usually a lag effect in achieving this catch up and while the second quarter was negatively impacted by a significant lag due to the sharp run up in raw material costs, price increases in the third quarter helped offset cost increases in the second and Third Quarter, and in certain areas we are taking additional actions in the fourth quarter to recover higher costs. Turning now to our segments; I’d like to provide some data on our segment basis. As you recall we segment the business into three areas

[Mike Barry:]

Thanks Mark and at this point we would like to address questions from any of the participants on this conference call.

[Operator:]

(Operator Instructions) Our first question comes from Robert Felice - Gabelli & Co.

[Robert Felice:]

I guess first on an absolute basis, how much of your raw materials increased year-to-date? You mentioned a percentage number but just wanted to get my hands around the absolute number.

[Mark Featherstone:]

Yes, I think we mentioned in our last phone call Rob that we expected a $40 million increase in raw materials for the full year ‘08, I think through the third quarter of around $25 million or so.

[Robert Felice:]

And you still expect that $40 million number?

[Mark Featherstone:]

Yes, that $40 million number.

[Robert Felice:]

And what’s the magnitude of your price cost GAAP?

[Mark Featherstone:]

We made some progress through the third quarter, but we still have some GAAP carried over from the second quarter.

[Robert Felice:]

And we’re finally starting to see base oil prices and other prices tic down although they haven’t obviously dropped as fast as crude has. Just wondering as those costs start to decline, do you anticipate holding onto your price despite the weak demand environment?

[Mike Barry:]

Well, I think we target to get a certain margin from our customers and of course as we went up in prices with our customers we work with them to try to reach a certain margin level that we need to have an acceptable profitability level. In a lot of cases we’re just getting to that point where we still haven’t reached that point. So as things begin to change, we get our price increases in place, raw materials begins to come down, once we get to a certain point and we exceed that profitability level, we will be working with our customers to adjust pricing downwards. So I’d say in the most part we still haven’t gotten to our margins EBITD as a whole, as a company, so we still expect to see margin expansion going forward but then once we get to a point where we feel they’re at the right place given everything considered, then we will expect to see some declines probably going in our pricing.

[Robert Felice:]

Okay and on the consolidated basis what would you say is that target op income margin, the appropriate level?

[Mike Barry:]

One of the things I kind of struggle with is I know when you’re looking at our P&L and looking at gross margin percentages and things line that and operating percentages, we tend to at a macro level look at things more on a margin per kilogram level with our customers and what kind of margin we need to get an acceptable rate of return or EVA with a customer. So we do this on a customer-by-customer basis, so it’s hard for me to kind of say at a macro level, where we would be and something that you’d be looking at on a gross margin percentage. Mark, I don’t know if you have anything.

[Mark Featherstone:]

I think that’s right and I think to add to Mike’s earlier comment, one of the things we’re finding also is while raw materials may decrease in the US as base oil prices drop, in Europe and other areas the rapid strengthening of the dollar has caused absolute prices in euro terms to continue to increase into the fourth quarter as well. So that’s part of the area we’ll be looking to further increase prices to recover margin.

[Robert Felice:]

Okay, I guess going back to the margin point, if either quantitatively or qualitatively you could help me get my hands around the absolute level of operating income improvement you’d expect before you get to a more normalized per kilogram or per customer margin level, what would that be?

[Mike Barry:]

I don’t want to again throw that number to you, because again I don’t have that right in front of me, but I think the other thing that you have to think about Robert is at the same time we’re getting, we will see higher margins if continue our margin recovery here in the fourth quarter, but at the same time our volumes are going to be down. So what is the effect of that as I mentioned in my comments is that it’s really hard to say. The volume effect can be significant, but so is our margin recovery and it really depends upon the net effect of those two and given the uncertainty that we’re seeing in our customer base right now with these production/reductions, it’s hard for us to really give a clear view on the fourth quarter.

[Robert Felice:]

Okay and I guess just to clarify what you said before on the fourth quarter, do you expect the level of year-over-year growth to slow or do you expect to show a year-over-year decline in the fourth quarter?

[Mike Barry:]

Well certainly from a volume perspective, it will be down year-over-year from what we know today. Now revenue, when you throw in the price increases and revenue stuff from CMS contracts, again I don’t have that off the top of my head, but overall again we expect to see the fourth quarter to be the least strong quarter with the least amount of strength of any quarter this year.

[Robert Felice:]

And from an earnings perspective year-over-year improvement or is that a stretch?

[Mike Barry:]

We’re not forecasting anything more about the fourth quarter than really just what I said.

[Operator:]

Your next question comes from Lee Amberg - Janney Montgomery Scott.

[Lee Amberg:]

Mike, you talked about in the press release partially on the cost side or market on the pass through versus the gross receipts. In general, how did the business perform during the quarter?

[Mike Barry:]

The CMS business?

