Ashland Inc. F4Q08 (Qtr End 9/30/2008) Earnings Call Transcript

Oct.28.08 | About: Ashland Inc. (ASH)

Ashland Inc. (NYSE:ASH)

F4Q 2008 Earnings Call

October 28, 2008 9:00 am ET


Eric Boni – Director of Investor Relations

James J. O’Brien – Chairman, Chief Executive Officer

Lamar M. Chambers – Senior Vice President, Chief Financial Officer

J. Kevin Willis - Treasurer


Mike Sison – Keybanc

Jeff Zekauskas – J.P. Morgan

Dmitry Silversteyn – Longbow Research

Laurence Alexander – Jefferies & Co.

[Steven Velgard] - FIG


Good day ladies and gentlemen and welcome to the fourth quarter 2008 Ashland earnings conference call. My name is [Tawanda] and I will be your coordinator for today. (Operator Instructions) I would now like to turn the presentation over to Mr. Eric Boni, Director of Investor Relations. Please proceed sir.

Eric Boni

Thank you Tawanda. Good morning and welcome to Ashland’s fourth quarter fiscal 2008 conference call and webcast. We released our fourth quarter results at 7:00 am Eastern Daylight Time today. These results are preliminary until we file our 10-K in November. Our speakers with me here today are Jim O’Brien, Ashland’s Chairman and Chief Executive Officer and Lamar Chambers, Senior Vice President and CFO.

Please turn to Slide 2 for our cautionary language regarding forward-looking statements. Statements may be made during the course of this presentation that constitute forward-looking statements as that term is defined in relevant securities laws. Ashland believes its expectations regarding its operating performance and the Hercules transaction are based on reasonable assumptions, but it cannot assure that those expectations will be achieved. Therefore, any forward-looking statements may prove to be inaccurate.

On Slide 3 you will also see the mandatory additional information we must provide in connection with the proposed acquisition of Hercules. Please turn to Slide 4.

Before we get started, I will give you an outline of the call. First, I will review Ashland’s overall fourth quarter results and our progress on cost structure initiatives and Lamar will get into the specifics of our businesses. Jim will then discuss our 2008 full year highlights and conclude our prepared remarks with an update on the Hercules transaction. After that, we will take your questions.

We can take a look at the fourth quarter highlights on Slide 5. We experienced a difficult fourth quarter as our guidance indicated in our last quarterly earnings call in July. You will remember that back at the time of the call, the focus of much of the chemical industry was on implementing a large number of price increases, many in the range of 20 to 30 percent driven by significant increases in crude oil. This was also the overriding theme of our business for the first month-and-a-half to two months of the quarter.

It was a great challenge to implement the necessary price increases in order to recover our own increased costs. In general, we were reasonably successful by the end of the quarter. As we entered the second half of the quarter, a new challenge emerged. Rapidly weakening demand in Europe in particular and to a lesser extent in North America Asia provided a substantial headwind as we closed the quarter. The combination of both of these factors led to a 41% decline in our operating income, excluding key items, versus the year ago September quarter. We will discuss these key items shortly.

Declines in three of our four businesses more than offset this significant improvement in our Ashland Distribution business. Ashland Performance Materials was down considerably, and Valvoline to a lesser extent while Ashland’s Water Technologies reported a loss for the quarter. Nevertheless, we are encouraged by the $10.6 million operating income increase excluding key items in Distribution which performed reasonably well given the weaker market demand and higher product costs.

EBITDA declined by 11% or $8 million in the September 2008 quarter versus the same 2007 quarter. Results were considerably skewed by adjustments to Ashland’s tax provision in the fourth quarter, which negatively affected earnings by approximately $0.30 per share based on the full year effective tax rate of 33%. The organizational focus on working capital continued to produce good results, driving operating segment trade working capital to 12.3% of sales, a level we haven’t seen in several years.

Please turn to our preliminary fourth quarter results on Slide 6. Sales increased by 6% in the 2008 September quarter, reflecting increased average selling prices, partially offset by declines in volume. Gross profit percentage decreased significantly versus the prior year quarter and sequentially, primarily the result of timing lags, implementing price increases to offset raw material cost increases. Absolute gross profit dollars decreased by $27 million or 8% although we were able to recover about 90% of our raw material costs.

Reductions from the prior year’s $338 million of SG&A expenses enabled operating income to increase on a reported basis. 11% decline in EBITDA reflects a significant reduction in Water Technologies, offset by Ashland Distribution while Performance Materials and Valvoline experienced EBITDA reductions of nearly 20%.

Please turn to Slide 7 to review the key items affecting operating income that I mentioned earlier. Benefiting operating income in the 2008 fourth quarter was $11.3 million of income from favorable claims experience related to our self insurance program as compared with $8 million in the prior year quarter. Severance costs in our Performance Materials and Water Technologies businesses, related to our cost structure efficiency initiatives, were $7.3 million in the September 2008 quarter.

Several key items affected only the September 2007 quarter. Operating income benefited from one time income of $5.2 million, related to the elimination of a one month financial reporting ladies and gentlemen for our wholly owned entities outside North America, which created a four month quarter and a 13 month year for certain of our non-North American businesses. Operating income in the 2007 quarter was negatively affected by a litigation reserve adjustment of

$5.5 million, a $10.6 million asset impairment in Water Technologies, and a one time

$11.3 million expense related to post retirement medical plans in Canada.

As we’ve noted in the past, we believe the use of adjusted operating incomes, which represent the base earnings of our businesses as shown on the all other income line highlighted on this table, is appropriate to enhance understanding of our current and future performance. With this in mind, all other income for the September 2008 quarter totaled $23.8 million versus $40.4 million in the same prior year quarter.

Please turn to Slide 8 to look at Ashland’s income bridge. As you can see from this slide, there were three major drivers of Ashland’s operating income performance during the September quarter. Volume declines in Distribution and Performance Materials negatively impacted earnings in the quarter. Meanwhile, significant margin improvements in most of Ashland’s Distribution lines of business more than offset margin declines in our other three segments resulting from the time lag between our receipt of cost increases and our ability to pass those cost increases into the marketplace.

The key items I just reviewed on Slide 7 were the third major factor impacting operating income. Please turn to Slide 9 to look at our diluted earnings per share. As you look down the chart, key differences between the 2008 and 2007 September quarters were in the net interest, income tax expense and discontinued operations lines. Net interest decreased by $10 million, primarily the result of lower interest rates on Ashland’s short term cash and investment securities. The large increase in the fourth quarter tax expense reflects the net unfavorable affect of adjustments to the annual estimated tax provision taken during the quarter.

The effective tax rate was negatively impacted by final results for foreign taxable jurisdictions. In addition, the significant volatility in the capital markets as it relates to certain compensation investments also impacted the effective tax rate for the quarter. These factors, along with several others, drove the need to adjust our tax reserves to take us from the effective tax rate we had through three quarters up to the full year rate.

The September 2008 quarter also included a loss from discontinued operations of $9 million, which primarily consisted of various adjustments to asbestos related insurance receivables, resulting from Ashland’s ongoing assessment of these matters. Diluted EPS from continuing operations was a loss of $0.01 per share versus income of $0.51 in the prior year quarter.

Slide 10 shows the components of our earnings per share from continuing operations. Excluding key items and the impact of the tax provision adjustment, all other earnings per share from continuing operations totaled $0.25 as compared with $0.60 in the September 2007 quarter.

Now let’s turn to Slide 11 to review our operating cash flows. We generated $57 million of operating cash flows in the 2008 fourth quarter. This is a $72 million reduction from the year ago quarter. This change was driven primarily by lower net income, a smaller reduction in operating assets and liabilities, and an additional $35 million in capital expenditures during the quarter driven in part by our new regional headquarters and R&D center in China, and expenditures related to several Valvoline facilities including Hernando, Mississippi; Australia; and Dordrecht, the Netherlands.

Please turn to Slide 12 for a look at our progress on operating segment trade work and capital. As I noted earlier, we have made significant progress in reducing trade work and capital as a percentage of sales, particularly in the last nine months of our fiscal year. Most businesses and regions have contributed 430 basis point improvement you see here, driven largely by attention to optimizing inventory and accounts receivable. Another major initiative at Ashland is centered around our cost structure efficiency, which we discuss on Slide 13.

Through the end of the 2008 fourth fiscal quarter, we have achieved run rate savings of

$41 million, including $9 million achieved during the fourth quarter. Significant actions taken during the quarter included the consolidation of our composite polymers and specialty polymers and adhesives business units within Performance Materials and the resultant consolidation of a number of sales, marketing, technical and administrative roles. We’ve reduced hours of operations and headcount at five manufacturing facilities as a result of reduced demand in many of our key North American markets.

Similarly, we have implemented reductions in sales, technical service and supply chain support in our Water Technologies business to implement the business model redesign work we’ve been discussing for the last several years. The head of this business is integration into the Hercules Paper Technologies business. As we’ve noted in the past, we expect to achieve a total of

$65 million of run rate savings from our current operations by the end of fiscal 2009. In addition, as Jim will share with you a little later, we have identified additional synergies from our pending acquisition of Hercules, Incorporated.

Before I turn the presentation over to Lamar Chambers to discuss the results and outlook for our four business segments, I’d like to leave you with these thoughts on Slide 14 about the quarter just ended. Operating income was down 41%, primarily due to margin compression that hit three of our four businesses early in the fourth quarter, coupled with the deeper downturn in the economy that also occurred in the latter half of the quarter. Throughout the quarter, we took aggressive action on pricing and that has enabled us to recover 90% of these very substantial cost increases received from our suppliers.

Despite this lower income, we generated nearly $150 million of cash flows from operating activities during the quarter and for the year generated cash flows of nearly $500 million. In addition, we substantially reduced working capital and significantly exceeded our target for getting costs out of our businesses. I’ll turn it over to Lamar.

Lamar M. Chambers

Thank you Eric and good morning. Let me start with Ashland Performance Materials. As you can see on Slide 15, a number of key items affected quarterly operating income comparisons for this segment. As we continue through the presentation you’ll see this chart for each of our business segments before we get into their results.

