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Executives

Mark Sutherland - IR

James L. Hambrick - Chairman, President & CEO

Charlie Cooley - SVP, Treasurer & CFO

Greg Taylor - VP, Planning, Development & Communications

Analysts

Jeff Zekauskas - JPMorgan

James Sheehan - Deutsche Bank

PJ Juvekar - Citigroup

Rosemarie Morbelli - Ingalls & Schneider

Laurence Alexander - Jefferies & Co.

Saul Ludwig - Keybanc

Robert Felice - Gabelli & Company

Dmitry Silverstein - Longbow Research

Jeffrey Strong - QVT Financial

Lubrizol Corp. (LZ) Q3 2008 Earnings Call Transcript October 30, 2008 11:00 AM ET

Operator

Ladies and gentlemen, we thank you for your patience and welcome to the Third-Quarter Earnings Results Conference Call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session. (Operator Instructions). As a reminder, today's call is being recorded.

I' would now like to turn the conference over to Mark Sutherland. Please go ahead.

Mark Sutherland

Thank you, Gloria and thank you all for joining us today, October 30, 2008, for a discussion of our third-quarter 2008 results, which were released this morning. We apologize for the slight delay in getting started this morning. The call is being webcast by ccbn.com and it will be available for digitized replay beginning about 1:00 pm Eastern Time today and continuing for the next 30 days.

Our Internet site, www.lubrizol.com, has several supporting documents for this call at the investor relations earnings release page. You can access the presentation entitled third quarter teleconference overview that you can follow along with during today's teleconference. From this site, you can also access the replay and a written transcript of the call.

Also on our site, you will find reconciliations to GAAP financials. Our prepared remarks today include references to non-GAAP financials in our discussions of earnings, EBIT and outlook.

We want to remind everyone that this webcast contains time sensitive information that is accurate only as of today. Any redistribution, retransmission or reproduction of the call without the Company's written consent is prohibited.

Participating in the call with me today are James L. Hambrick, Chairman, President and Chief Executive Officer; Charlie Cooley, Senior Vice President, Treasurer and Chief Financial Officer; Greg Taylor, Vice President for Planning, Development and Communications; and Scott Emerick, our Controller.

James will start today's call with some opening comments. Charlie will then provide his remarks and provide an update on our outlook for the balance of 2008. We will then open the line for questions and discussion.

I need to remind you that some of the information to be furnished in today's session will constitute forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995.

Forward-looking statements are those focused on future plans, objectives or performance as opposed to historical items. We remind you that actual results could differ materially from results projected or referenced in these forward-looking statements.

Additional information concerning factors that could cause actual results to differ materially from those in the forward-looking statements in this teleconference are contained in the risk factors section and the forward-looking statement section of Lubrizol's most recent filings with the Securities and Exchange Commission.

I will now turn the call over to James.

James L. Hambrick

Thank you, Mark and good morning, everyone. Again, I would also like to offer my apologies for keeping you waiting. I know how busy your schedules are this morning. So with no further do, I will keep my opening comments rather brief. I have got two topics that I want to cover. First, a quick look at third quarter and full year results. Secondly, my thoughts on preparing the organization for 2009.

Third quarter results were good considering the circumstances. Volume was strong for additives setting an all time third quarter record and that is despite a two week hurricane shutdown. Advanced Materials volume was down, primarily based on higher relative exposure to the North American and European coatings market weaknesses.

Both segments continued to make good progress in recovering cumulative 2008 material cost increases. We have got more work to do there, but unit margins increased due to good third quarter pricing action execution, positioning us well for the fourth quarter and really for the full year 2008. We did have solid volume in October; we can see the November order book, I would characterize fourth quarter as tracking per plan.

Looking forward, through the remainder of this year and into next year, our priority is going to continue to be focused on maintaining and improving unit margins. We really have to work on this everyday, good margins are essential to earning the appropriate returns and justifying needed investments in technology and plants to serve our customers now and with new change forces in the transportation industry.

