Quaker Chemical Corporation (KWR) Q4 2011 Earnings Report, Transcript and Summary

Greetings, and welcome to the Quaker Chemical Corporation Fourth Quarter and Full Year 2011 Results Conference Call. [Operator Instructions] As a reminder, this conference is being recorded. It is now my pleasure to introduce your host, Michael Barry, Chairman, Chief Executive Officer and President for Quaker Chemical Corporation. Thank you, Mr. Barry. You may begin.

Thank you, Rob. Good morning, everyone. Joining me today is Mark Featherstone, our CFO; and Jeffry Benoliel, our General Counsel and Head of Global Metalworking and Fluid Power. As usual, after my comments, Mark will provide the details around the financials, and then we will address any questions that you may have. We also have slides for our conference call. You can find them in the Investor Relations part of our website at www.quakerchem.com. I will start it off now with some remarks about the fourth quarter and the full year and then follow with some comments about 2012. The fourth quarter net income was consistent with our expectations. However, we saw some meaningful swings in a few of the P&L lines. In short, relative to the third quarter, our sales declined, our SG&A was up, and our tax rate was down. Let me now say a few words about each of these. Sales were down 5% from the third quarter. In fact, we saw a sequential quarterly decline in each of our 4 regions with Europe having the most impact. The decline was expected due to seasonality effects, as well as some adjustments of inventory levels in our customer supply chain. Our gross margins increased slightly during the quarter, but the full impact of our price increases were amassed by other factors such as a decline in our volume, as well as regional and product mix effects and the purchase accounting related to the G.W. Smith acquisition. On the SG&A side, we did have some timing-related swings relative to incentive compensation and higher acquisition-related costs. And we also had a lower-than-typical tax rate. Mark will provide more details around each of these in his remarks. So overall, as I think about the fourth quarter and try to strip out some of the uncommon items, I see positives and negatives. On the negative side, I see each of the key regions showing lower sequential volumes, primarily due to the seasonality, as well as a slowdown in numerous economies around the world. On the positive side, we made progress in our margins, more than is showing in our P&L due to weather effects. We are also gaining business and continuing to do well in our competitive space. And looking at the year as a whole, we had a record year in sales, earnings and EBITDA. In fact, both sales and earnings were up approximately 25% from 2010, which already was a record year for Quaker. Just as important, I am pleased with the progress we made in our strategic initiatives. These initiatives enabled us to increase our market share and help offset some of the softness we are experiencing in our core markets. In addition, over the last 20 months, we made 4 strategic acquisitions. While the size of the acquisitions are relatively modest, each of them adds either a new technology to our portfolio or strengthens our position in an emerging market. With the new acquisitions, we now have specialty grease, die casting lubricants and aluminum hot rolling lubricants in our product portfolio. And while we bought the businesses in North America, we are -- or will be rolling out the technologies globally to our customer base. I have 2 examples I thought I would share. The first one has to do with the aluminum hot rolling acquisition we made in July 2010. We are now gaining business outside of the U.S. with this new technology, as well as selling other Quaker products to the acquired customer base. The second example has to do with our acquisition of Summit Lubricants, a specialty grease manufacturer. We combined our knowledge of making fire-resistant lubricants with their formulating capability and have created a fire-resistant, biodegradable grease, the first of its kind in the marketplace. We are now in the initial stages of selling this product to the steel and mining industries. So I continue to be excited about our strategic positioning of Quaker. We intend to be a $1 billion company, and we have numerous strategic growth initiatives that will get us there over time. Looking forward to 2012, I see a mixture of positives and negatives as it relates to our markets. On the negative side, we see sluggishness and uncertainty in several of our markets, such as Europe, China and Brazil. Our expectation is that we will see some increases in industrial production as the year progresses in each of these areas, although it's hard to predict this with certainty. The other potential negative has to do with our raw material costs. It's a potential negative at this point since we have not been materially impacted as of yet with the recent spike in crude prices. However, if history is any indication, we probably will be impacted down the road, and this could lead for the need for further price increases, which typically causes a negative lag effect on our margins. Hopefully, crude will stabilize at lower levels. But if not, we are prepared to take action. On the positive side, we see a strong U.S. market in terms of steel and auto production. We also expect to get increasing contributions from our acquisitions, as well as growth in our core markets from our strategic initiatives. Putting all this together, we expect to have 2012 net income that exceeds our 2011 net income of $40.9 million, which excludes the non-cash gain related to our Mexican acquisition. The bottom line is that I'm confident in our future. We have demonstrated in the past that we can manage through uncertainty, and we see this year as no different. Our expectations are to build upon the record years of 2010 and 2011, and make 2012 another strong year for Quaker. In closing, I want to thank all of our Associates, whose dedication and expertise helps to create value for our customers and differentiate Quaker in the marketplace. And now, I will turn it over to Mark Featherstone, our CFO, so that he can provide you with more details behind our financials. And after that, we will address any questions you may have.

