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A. Shulman Inc. (NASDAQ:SHLM)

Q4 2008 Earnings Call

October 21, 2008 10:00 am ET

Executives

Joseph M. Gingo - CEO and President

Paul F. DeSantis - Chief Financial Officer

Analysts

Saul Ludwig – Keybanc Capital Markets

Robert Felice – Gabelli & Company

Rosemarie Morbelli – Ingalls & Snyder LLC

Christopher Butler – Sidoti & Company

[Ken Roeskin - Tigeman Fund Management]

Gregory Macosko - Lord Abbett

Operator

Good day and welcome to the A. Shulman fourth quarter 2008 conference call. Before we begin the company would like to remind that statements made during this conference call which are not historical facts may be considered forward-looking statements. Forward-looking statements involve risks and uncertainties that could cause actual events or results to differ materially from those expressed or implied. In addition, this conference call contains time sensitive information that reflects management’s best analysis only as of the date of this live call. A. Shulman does not undertake any obligation to publicly update or revise any forward-looking statements to reflect future events. The information or circumstances that arise after the date of this call. For further information concerning issues that could materially affect financial performance related to forward-looking statements, please refer A. Shulman’s quarterly earnings release and periodic filings with the Securities and Exchange Commission.

I will now turn this call over to Mr. Joe Gingo, CEO and President. Please proceed, sir.

Joseph M. Gingo

Thank you. We are extremely pleased to report our fiscal 2008 results to you today. In a very challenging year, our net income excluding unusual items of $37.1 million not only exceeded our $36 million guidance but was a 56% improvement over fiscal 2007 results. I’m also very pleased with our management team’s progress on our days and working capital which dropped from 92 days to 73 days, a 21% improvement and that we generated $156 million in operating cash flow compared with $65 million last year.

These improvements were driven by the 100 day and 265 day plans we launched last January when the board named me President and CEO. In which all of our associates executed over the past eight months. I will now turn the meeting over to Paul F. DeSantis, Shulman’s Chief Financial Officer, to take you through our financials. After Paul gives his presentation, I will return to provide some insights on our operational and strategic action agendas. Then Paul and I will address any questions you may have. Paul?

Paul F. DeSantis

Thanks, Joe. Overall as Joe mentioned, we’re very encouraged by our performance in the fourth quarter and full year especially considering the current economic climate. We exceeded our $36 million net income excluding unusual items commitment and generated more than $150 million of cash from operations with improved working capital management and improved operating earnings driving the majority of that cash flow increase. We’re beginning to see the success of our ongoing strategy to improve profitability and reduce working capital to create a financially stronger company.

As you can see from today’s press release, we had a number of unusual items. In total, we booked a net $2.1 million of unusual after tax items for the quarter bringing our full year total to $19.1 million. These charges are primarily associated with the continuation of our restructuring activities that started with Joe’s 100-day plan. By comparison, in the fourth quarter of fiscal 2007, the effective unusual after tax items was to increase net income by $1.4 million. For the full year of fiscal 2007, we recorded $1.2 million of costs associated with unusual items. I will not go through the details because they’re in the press release and will be in the 10-K scheduled to be filed around the end of the month.

Reported earnings per diluted share for the fourth quarter, these are earnings including all of the unusual items were $0.17 compared with $0.30 reported last year. For the year, we reported earnings of $0.66 for fiscal 2008 compared with $0.82 last year. Excluding unusual items, we would’ve reported earnings per share for the quarter of $0.26 per diluted share compared with $0.25 per diluted share last year. For the full year, our adjusted earnings would’ve been $37.1 million or $1.36 per diluted share up more than 50% from last year’s $23.8 million or $0.87 per diluted share. The majority of this increase was driven by Europe’s performance along with the translation effect of foreign exchange which increased net income by approximately $9.2 million for the full year period when we look at the exchange affect excluding unusual items.

For the company as a whole we saw tonage decline 12% for the quarter and 4% for the year. The biggest driver of the tonage change was the strategic decision to sell our North American engineered plastics, low margin Texas tolling facility. Excluding the effect of the Texas sale, Shulman’s volume would be down 8% for the quarter and less than 2% for the year.

SG&A was up $21 million or 13% for the full year. Excluding $12 million of foreign exchange effect, SG&A was up $9 million or 6%. There were several large items that made up the majority of this variance. The first three are included in the unusual items list including $3.6 million of CEO transition expense during the second quarter, $600,000 of costs related to the termination of the lease for the company airplane during the second quarter, and $700,000 in proxy contest expenses recorded during the first and second quarters. We also recorded $1.8 million during the second half of the year for outside consulting services helping us refine and upgrade our business unit financial plans and business unit strategies and over $2 million in North America for four large customer bankruptcies during the second and fourth quarters.

North American administrative spending continues to run favorable as we see the positive effects of our ability to manage costs within our control. Looking at the North American segments and their performance over the last few years, it’s clear that the dramatic actions we’ve taken to shore up the business were completely necessary to properly position them for future growth. The North American engineered plastics business is our business under the greatest market stress. In an effort to bring that business’ capacity in line with demand and focus on higher margin sales, we sold the Texas tolling facility in March and closed the Canadian plant fully by the end of June.

