Item 7.
Management’s Discussion and Analysis
of Financial Condition and Results of Operations.
As used in this Annual Report on Form 10-K (the “Report”),
the terms “Quaker Houghton”, the “Company”, “we”,
and “our”
refer to Quaker Chemical Corporation (doing business as Quaker
Houghton), its subsidiaries, and associated companies, unless the
context otherwise requires.
The term Legacy Quaker refers to the Company prior to
the closing of its combination with Houghton
International, Inc. (“Houghton”) (herein referred
to as the “Combination”) on August 1, 2019.
Throughout the Report, all figures
presented, unless otherwise stated, reflect the results of
operations of the combined company for the year ended
December 31, 2020,
for the year ended December 31, 2019 includes the
result of Legacy Quaker plus five months of Houghton’s
operations post-closing of
the Combination on August 1, 2019, and for the year ended
December 31, 2018, the results only of Legacy Quaker.
Executive Summary
Quaker Houghton is a global leader in industrial process
fluids.
With a presence around the world,
including operations in over
25 countries, our customers include thousands of the world’s
most advanced and specialized steel, aluminum, automotive, aerospace,
offshore, can, mining, and metalworking
companies.
Our high-performing, innovative and sustainable solutions are
backed by best-
in-class technology,
deep process knowledge, and customized services.
Quaker Houghton is headquartered in Conshohocken,
Pennsylvania, located near Philadelphia in the U.S.
Overall, the Company’s
2020 performance, like most other companies in the
world, was negatively impacted by the COVID-19
pandemic and its impact on the global economy,
including
most of the Company’s
customers.
However, the Company’s
acquisition
activity in late 2019, including the Houghton Combination
and the Norman Hay acquisition, drove a 25% increase in 2020 net
sales to
$1,417.7
million compared to $1,133.5 million in 2019.
Excluding net sales from acquisitions, current year net
sales would have
declined approximately 11% primarily
due to a 9% decrease in sales volumes associated with the negative
impacts of COVID-19 on
global production levels throughout each of the Company’s
segments.
Similar to net sales, the Company’s
gross profit and selling,
general and administrative expenses (“SG&A”) also increased
due to the full year inclusion of Houghton and Norman
Hay, but both
also benefited from the realization of cost savings associated with
synergies achieved with the Combination as well
as the impact of
cost saving measures put in place to help offset
the impacts of COVID-19.
The Company’s 2020 reported operating
income of $59.4
million increased compared to $46.1 million in 2019.
Excluding all one-time costs and other non-core items that largely
related to the
Combination and Norman Hay in each period, the Company’s
non-GAAP operating income of $134.0 million
increased 10%
compared to $122.0 million in 2019, primarily due to
the net sales increases and cost synergies and savings
mentioned above.
Further
details of the Company’s
consolidated operating performance are discussed in the Company’s
Consolidated Operations Review,
in the
Operations section of this Item, below.
The Company’s net income
and earnings per diluted share of $39.7 million and $2.22 in
2020, respectively, increased
compared
to $31.6 million and $2.08 per diluted share, respectively,
in 2019.
Excluding all one-time costs and other non-core items that largely
related to the Combination and Norman Hay in each
period, the Company’s current
year non-GAAP net income and non-GAAP
earnings per diluted share were $85.2 million and $4.78,
respectively, compared
to $88.7 million and $5.83, respectively,
in 2019.
The increase in the Company’s current
year reported earnings drove a 28% higher adjusted EBITDA of
$222.0 million compared to
$173.1 million in 2019, primarily due to the Houghton
and Norman Hay acquisitions as well as the benefit of costs savings
associated
with the Combination,
partially offset by the negative impacts of COVID-19.
See the Non-GAAP Measures section of this Item,
below.
The Company’s 2020
operating performance in each of its four reportable segments: (i)
Americas; (ii) Europe, Middle East and
Africa (“EMEA”); (iii) Asia/Pacific; and (iv) Global Specialty
Businesses, reflect similar drivers to that of its consolidated
performance.
