Quaker Houghton

Greetings. Welcome to Quaker Houghton's second quarter 2021 results conference call. At this time, all participants are in listen-only mode. A brief question and answer session will follow the formal presentation. If anyone should require operator assistance during the conference, please press star zero on your telephone keypad. Please note this conference is being recorded. At this time, I'll now turn the conference over to Michael Barry, Chairman, CEO, and President. Mr. Barry, you may begin.

Thank you. 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 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're continuing to meet our customers' needs despite the 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 our integration. Our results for the second quarter were stronger than we expected. This was primarily being driven by continued strong sales. While sales volumes were down 3% from the first quarter, the first quarter was unusually strong as we believe some of our customers were replenishing their inventories. If we compare our second quarter sales to the fourth quarter of 2020, which was another strong quarter for us, our current quarter sales volumes were up 4%. You can see from chart eight, where we show our sales volume trends, that our sales volumes were up 35% from the second quarter of last year and has sequentially improved at a steady rate since then, with the first quarter being unusually high, as I mentioned earlier. Overall, our top line revenue was up 52% from the second quarter of 2020, with all segments showing strong growth since 2020 was particularly hard hit from COVID. On a sequential basis, sales were up 1% from the first quarter with three of our four segments showing growth, but our Asia Pacific segment was down 5%. Overall sales for Asia Pacific continued to be strong, but did sequentially decline compared to the first quarter due to unusually strong demand in the first quarter in our China metalworking business. This is largely due to certain customers replenishing their supply chain in the first quarter. We are also seeing higher selling prices, which we estimate increased an overall 6% in the quarter with increases in all four segments. I also want to point out that our ability to gain new pieces of business and take market share also contributed to the strong performance. As our analysis shows, we had total organic sales growth due to net share gains of approximately 4% in the second quarter of 2021 versus the second quarter of 2020. So we continue to feel good about our ability to deliver on our historical performance of consistently growing two to four percentage points above the market due to our share gains. And looking forward, we continue to feel good about these levels of share gains given the opportunities we have recently won or are actively working on. While strong 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 material costs were increasing the last time we talked, the increases have continued longer and at a higher level than we expected. Overall, our costs of raw materials have increased an additional 10 percent since our last call in May when our original expectation was that they would begin to stabilize in June. This has not been the case. There's tremendous stress on the supply chain of our raw materials and logistics. Further, the availability of raw materials has impacted us at times, for I'm proud to say that we've navigated this so far and have ensured that all our customers' businesses continue to operate. The increase in raw material costs did put downward pressure on our gross margin in the second quarter, and this increase in raw materials will continue into the third quarter, just given the sheer magnitude and duration of the additional increases. and the lag effect we experienced between the time raw material costs increase and the time we have to fully implement price increases to offset them. So, overall, we're very pleased with the quarter given the raw material issues we are facing as we achieved our second highest quarterly adjusted EBITDA ever. Our trailing 12-month adjusted EBITDA is now $277 million compared to the $222 million in 2020. So we are already experiencing the step change we projected in our profitability. Synergy achievement also was a factor in our results as we achieved $18.5 million in the current quarter compared to $12.5 million last year. Related to our liquidity, we did increase our net debt in the quarter due to increases in our working capital related to raw material costs and availability. Our leverage ratio of net debt to adjusted EBITDA continued to improve from 3.1 at the end of the first quarter to 2.7 now. As we look forward to the third quarter, we expect short-term headwinds from higher raw material costs and additional impacts in the automotive market due to the continued semiconductor shortage and some typical seasonality impacts. I do now see the third quarter as our lowest quarter of the year, both in terms of gross margin and profitability. However, we do expect our margins and profitability to sequentially improve in the fourth quarter. We expect raw material prices to stabilize by the end of the third quarter, and we expect our product margins to get back to their targeted levels as we exit the year. As I think about our full year, we are continuing with our previous guidance, which is the floor or the low end of our expected adjusted EBITDA. However, I'm more optimistic on the year than I was several months ago. While we may end up the year in the same place or slightly better based on our strong first half, the shape of our year's expected profitability trend has changed. Essentially, we are seeing higher demand for the year, but greater margin pressures in the near term, which is expected to be largely offset this higher demand. However, the margin pressures are expected to be short-term in nature once our price increases are fully implemented. So we are currently expected to exit the year at a better than expected demand for our products and our product margins largely returning to our expected levels. So we even though expect the year's profitability to be in a similar or slightly better place compared to our previous expectations, I feel better about this scenario than the already positive one I envisioned a few months ago. We will have a step change in our profitability, essentially complete our integration cost synergies, continue to grow above the market by taking share, and reach our target in net debt to adjust deep at the 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'm so proud 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 conditions we face. People are everything in our business and by far our most valuable asset, and ensuring their safety and well-being is and will continue to be a top priority for us 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 this quarter.