Tonage for North America engineered plastics was down 50% for the quarter and 25% for the year. The majority of this decline was due to the sale of the tolling facility. That facility accounted for 67% of the shortfall in the quarter and approximately 74% of the shortfall for the full year. The remainder of the shortfall was driven by weaker customer demand and the elimination of lower margin business lines. Although sales have suffered in the engineered plastics business as a result of the quickly weakening economy, the gross profit per pound on an operating basis increased more than 15% for the quarter and more than 60% during the month of August as we’re beginning to see the beneficial effects of these two actions.

This business is still not out of the woods though. We’re seeing, already, continuing fall off in volume to our plant due to the auto market that we’ve seen weakening through the latter half of the year and into September. That plan was implemented a few months ago as we closed the plant in Canada. As a result, we’re closely monitoring the situation and considering additional actions which can return this business to acceptable levels of profitability.

The North America poly batch business, Shulman’s name for the business that serves the master batch market, has the best operating margins among our North America segments. Volume was down 6% for the quarter and up 4% for the full year with the recent performance reflecting the challenging market conditions. North America poly batch is primarily driven from Mexico which accounts for almost 70% of this business unit’s sales. We’re very encouraged with the progress of our new Akron facility which will support this business in the US. We continue to believe that over time we can bring this business margins to be in line with our European margins which are significantly higher.

Our North America distribution business unit has been able to realize favorable results even in this challenging environment. North America distribution experienced declines in volume, quarter and the full year, resulting primarily from weak markets. However, we were successful in our efforts to increase pricing to help offset raw material costs. Selling prices are up 23% for the quarter and 13% for the year while gross profit per pound is up 17% for the quarter and 5% for the full year.

Meanwhile, envision continues to record losses as we refocus its strategy toward non-automotive markets and look for a strategic partner or buyer to help accelerate the success of this business. In Europe we’re seeing two effects on our top line. There was some softening going on in the markets and we have selectively begun to reduce our lower margin business. As a result, volume is off approximately 5% for the quarter. In spite of that volume decline, gross profit in Europe was up 9% in euros. Gross profit margin was up more than 130 basis points and euro profit per pound was up 15%. For the full year, volume was approximately flat while euro gross profit and gross profit per pound, both increased by almost 6%.

Taxes were almost $7 million favorable compared with last year. The reported effective tax rate was just about 50% for the year which compares favorably with the reported rate of 52% last year. However, if we remove the effect of the significant unusual items, the vast majority of which are in North America where we get no tax benefit, we see an effective tax rate closer to 36% for the year. A great improvement over last year.

Our working capital program has delivered tremendous results. Cash from operations was $156 million for the year. This represents a significant increase compared with $65 million last year. At the end of August we had almost $100 million of cash, compared with $43 million a year ago. Net debt has decreased to $16 million, compared with $84 million at the end of May and $83 million at the end of August 2007. The decrease in net debt is directly the result of our working capital initiatives, partially offset by our $42 million treasury stock repurchases and $16 million of dividends. Days in working capital were 73, down from 92 days last year, and down from our peak of 102 days in February of this year, while we realized significant improvements in days in inventory, receivables, and payables.

During the quarter, we completed our two million share repurchase by buying back 500,000 shares at $23.22 per share. That leaves us with approximately three million shares available to be repurchased, if we so choose, under our 2008 board authorization. As our results indicate, we’re on the right path to our building a financially stronger and more flexible company. We will continue our initiatives to improve working capital and increase cash flow while reducing costs and, if necessary, capacity.

With those comments, I’ll turn the call back over to Joe. Thank you.

Joseph M. Gingo

Thank you, Paul. It is encouraging that all of our business unit in Europe improved their results due to higher margins and tighter cost controls. The performance of our European segment was outstanding for the fourth quarter and entire year, driven by favorable foreign exchange and improved operating results. This more than made up for the continued deterioration in the North America market, particularly in the fourth quarter. In fact, the decline in the fourth quarter was largely responsible for our inability to match last year’s North American results. The decline was primarily volume driven.

On a positive side, we achieved the cost savings we had anticipated from closing our Canadian plant in June and selling our low margin tolling operation in Orange, Texas in March. We are also working to improve the performance of our Polybatch business in the USA. This business is primarily directed at the packaging industry. The first significant steps in this process will be the previously announced opening of our Akron Polybatch plant, which will free up capacity in our successful Mexican operation for additional exports to the South American markets. We currently anticipate having the Akron plant on stream before the end of this calendar year.

In addition, I am very pleased with the progress we have made on our four key profitability initiatives: Working capital, global purchasing, the new product engine, and continuous improvement. All are moving forward extremely well, but I am especially pleased with the results of our drive to reduce working capital, an initiative that we launched aggressively in March 2008. Not only did we reduce days by 19, we have impressive results in all three categories─ receivables, payables, and inventory. More importantly, as I mentioned earlier, we generated $156 million in operating cash flow, a 140% improvement over last year. These achievements are largely a result of the extensive working capital training we have conducted with all of our global staff over the past five months, and we expect continued improvement in our working capital.

Based upon our achievements during the past eight months, if we were operating under more favorable economic conditions or even conditions similar to what we have experienced during most of fiscal 2008, we would be very bullish regarding next year’s performance. However, as you are well aware, the economic environment we are now facing globally has created a very unusual level of uncertainty. Therefore, it would not be prudent for us to provide specific guidance for fiscal 2009 at this time. As the year unfolds, we will be in a much better position to determine what we can expect to achieve, and we will look forward to sharing more insights with you. In any case, we are committed to delivering exceptional shareholder returns in any economic environment, and I am confident we will exceed our 2008 net income result. That confidence is based upon our successful saving initiatives in fiscal 2008, as well as our contingency planning for fiscal 2009.

