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 years ended December 31, 2020
and 2021; and for the year ended
December 31, 2019, the results of Legacy Quaker plus five months
of Houghton’s operations post-
closing of the Combination on August 1, 2019.
Executive Summary
Quaker Houghton is the 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 2021 performance
was highlighted by the continued recovery from the impacts of COVID-19 in
2020 as
well as the ongoing execution of integration activities and synergy
realization, which led to record net sales and adjusted EBITDA in
2021 despite the continued escalation in raw material cost headwinds
and global supply chain pressures.
Specifically, net sales of
$1,761.2 million in 2021
increased 24% compared to $1,417.7 million in 2020, primarily
due to higher volumes of approximately
13%, including additional net sales from acquisitions of 4%, increases from
selling price and product mix of approximately 8% and
the positive impact from foreign currency translation of 3%.
The increase in sales volumes
compared to 2020 was primarily a result
of continued new business wins and the year-over-year
improvement in end market conditions since the beginning of the COVID-19
pandemic in early 2020, partially offset by lower automotive
sales due to semiconductor shortages and delayed shipments due
to
supply chain challenges that occurred towards the end of 2021.
The increase in selling price and product mix is primarily the result of
the Company’s broad price
increases implemented during 2021 to help offset the unprecedented
increases in raw material costs as well
as global supply chain and logistics cost pressures the Company has experienced
throughout 2021.
The Company’s net income and
earnings per diluted share of $121.4 million and $6.77 in 2021, respectively,
increased compared
to $39.7 million and $2.22 per diluted share, respectively,
in 2020.
Excluding non-recurring items, including costs associated with the
Combination and other non-core items in each period, the Company’s
current year non-GAAP net income and non-GAAP earnings
per diluted share were $122.8 million and $6.85, respectively,
compared to $85.2 million and $4.78, respectively,
in 2020.
The
increase in the Company’s current
year earnings drove a 23% higher adjusted EBITDA to a full year record
of $274.1 million
compared to $222.0 million in 2020, primarily due to the significant increase
in net sales year-over-year as well as higher realized cost
synergies from the Combination, partially offset
by lower gross margins driven by higher raw material and input costs and the
impacts
of disruptions in the global supply chain experienced in 2021 as well as higher selling,
general and administrative expenses (“SG&A”)
including the impact of higher sales on direct selling expenses and additional
SG&A from recent acquisitions.
The Company’s 2021
operating performance in each of its four reportable segments: (i) Americas; (ii) EMEA;
(iii) Asia/Pacific;
and (iv) Global Specialty Businesses, reflect similar drivers to that of
its consolidated performance.
All four segments had higher net
sales compared to 2020 reflecting the continued rebound in 2021
from the negative impacts of COVID-19 on the Company’s
end
markets as well as continued success of winning new business in each of the
Company’s segments during 2021.
Each of the
Company’s geographic segments
benefited from higher organic sales volumes in 2021
while all of the Company’s segments also
benefitted from additional net sales from acquisitions, the positive impact
from foreign currency translation due to the strengthening of
most major currencies against the U.S. dollar,
and from increases in selling price and product mix.
As reported, each of the
Company’s reportable
segment operating earnings were higher compared to 2020 reflecting the increase
in net sales including the
benefits of acquisitions and other factors mentioned;
however, all of the Company’s
segment’s operating earnings were negatively
impacted by persistent raw material inflation, higher logistics, labor and manufacturing
costs, impacts of disruptions to the global
supply chain as well as higher SG&A which were a result of an increase
in direct selling expenses associated with year-over-year
inflation increases and increases due to the increase in net sales as well as the lower levels
of prior year SG&A as a result of
temporary cost saving measures implemented in response to COVID-19.
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 7, below.
The Company generated net operating cash flow of $48.9 million in 2021
compared to $178.4 million in 2020.
The decrease in
net operating cash flow year-over-year
was primarily driven by a significant change in working capital compared
to the prior year,
mainly increases in accounts receivable, due to higher net sales and in inventory,
due to higher costs as well as building inventories in
response to global supply chain and logistics pressures.
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 7, below.