And that’s particularly true as we enter a significantly higher cost of capital environment. I do expect that 2009 will be very challenging as lower global growth combines with continued raw material volatility. We’re in the process now of preparing conservative 2009 capital and expense budgets. We will be deferring and eliminating wherever prudently possible without sacrificing our best profitable growth opportunities. And then we will add to or subtract from that base case operating plan as warranted based on how 2009 unfolds.

As I look forward to 2009 and look backwards over the last few years, I would say that we have grown our capabilities and we have improved our performance steadily. The collective strengths of our organization and the demonstrated performance in already difficult environments gives me confidence that, as we finish out this year and go into 2009, we will continue to perform well.

And with that, I will turn it over to Charlie.

Charlie Cooley

Great, thanks, James. Good morning, everyone. I'll start my comments as I usually do on the quarter with a couple of headlines. And then I will get into a more detailed discussion. First, Lubrizol set a new quarterly record for consolidated revenues thanks to the combined impacts of price and mix, currency and volume, particularly from the Lubrizol Additives segment.

Second, Hurricane Ike took a big bite out of earnings performance for the quarter. Our two additives facilities in Texas were closed for approximately two weeks as a result of the storm. We estimate that Ike impacted pre-tax earnings by approximately $17 million or about $0.18 per diluted share due to unabsorbed overhead, some minor repair costs and delayed shipments. If not for Ike, we estimate that we would have reported results in line with the analysts' estimates following our second quarter call of $1.16 per share.

And third, as we will review shortly in the segment discussion, we saw solid sequential improvement in unit material margins for both segments thanks to the price actions taken to address the significantly higher raw material and operating costs.

If you are following along with the PowerPoint presentation on our website's investor/earnings release page, I am now on slide four where you can see the consolidated earnings for the third quarter of 2008 compared with the year-ago period. As a reminder, all references to earnings per share will be on a diluted basis.

This morning, we announced that consolidated earnings for the third quarter of 2008 were $63.2 million, or $0.92 per share, including restructuring and impairment charges of $0.06 per share, primarily related to the closure of a Lubrizol Additives blending facility in Canada and business improvement initiative in our Performance Coatings product line.

Consolidated earnings for the third quarter of 2007 were $71.4 million, or $1.02 per share and included restructuring and impairment charges of $0.02 per share, primarily related to the impairment of a production line supplying businesses that were divested in 2006. When we exclude the restructuring and impairment charges in both years, adjusted earnings of $0.98 per share for the quarter decreased 6% when compared with the third quarter of 2007.

The primary drivers of the consolidated earnings decline were higher raw material costs, higher manufacturing costs, the impact of Hurricane Ike and increase in selling and administrative expenses and an increase in the effective tax rate. These unfavorable factors to earnings more than offset the positive impacts of an improvement in the combination of price and product mix favorable currency and contributions from our 2007 refrigeration lubricants acquisition.

In spite of Ike and excluding acquisitions, we experienced slightly higher volumes compared to the prior year quarter. As I noted earlier, we estimate that Ike adversely impacted third quarter 2008 earnings by approximately $0.18 per share. About half of this was due to unabsorbed manufacturing costs since production was curtailed for approximately two weeks, as well as incremental maintenance and repair costs.

The balance of the storm's impact on third quarter results was attributable to shipment delays. Most of these delays were for North American customers and we fully expect to make the majority of these shipments in the fourth quarter of 2008. We do not expect to lose any business due to this temporary interruption.

Turning to slide five, consolidated revenues increased 22% from the third quarter of 2007 to $1.36 billion. Compared with the year ago period, improvements and the combination of price and product mix increased revenues by 17%. Currency had a 3% favorable impact to revenues and volume increased 2%.

Included in these factors was the incremental impact from last year's refrigeration lubricants acquisition, which contributed approximately 2% to consolidated revenues in the quarter. Gross profit rose 3% in the quarter as the higher revenues more than offset higher raw material and manufacturing costs. Both segments contributed to this increased performance primarily through the timely implementation of price increases.