In the United States we are watching the automotive market very closely to determine the extent of further capacity reductions that may be required. We have already closed one line in our Bellevue plant, and in conjunction with our consultants, CRA International, are developing a detailed technical plan to further reduce capacity. We expect to initiate this plan before the end of our first quarter. Even in our successful North American Polybatch business unit, we are completing the consolidation of our U.S. color operation to improve efficiency through a 25% capacity reduction. We are also watching our European operations closely so that we will be prepared if and when a significant volume reduction occurs for the business unit. So far, we have seen some softening but no dramatic falloff in demand. In response, we have already cut back the work week from 5 days to 4 in one of our European manufacturing facilities. Moreover, we are finalizing a contingency plan that will reduce capacity between 5 and 10%. This plan is also ready to be initiated before the end of our first quarter. Fortunately, our European operations are primary directed toward the master batch packaging business, which is more resistant to recessionary pressures, with only a 5% automotive content.

With regard to our purchasing distribution operations, we continue to make excellent progress under the leadership of our chief procurement officer, Gary Miller, who I brought on board in April, reporting directly to me. We are controlling inventory to the minimum possible level. While we are avoiding fixed contracts in the highly volatile resin market, we are leveraging our purchasing power to procure global contracts and achieving savings and efficiencies on all other raw materials and indirect purchases. Purchasing, R&D, and marketing, in all of our business lines, are now actively focused on alternate sourcing and material substitution in order to reduce cost under Gary’s stewardship.

Overall, we are continuing to scrutinize our global SG&A activities. We have already announced our shared service center to consolidate back-office operations in Europe, and we are doing everything possible to accelerate its seamless implementation. In the USA, we continue to focus on bringing our health care plans in line with competitive market levels.

Regarding Invision Film: In September we launched our effort to find a strategic partner or sell the business. So far we have been very pleased with the response, as we have been contacted by more than a dozen strategic and financial investors. Our goal is to close this transaction during the first calendar quarter of next year. That is an aggressive target, but we think it is doable, given the level of interest that we have demonstrated.

Before I close, I want to provide an update on the special committee’s evaluation of strategic alternatives for the company, and I’d also like to comment on what we have seen so far in fiscal 2009.

As indicated in this morning’s news release, the special committee of the board, whose voting members are all independent directors, have been actively reviewing our strategic alternatives. UBS, the company’s financial advisor retained for this purpose, identified potential partners for a strategic transaction and reached the point that a tentative offer to purchase the company was made over the summer. However, the special committee concluded the offer was inadequate. Although the board left the door open for an improved offer, the other party declined that opportunity. So, the special committee will continue to pursue all strategic options, including a possible sale or merger of the company, potential acquisitions by the company, and continued execution of the company’s strategic plan.

At this point in time we have nothing more to announce, but we will provide further updates as appropriate, and as I am sure you can appreciate, I cannot and will not comment any further on the process or activities of the committee.

With regard to what we have seen in September and October, the start of our fiscal 2009: As any observer of the general economic environment would expect, we are experiencing further reduction in demand. However, our only significant volume loss has occurred in the U.S. automotive market. Otherwise, volume drops have been moderate, with some increase in gross margin rates. It remains to be seen whether this trend will hold up, but with our global market contingency plans in place, we are reasonably confident as we face our new fiscal year.

Finally, I want to emphasize that our initiatives are not just designed to get us through the current economic storm. What we are doing is building a stronger company for the future. Our focus on driving new product engine and continuous improvement, as well as our working capital and global purchasing efforts, will deliver long-term benefits and we believe will create long-term value for our share holders. I am confident we will see ample evidence of sustainable performance progress as we move into the next phase of our multi-year operational and financial turnaround at Schulman. I look forward to sharing our progress with you as we are aligned with you in realizing shareholder value creation.

Now, Paul and I are prepared to answer any questions you may have.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from the line of Saul Ludwig with Keybanc. Please proceed.

Saul Ludwig – Keybanc Capital Markets

Hey, good morning guys. Nice hitting the goal that you established. That’s quite an accomplishment.

Joseph M. Gingo

Thank you, Saul.

Saul Ludwig – Keybanc Capital Markets

In looking at some of the details, it’s clear that your corporate expense went up by 50%, or it hit you by $7 million additional this year; your North American in the aggregate was $5 million, $5.5 million worse, lost $17.5 million. In your planning for ’09, what do you think you’re going to be able to achieve relative to the $17.5 dollar loss that you’ve had in North America this year and the $21 million that you incurred in corporate expense.

Paul F. DeSantis

Well, Saul, there are a couple big drivers in the corporate expense, so I’ll take that question to start with. In the corporate expense there’s the 3.6 million of CEO transition costs that we talked about. There’s the $700,000 worth of proxy costs that we talked about. There’s a couple million dollars of extra costs that we have in there for CRA, our strategic consultants who are helping us. So, those costs are not part of the ongoing underlying spend at corporate but are much more discretionary, if you will, I guess. In terms of the North American loss, it’s clear we are and we would have been able to tell you a month ago, prior to the latest economic condition, that we believed our activities that we took during the year were going to significantly address that North American loss. So, closing the Canadian plant, selling the Texas polymer facility, should have addressed the vast majority of that loss. Part of that loss includes the Invision business, which I think Joe’s mentioned we’re addressing separately. So, going into this year, our expectation was that we would have moderated that loss quite significantly. Now it's up to us to look at where the markets are to help us understand what could go on with that.

Saul Ludwig – Keybanc Capital Markets

It looked like the most dramatic; the $5 million increase in the North American loss all came in the 4th quarter, where your loss was $5 million compared with only a million dollars a year ago.

Joseph M. Gingo

Yes. In fact, around 85% of the loss in North America occurred in the 4th quarter. Primarily, almost all of that was driven by automotive. There was a little bit in our MasterBatch but really, insignificant compared to the engineered plastics part of the business. So what we're faced with now, Saul, is one very sick business, EP in North America, which represents 10% of our revenue.

Despite the sale of Tipsi (ph 00:29:03) and the closure of Canada, when we closed Canada, we dropped much of our low-margin business. I find that was now insufficient. I did not anticipate the depth of the fallout in North America in volume or margin, particularly in the automotive sector. So we're faced with taking further action in North America. As I said in my comments, that plan will be rolled out before the end of our first quarter of this fiscal year.

Paul commented on it but truthfully, everything we were projecting up until this economic downturn in North America was looking at─ at least a break-even performance in North America. Now with the economic downturn, I fully realize that I'm going to have to make some further significant cuts in the EP business in North America, while we continue to grow our MasterBatch business.

Saul Ludwig – Keybanc Capital Markets

So, you would expect a 17 ½ point value loss to be shrunk dramatically although you will not get to a break even.

Joseph M. Gingo

I think at this point, that's a good conclusion on your part.

Saul Ludwig – Keybanc Capital Markets

Within that, you talk about EP and distribution, but then you still lost $15 million in this big catch-all, Other North America. Any comment on that $15 million expense?

Joseph M. Gingo

We'll address that.

Paul F. DeSantis

Saul, that Other North American expense is a collection of all the other costs associated with North America. It's like a North American corporate or a North American admin, if you will. So it would include IT expenses, it includes North American accounting, it includes any North American management that we have, purchasing. Anything that we haven't allocated back to the business units directly, but isn't corporate in nature that supports kind of the entire North American group is in that number.

Saul Ludwig – Keybanc Capital Markets

That's always got to be a loss.

Paul F. DeSantis

Yes, that's always going to be a loss. You have to add that up with all the other pieces of North America, including Invision to come up with where you're totally sapped.

Joseph M. Gingo

But I think as we look at reducing our activities in EP, there'll be some reductions in those costs as well, but it will always be a loss.

Saul Ludwig – Keybanc Capital Markets

Finally, Joe, you just hired a new VP or Senior VP of Marketing. What's his mission in life and how are you going to valuate him? Is he reporting into one of these business units or is he reporting to you? That's a high-level addition to your staff, a position that was never there before, so I thought that was a significant announcement.

Joseph M. Gingo

Yes. Thank you for bringing that up. Saul, when I came to the company, I did not find a global purchasing position. I felt when I looked at the organization here, this organization was an outstanding sales organization but really lacked what I would classify as marketing. One of the reasons that I had to bring CRA in was really to do market back analysis for us. Then, with the help of CRA, we actually recruited Paul and brought him aboard.

What's he going to do? He's going to report directly to me. We're going to be looking primary in his area at providing a lot more competitive intelligence, a lot more market intelligence, a lot more direction in market areas that we want to go into that have growth potential. What I think we did a lot of in the past was sales into the markets we were in without taking a really broad perspective of where our products could go.

He'll be doing this globally. It'll be a matrix type of structure and each business unit will have somebody that has a sales/marketing responsibility. That individual will report to the business line leader, and then he'll have a line into Paul.

I want to put more rigor and more numbers into marketing than I saw when I first came here, and that's what I'm hoping to accomplish with that position. I hope that answered your question.

Saul Ludwig – Keybanc Capital Markets

Thank you very much.

Operator

The next question comes from the line of Robert Felice with Gabelli & Company. Please proceed.

Robert Felice – Gabelli & Company

Hey guys. Just a couple of quick questions. For awhile, FX has been a real nice tail wind and it contributed about $11 million to the income improvement this year. But more recently, the dollar strengthened and that all started to go the other way. I was hoping you could walk us through the impact on your P&L and help us quantify the magnitude of the headwind you might be facing next year within the European segment.

Paul F. DeSantis

Sure, Robert. That's a great question. Just in general, for every penny that the rate changes, we are impacted around a half a million dollars. So if the rate goes from 35 to 34, it costs us $500,000. Hopefully, that'll help kind of set the benchmark. The other piece to that question is what was our average rate in 2008. Our rate was approximately 1.47/ 1.48, in that range, so you can do the math then based on that.

I guess the third question is what's the expectation for the Euro right now. Right now, it's trading around $1.34. We have an entire range. We've heard anywhere from $1.44 to $1.35, so I'm not sure where it's going to ultimately shake out. But clearly, it's going to put pressure on us the other way.

One of the things that we've been talking about internally is that our goal is going to be to maximize our Euro earnings. So when the Euro was helpful for us, it certainly helped the P&L. If the Euro turns against us, from a U.S. Dollar perspective, that'll give us some head winds, but we are going to go ahead and execute our plans and make sure that our Euro business is continuing to grow healthily and properly as we go forward.

Joseph M. Gingo

Robert, this is Joe. I think I'd like to elaborate a little bit on that, although I think Paul really answered the question very well. Obviously, what we're doing, and you saw it, we're reducing our costs in Europe, shared service center, a reduction in one of our plants from five to four days. We will be looking at a reduction in capacity of 5% to 10%. We're going to be focusing on costs there, but where we really have to drive our results is we have to improve our North American results because we can't face the losses we've experienced this year.

As I said, I was extremely disappointed because we really had taken a lot of steps that I felt were really going to be extremely beneficial and I'm very serious about that. I find now that I have to take more.

Robert Felice – Gabelli & Company

Okay. Given where the Euro is right now, assuming it stays where it is, you'll have about a $6.5 million head wind. Do you think given some of the actions that you're taking out there and despite some softening in Europe, you'll be able to offset that head wind – in other words, maintain a flat year in Europe as we look to '09?

Joseph M. Gingo

If you recall, I said in my notes and I think we said it in the press release, we plan to exceed our results from this year from a net income standpoint. To do that, we're going to have to do what you said and more.

Robert Felice – Gabelli & Company

Okay. Then in terms of Europe, you mentioned that you did see some softening there. Was it contained to specific regions or end markets? I was hoping you could just elaborate on how the demand unfolded throughout the quarter.

Joseph M. Gingo

Generally, it just was a softening that I would say was around 10% to 15% and it seemed to be pretty general. I'm sorry. I'm going to clarify that, 10% to 15% on volume.

Robert Felice – Gabelli & Company

Okay.

Joseph M. Gingo

We've been able, to some extent, as Paul said in his comments, to offset that volume with margin.

Robert Felice – Gabelli & Company

Okay. Then I guess lastly, I was hoping you can detail by how much your raw material costs increased during the quarter and what the delta was between your price increases and the cost inflation, where you stand on your price-cost gap.

Joseph M. Gingo

We have gotten our pricing up. Our only laggard was our Latin American operations, Mexico, and over the past month or so, Mexico has got their prices up. So we expect to see fairly good margins as we go forward. You're totally true about the volatility in the market and I think in my comments I mentioned that.

Right now, what we're trying to do is just keep our inventory to the absolute minimum possible. We're buying resin in the spot market and to the extent possible, like with our additives, we're trying to secure global contracts. So we're trying to leverage our volume in our additives and in our indirect purchases, but at the same time, then stay in the spot market in resins until we see a leveling. What we're seeing right now is volatility. It starts to go down and then a hurricane hits and it goes up for awhile, and then it goes down. Then another hurricane hits and it goes up.

I was talking to Gary Miller today and Gary said right now, it just like a roller coaster. It's up and down, but in the spot market today, it's down. We're going to try to stay in this spot until we see a leveling.

Robert Felice – Gabelli & Company

But it sounds like the way you're buying in the spot market and pricing, it's sufficient to maintain your price-cost gap or prevent further erosion. Is that fair?

Joseph M. Gingo

I think that's a very fair statement. The whole goal of any company is as raw material prices rise, you want to get your prices up as fast as you can. As raw material prices drop, what you want to do is hold your prices as long as you can. I think any company that's in any business, that's always your goal and your success is measured by how well you can do that.

Robert Felice – Gabelli & Company

All right. Keep up the good work and thanks for taking my questions.

Joseph M. Gingo

Thank you.

Operator

The next question comes from the line of Rosemarie Morbelli with Ingalls & Snyder LLC.

Rosemarie Morbelli – Ingalls & Snyder LLC

Good morning, all.

Joseph M. Gingo

Hello

Rosemarie Morbelli – Ingalls & Snyder LLC

I wanted to follow up on some of Robert's questions regarding the raw material costs coming down eventually, if oil stays where it is currently. If my memory serves me right, in the past, Shulman did a lot better in an inflationary environment than it did in the deflationary environment. Have you done anything to change that? Or should we expect actually that even though you want to hang on to those selling price increases, we are going to see a decline in gross margin?

Joseph M. Gingo

I tell you, I think the most significant thing we did was last April when we hired Gary Miller as our chief purchasing officer. Prior to that, this company did not have global purchasing. We now have a very experienced individual running that operation. I am absolutely confident that we won't see the margin deterioration that we've seen in the past. Now I would say this, almost any company will tend to do better in an escalating market. I think you're generally common, that's a commonly good statement to make. But I think the thing we have now that we did not have is global purchasing. Paul, would you like to elaborate on that?

Paul F. DeSantis

Yes, Joe. I think there are two other items that I want to add to that, Rosemarie, to answer that question. The next item is that we have been taking our inventory balances down and we keep aggressively taking those inventory balances down. And so as those inventories are reduced, we are less exposed to changes in the marketplace so that if we're forced to bring our price down we're also bringing our cost down. So that helps us.

And then another item that we've done is we've refocused the entire organization on the profitability of the sales that they are making. So for example, we changed the incentive plan in our North American Sales Force this year to incentivize our sales people on a contribution margin measure which is sales less cost-of-goods. So if they want to get incentivized, they will have to focus in on driving that gap between the selling price and the cost. So as those are moving around they will now be focused even better on that particular metric.

Rosemarie Morbelli – Ingalls & Snyder LLC

Okay. Thanks, that is helpful. Could you give us a feel for what you would expect in terms of the demand as a result of the Chrysler and GM getting together?

Paul F. DeSantis

I really don't have any specific numbers on that, but I would say this just as a general statement. If you look at automotive news any week, you see continued decline in the North American market and it doesn't matter who the auto maker is anymore. There used to be a path where we'd say the big three was down and everybody else was up. The latest numbers is everybody is down.

I just at this point in time see continued deterioration in the automotive market, which means that we have to take very swift action, and that's why, as I said, before the end of our first fiscal quarter, which ends in November, we will be giving you details of a forward-looking plan as how we're going to address that capacity further than we have in the past.

Rosemarie Morbelli – Ingalls & Snyder LLC

Could you get the automotive business to only the 25% of the total North American business that you have in Europe? Is that kind of the goal? Or is that still too high?

Paul F. DeSantis

Oh, no. My goal would be, if I look at it, if I look at all of Europe, the Engineer Plastics business is around 10% of our volume in Europe. Five percent of that 10 is automotive. I would like to see the Engineer Plastics business in the same kind of ratio in the North American operation that I have in Europe. Now, to do that we have to do two things, not just one.

One, we have to shrink the EP business; there is no question about it and we already have done a big step towards that with TPSI in Canada. We've got to take further action. But second to that is we have to grow the Master Batch business and with that, we, you know, put the plants into Akron, and I think that─ so it is a two-edged sword in North America. Grow Master Batch, shrink EP, but the ultimate goal you've hit on exactly right. I'm not asking to leave automotive altogether; automotive is very good for driving technology. If I could look at it more in line of the percentage that I have in Europe, I would be a lot more comfortable.

Rosemarie Morbelli – Ingalls & Snyder LLC

Okay. And then lastly, if I may, you had a strong Europe in the fourth quarter. You say you are seeing some decline. I just came back and things are actually a lot worse than one thinks. And how much of a lag do you think you will have before all of that decline catches up with you?

Paul F. DeSantis

I tell you, you are asking a great question, and if I was an economist I would give you a much better answer to that. My personal experience in Europe, and I only can go on my personal experience. I have 40 years, plus years at another company. Recessions in Europe tend not to be as deep and tend to last longer than recessions in the USA. Now, will that trend occur this time? I don't know. But historically, that's what we've seen. So what I would anticipate is not as steep as the drop and a longer period to get out.

Rosemarie Morbelli – Ingalls & Snyder LLC

Okay. Thanks a lot and good luck.

Paul F. DeSantis

Thank you.

Operator

Your next question comes from the line of Christopher Butler with Sidoti & Company. Please proceed.

Paul F. DeSantis

Hi, Chris.

Christopher Butler – Sidoti & Company

Hi. Good morning, guys. We talked a lot here about raw material costs, but in the numbers you had gross margin expansion in the quarter year-over-year. You know, in light of the significant reduction in inventory, what kind of boost did you get from selling lower-cost inventory during the quarter?

Paul F. DeSantis

That's a good question, and I'm going to try to think through that answer. What we, I think the place that we got our boost from was actually the price increases that we took, that we were able to drive through. We had price increases that we took in our Distribution business, price increases that we took in our Polybatch, our EP business in North America and our European business as well. All of those businesses had the effect of driving increases in the margin.

I think we saw some volatility in raw material costs in the fourth quarter, like Joe talked about. So I don't have the number in front of me to quantify how much is one versus the other, but I do know that speaking of September, we've seen some margin expansion continue, certainly in our North American Polybatch business, as we're really getting a handle on those price increases. So I'm going to chalk most of it up to pricing.

Christopher Butler – Sidoti & Company

But it's safe to say that there was some benefit in there?

Paul F. DeSantis

Of cost–

Christopher Butler – Sidoti & Company

Right, from–

Paul F. DeSantis

The average costing?

Christopher Butler – Sidoti & Company

Right.

Paul F. DeSantis

Yes.

Christopher Butler – Sidoti & Company

Okay.

Paul F. DeSantis

And as I said before, part of our goal is to get those inventory levels down to the point where that we're not benefiting or being hurt as prices move from an inventory perspective as much as historically.

Christopher Butler – Sidoti & Company

And, you know, looking at the, looking at your working capital and taking into consideration the fact that there was at least the prospect of a sale over the summer, are you comfortable with inventory levels where they are? Was there a deeper cut because of the prospect of sale that, you know, now we're possibly looking at stock outs or maybe an increase in levels looking forward here in the next quarter or two?

Joseph M. Gingo

No, the potential sale had nothing, absolutely nothing to do with the inventory. You know, if you looked at our historic working capital days versus our competitors in all categories, payables, receivables and inventory. We've been historically high.

So, what we did is we initiated a training program, actually a global training program that was given to everyone in our staff globally. And we focused on all three elements of working capital. And with that we drove inventory down. I can really tell you I had no complaints of customer service in the process. I think we still have more opportunities not only in inventory but in receivables and in working capital as well.

So no, this is just focused, that focus had not been there, that focus now is there and we'll see it continuing through this year. I have no doubts, and I think I say it, at least I said it in my remarks, is that we have room for improvement in working capital and that includes inventory.