Overall, the Company’s 2021 results
were good and reflected the Company’s
ability to navigate through persistent raw material
cost pressures, supply chain challenges and automotive semiconductor
shortages.
Increases in net sales in all segments were driven by
the continued year-over-year improvement
in the Company’s end-markets and increased
customer demand from lower levels
experienced during 2020 as a result of COVID-19; however,
each segment was negatively impacted by the significant
escalation of
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raw material costs as well as higher levels of SG&A compared to the prior
year which included certain temporary cost saving
measures adopted during the onset of COVID-19.
Continued strong customer demand in 2021 coupled with ongoing new business
wins and the execution of integration activities and synergy realization
helped to partially offset the negative impacts from the
continued escalation of raw material costs and continued supply chain pressures.
As the Company looks toward 2022, the business is well positioned to
continue to outpace market growth rates and deliver value-
added solutions and services to its customers.
Demand remains healthy across most of our end markets; however,
the Company
expects raw material cost pressures and supply chain disruptions to persist throughout
2022.
To mitigate these headwinds,
the
Company continues to implement further price actions and is actively
managing its cost structure.
The Company believes these
actions will begin to drive a recovery in margins as it progresses through
2022.
The Company remains committed to advancing its
customer intimate strategy and sustainability program and delivering
earnings growth in 2022 and beyond.
On-going impact of COVID-19
The global outbreak of COVID-19 has negatively impacted all locations where
the Company does business.
Although the
Company has now operated in this COVID-19 environment for almost
two years, the full extent of the outbreak and related business
impacts continue to remain 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.
During the pandemic, the Company initially experienced volume declines
and lower net sales as
compared to pre-COVID-19 levels, as further described in this section.
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.
The prolonged pandemic and resurgences of the outbreak including as new
variants continue to emerge, and
continued restrictions on day-to-day life and business
operations as well as increased border controls or closures and transportation
disruptions may result in volume declines and lower net sales in future periods.
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, 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.
The Company’s top priority,
especially during this pandemic, is to protect the health and safety of its employees
and customers,
while working to ensure business continuity to meet customers’ needs.
The Company continues to take steps to protect the health and
wellbeing of its people in affected areas through various
actions, including enabling work at home where needed and practicable, 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 has not and does not expect that it will incur material
expenses implementing these health and safety policies.
All of the Company’s more than 30 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.
The Company’s fiscal
year 2021 showed year-over-year improvement
from the prior fiscal year and continued a trend of gradual volume improvement which
began in the second half of 2020.
The Company continues to expect that the impacts from COVID-19 will gradually
decline subject
to the effective containment of the virus and its variants and successful
distribution and acceptance of the available vaccines and
treatments.
However, the incidence of reported cases of COVID-19
or a variant in several geographies where the Company has
significant operations remains high and continues to evolve 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
to pre-COVID-19 levels.
The Company took
various actions to temporarily conserve cash and reduce costs since the onset of
the pandemic and 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 to date 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,
25
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 $12.3 million and $13.1 million as of December 31,
2021
and 2020, respectively.
The Company recorded
expense to increase its provision for doubtful accounts by $0.7 million,
$3.6 million and $1.9 million for the years ended December
31, 2021, 2020 and 2019, 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 $0.1 million, $0.4
million and $0.2 million for the years ended December
31, 2021, 2020 and 2019, 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.
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, 2021
was $95.3
million, which included four
investments: $21.5 million for a 32% interest in Primex, Ltd. (Barbados);
$7.1 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 $66.4 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 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, 2021
and 2020, 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
26
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 charged
to income in the period such determination was made.
Both
determinations could have a material impact on the Company’s
financial statements.
Pursuant to the Tax
Cuts and Jobs Act (“U.S. Tax
Reform”), the Company recorded a $15.5 million transition tax liability
for
U.S. income taxes on the undistributed earnings of non-U.S. subsidiaries.
As of December 31, 2021, $7.0 million in installment have
been paid with the remaining $8.5 million to be paid through installments in future
years.
However, the Company may also be subject
to other taxes, such as withholding taxes and dividend distribution taxes,
if these undistributed earnings are ultimately remitted to the
U.S.