Ashland Performance Materials reported operating income of $1.6 million in the September 2008 quarter, a decline of $5.6 million versus a year ago quarter. However, severance costs had a $4.7 million negative impact on Performance Materials operating income in the 2008 quarter as compared with a net unfavorable impact of $6.7 million from all key items in the prior year quarter. Thus, all other income representing the underlying performance of the business totaled $6.3 million for the fourth quarter 2008 as compared with $13.9 million a year earlier.

Now let’s move to Slide 16 which summarizes Performance Materials quarterly results. As shown here, Performance Materials sales and operating revenue of $427 million declined 3% versus the September 2008 while volume per day increased 8%. However, both volume and revenue comparisons were affected by a number of factors; an extra month of non-North American business in 2007, volume gain from the acquisition of a line of business from Air Products in 2008, the transfer of certain sales to Water Technologies, and currency translation.

Excluding the effects of these factors, revenue increased 3% over the September 2007 quarter, largely due to price increases and volume per day decreased 6%, largely the result of weakness in North American and European markets. Gross profit as a percent of sales declined by 380 basis points and nearly 300 basis points sequentially, due largely to the time lag in recovering cost increases; volume reductions; and the impact of the lower margin Air Products business.

We believe we recovered approximately 60% of cost increases received during the quarter. The gross profit decline was a primary driver of the reduction in earnings in the quarter. SG&A costs improved by 13%, due to the impact of the 2007 key items I mentioned earlier. You’ve already heard about operating income, so let’s move on down the chart to EBITDA which was

$15 million for the September 2008 quarter as compared with $18 million for the same 2007 quarter. EBITDA margin declined 60 basis points to 3.5% of sales.

Slide 17 shows Performance Materials operating income bridge, comparing the 2008 and 2007 quarters. Volume was a primary driver for the reduction in operating income. Volume was down 7 to 8% both in Europe and the U.S. during the quarter. While this is not a significant change from the prior several quarters in the U.S., it is a sharp change in Europe. Asia continues to grow, albeit at mid single digits. Nearly all other factors were neutral or positive to income.

Please turn to Slide 18. The financial impact of the cost structure efficiencies that Eric talked about earlier should result in savings of approximately $8 million in SG&A in the December quarter versus the year ago quarter. We are in the process of mothballing manufacturing capacity in North America due to the continued decline in economic conditions. In Europe, we plan to reduce hours of operation in certain manufacturing plants to reduce capacity and payroll expense.

On a more positive note, as we’ve all recently seen, crude oil is experiencing a precipitous drop from its peak in July. We are starting to see the costs of several of our key raw materials, such as styrene, coming down in the spot market. We’ve continued to negotiate our raw materials contracts with our suppliers, but any cost reductions that we may receive will not be felt for several weeks.

Now let’s look at Ashland Distribution on Slide 19. As you can see from this chart, there were no key items affecting Distribution’s operating income in the September 2008 quarter. However, key items in the 2007 quarter reduced distributions $2 million of all other income to a loss of

$4.5 million on a reported basis. So on a comparable basis, Ashland Distribution’s earnings increased by more than $10 million, a significant achievement in a difficult economic environment.

Let’s look at the rest of Distribution’s financial results on Slide 20. On a comparable basis, volume per day declined 7% versus the September 2007 quarter, reflecting reductions across all lines of business, but particularly in plastics. The American Chemistry Council reports that thermoplastic sales in the U.S. were down 19% in August, versus the prior year. Our decline in this segment was less than half of the market decline. While soft, U.S. demand drove overall volume declines in Ashland Distribution.

The volume decline also shows some after effects of Hurricane Ike as extended power outages led to several products being placed on allocation during the September quarter. Operating revenue increased by 10% as reported and when the affects of the extra month of non-North American revenue in 2007 and currency translation are excluded, revenue increased by 14%. Average selling prices have increased by nearly $0.17 per pound or 20% versus the prior year quarter, including 7% versus the June 2008 quarter.

The gross profit percentage increased by 110 basis points due to increases across most of Distribution’s business lines. SG&A costs increased by $3 million or 4%. EBITDA increased by $16 million or 1.4% of sales versus the prior year quarter.

Now please turn to Slide 21 to review Distribution’s operating income bridge. As you can see here, the negative impact of volume and SG&A were significantly more than offset by the

$29.2 million increase obtained in gross margin. Again this reflects improvement across most of Distribution’s lines of businesses resulting from the increased focus on and improvements to the pricing process.

Now let’s go on to Slide 22. You’ve seen this chart for a number of quarters now depicting the improved proving trend and unit gross profit after a number of rough quarters. Gross profit exceeded $0.08 per pound for the first time and as you can see, pricing has nearly doubled in the last six years. With that, let’s review Distribution’s near term outlook on Slide 23.

We believe that difficult market conditions will persist well into 2009, driven by both volatile raw material costs and declining demand in our core markets; building and construction, coatings, automotive, and marine. Volume at our Distribution business largely hinges on U.S. industrial production. At the same time, we are also seeing evidence that European demand is dropping off significantly. We remain concerned about the level of business activity of our customers due to the global economic environment.

While any one customer would not have a significant impact on Distribution, the widespread nature of the credit crisis is likely to be reflected in reduced overall demand. On the positive side, our attention to the pricing process has enabled us to improve margins over the last three quarters and we believe that while negotiating the current volatile cost environment will be tricky, continued attention to price management may provide some opportunity for gross margin expansion.