Thanks, Mike. Good morning, everyone. Before I get into the results for the quarter, I'd like to remind everyone the comments made during this call include forward-looking statements, which are based on current expectations and are subject to risks and uncertainties that could cause our actual results to differ materially. For further discussion of these risks, please review the cautionary statements regarding forward-looking statements included in our earnings release and our Form 10-Q, which will be filed with the SEC later this week. In addition, please reference our risk factors disclosed in our 2020 Form 10-K for more discussion of the company's risks that could also impact our forward-looking statements. In addition, Mike and I make reference to several non-GAAP measures during this call. Such are consistent with the press release and call charts filed yesterday, and also there are reconciliations between U.S. GAAP measures and non-GAAP measures provided in our call charts on pages 11 through 22 for reference. Looking at our second quarter performance, we had another strong quarter, and as Mike mentioned, it was really the story of a positive. solid top-line performance, but tempered by a negative, higher input cost due to the global supply chain disruption that we and the rest of the world are currently facing. As I begin to discuss our quarterly performance, I'll point you to slides six, seven, and eight in our call charts, which provide a further look into our financials. And also, I want to remind everyone that our prior year comparison was heavily impacted by COVID-19 hitting us the hardest in the second quarter of 2020. Our record net sales of 435.3 million increased 52% from the prior year, and this was driven by 35% higher volumes, 8% from foreign exchange, 5% from acquisitions, and 4% from price and mix. When looking sequentially, we were up 1% from the first quarter, as increases from our pricing initiatives offset about 3% lower volumes quarter over quarter, as the first quarter enjoyed some additional volumes due to customers replenishing their inventories. Turning to our gross margin trend, Our second quarter margin ended at 35.5%, which, as we expected, was down roughly 1% sequentially due to the pricing lag that Mike previously discussed. That said, we did show improvement compared to 34% in the prior year, but this 1.5% improvement year over year is really due to the impact of fixed manufacturing costs on prior year low volume levels, as well as the benefit of strong execution of integration synergies. which offset higher raw material costs in the current quarter. We expect third quarter gross margins to be at or somewhat below our second quarter level before beginning to increase in the fourth quarter. As we exit the year, we do expect our product pricing to catch up to the current year raw material increases. However, the impact of price increases to our top line will naturally impact our overall gross margin levels as we price to ensure we retain our product margins at least on a per-kilo basis to ensure we maintain our levels of gross profit in dollars rather than percent. SG&A was up $22 million compared to the prior year quarter as we had additional direct selling costs due to our increase in sales, higher labor and other costs that were directly impacted by COVID last year, additional costs associated with our recent acquisitions, and higher SG&A due to the impact of foreign exchange, which were partially offset by additional savings from integration cost synergies. The net of this performance resulted in our second highest ever adjusted EBITDA of $70.1 million for the quarter, up 118% compared to the prior year COVID impacted $32 million. As you can see in chart 9, this increased our trailing 12-month adjusted EBITDA to a record $277 million. From a segment perspective, these results were really driven by higher operating earnings in each of the company's segments year over year. This was certainly attributable to the prior year weak performance due to COVID, but this quarter also benefited from recent acquisitions, higher integration cost synergies, as well as the market share gains Mike previously mentioned. When looking at our segment's sequential performance, each segment's top line was above the first quarter as global pricing initiatives offset some volume decline quarter over quarter, with the exception of Asia-Pacific. who had a decline in sales as they experienced a very strong first quarter, specifically in certain China metalworking markets. Each segment's top-line performance drove their sequential operating performance to be relatively consistent compared to the first quarter in the Americas, EMEA, and GSB, as their pricing initiatives largely all set lower volumes and the impacts of higher raw material costs. Whereas Asia Pacific did have a sequential decline in earnings, which was largely due to their exceptional first quarter that I previously mentioned. From a tax perspective, we had an effective tax rate of 32.2% in the quarter compared to 57.9% in the prior year. Excluding various one-time items in each period, our tax rate would have been 24% for the current quarter compared to 18% in the prior year, which was a bit low due to the impacts from COVID on our effective tax rate. To note, we do expect both our third quarter and full year effective tax rates will be in the range of 24% to 26%. Our non-GAAP earnings per share of $1.82 grew over 700% compared to the prior year as our strong operating earnings, coupled with over a million of interest savings due to lower borrowing rates, were partially offset by slightly higher tax expense. As we look to the company's liquidity, summarized on chart 10, Our net debt of $759.2 million increased about $9 million in the quarter, which is primarily driven by $7.1 million of dividends paid, $6 million of additional investments in normal CapEx, as well as a small acquisition, which were partially upset by $3 million of operating cash flow. The quarter's low operating cash flow was driven by further investment in the company's major capital requirement, working capital. Specifically, The company had considerable increases in the inventory, which were due to higher raw material costs, restocking of low levels given past impacts of COVID, as well as bulk purchases to ensure safety stock given the disruption in our global supply chain. Looking ahead to the second half of the year, we believe our operating and free cash flow will return to the typical levels we've demonstrated in the past, as we don't believe we will have such dramatic increases in working capital to sustain our day-to-day operating requirements. Despite an increase in net debt, the company was able to significantly improve our reported leverage ratio to 2.7 times as of Q2 2021, compared to 3.1 times at the end of March. Overall, I want to emphasize we are committed to prudent allocation of our capital. This includes prioritizing debt reduction while continuing to pay our dividends, which we just announced a 5% increase, as well as investing in acquisitions that provide growth opportunities, which makes strategic sense. and all while remaining committed to reducing our leverage, which we still expect to be at our target of 2.5 times by the end of the year. So to summarize, Quaker Houghton had another strong quarter that was above our expectations due to continued strength in demand and good market share gains, which partially offset higher input costs. Our liquidity remains very healthy, and we remain committed to our overall capital allocation and deleveraging strategy. That concludes my remarks. Thank you for your interest in Quaker Houghton, And I'll now turn it back to Mike. Thanks, Shane.

We'll now open it up for questions.

Thank you. At this time, we'll be conducting a question and answer session. If you'd like to ask a question, press star 1 on your telephone keypad, and a confirmation tone will indicate your line is in the question queue. You may press star 2 if you'd like to remove your question from the queue. For participants using speaker equipment, it may be necessary to pick up your handset before pressing the star keys. One moment, please, while we poll for questions. Thank you. And our first question is from the line of Mike Harrison with Seaport Global. Please proceed with your questions.

Hi, good morning. Morning, Mike. Morning, Mike. Congrats on a nice quarter. Had a couple questions on the pricing front. First of all, you mentioned the 4% price mix number, but I think I also heard a 6% pricing number. So was the 6% pure pricing or was that a sequential number?

Yeah, that's what we estimate our prices were higher in the second quarter because of the price increases that we put in place.

So it's 6% pricing and maybe a negative two mix is the way to think about it. Exactly, Mike, yes. Got it, okay. And then are you guys taking a different approach than normal in this inflationary environment when it comes to pricing? Are you kind of, business as usual? Or, you know, are you putting, I guess, more pricing actions in place or going for more global price increases? How are you approaching it? And I guess maybe how much more pricing is needed in order to get the type of margin recovery that you've telegraphed exiting the year?

Yeah, in some ways, it's business as usual, what's what's not usual here is just the magnitude and the continuation of how many increases we have to do in such a short period of time. So that's what's been the unusual event here. So we've had to continually go out. We're, I would say, on probably price increase number four or so in most of our places around the world and looking at price increase number five. So that's very unusual to have to go out that many times, and it's just because of the magnitude. But again, our approach is similar and usual as it typically is. It's just that we have to do it more often. Again, we're trying to get out there to recover it, but we're always going to have this kind of a lag effect that takes place.

And then a couple questions on the guidance. Just trying to get a little better sense on your views on Q3. You said you expect the lowest EBITDA of the year, which would mean below $70 million. But do you think you should still be ahead of last year's Q3, which was around $64 million? And then we should be modeling sequential EBITDA improvement in Q4?

Yeah, it's hard to give exact guidance like that. It all depends upon how raw materials and demand, of course, continue on here. So I think one thing we said that our margins will be either at or somewhat below from a gross margin perspective. And so I don't think we want to try to give any more guidance than what we already said.

Maybe a question on the free cash flow front, Ben. It sounds like a lot of the working capital investments in the first half are not going to continue in the second half. So should we expect that free cash flow number to be better than the $160 million you did last year?