STAR expenses increased 4% compared with the third quarter of 2007. Research and testing expenses of $56 million in the quarter approximated the prior year period while selling and administrative expenses increased 7% to $111 million. The increase in these expenses primarily was due to higher expenses associated with our SAP implementation in the Advanced Materials segment and an unfavorable currency impact, which were offset partially by lower variable incentive compensation expenses. Compared to the third quarter of 2007, we estimate the impact of currency to be a favorable $0.14 per share based on our calculation that compares actual results to pro forma results when translated at the prior period exchange rate.

Adjusted EBIT, which excludes restructuring and impairment charges, declined approximately 2% in the quarter to $113 million. Net interest expense was $18 million in the quarter, approximately $3.5 million higher than a year ago, largely due to reduction in interest income.

Turning to taxes, earnings as adjusted for restructuring and impairment charges were taxed at an effective rate of 29.5% in the quarter as compared with 27.6% in last year's third quarter. Last year's rates benefited from the resolution of some tax matters from prior years. A 29.5% tax rate for the third quarter is lower than forecast in our July guidance largely because of the tax favorable improvement in geographic earnings mix.

And now will turn to segment results, which are shown starting on slide six. Revenues for the Lubrizol Additives segment in the quarter were up 27% year-over-year on 4% higher volume approximately half of which was provided by the 2007 refrigeration lubricants acquisition. A combination of price and product mix improved revenues 20% and currency contributed 3%.

Volume for Lubrizol Additives established to new record for our third quarter. Asia Pacific volume was up 19% and Europe was up 13% increases in both regions are generally attributable to stronger customer demand. Volume in North America declined approximately 11% as the result of the hurricanes' impact, lower customer demand and the introduction of more concentrated products.

If we include in the quarter, our estimates of the delayed shipments caused by Hurricane Ike, the North America volume decline would have been less than 4%. Latin America volume was off 2% as this region also was impacted by the Hurricane. Unit material margin is one of our primary metrics for measuring price increase success. It is calculated as material margin dollars per unit of products sold.

In our ongoing effort to restore unit material margin to more acceptable levels that justify capital reinvestment and in the wake of significant raw material and operating cost increases, Lubrizol Additives has implemented four price increases since the third quarter of 2007. Our most recent price increase was announced on July 3, for implementation in the third quarter.

In last quarter's earnings call, we projected that third quarter unit material margin would exceed the level we saw in mid 2007, a period that preceded the recent rapid run up in material costs. In the quarter, Lubrizol Additives' unit material margin did indeed improve sequentially and compares even more favorably to mid 2007 levels.

With the recent price increase now being fully implemented, we forecast fourth quarter unit material margin to grow more substantially. And while we are very pleased with the margin improvement, we still have not yet recovered fully the margin dollars lost during the recent run up in raw material costs. As James noted, sustaining the current margin level and recovering the lost margin dollars will remain a major focus for us.

Segment gross profit improved 3% to approximately $181 million as improvements and the combination of price and product mix, higher volume, favorable currency and contributions from the 2007 acquisition more than offset higher raw material and manufacturing costs. Raw material costs increased 34% in the quarter compared with the year earlier period.

Segment operating income increased 1%, primarily as a result of the improvement in price mix, higher volume, favorable currency and the contribution from the refrigeration lubricants acquisition, which more than offset the impacts of higher raw material and manufacturing costs.

Turning to the Lubrizol Advanced Materials segment on slide 7, third quarter revenues were up 10% over last year. The increase reflected a 12% favorable impact from the combination of price and product mix a 2% favorable currency impact and a 4% decline in volume. The increase in price mix reflected pricing actions across all product lines and regions.

Unit material margin was 12% higher than last year's third quarter and increased 6% sequentially. While Advanced Materials unit material margin has improved significantly, we have not yet recovered fully the recent increases in raw material costs. Recapturing this lost margin will continue to be one of the segment's major priorities going forward.

Reviewing segment volume by region, volume in North America was down 8%, primarily due to general weakness in our performance coatings product line that was offset partially by record volume in TempRite engineered polymers, which had very strong sales of commercial water, industrial and fire sprinkler products.

Segment volumes in Europe, were down 4% and were impacted by weak coatings market and the slowdown at some of our Noveon consumer specialties global customers in the region. Volume in Asia Pacific was up 20% due to strong customer demand in our performance coatings and TempRite businesses.

I will now go into the Advanced Materials product line in a little more detail. The Noveon consumer specialties product line had revenues of $115 million up 12% from the third quarter of 2007. The increase primarily was due to improved price mix and favorable currency as volume was down 1%. Surfactants volume, which makes up two thirds of the volume in this product line, was down 3% due to a strategy to shed low margin business.

Liquid Carbopol products continued their excellent performance with 22% higher volume. Worldwide powdered Carbopol volumes were flat with the prior year quarter due to reduced demand. Revenues in the performance coatings product line were $138 million, up 1% from the third quarter of 2007. The product line continued to experience weakness in the North American and European textiles and coatings industries, but had strong volume growth in Asia Pacific. The product line achieved a 12% increase in price mix and continued to make progress on its business improvement plan.

As a final comment on coatings, we expect the initial phase of our new production facility in China to be operational in the second quarter of 2009.

The engineered polymers product line consisting of TempRite and Estane engineered polymers reported revenues of $169 million in the quarter, up 18% from the third quarter of 2007. Estane revenues increased 5% from the third quarter of 2007 due to higher pricing and favorable currency, which more than offset a 5% decline in volume.

In North America, after double digit volume increases in the first half of the year, volume in the third quarter was flat with 2007. Asia Pacific volume was down 12% due to softness in demand around the Olympics time period reduced orders for Chinese military applications and weak demand in the electronics industry.

TempRite revenues rose 31% on 18% higher volume and a 13% improvement in price mix. As I noted earlier, we had record volumes in our North American commercial water, industrial and fire sprinkle products, as well as double digit increases in all international regions, particularly China -- particularly India, the Middle East and China.

Total North American CPVC volume was up 7%, mainly due to purchases in advance of price increases that were effective at the beginning of the fourth quarter. Thanks to the higher volume and the two global price increases announced in the second and third quarters the TempRite business experienced a significant increase in operating income.

Advanced Materials' segment gross profit improved 5% to $103 million in the third quarter as improvements and the combination of price and product mix and favorable currency more than offset the volume decline and increases in raw material and manufacturing costs. Advanced Materials' segment operating income in the quarter decreased 8% from the third quarter of 2007 the consumer specialties and TempRite businesses delivered strong year-over-year earnings growth.

The Estane product line showed a decline in operating income due to the slowdown in its markets in North America and Asia Pacific. And the weak North American coatings and construction markets continued to impact performance coatings, which also had a decline in earnings from last year.

The third quarter segment results also included $2.5 million of incremental IT expenses versus the third quarter of last year, mostly related to our SAP implementation. So, excluding the incremental SAP spending Advanced Materials' operating income was even with last year.

Looking forward, we maintain our outlook for a significantly improved fourth quarter compared to the prior year fourth quarter, thanks in particular to the pricing momentum that we have established and the continued impact of our business improvement initiatives.

I will now comment on several other financial items noted on slide 8. Corporate expenses were $17 million in the third quarter of 2008. Essentially unchanged from the prior year period as the favorable impact of the mark-to-market effects of the stock based incentive compensation plan for international participants was offset by increases in salaries and benefits costs.

We generated $183 million in cash flow from operations in the first nine months of 2008 down from $407 million in the same period in 2007. This decrease in operating cash flow was driven by the higher dollar value of our working capital this year driven by higher raw material costs and higher product selling prices.