Now onto Valvoline on Slide 24. As you can see here there was a slight negative impact on Valvoline’s operating income in the fourth quarter of 2007 from key items. Excluding that effect, Valvoline had a $5.7 million decline in income for the September 2008 quarter. Please turn to Slide 25.

Valvoline’s total lubricant volume was essentially even with the prior year quarter while revenue increased 18% over the September 2007 quarter largely due to price increases. Volume in the do-it-yourself market channel increased approximately 7% versus a weak prior year quarter and international volumes increased 9%, primarily due to the commencement of a [tolling] contract in Europe.

The do-it-for-me installer channel however lost approximately 8% in volume, which we believe is pretty consistent with the overall market declines in the quarter, but also was impacted by installers managing inventory levels due to numerous price increases. Gross profit as a percent of sales dropped by 540 basis points versus the September 2007 quarter, primarily a result of the implementation time lag between cost increases received and price increases put into the marketplace.

Valvoline’s EBITDA for the September 2008 quarter was $21 million, $5 million below the year ago quarter and EBITDA as a percent of sales declined by 220 basis points. Let’s go to Valvoline’s income bridge on Slide 26. By far the greatest impact on operating income during the September quarter was the $10.6 million decline in gross margin, which more than offset the benefits of all the other performance factors shown here.

Let’s look at Valvoline’s outlook going into fiscal 2009 on Slide 27. Throughout the summer months Valvoline implemented a number of price increases in order to recover raw materials cost increases received. These price increases should restore our gross profit on a per unit basis to levels achieved during the first nine months of fiscal 2008. We do expect downward pressure on raw material costs during 2009 and given the soft lubricant demand it is likely to persist for some time, we’re planning for highly competitive conditions in the marketplace.

Nonetheless our outlook remains positive as U.S. margins should stabilize and our Valvoline Instant Oil Change and international businesses are poised for continued earnings growth. Now please turn to Slide 28 to review Water Technologies results.

Water Technologies reported an operating loss of $5.9 million for the September 2008 quarter as compared with a loss of $1.5 million in the prior September quarter. Taking into account key items affecting the operating income in both quarters, Water Technologies all other income of

$6.6 million in the September 2007 quarter swung to a loss of $3.3 million in the September 2008 quarter. Now let’s look at the rest of Water Technologies results on Slide 29.

For the September 2008 quarter, Water Technologies operating revenue of $226 million declined 9% as compared with the same prior year quarter. Revenue comparisons were affected by an extra month of non-North American business in 2007, the transfer of certain sales from Performance Materials and currency translation. Excluding these factors, revenue increased 1%. Gross profit as a percent of sales decreased by 680 basis points versus the year ago quarter, primarily reflecting increased raw material costs as well as unfavorable adjustments related to the resolution of invoice accuracy issues.

EBITDA for the 2008 September quarter was $1 million as compared with $17 million in the previous September quarter. And EBITDA margin declined 640 basis points to 0.4% of sales. Please turn to Slide 30 for Water Technologies income bridge.

As you can see, the $14.8 million declining gross margin was the primary factor in Water Technologies income decline. Like our other businesses, Water Technologies continues to be negatively impacted by increases in the costs of its raw materials and improvements in sales and SG&A were not enough to overcome that deficit. That said we’re beginning to see the benefits of cost structure changes on this business. Please go to Slide 31 for Water Technologies outlook.

Like Performance Materials, we’re taking steps within Water Technologies to get our cost structure in line with what it takes to support the business. Toward that end, during the fourth quarter we reduced sales, marketing, technical, administrative and plant staffing with additional reductions targeted in fiscal 2009. During our first fiscal quarter, 35 to 40% of our full service and municipal contracts come up for annual renewal and renegotiation and we expect to re-price a relatively high percentage of these contracts.

This should restore the margin erosion we’ve been experiencing with these accounts. We also expect to negotiate new terms and conditions that allow more flexibility in pricing adjustments during the course of the year. And as we’ve previously stated, assuming the completion of the Hercules acquisition during the current quarter, Ashland Water Technologies will be consolidated into the Hercules Paper Technologies business. And we expect to begin reporting financial results on a combined basis for the first fiscal quarter of 2009.

With that, I’ll turn the presentation over to Jim O’Brien to review Ashland’s overall fiscal 2008 results and our progress on the Hercules transaction. Jim.

James J. O’Brien

Thanks Lamar. On Slide 32 you’ll see that operating revenues for fiscal 2008 increased by 8%, benefiting from price increases across all our businesses. Gross profit percentage declined 140 basis points to 15.8% of sales, primarily reflecting raw material cost increases and the timing ladies and gentlemen inherent in implementing price increases to our customers. Operating income of $213 million was relatively even with the prior year.

Ashland’s EBITDA for the year was $358 million as compared with $349 million for 2007, representing a 3% increase in what was a very difficult macroeconomic environment, particularly in the U.S. housing and automotive markets. Let’s move to Slide 33 to review our business operating income results for the fiscal year.

As you are well aware, 2008 has been a challenging year for chemical businesses and Ashland was no exception, particularly in our Performance Materials and Water Technology businesses, both of which saw double digit declines in EBITDA. Performance Materials results were driven by significant declines in its major end markets, construction and transportation, coupled with substantial increases in raw materials.