Mike, this is Shane. I wouldn't comment against last year, but certainly it's going to be better than the first half. As I think about the working capital drain, we will have some release of the working capital that we spent in the first half. But, you know, I don't really want to comment compared to the prior year.

All right. Thanks very much. Thanks, Mike.

Our next question comes from the line of Catherine Griffin with Deutsche Bank. Pleased to see you with your questions.

Good morning. Thanks for taking the question. First, I wanted to get a sense of the impact that you saw in Q2 from the lower automotive demand, the issues with the chip shortage. It's certainly been well documented, I think, this earnings season. So any kind of quantification or just kind of more color you can provide there would be helpful so that we can think about it correctly for Q3 and for the rest of the year.

Sure. Good morning, Catherine. Yes, we're impacted by the semiconductor shortage in the second quarter, certainly more so than I would say the first quarter. And I think it's hard to quantify. We're not going to kind of throw out any numbers of exactly what that is. But just to give you some more context, I guess, is that For example, in the first quarter of the year, we did not see really much impact in the China automotive market around this issue, but starting to pick up in the second quarter there, and that will continue into the third quarter here, for example, and other places around the world are continuing into the third quarter. So, you know, I think eventually this will lighten up, but we don't see it in the short term. You know, I think it's going to be, you know, continue to be an issue or, you know, a tail end or headwind for us a little bit in the third quarter. And then hopefully after that, it will start to get better. But as people have said, you know, I think originally we thought maybe this will be a, we'll get it back in the second half of the year. But I think people, you know, what we read is this will be extending into a

2022 as well okay great and then um yeah maybe on that point i'm wondering if you can kind of opine a little bit for us just on next year and um you know kind of what is a normalized um you know earnings growth for for quaker houghton maybe on a um sort of pre-pandemic basis if there was one

Okay. You know, when we think about a normalized earnings growth, I would say the way I think about it is our markets tend to grow on average one to three percentage points. So let's say on average 2%. And then, of course, we're trying to and have been, you know, continually having additional business wins in the marketplace that would increase that from an additional 2 to 4 percentage points. So let's say on average 3%. So under a normal situation, I would say 5% would be kind of the growth we would expect to see. The question will be is what kind of conditions we're facing in 2022. For example, in semiconductor, if that turns to be more positive and we have different end use markets that you know, for example, like aerospace that are coming back, that's taking longer. So again, maybe that will be higher than normal next year as well. So it's really hard to kind of give precise numbers on that, but hopefully that kind of gives you kind of some sense. I would hope we're still coming back a little bit more from the pandemic next year, and that hopefully will lead to higher than normal growth.

Great. Thanks, and congrats again on the strong quarter.

Thank you. Thank you. As a reminder, you may press star one to ask a question. The next question is from the line of John Tanwatin with CGS Securities. Please proceed with your questions.

Hey, good morning, guys. Thanks for taking my question. Really great quarter. Good job. First of all, can you update us on your expectations for capital allocation and specifically the M&A environment as your willingness to engage changed and kind of how has the target environment changed since you last reported? Sure.

You know, we're kind of consistent, I think, what we've been saying, I think, since the combination was completed two years ago, is that we really wanted to focus on reducing our debt and have our leverage be at this 2.5 level. Now we're at 2.7, so we're closing in on that, and we expect to be there by the end of the year. So in the meantime, we said we would you know, continue to focus on smaller type of acquisitions. We've done a number of those, you know, since the combination, the largest being Norman Hay, but then we did two, one in December, one in February this year. We recently made a very small one in that coatings area, but that was pretty small. So we're going to continue to look at those. We are actively looking at smaller acquisition opportunities, but as I would say, as we get into The fourth quarter and certainly the first quarter next year, we will then kind of be looking at hopefully larger opportunities.

Okay, great. Thank you. And, Mike, I just wanted to clarify your commentary on feeling better about the year. Are you saying that maybe the minimum that you're expecting to generate is a little bit higher than when you entered the year? And kind of how do you square that with just, you know, reaffirming the guidance that you have out there?

I would say, I guess the way I would pose it is I think when I, you know, if I think back to the beginning of the year and how we thought the year was going to be transpiring, I would say I feel we'll either get to that same point that we originally expected or be better because of the strong first half. But what I feel really a lot better is kind of how we would exit the year because we'll be exiting the year with stronger demand profile. So as we enter into 22, we'll have stronger demand. What's kind of keeping it down this year from being even a lot better year is the margin issues that we're facing with raw materials. And hopefully that will be behind us as we exit the year as well. So that's What I'm really kind of trying to emphasize, I guess, is more how we exit the year, I think, will be in a much better place than I expected.

Understood. Thank you for that clarification. Again, great job.

Thanks, John.

Thanks, John.

Thank you. Our next question is a follow-up from the line of Mike Harrison, Seaport Global. Please receive your questions.

Hi. Thanks for taking a couple more. In terms of the chip shortage impact, you guys are in kind of a unique position where you serve some automaker OEMs directly and you also serve some tier one and tier two suppliers. Were there any differences between the types of demand levels that you saw from the OEMs and what you saw from the suppliers?

just trying to get a sense of whether whether the the tier one and tier two guys are still continuing to produce uh even if there's some slowing at the oem level i think in general they're they're both being impacted in a similar way um we we are we do have differences we do see differences in our portfolio based on obviously different customer mixes that we have and the different things in the different regions like i mentioned with china was really from our perspective, being less affected in the first part of the year and now starting to get a little bit more. But in general, I think I would say that OEM and Tier 1 tend to come together in a similar fashion.

Okay, and then you mentioned the aerospace business and the kind of lagged recovery that you've seen there. What we're starting to hear is that the narrow body production is picking up, but wide body production is still going to remain pretty depressed. Do you guys have relatively stronger positions in narrow bodies such that that's going to help drive recovery, or do we really need to see this wide body production rate recover before your business gets back to pre-pandemic levels?

I would say, you know, we're in all the aircraft. And I would say the main, you know, if I had to say what has been a main driver for us in the past has been, for example, something like the 737 MAX. That's been a big, big part of, you know, if I look at the 2019 sales and the type of production that they had. And we are, you know, we're seeing the same thing that they are beginning to produce more. Certainly, it was essentially down to nothing last year, and now it's coming up, and it's probably a little better this year than maybe we had expected, but still nowhere near where it was in 2019. But we would expect, based on what Boeing said, for that to come back over time. So again, I think that will be... relatively small piece of our overall business, you know, maybe four percentage points of our sales or something like that. But it is, you know, we do see that going to be about market growth probably for us over the next couple years.

All right. And then last one for me, not that we're trying to get rid of you, Mike, but any update on the CEO search process?

Yeah, so nothing new to report. Obviously, if we had news, we would be reporting it, but we are continuing on our process. We are getting towards, let's say, the last third of the process at this point, so I would expect that we'd be concluding that over the next several months and making an announcement at some point.

Is it your hope to have an announcement made before year end so that there could be kind of a transition period, or do you think that the announcement will be okay? Yes.

Like I said, I think it could be an announcement sometime this quarter, so we'll see how the process ends up here.

All right. Thanks very much.

Thanks, Mike.

Thank you. The next question is from the line of Garo Norian with Palisade Capital Management. Please proceed with your questions.

Good morning, guys. I wanted to just ask, you guys highlighted the market share gains. Is it kind of just the typical market share gains that you get year in, year out? Or with the challenges across the supply chain, have you been able to maybe service some customers that competitors were challenged to service?

Sure. It's a great question, Garo. I would say They're more the typical gains that we have. We've actually had some opportunities, like you pointed out, to kind of step in at times. But given how the supply chain is and how short things are, we feel it's really been important to continue to service our existing customers. So I don't think any of this 4% is really due to anything that is picking up new opportunistic business at this time.

Got it. And then secondly, a lot of companies have been really challenged on the labor side. And I guess you guys didn't really highlight that. So I'm curious, have you had any difficulties there? Because of the way your business is, it hasn't been as much of a challenge.

There's certainly pockets of areas where we, you know, people in certain plants and certain parts of the world that you have labor shortages and we're, you know, have to manage our way through that. But so far that hasn't been an issue that has kept us from losing any sales or products, you know, production rather.

Great. That's all I got.

Thank you, Gar. Thanks, Gar.

Thank you. At this time, we've reached the end of our question and answer session, and I'll turn the call over to Mr. Michael Barry for closing remarks.

Okay. Given no other questions, we will end our conference call now, and I want to thank all of you for your interest today. Our next conference call for the third quarter will be in early November, and if you have any questions in the meantime, please feel free to contact Shane or myself. Thanks again for your interest in Quaker Houghton.

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