Christopher Butler – Sidoti & Company

All right. And looking at the repurchases over the quarter, we're now looking at a share price that's lower due to market conditions. Is this the time to be aggressive in purchase back more shares or be conservative because of global economic environment?

Paul F. DeSantis

Well, that's a great question. One of the things we've been looking at is our liquidity. I'm also pleased to report that our working capital performance has continued into at least the first month of this fiscal year, through September. And so we're looking at our liquidity and we believe we have lots of options with that liquidity, including share repurchase. And so those are all things that we are going to be looking at, that we are looking at, and –

Joseph M. Gingo

We're going to be opportunistic, there's no question about it. We have cash and we do believe we're undervalued at this point in time, although we've held up fairly well in relationship in the market. But we do believe we're undervalued.

Christopher Butler – Sidoti & Company

Thank you for your time.

Operator

Your next question comes from the line of Ken Roeskin with Tigeman Fund Management. Please proceed.

Paul F. DeSantis

Hi, Ken.

[Ken Roeskin - Tigeman Fund Management]

Hello there Paul and Joe. Paul I think I got the answer I wanted but I just wanted to confirm that the sharp free cash flow generation wasn't related to any timing issue around the close of the quarter that would be changing going forward.

Paul F. DeSantis

No, actually that was something that we were looking at as well. Ken, I'm going to elaborate here for a second. We've changed all of our incentives to include a big portion of working capital. And so we have a much different focus on working capital than we have historically up to and including our monthly financial review meetings, they're called Profit and Cash Meetings because we're giving practically equal treatment to working capital as we are to profitability within our business units.

And so we've had a focus on that; we've understood that there's tremendous volatility in the marketplace right now. It goes from a receivables perspective and from an inventory perspective and we concentrate on bringing those down and we've seen that trend continue through at least through September.

[Ken Roeskin - Tigeman Fund Management]

Okay, thank you.

Operator

Your next question comes from the line of Gregory Macosko with Lord Abbett. Please proceed.

Gregory Macosko - Lord Abbett

Yes, thank you. Forgive me if I've missed a little bit here. But I just wanted to understand what the volume was, tonnage volume, in North America, ex-automotive. Give me a feel for that.

Paul F. DeSantis

We don't do North America as a segment any longer separately, so I don't have the total North American. Let me try to pull some numbers out here real quick. If I look at the total company, volume was down, let's see, we're talking about 12% for the quarter, 4% for the year.

Gregory Macosko - Lord Abbett

And 8%. And was 8% X that without the tolling, so that was─

Paul F. DeSantis

Without the tolling. Right. Now, let me see here. I've got a total historical North America. Unfortunately, that's a good question. I didn't calculate that. Let me see here.

Gregory Macosko - Lord Abbett

How close would that number be to what was reported for NAPB? The polybatch─ that has a fair amount of auto in it or not?

Paul F. DeSantis

The polybatch does not have a lot of auto in it, no, the polybatch business that we’ve seen, there was a volume decline, I think it’s approximately 6% for the quarter, a 4% increase for the year-to-date period.

Gregory Macosko - Lord Abbett

Okay, so that’s somewhat representative of the rest of the North American Market perhaps.

Paul F. DeSantis

Now I would say that if I look at polybatch, it’s more reflective of our European market overall. It seems to me the master batch business is running in the same kind of level globally in the 10% - 15% volume range, softening; whereas the automotive is significantly, three-times more than that.

Gregory Macosko - Lord Abbett

Right. Okay, so basically what we’re seeing, there are no niches or submarkets that have any glimmers of hope out there, or glimmers of strength is a better way to put it.

Paul F. DeSantis

Well, I would say I guess─ In a recession, what I would always say about the polybatch business is this; there is no business that is recession proof. I do believe packaging is much more recession resistant, so I think that’s what we’re seeing right now.

Gregory Macosko - Lord Abbett

Okay, and then with regard to your statement that given current economic conditions with regard to ‘09’s net income expectations, are you saying that the current economic conditions at the end of the fourth quarter? Is that how you’re looking at it?

Paul F. DeSantis

No, today.

Gregory Macosko - Lord Abbett

Today, okay. And that net income would include any particular write offs or any restructuring charges or not?

Paul F. DeSantis

No, we would─ the net income number that we gave, Joe’s number is exceeding the current year’s $37.1 million, would exclude any─ if we had any, restructuring charges. I would fully anticipate that we will have restructuring charges this year. I can’t tell you what they are yet, because we don’t have the plans completely finalized yet, but my expectation is we would have those, those would be excluded from our number that we would count as our target.

Joseph M. Gingo

We had really anticipated that that was behind us last year. We really had felt that we were okay, but as I mentioned, we did not anticipate the depth of the fall out in the North American automotive market.

Gregory Macosko - Lord Abbett

I had assumed that would be where the focus probably would be.

Joseph M. Gingo

You can take away probably.

Gregory Macosko - Lord Abbett

Okay, thanks very much.

Operator

The next question is─ you have a follow up question from the line of Rosemary Morbelli with Ingalls and Snyder, please proceed.

Rosemarie Morbelli – Ingalls & Snyder LLC

Two quick questions, Joe, when you talked about interested NPT’s (ph 00:55:24), were you talking about interest in acquisition of the company as a whole? Or was Envision? Could you stipulate the level of interest in both pieces?

Joseph M. Gingo

My whole comment was with regard to Envision, and that was the comment with regard to the interest and the level of activity. We had anticipated interest in envision, the interest exceeded our expectation. It came from many quarters, a lot of different companies.