As of December 31, 2021, the Company has a deferred tax liability of
$8.4 million, which primarily represents the estimate of
the non-U.S. taxes the Company will incur to remit certain previously
taxed earnings to the U.S.
It is the Company’s current intention
to reinvest its future undistributed earnings of non-U.S. subsidiaries to support
working capital needs and certain other growth
initiatives outside of the U.S.
The amount of such undistributed earnings at December 31, 2021
was approximately $377.4
million.
Any tax liability which might result from ultimate remittance of these earnings
is expected to be substantially offset by
foreign tax credits (subject to certain limitations).
It is currently impractical to estimate any such incremental tax expense.
See Note
10 of Notes to Consolidated Financial Statements in Item 8 of this Report.
Goodwill and other intangible assets:
The Company accounts for business combinations under the acquisition
method of
accounting.
This method requires the recording of acquired assets, including separately identifiable
intangible assets, at their
acquisition date fair values.
Any excess of the purchase price over the estimated fair value of the identifiable
net assets acquired is
recorded as goodwill.
The determination of the estimated fair value of assets acquired requires management’s
judgment and often
involves the use of significant estimates and assumptions, including
assumptions with respect to future cash inflows and outflows,
discount rates, royalty rates, asset lives and market multiples, among other
items.
When necessary, the Company consults with
external advisors to help determine fair value.
For non-observable market values, the Company may determine fair value
using
acceptable valuation principles, including the excess earnings, relief
from royalty, lost profit or cost
methods.
The Company amortizes definite-lived intangible assets on a straight-line
basis over their useful lives.
Goodwill and intangible
assets that have indefinite lives are not amortized and are required to be assessed at least annually
for impairment.
The Company
completes its annual goodwill and indefinite-lived intangible asset impairment
test during the fourth quarter of each year, or
more
frequently if triggering events indicate a possible impairment.
The Company’s consolidated
goodwill at both December 31, 2021 and
2020 was $631.2 million.
The Company completed its annual impairment assessment over goodwill during
the fourth quarter of 2021
by performing a qualitative assessment.
Based on the assessment performed, the Company concluded that there
was no evidence of
events or circumstances that would indicate a material change from
the Company’s prior year quantitative
assessment by reporting
unit and, therefore, no impairment charges were
warranted.
The Company’s consolidated indefinite
-lived intangible assets at
December 31, 2021 and 2020 were $196.9 million and $205.1 million,
respectively, which primarily
consists of Houghton and
Fluidcare
TM
trademarks and tradename.
The Company completed its annual indefinite-lived intangible asset impairment assessment
during the fourth quarter of 2021, and determined that no impairment
charge was warranted.
The determination of estimated fair
value of these indefinite-lived intangible assets is based on a relief from royalty
valuation method, which requires management’s
judgment and often involves the use of significant estimates and assumptions,
including assumptions with respect to royalty rates, as
well as revenue growth rates and terminal growth rates.
The Company’s impairment assessment
concluded that the carrying value of
acquired Houghton and Fluidcare
TM
trademarks and tradename intangible assets exceeded fair value by
approximately 61%.
See Note
16 of Notes to Consolidated Financial Statements in Item 8 of this Report.
As previously disclosed, as of March 31, 2020, the Company concluded that
the impact of COVID-19 did not represent a
triggering
event with regards to any of the Company’s
indefinite-lived and long-lived assets, except for the Company’s
Houghton and
Fluidcare
TM
trademarks and tradename indefinite-lived intangible assets.
In the first quarter of 2020, as a result of the impact of
COVID-19 driving a decrease in projected legacy Houghton net sales during
that year and the impact of the sales decline on projected
future legacy Houghton net sales as well as an increase in the weighted average
cost of capital assumption utilized in the quantitative
impairment assessment, the Company concluded that the estimated fair
values of the Houghton and Fluidcare
TM
trademarks and
tradename intangible assets were less than their carrying values.
As a result, an impairment charge of $38.0 million
was recorded
during the first quarter of 2020 to write down the carrying values of these intangible
assets to their estimated fair values.
27
Pension and Postretirement benefits: