Greetings. Welcome to Quaker Houghton's Second Quarter 2021 Results Conference Call [Operator Instructions]. 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 Web site 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 8, 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% for 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 3 of our 4 segments showing growth, but our Asia Pacific segment was down 5%.

Overall sales for Asia Pacific continue 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 2 to 4 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 on a higher level than we expected. Overall, our cost of raw materials have increased an additional 10% 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, but 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 cost 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.

However, our leverage ratio of net debt to adjusted EBITDA continued to improve from 3.1x at the end of the first quarter to 2.7x 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 expect to exit the year at a better-than-expected demand for our products and our product margins largely returning to our expected levels.

So even though we 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 targeted net debt to adjusted EBITDA leverage of 2.5x.

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 of how our team has performed in servicing our customers, meeting their needs, and successfully continuing with our integration execution, which is both critical and difficult for us given the 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, and good morning, everyone. Before I get into the results for the quarter, I'd like to remind everyone that 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 US 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 costs 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 Slide 6, 7 and 8 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 margin 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 priced 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 offset 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 onetime 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 our -- 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 $1 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 offset 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 2.7x as of Q2 2021 compared to 3.1x 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 make strategic sense, and all while remaining committed to reducing our leverage, which we still expect to be at our target of 2.5x 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..

[Operator Instructions] Our first question is from the line of Mike Harrison with Seaport Global..

I had a couple of 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 it 6% pure pricing? Or was that a sequential number?.

Yes, 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 2% mix is the way to think about it?.

Exactly, Mike. Yes..

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 are you putting, I guess, more pricing actions in place or going from 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?.

In some ways, it's business as usual. 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 where, I would say, 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 had to do it more often. Again, we're just -- we're trying to get out there to recover it, but we're always going to have this kind of lag effect that takes place..

And then a couple of 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?.

Yes, it's hard to give exact guidance like that. It all depends upon how raw materials and demand, of course, continue on here. 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 then. 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?.

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 I don't really want to comment compared to the prior year..

Our next question comes from the line of Katherine Griffin with Deutsche Bank..

First, I wanted to get a sense of the impact that you saw in Q2 from the lower automotive demand, the issuance of 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..

Katherine, yes, we were 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 I think eventually, this will lighten up, but we don't see it in the short term. I think it's going to continue to be an issue or a tailwind 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, I think, originally, we thought maybe this will be -- we'll get it back in the second half of the year, but I think people -- what we read is this will be extending into 2022 as well..

And then, yes, maybe on that point, I'm wondering if you can kind of opine a little bit for us just on next year and kind of what is a normalized earnings growth for Quaker Houghton, maybe on a sort of pre-pandemic basis, if there was one?.

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 1 to 3 percentage points. So let's say, on average, 2%.

And then, of course, we're trying to -- and have been 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. If the -- for example, in semiconductor, that terms to be we're positive, and we have different end-use markets that, for example, like aerospace that are coming back, it'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..

[Operator Instructions] The next question is from the line of Jon Tanwanteng with CJS Securities..

First one, can you update us on your expectations for capital allocation and specifically the M&A environment? Has your willingness to engage changed? And kind of how is the target environment changed since you last reported?.

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 2.5x level. Now we're at 2.7x, 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 continue to focus on smaller type of acquisitions. We've done a number of those since the combination, the largest being Norman Hay, but then we did 2; 1 at December, one in February this year. We've recently made a very small one in the 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..

And Mike, I just wanted to clarify your commentary on feeling better about the year.

Were you -- are you saying that maybe the minimum EBITDA 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 reaffirming the guidance that you have out there?.

I would say, I guess the way I would pose it is, I think when I -- if I think back at 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 here 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 we'll be in a much better place than I expected..

Our next question is a follow-up from the line of Mike Harrison, Seaport Global..

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 1 and Tier 2 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 the Tier 1 and Tier 2 guys are still continuing to produce, even if there's some slowing at the OEM level..

I think in general, they're both being impacted in a similar way. 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, are now starting to get a little bit more.

But in general, I think, I would say that our OEM and Tier 1 tend to come together in a similar fashion..

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 rates recover before your business gets back to pre-pandemic levels?.

I would say, no, we're in all the aircraft. And I would say the main, 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 -- if I look at the 2019 sales and the type of production that they had.

And 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 it's a relatively small piece of our overall business, maybe 4 percentage points of our sales or something like that. But we do see that going to be above-market growth probably for us over the next couple of years..

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?.

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 the, let's say, the last 1/3 of the process at this point. So I would expect that we'd be concluding that over the next several months and making 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 investment will be….

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

The next question is from the line of Garo Norian with Palisade Capital Management..

I wanted to just ask, you guys highlighted the market share gains.

Is it kind of just the typical market share gain 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?.

I would say, they are more of 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 really see -- I don't think any of this 4% is really due to anything that is picking up new -- opportunistic business at this time..

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 or you -- because of the way your business is, it hasn't been as much of a challenge?.

There are certainly pockets of areas where we -- people in certain plants and certain parts of the world that you have labor shortages, and 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 or production rather..

At this time, we've reached the end of our question-and-answer session. 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..