Water Technologies continued to work the business model [with] limitation as it addressed key issues around pricing management, cost structure, and supply chain optimization. At the same time it has been dealing with rising raw material costs. The good news as you’ve heard is that Water Technologies has made some headway, and indeed has achieved run rate cost savings of around $14 million.

Distribution achieved EBITDA growth of 19%, driven by its focus on pricing to margins. Valvoline also navigated the volatile raw material cost environment well, with EBITDA just 2% below the record set last year. In addition, our Valvoline Instant Oil Change business and Valvoline International both achieved record annual operating income. Overall, EBITDA for Ashland increased 3% for the year. Let’s go to Slide 34.

Eric already shared with you our progress on cost structure efficiency, and I fully expect to achieve the targeted run rate savings of $65 million from our existing businesses before year end 2009. Plus additional synergies from the Hercules transaction, which I’ll discuss shortly. Our focus on cash flow generation has paid off in a big way in fiscal 2008 as we generated nearly $500 million of cash flows from operations. This also represents a nearly $300 million increase over 2007.

Our working capital decreased by 300 basis points to 12.3% of sales largely driven by inventory optimization at Ashland Distribution, but also benefited from attention to accounts receivable across all of our businesses. We are pleased with our success to date, particularly the latter part of the year, and we will continue our focus on maximizing cash flow.

Certainly a highlight of fiscal 2008 was the announcement of our coming acquisition of Hercules, which is a major step in achieving our objective to create a major global specialty chemicals company. Let’s go to Slide 35 for more on the Hercules transaction.

With all of the regulatory approvals received, our next milestone is the Hercules shareholder vote on November 5. Assuming the transaction is approved, we would anticipate closing by November 13. I’m sure everyone is well aware of the challenging conditions in the credit markets. We continue to work with our lead banks on the structure and terms of the financing for this transaction and it now appears that our blended interest rate for new and retained debt will be a couple of percentage points higher than we originally projected back in July.

Bank of America and Scotiabank continue to emphasize their commitment to fund this transaction. We have been taking steps in conjunction with the transaction. One step was entering into cross currency swaps to neutralize the impact of the swaps that Hercules has in place and limit any additional exposure to movements in currency one way or the other. Another step has been our significant integration planning. Both the Ashland and Hercules employees involved in integration efforts have been highly engaged and we appreciate their enthusiasm and work towards ensuring a smooth transition.

Part of the activity of this team has been to further identify and develop action plans to achieve the synergies we discussed on our calls in July. We are pleased that we have now identified synergy opportunities totaling approximately $120 million which was the upper end of the range previously announced. We currently expect to generate run rate synergies of approximately

$80 million by the one year anniversary of the closing.

We are still analyzing the expenses necessary to achieve all $120 million of synergies but expect the expenses including the sum that may be capitalized based upon the accounting rules to be greater than the $60 million forecast we provided in July. Let me reiterate. While this is not the ideal market to finance this transaction, the strategic reasons for undertaking the transaction have not changed. In fact, the current economic environment reinforces the importance of owning businesses with more stable earnings during the down part of the cycle.

Hercules fulfills our objective to transform Ashland into a significant chemical company as is evidenced by the approximately 75% of EBITDA that will come from our specialty chemicals core. Combined, the company will have greater focus and expanded scale and three specialty chemical businesses; Specialty Additives and Ingredients, Paper and Water Technologies, and Specialty Resins. And approximately one third of our pro forma EBITDA will come from renewable and sustainable chemistries, primarily through Hercules well regarded [Aqualizer].

We will also create a $2 billion company in the paper and water business, combining Ashland Water Technologies with Hercules Paper Technologies group. We expect this acquisition to significantly enhance our financial profile through reduced earnings volatility, improve profitability and stronger cash flow generation. It is for these reasons that we are committed to completing the Hercules transaction. With that, we’ll take your questions.

Eric Boni

Do we have any questions?

Question-and-Answer Session


(Operator Instructions) Your first question comes from Mike Sison – Keybanc.

Mike Sison – Keybanc

Give us a feel for – if you think about the Ashland businesses on its own and think about the current economic backdrop and potential for [low] raw materials, sort of what the potential you see in the separate businesses heading into ’09 and 2010 assuming let’s say Hercules wasn’t on the table? Just to get a feel what the potential is for the base business at this point in time.

James J. O’Brien

As far as the potential for raw material decreases, obviously Ashland Distribution’s done a very good job moving through the pricing increases and as prices will come down, they will have to react to that in the marketplace as well. Performance Materials I think will benefit the greatest, because they’ve had the most difficulty in getting the pricing through because of the difficult demand structure that that business has experienced over the last 18 months.

So I think Performance Materials captured about 55% of the raw materials increases that we had the last quarter. So hopefully as prices come down, we can get back to more normal margins and as we talked about in the call, we’re also restructuring the cost structure of that business. We took significant cost cuts this last quarter as well as taking capacity out to bring our utilization rates up. So as this business becomes smaller due to the size of the market, hopefully it will be able to retain a level of profitability that will create a return. So that’s going to be beneficial.