Each segment’s net sales benefited
from a full year of Houghton and the Company’s
Global Specialty Businesses
segment also benefited from a full year of Norman Hay.
Without the inclusion of Houghton and
Norman Hay, net sales would
have
been lower in all segments compared to the prior year,
primarily driven by declines in volume primarily due to the
negative impacts of
COVID-19 on the Company’s
end markets.
As reported, all of the Company’s
segment operating earnings were higher compared to
2019 because of the inclusion of a full year of Houghton and
Norman Hay as well as cost synergies achieved
with the Combination
and other cost savings actions taken due to COVID-19,
partially offset by the negative impacts of COVID-19
on global sales volumes.
Additional details of each segment’s
operating performance are further discussed in the Company’s
reportable segments review,
in the
Operations section of this Item, below.
The Company generated net operating cash flow of $178.4
million in 2020 compared to $82.4 million in 2019.
The 117%
increase in net operating cash flow year-over
-year was primarily driven by the inclusion of a full year of earnings
from Houghton and
Norman Hay, as well as
higher operating cash flow due to changes in working
capital.
The key drivers of the Company’s
operating
cash flow
and overall liquidity are further discussed in the Company’s
Liquidity and Capital Resources section of this Item, below
.
Overall, the Company’s
2020 results reflect the fact that the negative impacts of COVID-19
were partially offset by the positive
impacts of a full year of Houghton and Norman Hay performance
,
Combination synergies and cost savings actions
.
The Company’s
performance showed a good quarterly growth trend across the
globe beginning after the second quarter of 2020, during
which the
impacts of COVID-19 were most severe, indicating
a gradual improvement in the Company’s
end markets and continued market share
gains.
Despite these challenges, the Company was able to generate significant
net operating cash flow in 2020, continue to pay its
regular dividends, pay down its debt above its required commitments
,
and continue to execute its integration plans for the
Combination.
25
The global economic slowdown and other impacts due
to COVID-19 posed an unprecedented challenge in 2020, but the
Company successfully navigated this downturn, demonstrating
its ability to respond quickly to changing market conditions and
deliver
on the benefits it anticipated from the Combination
with Houghton.
In 2020, the Company continued to service and supply its
customers despite very difficult economic
conditions, it continued to gain share in the market, it completed
a significant part of the
integration activities, and realized $58 million of cost
synergies which exceeded the original estimate of $35
million.
The Company
also made recent bolt-on acquisitions which are expected
to contribute towards earnings growth in 2021 and, even with those
acquisitions, the Company reduced its net debt by
12% or $94 million during 2020.
As the Company looks forward, it
expects some
short-term headwinds from higher raw material costs and
lower than expected volumes in the automotive market due
to the
semiconductor shortage.
However, the Company expects 2021
to result in a step change in its profitability from 2020 as the Company
completes its integration cost synergies, continues
to take further share in the marketplace, benefits from a projected
gradual rebound
in demand, and sees the positive impact of its recent acquisit
ions.
Impact of COVID-19
In early 2020, the global outbreak of COVID-19
negatively impacted all locations where the Company
does business.
Although
the Company has now operated during several quarters
in this COVID-19 environment, the full extent of the outbreak
and related
business impacts remains
uncertain and volatile, and therefore the full extent to which COVID-19
may impact the Company’s future
results of operations or financial condition is uncertain.
This outbreak has significantly disrupted the operations
of the Company and
those of its suppliers and customers.
The Company has experienced significant volume declines and
lower net sales as further
described in this section, initially at its China subsidiaries in the
first quarter of 2020 and, beginning in late March continued
throughout the rest of its business due to the global economic
slowdown brought on by COVID-19.
Management continues to
monitor the impact that the COVID-19 pandemic is having
on the Company,
the overall specialty chemical industry and the
economies and markets in which the Company operates.