In 2007, cash flow benefited from our initiative to reduce inventories, as measured in days, our working capital continues to be well managed and is at levels similar to last year. Regarding our uses of cash in the quarter, capital expenditures were $49 million. We paid out dividends of slightly over $21 million and we repurchased 475,000 common shares for $25 million.

Given the status of the credit markets, I would like to comment on our cash and liquidity position, which is shown on slide 9. Our cash balance at September 30, 2008 was $372 million compared with $502 million at December 31, 2007. We plan to use some of these cash to retire $200 million of debt in December.

At September 30, we also held $50 million in the reserve primary fund. During September, this fund froze all distributions due to liquidity constraints. Although we gave our redemption notice prior to the fund closing, we have not yet received our distribution. The fund is being liquidated under the supervision of the SEC.

At September 30, this amount was classified as investments, the majority of which is included in current assets. We have two revolving credit facilities, a $350 million revolver that expires in September 2011 and a EUR250 million revolver that expires in September 2010. Both facilities were undrawn at September 30.

While we believe we have access to ample liquidity, we think its prudent to suspend our share repurchase program for the time being. In looking ahead, we have $382 million of debt maturing on October 1 of next year. In anticipation of refinancing that maturity, we recently filed a shelf registration with the SEC.

And now I will turn to our outlook on slides 10 and 11. Our outlook is premised on an expectation of continued economic softness in North America, as well as in some of our European and Asian end use markets. Our only update to guidance reflects a slight increase in full year restructuring and impairment charges. We maintain our previous guidance for EPS as adjusted.

Our updated guidance is $4.19 to $4.34 per share including, $0.24 per share for restructuring and impairment charges. The last page of the teleconference presentation provides an outline of these charges, which relate to the improvement initiatives in our performance coatings product line and the planned closure of our Canadian additives blending operation.

Our reaffirmed guidance for adjusted earnings, excluding restructuring and impairment charges is in the range of $4.43 to $4.58 per share, which is a 9% to 13% increase in adjusted earnings compared with 2007 results.

Here are the updates to our key assumptions, consolidated revenue growth of approximately 17% and consolidated adjusted EBIT growth of approximately 10% compared with 2007. For Lubrizol Additives, excluding acquisitions, we are projecting approximately 2% to 3% volume growth for the year. For Lubrizol Advanced Materials, we now project volume contraction of approximately 4% due to general demand weakness in North America and Europe, as well as shed of business associated with our performance coatings restructuring activity.

We are modeling unit material margin in both segments to continue to improve in the fourth quarter. We are projecting net interest expense of approximately $68 million. We have revised downward our effective tax rate assumption for the year to 30%, largely as a result of the October enactment of the US Research Credit Extension retroactive to January 1, 2008. And in our model, we assume the euro to average $1.39 for the fourth quarter. As of this morning, the euro was trading at approximately $1.30. So as a sensitivity if the euro were to average $1.30 for the remaining two months of the quarter, we would have headwinds of approximately a penny per share.

The key updates to our cash flow outlook are shown on slide 11, and these are capital spending is now projected to be between $205 million and $215 million, down slightly from our earlier guidance and we continue to assume a working capital build in excess of $200 million for the year due to higher inventory values and selling prices, as well as our plans to maintain security of supply for our customers.

And now I would like to conclude by saying that despite the effects of the hurricane and the enormous economic uncertainties out there, we are pleased with our operating and financial performance in the quarter and we remain cautiously optimistic that we will have a strong fourth quarter.

And now, Gloria, we can open it up for Q&A.

Question-and-Answer Session

Operator

(Operator Instructions) And we'll go to line of Jeff Zekauskas with JPMorgan. Please go ahead.

Jeff Zekauskas - JPMorgan

Hi, good morning. Can you hear me?

James L. Hambrick

Yes.

Jeff Zekauskas - JPMorgan

You said that you thought that your margins in lube additives would widen in the fourth quarter. I take it that’s because you expect your average prices to move up from the third-quarter level to the fourth quarter level. So what is the magnitude of that? So your prices were up 20% this quarter. So are they up 22% or 24% next quarter? What’s the magnitude?