Thanks, Mike. Good morning, everyone. Yesterday, we announced earnings of $9.8 million or $0.75 per diluted share for the fourth quarter of 2011. This compares to $6.9 million or $0.59 per share in the fourth quarter of 2010. While the bottom line results for the quarter were in line with our expectations, there are some pluses and minuses that I will discuss further. Both last year's and this year's fourth quarters included some unusual items. Last year's fourth quarter included charges of only $0.10 per share related to a non-income tax contingency and an out-of-period charge, while the fourth quarter 2011 results were impacted by the timing of several items related to incentive compensation. Fourth quarter 2011 EPS also reflects a $0.07-per-share diluted impact from the 2011 equity offering. I will now go through the fourth quarter P&L, and then we will go on to questions. Revenues for the fourth quarter, compared with the same period last year, were up 22% to $173 million. As expected, compared to the third quarter of 2011, sales were down about 5% due to seasonal factors and some sluggishness in Europe, Asia and Brazil. And you can see that on Chart 1. Compared to the last year's fourth quarter, overall product volumes were up about 14% including acquisitions, while exchange rates decreased revenues by about 1%. Price and mix accounted for the remaining 9% increase in sales. Acquisitions represented about 11% of the overall 14% increase in volume for the quarter. Now if you look at Chart 2, North American steel industry production levels were fairly steady for most of 2011, as capacity utilization rates generally hovered between 70% and 75%. For 2012, we expect a little improvement with capacity utilization rates generally in the 75% to 80% range. And so far in 2012, they have been in that range. Last quarter, I indicated that we anticipated more economic uncertainty around the world in the fourth quarter, and the fourth quarter certainly played out that way. Overall, we are expecting a similar start to 2012 in most of the world, with the U.S. showing a little more strength. So we continue to have some demand uncertainty in the short term. Now on the positive side, overall inventory levels in the steel industry remain in much better shape than they were several years ago, with a combination of slackening demand and high inventory levels, resulting in a double hit to steel production. Then what we've also seen is that Quaker's recent acquisitions and the new business that we have gained also has helped us offset any volume impacts from the uncertain global economy. Turning to gross margins. Historically, we have generally experienced a 3- to 6-month lag in recovering higher raw material costs through pricing actions. As we discussed last quarter, we implemented significant price increases in the third quarter, and we began to see signs of margin recovery in the third quarter. This continued into the fourth quarter as we saw a sequential increase in gross margin percentage. However, the favorable impact was diminished somewhat by the impact of mix, acquisitions and other factors. As we have discussed previously, some of our recent acquisitions have gross margin percentages that are lower than the existing business. So you take out some of the mix and acquisition impact, gross margin percentage would have been around 30%. And as you are aware, crude oil prices have spiked in recent weeks. And while the impact on our raw materials has been limited so far, we are monitoring the situation closely. Now let's move on to SG&A and other expenses. As I mentioned previously, there are a few unusual items in SG&A that I would like to discuss further. In absolute terms, SG&A in the fourth quarter was higher than last year's fourth quarter, primarily due to higher incentive compensation expense and the impact of the recent acquisitions. In addition, we also incurred transaction and related costs in connection with our recent acquisition activity. Together, these items represented more than 2/3 of the increase in SG&A compared to the prior period. Regarding the increased incentive compensation expense that I referred to earlier, there are 2 primary components: one related to our long-term incentive plan, and the second related to our annual incentive plan. Now part of our long-term incentive plan is determine on how Quaker's total shareholder return does compared to our peer group. During the third quarter, when our stock price fell below $30 per share, our relative ranking declined, and we reduced this accrual. In the fourth quarter, as our stock price recovered, our relative ranking improved, and additional expense was approved. In total, about $700,000 more expense was incurred in the fourth quarter of 2011 than in Q3. Regarding our annual incentive plan, by the end of the third quarter of 2010, we were almost fully accrued at a max bonus level, and very little bonus expense was accrued in the fourth quarter of 2010. And as you recall, EPS for 2010 was about 88% above the previous year, driving that bonus expense. In 2011, our overall full year bonus expense is lower than 2010, but much more of this bonus was accrued in the fourth quarter for the reasons outlined above. In addition to the acquisition and the incentive compensation expense I talked about, we have also continued to invest in additional resources where we have good growth opportunity, particularly in the emerging markets. Also included in other income for the fourth quarter is about a $600,000 gain related to a fair value adjustment for our contingent consideration liability. Now looking at our tax rate. As expected, our tax rate in the fourth quarter was lower than the third quarter. The fourth quarter tax rate benefited from the recognition of the previously unbenefited tax credits, a change in the amount of certain foreign dividends, as well as the mix of foreign earnings, especially from China, where we continue to benefit from a low tax rate. Now our full year 2011 tax rate finished in the mid-20% level. We currently anticipate that our 2012 tax rate will be around 30%. We will continue to benefit from a lower tax rate in China in 2012. However, with the increase in profitability in the U.S., which has one of the world's highest corporate tax rates, our overall tax rate is expected to increase. Now looking at our balance sheet and cash flows. We've generated more than $15 million of operating cash flow during the fourth quarter, and our plans call for further progress in operating cash flow during 2012. Now in 2012, we are continuing the construction of our second plant in China, and we also expect to purchase land and begin construction on a plant in India. This will result in capital spending levels higher than the last few years. Now as you can see on Chart 3, our EBITDA in 2011 was an all-time record. And our leverage ratio, which is debt divided by EBITDA, is very healthy at less than 1x EBITDA. This provides us with significant financial flexibility to take advantage of acquisitions and other opportunities as they arise. And that concludes my prepared remarks.