Given the speed and frequency of the continuously evolving developments
with respect to this pandemic, the Company cannot, as
of the date of this Report, reasonably estimate the
magnitude or the full extent of the impact to its future results of
operations or to the
ability of it or its customers to resume more normal
operations, even as certain restrictions are lifted.
The prolonged pandemic and a
resurgence of the outbreak, and continued
restrictions on day-to-day life and business operations may result
in volume declines and
lower net sales in future periods as compared to pre-COVID-19
levels.
To the extent that the Company’s
customers and suppliers
continue to be significantly and adversely impacted by
COVID-19, this could reduce the availability,
or result in delays, of materials
or supplies to or from the Company,
which in turn could significantly interrupt the Company’s
business operations.
Given this
ongoing uncertainty,
the Company cautions that its future results of operations could be significantly
adversely impacted by COVID-
19.
Further, management continues to
evaluate how COVID-19-related circumstances, such as remote
work arrangements, illness or
staffing shortages and travel restrictions have affected
financial reporting processes and systems, internal control
over financial
reporting, and disclosure controls and procedures.
While the circumstances have presented and are expected
to continue to present
challenges, and have necessitated additional time
and resources to be deployed to sufficiently address the
challenges brought on by the
pandemic, at this time, except as otherwise noted in
Item 9A of this Report, management does not believe that
COVID-19 has had a
material impact on financial reporting processes, internal
controls over financial reporting, or disclosure controls and procedures.
For
additional information regarding the potential impact of COVID-19,
see Item 1A of Part I of this Report.
The Company’s top
priority is, and especially during this pandemic remains, to protect the health
and safety of its employees and
customers, while working to ensure business continuity
to meet customers’ needs:
●
Our People
– The Company has taken steps to protect the health and wellbeing
of its people in affected areas through various
actions, including enabling work at home where needed and
possible, and employing social distancing standards,
implementing travel restrictions where applicable, enhancing
onsite hygiene practices, and instituting visitation restrictions
at
the Company’s facilities.
The Company does not expect that it will incur material
expenses implementing health and safety
policies for employees, contractors, and customers.
●
Our Operations
– Currently, all of
the Company’s 31 production
facilities worldwide are open and operating and are deemed
as essential businesses in the jurisdictions where they are
operating.
The Company believes that to date it has been able to
meet the needs of all its customers across the globe
despite the current economic challenges.
●
Our Business Conditions
– The Company’s second
half of 2020 showed solid improvement over the first half,
which was
consistent with expectations that April and May would
be the worst months of the year and that the Company
would show
gradual quarterly improvement sequentially throughout
the remainder of the year.
However, demand still remained lower
than pre-COVID-19 levels as many customers maintained
reduced production levels through the end of 2020.
Excluding
Houghton and Norman Hay net sales, all four of the Company’s
reportable segments showed declines in net sales due to
COVID-19 during 2020 compared to the prior year,
with the Americas and EMEA being the most impacted and
Asia/Pacific
being the least impacted.
The Company currently expects that the impact from COVID-19
will gradually improve each
quarter in 2021 subject to the effective containment
of the virus and successful distribution of a vaccine.
However, the
incidence of reported cases of COVID-19 appears to
be again increasing in several geographies where we have
significant
26
operations and it remains highly uncertain as to how long
the global pandemic and related economic challenges will last and
when our customers’ businesses will recover.
●
Our Actions
– The Company took various actions to temporarily conserve
cash and reduce costs during 2020.
Some of these
actions during 2020 included eliminating all discretionary
expenditures, delaying or freezing salary increases where legally
permitted, reducing executives’ salaries for a period of
time, lowering 2020 planned capital expenditures by approximately
30%, and accelerating and fine-tuning the Company’s
integration plans.
These temporary initiatives were designed and
implemented so that the Company could successfully manage through
the challenging COVID-19 situation while continuing
to protect the health of its employees, meet customers’ needs,
maintain the Company’s
long-term competitive advantages and
above-market growth, and enable it to continue to
effectively integrate Houghton.