Charlie Cooley

Let me answer your question, Jeff, in terms of the unit material margins because, as we have been saying, that's our main way of looking at improving the profitability in all of our businesses. Whereas the sequential improvement in material margin -- unit material margin for additives going from the second to third quarter was a couple of percent, the outlook for fourth quarter unit material margin versus third is more like 11% improvement. And this is reflecting the full rolling in of that July 3 price increase. And I will add while I'm on it, and this is even with an expectation of slightly higher raw material costs going into the fourth quarter from the third.

Jeff Zekauskas - JPMorgan

Okay, secondly, I am looking at your volume table for additives and your overall additives look like they are up 2%. But I look at the volume changes and I can't get it to really put in that maybe North America is 25% larger than Europe and so maybe there is a slight negative variance between North America being down 11% and Europe being up 13%, but Asia has got to be at least three times the size of Latin America and you are up 19% there. So when I look at these volume changes it, looks like it is much more than 2% or flat or whatever as you reported.

Charlie Cooley

Well, the largest market is North America and so when it declines in the magnitude that it did, it will heavily influence the global volumes for lube additives. The kind of percentage increases that we have been reporting or reporting for this year quarter in Europe and Asia Pacific are comparable to the kind of growth we have seen now for the last several quarters. So it is just reflecting continued success with those customers in those parts of the world but those numbers do balance.

Jeff Zekauskas - JPMorgan

And lastly, you said that you bought 475,000 shares I think at $25, and you spent $25 million, so you bought them at $52 a share. Your outlook is I guess the same as you thought it was, but you are suspending your share repurchase now that the stock is at $34. Do you think that that’s -- do you think that that is a prudent thing to do?

Charlie Cooley

Fair question. And as you know, Jeff, we’ve been asked this question during the course of the year, asking why our share repurchase program has been as kind of methodical and systematic as it has been. We have never viewed the share repurchase program as primarily being a tool of making a call on our share price. Rather we see it as a way of balancing our use of cash and adjusting capital structure. It’s lost on no one that we are in unprecedented times as a relates to the credit market and we simply think it’s improvement – it’s prudent to preserve cash, preserve our liquidity. As James noted in his comments, we are approaching 2009 with a very keen eye towards controlling capital spending and expense. This is all about maintaining the strong financial help that we have enjoyed for years. So it’s suspended temporarily and we’ll look for an opportunity to get back into a share repurchase mode.

And let me just come back to your volume question, Jeff, actually the European market has actually become the number one volume zone for lubricant additives surpassing the North American zone. So I think with that perspective that probably makes those relative volume changes by region maybe more understandable for you.

Jeff Zekauskas - JPMorgan

I would think it would make it less understandable because Europe was up 13% and North America was down on 11%.

Charlie Cooley

Those volume gains that we have seen over the last couple of quarters in Europe or what has enabled it to get to that level.

Jeff Zekauskas - JPMorgan

Okay. Thank you very much.

Operator

And next we’ll go to the line of James Sheehan with Deutsche Bank. Please go ahead.

James Sheehan - Deutsche Bank

Thank you. It looks like you had a nice acceleration in TempRite revenues and also the volumes that were up 20% in Asia. Do you think that this kind of performance is sustainable given the weaker macro environment?

Charlie Cooley

This is Charlie. I will tackle that; it’s fair question, actually, as we look at our outlook for the fourth quarter, TempRite is one of the businesses which we look to show good sequential and year-over-year improvement. We actually are looking at pretty solid year-over-year volume growth in TempRite.