Thanks, Mark. At this stage, we would like to address any questions from any participant on this conference.

[Operator Instructions] Our first question is from the line of Laurence Alexander with Jefferies & Company. Gentlemen, we'll move on to our next question. It's from the line of Peter Cozzone of KeyBanc Capital Markets.

On the SG&A front, if we kind of back out the higher compensation costs during the fourth quarter and take into consideration escalating emerging market costs, what's kind of like the normalized absolute range we should be thinking on a quarterly basis for 2012?

Yes, I think -- yes, as you correctly pointed out that the SG&A expense for the -- of $45 million for the fourth quarter was on the high side for the factors I explained. I think we generally expect SG&A expense to increase from the -- through the year but start off a couple of million dollars lower than we were for the fourth quarter and then gradually build. We are planning in 2012 to be adding additional resources, particularly in the emerging markets, as we continue to grow our business.

Okay. And then in terms of the first quarter, can you talk about normal seasonality on a sequential basis from a sales standpoint? And it doesn't sound like you've seen a meaningful impact from rising oil prices so far. But maybe what are the kind of the puts and takes on the gross margin front near term?

Well, in the first quarter, historically, it tends to be one of our weakest quarters from a volume perspective. And generally, you start out slow because sometimes people over the Christmas holidays extend into the New Year, that's one factor. For example, this year, Chinese New Year, which -- of course, a good part of our business is in China, and that happened in January. In Brazil, you have Carnival. So you have some of these major holidays, so generally, you kind of start first 2 months a little weaker than normal. And then by the time you hit March, it tends to be a much better month, a much more typical month that we could expect to see. And that's kind of how we're seeing things. We start to see a slowdown as we went through the fourth quarter and it's kind of almost the reverse effect of that in the first quarter, where the first part of the first quarter is slow, but the last part is -- should be better.

And then kind of looking at the gross margins and on a sequential basis, I mean, just given the seasonality on the volume front, I mean, is there any way you can continue to improve gross margins in the first quarter? I mean, would that just be done on the lower volumes?