While the actions taken in 2020 to protect
our workforce, to continue to serve our customers with excellence
and to conserve cash and reduce costs, have been effective
thus far, further actions to respond
to the pandemic and its effects may be necessary as conditions
continue to evolve.
Critical Accounting Policies and Estimates
Quaker Houghton’s discussion
and analysis of its financial condition and results of operations
are based upon its consolidated
financial statements which have been prepared in accordance with
accounting principles generally accepted in the United States (“U.S.
GAAP”).
The preparation of these financial statements requires the Company
to make estimates and judgments that affect the
reported amounts of assets, liabilities, revenues and expenses, and
related disclosure of contingent assets and liabilities.
On an
ongoing basis, the Company evaluates its estimates, including
those related to customer sales incentives, product returns, bad
debts,
inventories, property,
plant and equipment (“PP&E”), investments, goodwill, intangible
assets, income taxes, business combinations,
restructuring, incentive compensation plans (including
equity-based compensation), pensions and other postretirement benefits,
contingencies and litigation.
Quaker Houghton bases its estimates on historical experience
and on various other assumptions that are
believed to be reasonable under such circumstances, the
results of which form the basis for making judgments about the
carrying
values of assets and liabilities that are not readily apparent
from other sources.
However, actual results may differ
from these
estimates under different assumptions or
conditions.
Quaker Houghton believes the following critical accounting
policies describe the more significant judgments and
estimates used
in the preparation of its consolidated financial statements:
Accounts receivable and inventory exposures:
Quaker Houghton establishes allowances for doubtful accounts
for estimated
losses resulting from the inability of its customers to
make required payments.
If the financial condition of the Company’s
customers
were to deteriorate, resulting in an impairment of their
ability to make payments, additional allowances may be required.
As part of
our terms of trade, we may custom manufacture products
for certain large customers and/or may ship products
on a consignment basis.
Further, a significant portion of our
revenue is derived from sales to customers in industries where
companies have experienced past
financial difficulties.
If a significant customer bankruptcy occurs, then we must judge
the amount of proceeds, if any,
that may
ultimately be received through the bankruptcy or liquidation
process.
These matters may increase the Company’s
exposure should a
bankruptcy occur, and may require
a write down or a disposal of certain inventory as well as the failure
to collect receivables.
Reserves for customers filing for bankruptcy protection
are established based on a percentage of the amount of receivables
outstanding
at the bankruptcy filing date.
However, initially establishing
this reserve and the amount thereof is dependent on the Company’s
evaluation of likely proceeds to be received from the
bankruptcy process, which could result in the Company
recognizing minimal or
no reserve at the date of bankruptcy.
We generally reserve
for large and/or financially distressed customers on
a specific review basis,
while a general reserve is maintained for other customers
based on historical experience.
The Company’s consolidated
allowance for
doubtful accounts was $13.1 million and $11.7
million as of December 31, 2020 and 2019, respectively.
The Company recorded
expense to increase its provision for doubtful accounts by
$3.6 million, $1.9 million and $0.5 million for the years
ended December
31, 2020, 2019 and 2018, respectively.
Changing the amount of expense recorded to the Company’s
provisions by 10% would have
increased or decreased the Company’s
pre-tax earnings by $0.4 million, $0.2 million and $0.1 million
for the years ended December
31, 2020,
2019 and 2018,
respectively.
See Note 13 of Notes to Consolidated Financial Statements in Item
8 of this Report.
Environmental and litigation reserves:
Accruals for environmental and litigation matters are
recorded when it is probable that a
liability has been incurred and the amount of the liability
can be reasonably estimated.
Environmental costs and remediation costs are
capitalized if the costs extend the life, increase the
capacity or improve the safety or efficiency of the property
from the date acquired
or constructed, and/or mitigate or prevent contamination
in the future.
Estimates for accruals for environmental matters are based on a
variety of potential technical solutions, governmental regulations
and other factors, and are subject to a wide range of potential
costs
for remediation and other actions.
A considerable amount of judgment is required in determining
the most likely estimate within the
range of total costs, and the factors determining this judgment
may vary over time.