Having said that, I think there could be some risk to our outlook just because the underlying markets, construction markets, particularly North American housing have been a challenge. But the real strong story the TempRite over the last couple of years really has been -- the terrific market penetration and growth that TempRite has achieved in the non housing area, specifically commercial and fire sprinkler applications. So it has been seeing really good differential growth there. So the volume outlook for fourth quarter for TempRite at this point is looking good, as well as similar to the lube additives story. The pricing actions that TempRite business has taken over the last several quarters should show up at the bottom line in the fourth quarter.

James Sheehan - Deutsche Bank

Okay. And can you also comment on how long you think you can maintain lubricant additive pricing following this week's $0.40 drop in base oil prices given the weaker demand environment we are now seeing?

James L. Hambrick

This is James. We really are -- I am sorry to be this way. I am trying to teach you all a lesson. We are not -- we are focused on margins and that’s the way we manage it internally that’s the way we manage it with our customers, and that’s the way we are going to manage it with you. So it’s not really about finished good pricing and raw material pricing, it is about the spread between those including the operating and energy cost to convert them. And We’ll continue to manage that spread.

James Sheehan - Deutsche Bank

Okay. And finally, just on the powder to Carbopol, the slowdown in volume there. Can you give us some more color on what was driving that?

Charlie Cooley

Yes, this is Charlie. As I noted in my remarks, we have seen some reduced orders from our large global customers, particularly in Europe, as well as in North America. I think that is an indicator of overall economic conditions perhaps at the end use level. Consumers kind of going down a market in terms of the types of products that they are interested in paying for. But over all the personal care portfolio both the liquid and cut powdered combine continued to perform very well. It is one of our strongest product lines.

James Sheehan - Deutsche Bank

Okay, thanks a lot.

Charlie Cooley

Yep.

Operator

And next we’ll go to the line of t PJ Juvekar with Citi. Please go ahead.

PJ Juvekar - Citigroup

Yes, hi, good morning.

Charlie Cooley

Good morning.

PJ Juvekar - Citigroup

Charlie, lubricant volumes, US was down 4% and Europe was up 13%. Is it just that Europe is lagging behind the US or is there something going on regionally that separates US from Europe?

Mark Sutherland

I think this is the problem Jeff was having, Charlie. We have quoted two different figures for North America. So maybe you were clear that up.

Charlie Cooley

Yes, North America is down 11%, but if you exclude --

PJ Juvekar - Citigroup

Yes, I excluded the hurricanes.

Charlie Cooley

-- hurricanes it was more, a little less than 4% volume decline. I think it is safe to say, correct me if you are confused -- that the impacts of economic softness on lube demand has showed itself earlier in North America than it has yet to show itself in other parts of the world.

James L. Hambrick

PJ there is another -- actually a couple of other effects here there is a product mix effect. Our technology is particularly strong in the diesel area, so Europe is a higher proportion of diesel power plants that tends to be a mitigating factor. Additionally, a portion of the strength of our European business has been based upon growth in Eastern Europe and former Soviet Union. And frankly that has continued. Now the question is what kind of lag will begin to take effect here as that part of the market cools a bit, and it surely will. But so, I think your analogy is right there is a little bit of a lag, but there is also some secular strength from a product mix point of view.

PJ Juvekar - Citigroup

Okay. Okay. And Charlie you said that you had $0.14 per share gain from foreign exchange in the quarter. And I think towards the end you quantified the impact of strengthening dollar, I think you said $0.01 but I could be wrong on that.

Charlie Cooley

Thanks. What I was trying to get there is that when I gave the guidance, PJ, for the remainder of the year I said our model is based on EUR1.39, which might strike some as may be being a bit high. And when we put our model together that was workings were. Today the dollar or euro relationship is more like $1.30. And if that relationship were to hold for the remaining two months of the quarter relative to the guidance I gave you earlier, that is about a penny headwind.

PJ Juvekar - Citigroup

Right. I know it’s changing daily, but how are you looking at 2009? Nobody knows where the dollar is going to end up, but let's assume that it sort of continues in this range.

Charlie Cooley

Yeah, gosh, I mean, I think any question whether it is currency or demand or anything in terms of outlook for '09 we are just going to kind of stand back and not say anything. It is anybody's guess.