Valvoline had a very good series of price increases where they passed through all the costs of the lube stock that went up during the quarter. Now as lube stocks potentially come down in the near future, they will have to work through that with their various accounts and price accordingly, but we feel that the market is structured as such that Valvoline will have good margins going through this period.

Water on the other hand will probably benefit like Performance Materials in that they achieved only about 33% of the capture of raw materials through the quarter. The issue being that they still have a lot of contract business that takes three to four months to get through and we have approximately 30 some odd percent of our contracts coming due this quarter, being the last calendar quarter of the year or our first fiscal quarter.

So those contracts will enable us to reopen price discussions and given the raw material costs as they stand at that time, we hope it will bring margins back to a historic level. So Water going through this period should benefit from having a lot of contracts reopening between now and March and be able to get appropriate pricing in. So as I look at the conditions, volume obviously will be challenged but if materials continue to soften I think our Performance businesses, our Water businesses and Valvoline will benefit from this. And Distribution as they have been doing will price according to the marketplace and retain as much margin as possible.

Mike Sison – Keybanc

It certainly sounds like you guys are very committed to the Hercules transaction and you’re within two weeks of closing but are there any odd signs, just in terms of curiosity in terms of I mean if there was something that you found the next two weeks that really didn’t add up, is there any way for you to get out of the transaction? Or are you pretty much set in stone at this point to sort of go forward?

James J. O'Brien

We’re still very committed to the Hercules transaction and we can’t speculate on what issues may arise that would cause any type of change to that. All I can tell you at this time is we continue to negotiate with our banks to finalize the financing, and that is one of the final conditions that has to be met before we can close. So the financial markets as you know are difficult, the banks continue to be committed to the transaction, but we’re still in the throes of negotiating the final terms.

Mike Sison – Keybanc

Then in terms of the recent backdrop of the economic environment and you think about Hercules going forward, any changes to what might have been, what you thought could be the potential I guess earnings creation from July to now concerning things are a little bit more difficult in the economic environment?

James J. O'Brien

Well certainly the economic environment will impact not only our businesses but Hercules businesses. When you look at the strategic reasons why we went forward, they have not changed. We still like their more consistent cash flows. I think they have positions in certain markets which although they’re going to be impacted by a total worldwide economic slowdown I think are less sensitive than some of the markets that we participate in. So I think as far as imbalance it gives a much more stable earnings picture for us.

And I think also it gives as I stated in our discussion here, there are significant cost reductions that can be made to improve our cost structure with the two combined companies. So when you take all those things together I think the two companies together, in spite of the economic slowdown that we’re facing will be stronger as combined units.


Your next question comes from Jeff Zekauskas – J.P. Morgan.

Jeff Zekauskas – J.P. Morgan

At the beginning of the presentation, you said that you thought your interest costs for the transaction might be up a couple of hundred basis points from where you originally forecast. Can you remind me where you originally forecast or what do you think the average cost of debt for Hercules is now going to be?

James J. O'Brien

I’ll have Lamar answer that question. Go ahead Lamar.

Lamar M. Chambers

Yes. Thank you Jim. We originally indicated that we thought our all in blended interest costs would be in the range of 7.25 to 8.25% across all the tranches of debt and debt assumed. As we said earlier in the comments we’re now looking at a couple percentage points above that as the likely scenario.

Jeff Zekauskas – J.P. Morgan

So that means 9.25 to 10.25?

Lamar M. Chambers

That’s correct.

Jeff Zekauskas – J.P. Morgan

So you said that you’re in negotiations with the bank. I mean, these are really substantially above what you expected before.

Lamar M. Chambers

Of course we as part of our commitments with the bank we also have flex built in to the rates and the structure of the transaction and that’s what we’re working with the banks now to finalize is exactly how that structure looks and how the flex is managed through the closing. So this is in line with our expectations around what these rates could get to.

Jeff Zekauskas – J.P. Morgan

So all things being equal, unless you’ve really changed your depreciation assumptions, this is now a very dilutive transaction. Is that the way you see it? Or do you see it as accretive or slightly dilutive? How do you see it next year?

Lamar M. Chambers

From a reported GAAP earnings basis I think we indicated when we announced the transaction, we did expect it to be modestly dilutive in the first year, substantially accretive on a cash earnings basis excluding the effects of the purchase accounting write ups on depreciation and so forth. Even in year one we expect it to be accretive on the cash earnings basis. So that’s still our expectation. Clearly the higher interest costs put additional burden on the earnings as well as the economic environment.

We’re looking at that as we move forward here. But this is well within our expectations of the economics of the transaction as far as the way we’ve stress tested it against the economic and escrow scenarios.

Eric Boni

Jeff also keep in mind, too, you’ll remember our initial base case on synergies was $50 million and about 60% of that on a run rate basis in year one. We’re now forecasting $120 million in synergies and $80 million on a run rate basis in that first year.

Jeff Zekauskas – J.P. Morgan

The other half of this transaction is that your own stock is trading or your own EBITDA is trading at I don’t know 2.3 times. So is there sort of a gradual – is there a reassessment or some sort of analysis of the pluses and the minuses of this transaction, especially in response to the stiff financing environment? Or are you going great guns to get it completed? I mean is there any interest rate or any set of circumstances that might give you pause?