Similarly, reserves for
litigation and similar
matters are based on a range of potential outcomes and
require considerable judgment in determining the
most probable outcome.
If
no amount within the range is considered more probable
than any other amount, the Company accrues the lowest amount
in that range
in accordance with generally accepted accounting principles.
See Note 26 of Notes to Consolidated Financial Statements in
Item 8 of
this Report.
27
Realizability of equity investments:
The Company holds equity investments in various foreign
companies where it has the
ability to influence, but not control, the operations of the
entity and its future results.
The Company would record an impairment
charge to an investment if it concluded that a
decline in value that was other than temporary occurred.
Adverse
changes in market
conditions, poor operating results of underlying investments,
devaluation of foreign currencies or other events or circumstances
could
result in losses or an inability to recover the carrying value
of the investments, potentially leading to an impairment charge
in the
future.
The carrying amount of the Company’s
equity investments as of December 31, 2020 was $95.8 million,
which included four
investments: $19.4 million for a 32% interest in Primex, Ltd.
(Barbados); $7.8 million for a 50%
interest in Nippon Quaker Chemical,
Ltd. (Japan); $0.3 million for a 50% interest in Kelko
Quaker Chemical, S.A. (Panama); and $68.3 million for a 50% interest
in Korea
Houghton Corporation (Korea).
The Company also has a 50% interest in a Venezuelan
affiliate, Kelko Quaker Chemical, S.A
(Venezuela).
Due to heightened foreign exchange controls, deteriorating
economic circumstances and other restrictions in Venezuela,
during the third quarter of 2018 the Company concluded that it no
longer had significant
influence over this affiliate.
Prior to this
determination, the Company historically accounted
for this affiliate under the equity method.
As of December 31, 2020 and 2019, the
Company had no remaining carrying value for its investment
in Venezuela.
See Note 17 of Notes to Consolidated Financial
Statements in Item 8 of this Report.
Tax
exposures, uncertain tax positions and valuation
allowances:
Quaker Houghton records expenses and liabilities for taxes
based on estimates of amounts that will be determined as deductible
in tax returns filed in various jurisdictions.
The filed tax returns
are subject to audit, which often occur
several years subsequent to the date of the financial statements.
Disputes or disagreements may
arise during audits over the timing or validity of certain
items or deductions, which may not be resolved for extended
periods of time.
The Company also evaluates uncertain tax positions on
all income tax positions taken on previously filed tax returns or
expected to be
taken on a future tax return in accordance with FIN 48,
which prescribes the recognition threshold and measurement attributes
for
financial statement recognition and measurement of tax
positions taken or expected to be taken on a tax return
and, also, whether the
benefits of tax positions are probable or if they will be more
likely than not to be sustained upon audit based upon the
technical merits
of the tax position.
For tax positions that are determined to be more likely than not to
be sustained upon audit, the Company
recognizes the largest amount of benefit that
is greater than 50% likely of being realized upon ultimate
settlement in the financial
statements.
For tax positions that are not determined to be more
likely than not sustained upon audit, the Company does not recognize
any portion of the benefit in its financial statements.
In addition, the Company’s
continuing practice is to recognize interest and/or
penalties related to income tax matters in income tax expense.
Also, the Company nets its liability for unrecognized tax benefits
against deferred tax assets related to net operating
losses or other tax credit carryforward on the basis that the uncertain
tax position is
settled for the presumed amount at the balance sheet
date.
Quaker Houghton also records valuation allowances
when necessary to reduce its deferred tax assets to the amount
that is more
likely than not to be realized.
While the Company has considered future taxable income
and assesses the need for a valuation
allowance, in the event Quaker Houghton were
to determine that it would be able to realize its deferred tax assets in the future
in
excess of its net recorded amount, an adjustment to
the deferred tax asset would increase income in the period
such determination was
made.
Likewise, should the Company determine that it would not be able
to realize all or part of its net deferred tax assets in the
future, an adjustment to the deferred tax asset would be