Quaker Chemical Corporation — Q2 2018 Form 10-Q Summary
Business Context and Reporting Period
Quaker Chemical develops and sells formulated process fluids, specialty chemicals, and chemical management services to industrial customers, including steel, metalworking, automotive, aerospace, mining, and durable-goods manufacturers. Reported segments are North America, EMEA, Asia/Pacific, and South America. This unaudited Form 10-Q covers the three and six months ended June 30, 2018, compared with the corresponding 2017 periods.
Financial Performance and Position
| Metric | Q2 2018 | Q2 2017 | Change |
|---|---|---|---|
| Net sales | $222.0 million | $201.2 million | +10% |
| Gross profit | $80.9 million | $71.8 million | +13% |
| Gross margin | 36.5% | 35.7% | +80 bps |
| Operating income | $22.6 million | $17.9 million | +26% |
| Net income attributable to Quaker | $19.2 million | $11.9 million | +62% |
| Diluted EPS | $1.44 | $0.89 | +$0.55 |
| Adjusted EBITDA | $32.2 million | $28.0 million | +15% |
| Adjusted EBITDA margin | 14.5% | 13.9% | +60 bps |
For the six months ended June 30, 2018, net sales were $434.0 million versus $396.1 million, gross profit was $156.4 million versus $142.7 million, operating income was $42.8 million versus $31.7 million, net income attributable to Quaker was $32.0 million versus $18.9 million, and diluted EPS was $2.40 versus $1.42. Six-month gross margin was 36.0% in both periods, while adjusted EBITDA increased to $63.0 million from $56.2 million.
Management attributed the quarterly sales increase to 5% volume growth, approximately 3% from pricing and product mix, and a 2% favorable foreign-currency translation effect. Pricing initiatives and product mix more than offset higher raw-material costs. Sales increased in all regions; Asia/Pacific grew fastest at 16%, followed by EMEA at 10%, North America at 8%, and South America at 5%.
Six-month operating cash flow was $19.7 million, compared with $20.8 million in 2017. Cash used in investing activities was $5.4 million, including $5.6 million of capital expenditures and $0.5 million for an acquisition. Cash used in financing activities was $11.1 million, including $9.5 million of dividends. Cash, cash equivalents, and restricted cash totaled $111.0 million at June 30, 2018, including $20.7 million restricted for asbestos-related claims and defense costs.
At June 30, 2018, total debt was approximately $64.1 million, comprising $5.7 million of current debt and $58.4 million of long-term debt. Credit-facility borrowings were $46.2 million. Net debt to adjusted EBITDA was below 1.0x, versus a 3.50x covenant limit, and the company reported compliance with its debt covenants. A $5.0 million industrial development bond matures in December 2018 and is expected to be repaid at maturity.
Material Changes Versus the Prior Comparable Period
- Quarterly revenue growth reflected higher volumes, pricing and mix, and favorable currency translation across most regions.
- Gross margin improved in the second quarter, while six-month gross margin remained unchanged at 36.0%.
- SG&A increased because of foreign-currency translation and higher labor and incentive-compensation costs.
- Combination-related expenses were $4.5 million in Q2 and $10.6 million year to date, compared with $4.3 million and $13.4 million, respectively, in 2017.
- The effective tax rate declined to 16.8% in Q2 and 22.8% year to date, from 26.2% and 37.4%, respectively, primarily because of the lower U.S. statutory tax rate and a $1.2 million favorable transition-tax adjustment.
- Operating cash flow declined modestly because increased accounts receivable and inventory absorbed working capital as sales grew.
- The 2015 restructuring program was completed in the first half of 2017; no restructuring charges were incurred in 2018.
Guidance, Outlook, Risks, and Unusual Items
Management expected current Quaker operations to maintain solid volume levels during the second half of 2018, with gross margin in the low-to-mid 36% range. Modestly growing global end markets, market-share gains, and U.S. tax reform were expected to offset potential foreign-exchange headwinds and higher raw-material costs.
The pending Houghton International combination remained subject to U.S. and European regulatory approvals, customary closing conditions, and potential divestitures. Management expected to present a regulatory remedy in the third quarter and close the transaction in the fourth quarter of 2018. The transaction was expected to approximately double annual sales and adjusted EBITDA, with anticipated synergies of at least $45 million when fully achieved by the third year after closing. Additional pre-closing combination expenses and cash outflows were estimated at approximately $30 million to $35 million through closing.
The proposed combination would be financed through a contingent $1.15 billion credit facility, including a $400 million revolver, $600 million U.S. term loan, and $150 million euro-equivalent term loan. The facility was not effective until closing and was expected to carry floating interest costs of approximately 3.50% to 3.75% based on then-current rates.
- Key operating risks include cyclical demand from steel, automotive, aerospace, appliance, and other industrial customers; production shutdowns; raw-material cost inflation; customer financial instability; foreign-currency volatility; and global economic and political conditions.
- Combination risks include failure to obtain regulatory approval, unacceptable divestiture requirements, financing or closing delays, integration difficulties, business disruption, and litigation.
- Venezuela remained hyper-inflationary; related currency conversion charges were less than $0.1 million in Q2 and $0.2 million year to date.
- Argentina became hyper-inflationary for U.S. GAAP purposes effective July 1, 2018; the company expected to change the affiliate’s functional currency in Q3.
- The company reported environmental remediation exposure of approximately $0.1 million to $1.0 million at an ACP site and projected approximately $1.9 million of asbestos-claim liability over the next 50 years, excluding defense costs.
- Gross unrecognized tax benefits, including interest and penalties, totaled $9.2 million at June 30, 2018. The company believed reserves were adequate.
- The company adopted new revenue-recognition guidance in Q1 2018; the impact on earnings and cash flows was immaterial, with a $0.8 million reduction to retained earnings recorded at December 31, 2017.
Important Facts for Investors to Verify
- Whether the Houghton transaction received all required regulatory approvals and closed on the expected terms and timing.
- The final acquisition financing, leverage, interest expense, dilution, required divestitures, and realized synergies following any Houghton closing.
- Whether pricing actions continue to offset raw-material inflation and whether gross margins remain in the guided low-to-mid 36% range.
- The sustainability of volume growth and the extent to which reported sales growth depends on favorable currency translation.
- Working-capital requirements and conversion of earnings into operating cash flow.
- Payment and maturity of the $5.0 million industrial development bond and continued compliance with credit covenants.
- Resolution of Italian tax assessments, uncertain tax positions, environmental remediation, and asbestos-related claims.
- The effect of Argentina’s hyper-inflationary accounting treatment and continuing Venezuela-related currency devaluation.