James J. O'Brien

Well certainly the external environment has us concerned and we have run several cases to make sure that the interest rate that is being discussed here can be accomplished. And if you look at the transaction, it’s – we’re still very focused on completing the transaction because it’s as I stated the same strategic financial reasons [previously] stated. And importantly to sit there and to speculate what some of the issues you raise is really inconsistent with our obligations under the merger agreement. So from that standpoint, it’s really something that concerns us but it doesn’t really impact our decision.

Jeff Zekauskas – J.P. Morgan

What’s your capital expenditure expectations for the combined entities next year?

Lamar M. Chambers

We’re looking at a capital expenditure that’s pretty broad ranged at this point, depending on how the economic environment shakes out but we’re looking at CapEx at maybe as low as

$200 million for the combined entity and as high up to $300 million. We’re certainly entering the year with a cautious mindset and looking at deferring certain projects until we get more clarity under the economic environment. So our expectation going into the year would be in that $200 to $300 million range.

James J. O'Brien

And Jeff I think probably we’d be best to assume that we’re going to be at the lower end of that range, because obviously without knowing how bad the economy’s going to get and all the issues around cash flow, we are going to have a very, very stringent program this year to conserve as much cash flow as possible. And probably only do the projects that are absolutely necessary.

Jeff Zekauskas – J.P. Morgan

Yes. I think even getting below the bottom end of the range might be something at least to contemplate.

James J. O'Brien

Yes I think that you’re right. We’re looking at a very, very skinny program this year with all the things that we’re going to be facing in the company.

Jeff Zekauskas – J.P. Morgan

Have you seen much change in base oil prices?

James J. O'Brien

There’s been now one announced price decrease of about $0.30 and that one probably won’t be felt for several weeks. But with the – the problem with lube stock today, it’s still tight as far as it’s unit volume. So the pricing I think is naturally because of where crude is it’s going to be downward but there hasn’t been any significant announcements. But certainly there is anticipation.

Jeff Zekauskas – J.P. Morgan

So Valvoline on a sequential basis really came down quite a lot. Is this the 13 sort of a run rate level of earnings for Valvoline or –

James J. O'Brien

What we said in the call is –

Jeff Zekauskas – J.P. Morgan

Forgive me.

James J. O'Brien

That’s okay. It came down substantially because of the way the raw material prices came through and our ability to pass them through. If you recall, going back probably 18 months it was a very similar situation where they had sizable increases. It took about a quarter to get them passed through all the various segments of the market. And then you come out the next quarter fully recovered and you recover back to the margin you had. And what we said on the call is the margins will be reflective of more what you saw in the first eight months versus the last quarter.

So again Valvoline recovers very quickly from the price increases. The market is much more defined and there’s fewer segments to move the price through. So it recovers fairly quickly. So our anticipation for next quarter is fairly optimistic in spite of obviously some tightening of demand because of people driving less.


Your next question comes from Dmitry Silversteyn – Longbow Research.

Dmitry Silversteyn – Longbow Research

First of all I was curious to hear you listing marine market as one of the reasons for the weakness in your businesses. From other companies that participated in the market, my understanding was that the third quarter was still pretty decent for marine. Can you give us a little bit more detail of maybe it’s the segment that you play in or a particular part on the supply chain going into the marine market, but can you give us a little bit more information on what’s going on there?

James J. O'Brien

Sure. It’s probably the way we define marine. We talk about marine in the context of our Performance Materials business and not marine in the sense of moving goods across the seas. If you look at our Drew Marine business it did quite well. So you’re right there that if you’re actually in the business of transportation, it’s still doing well.

What we were describing is the marine business we have through Performance on our composites, where it’s recreational boat is the reference that we made with that portion of the marine market.

Dmitry Silversteyn – Longbow Research

So that’s an economically sensitive segment I would imagine.

James J. O'Brien

Yes, very much so. I mean obviously it’s the consumer and it’s what do they have as far as excess reserves that they have to divide leisure type products and those are being hit quite hard.

Dmitry Silversteyn – Longbow Research

Secondly you talked a lot about the transformation you tried to achieve in Water Technologies and how Hercules hopefully with their Paper Technologies business will help that. As you go through kind of your redefinition of the business model and reach another business model in taking out some service perhaps or doing some other things to simplify the cost structure, what’s the confinitive environment is like?

What are the other players in the industry are doing? Are you facing something specific to Ashland when it comes to the cost structure and the service component? Or is this an industry wide move to kind of simplify or to reduce the service component given that the customers don’t seem particularly willing to pay for it?

James J. O'Brien

When you take a look at the broader industry, I think that Ashland is probably a close follower here as far as what we’re trying to accomplish through our restructuring. Many of the – our competitors have been through this already and we’re trying to get on the same basis of competitiveness. So I don’t think that we’re leading a new way of serving the customers. I think this is something that customers are pretty much driving and demanding as far as how they’re receiving our services and our products and how they want to be served.

So from that standpoint I think we’re consistent with the market. The consolidation between Ashland and Hercules in this area is to help us with scale and I think also broader management structure over the business. So I think that as a combined company, what we’ll bring forward I think are some management skills and opportunities to manage the business differently but what we’re trying to accomplish here in the near term is have the business at least positioned so it’s no worse than as far as its cost structure and its pricing opportunities than the competitive set.