Well, it would depend overall. One of the impacts is certainly how is the volumes overall versus the fourth quarter. We don't expect it to be materially lower or anything like that -- than the fourth quarter. The -- then the other aspect is what's happened to our raw materials. And raw materials -- and as we said, we've been -- if you go back to the third quarter of last year, that's kind of when we hit the height of raw materials in general. And since that time, they stabilized. Some have come down. So we've had some expansion in our gross margin. Some of that was masked for the reasons we've talked about in the fourth quarter. So we would expect to see some uptick in our gross margin in the first quarter.

Okay. And then lastly, can you provide some color on the market share gains you're achieving? What are you doing particularly well? Or maybe where are the areas that you're seeing the most traction? And then how much of recent acquisitions played a part in these gains?

Yes. I kind of think of them in 3 buckets, maybe. I think one part of our gains is because when -- as we -- the whole industry went through this downturn 3 years ago. Some of our competition has cut back on their service levels. And so over the past few years, we've gotten opportunities at different places around the world that we historically weren't able to get, and because people were unhappy with the competition, and they went to us. So that's one part of things. And usually, in our type of business, it takes a while to get a new piece of business. Usually, trials and things like that. So over time, over the past few years, we've been picking up some pieces of business that way. Another aspect is that we've really focused in on key areas in our -- both for our steel business and our metalworking areas that -- really drive kind of double-digit growth. And we focused on key areas, and through that kind of focus, like tube and pipe market, if I use an example, we continue to see double-digit growth associated with our initiatives around tube and pipe. And we have a whole series of these kind of items. And then the other aspect, the third bucket would be, like you mentioned, the acquisitions. And again, the acquisitions, we see promising on a couple of different fronts. One is we bought these technologies in one part of the world in the United States, and we're in the process in different stages of rolling that out globally. The initial one of the 4 acquisitions is farther along than the other ones just because we've been in it for 20 months now. And we are picking up new pieces of business around the world, and the other ones are more, the ones that are closer in, we're just in the beginning part of that. And plus, the other aspect of the acquisitions is we are able to start selling some of our Quaker products into their customer base as well, and that helps as well.

[Operator Instructions] Our next question is from Liam Burke of Janney Montgomery Scott.

Mike, Mark, you both touched on the gross margins where they are being negatively affected by new products through acquisition, but operating margins are positively affected because they carry less SG&A? You must have -- you have stated goals in -- hopefully in gross margin and operating margins. Do these acquisitions sort of change things in terms of your gross margin or operating margin objectives?

Yes. I think we've talked before about a target gross margin percentage of 35% in the longer term. Certainly, the raw material environment made that a little challenging but -- and also the kind of law of large numbers that as our sales increase, that the number increases. But that is still our goal. We've also talked about an operating income, our operating margin percentage goal of 10%. That's still our goal, in fact we like to go beyond that as well because a lot of times, as you've mentioned, while an acquisition may have a little bit lower gross margin percentage, there may be less service needed once the product is in place so that the overall operating margin can be -- still can be similar.

Okay. And Mark, on the working capital line, you had a big step-up in accounts receivable and on inventory. Is there anything in there that's different from the year before?

Well, I think working capital has increased throughout the year. I think with these higher raw material prices we've been experiencing, the same amount in inventory at today's prices is obviously carrying a higher value in terms of dollars. Similarly, as we go out to our customers and charge them higher prices, that's going to increase the accounts receivable level. And we do have programs in place to try and reduce inventory levels. We expect to get some benefits out of that in 2012, we saw the initial benefits of that in the fourth quarter. But in terms of receivables, aging or potential bad debts, the situation is really no different from where it was a year ago.

Okay. Because if I look at the cash flow statement for the year, I mean, typically you guys are very strong generators of free cash. It was lower than normal. Obviously, you had the capital programs and the expansion programs, but it looked like working capital was a drag on cash flows.

Yes. Certainly, working capital levels were a little higher than we expected, and that's why at least I was encouraged by the $15 million of operating cash flow we generated in the fourth quarter that we're kind of getting our way back to where we should be.

Gentlemen, there are no further questions at this time. I'd like to turn the floor back to management for closing comments.

Okay. Given there are no other questions, we'll end the conference call now, and I want to thank all of you for your interest today. We are pleased with our results for 2011, and we continue to be confident in the future of Quaker Chemical. Our next conference call for the first quarter results will be in late April or early May. 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.

This concludes today's teleconference. You may disconnect your lines at this time. Thank you for your participation.