With regard to the special committee activities on the whole company, I’m sticking totally to the statement that I made, and I’m not going to make any further comments about the special committee’s activities regarding the whole company other than what was in the news release.

Rosemarie Morbelli – Ingalls & Snyder LLC

Okay, which was─ just making sure I understood it properly, which was that you had an offer, but it was not in line with what you felt the company was worth.

Joseph M. Gingo

The committee concluded the offer was inadequate. They did ask for an improved offer that wasn’t forthcoming, but read further, the special committee is continuing to pursue all strategic options, including a possible sale or merger of the company, potential acquisitions by the company, and continued execution of our company’s strategic plan, so the special committee remains active.

Rosemarie Morbelli – Ingalls & Snyder LLC

Okay, and then lastly, you had $2 million dollars of bad debt in the fourth quarter. Are you expecting more going forward? Did you add to your reserves? What is the situation there?

Joseph M. Gingo

Let me make, Paul, why don’t you address the reserve question and I’ll address just the general economic question.

Paul F. DeSantis

I think that the reserves are more-or-less consistent with where they’ve been historically. What we’ve done─ and I think Joe will probably address the rest of our actions─

Joseph M. Gingo

What we’re seeing right now is an unbelievably volatile environment, there is no question about it, and it’s very different then what I’ve personally experienced in the past, because the people that have gone bankrupt on us were all current. This is─ at least in my experience─ that was never the case, the people that went bankrupt on you were generally delinquent and were dragging on payments. We didn’t see any of that from the big bankruptcies we face, so it’s an uncertain future going on, but to say that we wouldn’t have concern about automotive would be wrong. Automotive, again, it’s a dramatic fall off. It’s in all sectors of automotive, it’s every automotive company. It’s very large, and we’re being very, very careful on this. We’re really monitoring, we’ve put in new controls with our credit department having a final say versus our sales department on any type of business activity with anybody we even have a suspicion of a problem. We’ve altered our bonus program for our sales people in North America. Paul mentioned a part of the altering, and that was that we’re basing a very large portion on contribution margin, which we didn’t do in the past. But we’re then taking a smaller portion of that bonus─ I think it’s 25% off the top of my head─ which is totally tied to accounts receivable performance of the accounts they deal with.

So, we’re putting a lot of focus on this, because I think in this environment, you have to be concerned.

Rosemarie Morbelli – Ingalls & Snyder LLC

Okay, thank you very much.

Operator

(Operator Instructions) You have a follow up question from the line of Saul Ludwig with Keybanc. Please proceed.

Saul Ludwig – Keybanc Captial Markets

What do you expect cap spending to be this year?

Joseph M. Gingo

We have a range of $40 to $50 million that will show up in the 10 K.

Saul Ludwig – Keybanc Captial Markets

$40 to $50 million? You guys crazy? What are you going to spend so much money on?

Joseph M. Gingo

We have the North American polybatch plant as the primary item that’s driving that.

Saul Ludwig – Keybanc Captial Markets

How much is that?

Joseph M. Gingo

I want to say $10 million off the top of my head.

Saul Ludwig – Keybanc Captial Markets

Okay, so that even gets you down to $30 to $40, what would be another major project that could consume that amount of money?

Joseph M. Gingo

I mean if you look at our working capital spending that we had this year, I think it was around $25 or $26 million, that was purely maintenance capital, basically, so we would have purely maintenance capital, plus if you add another $10 million, it gets you to $35. Round it up to $40 to $50 just to be safe in terms of the range, that’s the number that we’re going to put in the 10 K.

Saul Ludwig – Keybanc Captial Markets

Paul, you mentioned in discussing this other North American expense, that the $2 million that you spent with Charles River (ph 01:00:17), are you going to continue to have about that level of spending with them this year? Or might that even be more because you didn’t really have them for the full year?

Paul F. DeSantis

It will not be more than that number. It is also in our corporate spending line, and it will not be more. We have some assignments that Charles Rivers CRAI is working on at the moment, and then we expect that that will tail off.

Saul Ludwig – Keybanc Captial Markets

Joe, as you think about this outlook for improved earnings this year, which is terrific to achieve in a challenging economic environment. Would you expect that with the gross margins improvement, to show progress as we move through each quarter? Or do you see any big hiccup starting at the start of the year, and then catch up later?

Joseph M. Gingo

At this point, we don’t have much visibility, as you’re well aware Saul; we have one month and a half. We’re looking at continuing─ I think Paul made the comment─ gross margins are continuing to improve for us.

Saul Ludwig – Keybanc Captial Markets

Okay, very good. Thank you very much.

Joseph M. Gingo and Paul F. DeSantis

Thank you, Saul.

Operator

At this time there are no further questions, I will turn the conference back over to Mr. Joe Gingo.

Joseph M. Gingo

Thank you for joining Paul and me today. We hope the information we have provided makes you as confident as we are that we will be successful despite the very unpredictable, global economic environment we are experiencing. We look forward to talking with you in the future when we have a clearer picture of the financial results we can expect in fiscal 2009.

Thank you, and goodbye.

Operator

Thank you for your participation in today’s conference, this concludes the presentation, you may now disconnect. Good day.

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Source: A. Shulman Inc., Q4 2008 Earnings Call Transcript
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