And that’s the work we’ve been doing over the last several months, really over the last 18 months.

Dmitry Silversteyn – Longbow Research

So it sounds like it’s a high probability that you’ll get there in terms of getting this transformation done without much of a market impact in terms of share loss or anything like that.

James J. O'Brien

That’s our anticipation, but nothing’s assured. But certainly the way we’re kind of structuring how we’re going to go to market and the changes we’ve made to the business, I think we’ve given ourselves the highest opportunity to have the least disruption as possible.

Dmitry Silversteyn – Longbow Research

I’m not that familiar with the business but the Valvoline business when you had a decline in the do-it-for-me market of high single digits and I believe you had a 6 or 7% growth in the do-it-yourself portion of the business, is this something that’s been going on for a while and just kind of a market transformation where people are more cost conscious or maybe have gotten a little bit better at changing their own oil? Or is this something specific about the quarter or the season that resulted in declining do-it-for-me revenues and higher do-it-yourself revenues?

James J. O'Brien

What you’re seeing there is the continuation of a trend. The do-it-yourself has been declining really for the last ten years, so you’re right there that this is a trend that’s been going on for some time. And what you saw in the quarter is the DIY customer who is a little more economic sensitive than the do-it-for-me side. And at the same time our balance of oil change and I think the how we go to market is different than our competitors. And our business model is being well received by the consumer.

So it’s a combination of the DIFM is slightly less sensitive than the DIY but we’re I think we’re performing very, very well there and probably outperforming the market, whereas in DIY I think we pretty much represented the market. And that was more representative of the cars declining as far as the miles driven. So it reflected in those numbers for the quarter.

We probably only have time for about two more questions.


Your next question comes from Laurence Alexander – Jefferies & Co.

Laurence Alexander – Jefferies & Co.

Lamar, what do you see as the tax rate running forward for the combined business? And have you outlined the compensation investment implication and how that affected the tax rate this year?

Lamar M. Chambers

Sure. One thing we have said in the past on these calls is we’ve found it challenging to project tax rates accurately, but as far as the long range expectation I think you ought to think in terms of Ashland and Hercules combined with a tax rate in the high 20s to low 30% range. We closed 2008 with an effective tax rate of 33%, which is higher than we would expect even for just the Ashland component going forward by a couple of percentage points.

The reference we made to the market value impact on that, certain of our benefit plans if you will or internal plans, one of which relates to a [Rabbi] Trust has a funding underneath it tied to the market, equities and fixed investments, and as the market went down we take a P&L charge for the client and the value of those instruments. We get no tax deduction for that structured under cash value life insurance program, so it was really a pre-tax effect that had no tax benefit that we were referencing there.


Your next question comes from [Steven Velgard] – FIG.

Steven Velgard – FIG

I had a question about to the extent that you can talk about the negotiations with the banks. Now that both Ashland and Hercules have reported the quarter, is this concerning rates going forward based on your quarterly EBITDA or could you just give us a better idea? I know that there were certain commitments in place regarding the flex schedule, but I’m not sure now that you’ve reported what’s left really in the negotiation?

Lamar M. Chambers

I said nothing that we’ve reported “we are Hercules” in terms of our earnings for this September quarter has any direct implications to the commitments or the flex. There’s been no implications off of earnings or EBITDA’s that would change the financing picture whatsoever.

Steven Velgard – FIG

The interest income in the quarter was only $2 million. Was there some sort of charge in there? Or why was the interest income so low given your cash balances and I know that there’s perhaps an issue with the student loans. But what – why is that so low in the quarter?

Lamar M. Chambers

Within that interest line, there’s some netting of some interest expense that flows through on a little bit of debt obligation we have, as you can see on our balance sheet it is a small amount. But the interest rates on the securities we invest in, the short term instruments has declined significantly. So that’s really the affect you’re seeing in the change in our interest portfolio.

Steven Velgard – FIG

I mean, less than one percent kind of annualized. Is that correct?

Lamar M. Chambers

Just on the investments piece we’re looking slightly at in excess of 2% on average for the quarter for the short term overnight type investments. We have with us in the room here today Kevin Willis, our treasurer. Kevin, do you have any added perspective on that?

J. Kevin Willis

Sure. As Lamar indicated, the amount of interest income that we earn on our portfolio is on a weighted average basis is just in excess of 2% probably for the quarter. In addition some interest expense going through that part of the P&L there are also some other financial costs, if you will, that tend to get captured in that area and those would also net against the interest income number.

Eric Boni

Well we want to thank everyone for your participation on the call and we look forward to talking with you soon. Thank you very much.


Thank you for joining today’s conference. That concludes your presentation. You may now disconnect and have a wonderful day.

Copyright policy: All transcripts on this site are the copyright of Seeking Alpha. However, we view them as an important resource for bloggers and journalists, and are excited to contribute to the democratization of financial information on the Internet. (Until now investors have had to pay thousands of dollars in subscription fees for transcripts.) So our reproduction policy is as follows: You may quote up to 400 words of any transcript on the condition that you attribute the transcript to Seeking Alpha and either link to the original transcript or to All other use is prohibited.


If you have any additional questions about our online transcripts, please contact us at: Thank you!