[Lee Amberg:]

Yes.

[Mike Barry:]

The CMS business in general has been a pretty stable business for us and continues to perform very well. We get profit in different ways from our CMS business. We get it from fees that we charge our customer for managing the business. That’s relatively stable. We also get through our products that we sell to these customers and there and there it’s kind of a double-edged story. We’ve actually made significant progress and continue to sell and get more of our share of products into our customer base, but at the same time the automotive customer base is declining pretty rapidly in the United States. The US economy this year, auto production is way down as you know. It has been historically over 60 million and this year it’s going to be under 14 million vehicles and our customer base has certainly felt that quite a bit. So we haven’t seen the full brunt of that because of these conversions. So from a product perspective its down, from a service perspective, it’s been pretty good.

[Mark Featherstone:]

The other thing I’d just to add to that as well is some of our contracts have indefinite to us, so the pull through of raw material prices have not yet been reflected on the index, just based on where the index will be set. So that’s hurt us a little bit in the fourth quarter, but we expect to get that back in the fourth quarter ‘09.

[Lee Amberg:]

Okay and on the Middletown Ohio project, year-over-year your capital expenditure is up. I presume that’s the expansion of that plant. In terms of percentage completion, how far are you along on that project?

[Mike Barry:]

Well we broke ground in the third quarter, so we’re looking to finish that third quarter next year, so we’re still in the early stages, but as I mentioned before the financing for that is all set up.

[Lee Amberg:]

Okay and then one last related question. Mark, your capital expenditure for the full year; if you can share some general guidelines?

[Mark Featherstone:]

Yes, I think our Middletown spending will accelerate a little bit in the fourth quarter compared to the third, but our base run rate of other CapEx should be roughly the same. I think we’ve had about somewhere between $2.5 million to $3 million of CapEx in Middletown so far this year. So I think if you back that off of our year-to-date and project that forward then say Middletown will probably be about the same in the fourth quarter as it has been so far this year.

[Operator:]

Your next question comes from Robert Felice - Gabelli & Co.

[Robert Felice:]

Just one or two follow-ups; obviously there’s just a lot of structural change taking place within the automotive industry, potential for some pretty big consolidation. As you think about the changes that are taking place there, how is Quaker positioned to deal with it and how do you think about the risks associated with potential customers consolidating?

[Mike Barry:]

Well, certainly, we have very large positions with both General Motors and Chrysler and we would expect to continue to have those positions and end up working together. We’ve been I think by their own admissions a very significant part of cost reductions for them, so I think they’re very happy about us as a supplier to them of services and products, so I don't expect any negative reaction from that perspective. Over time we have been living with just a general decline in the auto industry, in the US but we expect to continue to try to expand in the auto industry elsewhere around the world, especially in Asia, India and so forth as things expand in different parts of the world. So I don’t see the continuing trends that we have been experiencing to take place and for example we are becoming more and more active in Mexico where there’s more and more opportunities as the auto guys as Chrysler, GM tend to expand their Operations in Mexico and we expect to have more of a service presence down there and get more of that business going forward. So it’s just really I see a shifting around the world of where these opportunities will take place.

[Robert Felice:]

And then I guess lastly, your corporate unallocated expense for the year is running below last year’s level; could you provide any guidance as to what that will be for the fourth quarter for the full year?

[Mark Featherstone:]

Overall, I’d say it will probably continue on the same kind of trend year-to-date. I think last year was a little higher; we had some environmental costs that were included in there and we also had some higher incentive compensation costs last year, if you look at the year-to-date ‘07 versus ’08; so we’re not seeing those kinds of things for 2008.

[Robert Felice:]

Okay, so similar to the third quarter level I’d say?

[Mark Featherstone:]

Similar.

[Operator:]

Your next question comes from Daniel Rizzo - Sidoti & Co.

[Daniel Rizzo:]

One quick follow-up question; in terms of your sales to the auto industry do you sell into the Japanese automakers or into Japan at all?

[Mike Barry:]

No, not to a great extent, we have very minor sales. Certainly a scenario we want to focus on more and it is an initiative for us, but it isn’t a big part of our business today and that’s primarily due to a lot of the Japanese OEMs tend to buy from Japanese companies today, but we’re hoping that through different mechanisms that we’re working with including enhanced technology products that we provide, including the kind of service programs that we provide, that over time we will be able to penetrate more of the Japanese OEMs.

[Operator:]

(Operator Instructions) Thank you, but there appear to be no more questions at this time. I would like to turn the floor back to management for closing comments.

[Mike Barry:]

Great, thank you. So I’d like to thank all of you for your interest today. While these are challenging times we will get through them and we will continue to prosper as a company. Our next conference call for the fourth quarter results will be at the end of February and if you have any questions in the meantime, please feel free to contact Mark Featherstone or myself. Thanks again for your interest in Quaker Chemical. Goodbye.