PJ Juvekar - Citigroup

Okay. Understand, and just finally, one quick question. Do you have a sense of what inventory level is of lubricant additives at your customers?

James L. Hambrick

Our sense is that inventory levels are not high that would be our sense, generally speaking not high. It is also our sense that as predictions, forecasts for global economic growth rates dropping people will naturally --. I mean you are coming to the end of the year, there is always a natural tendency to bring inventories down. That will occur somewhat then there is the '09 forecast will put a little additional pressure on that. So that is basically the way I see it, PJ.

PJ Juvekar - Citigroup

Okay. Thank you very much.

Operator

And next we’ll go to line of Rosemarie Morbelli with Ingalls Schneider. Please go ahead.

Rosemarie Morbelli - Ingalls & Schneider

Good morning all. Just following up on the last question regarding the dollar versus the euro, let's assume that the dollar stays at $1.30. What would then be the impact on -- would have been the impact on '08 which will allow us to have kind of a feel for what it would have been what it could be in 2009?

Charlie Cooley

Let me just give you just a rule of thumb; maybe this will be helpful to you. For a full year impact, a percent change in the dollar/euro relationship is about $0.02 a share on earnings. So maybe you can -- then you can maybe make your own assumptions as to where you see the euro/dollar exchange rate being in 2009.

Rosemarie Morbelli - Ingalls & Schneider

Okay, that is helpful. Thanks. And in your manufacturing cost increases, I know you had the impact of $0.18 per share, what did the manufacturing costs go up as well once you exclude the impact of Ike and what was the reason?

Charlie Cooley

Yes, the answer is yes. Manufacturing costs were up and some of the drivers there have been factors that we have been living with for quite some time, and in fact have been the basis for price increases and I am speaking specifically about the cost of utilities, as well as outside supplies and services. We’ve noted in past calls that the cost of contract labor and materials, particularly in the US Gulf Coast and in Europe, has gone up considerably and so these are additional costs that have showed up in our manufacturing line that have also been the basis for our trying to recover in selling price increases currency was also a factor.

Rosemarie Morbelli - Ingalls & Schneider

Okay. And so following up on that given the difficult environment of slower demand and I am thinking particularly of Advanced Materials. Do you think that you can continue increasing prices or the competitive environment is such that you may not be able to recover all of your additional costs?

James L. Hambrick

We have every intention and are properly positioned to recover all of the raw material costs that we have incurred, so there is not any question about that. But with respect to our ability to give you at this time a look at what margins do and what impact that has on ’09, we are not prepared to do that right now.

Rosemarie Morbelli - Ingalls & Schneider

And do you expect to lose, are you willing to lose volume? Do you have a lot of lower margin volume that you are willing to give up in order to get the margin that you are requiring? And do you have a feel for that amount of business that you are totally happy to walk away from?

James L. Hambrick

And if I answer that question yes, are you then going to ask me how much it is and where? I mean Yes, ma'am, we have a plan. That is as far as I am going to go and we have a plan.

Rosemarie Morbelli - Ingalls & Schneider

Okay. Thank you.

Charlie Cooley

Rosemarie, for example, in the personal care area, we noted that in the surfactants area, which is a low margin part of our portfolio, we saw some volume decline there and that was business was we walked by.

Rosemarie Morbelli - Ingalls & Schneider

As we in coatings, same thing.

Charlie Cooley

Coatings same way. In fact, part of our restructuring activities in the Performance Coatings product line has been about exiting certain markets and product lines that don't meet our margin requirements.

Rosemarie Morbelli - Ingalls & Schneider

Okay, thank you.

James L. Hambrick

Then I would just say -- I am sorry to interject here at the last moment, but I would -- it is really a great opportunity to again make the point for all listeners that this strategy is one we have employed really across every product line. Actually Lubricant Additives was the first one to take it out and lead the way in selectively trying to manage a product and margin with essentially fixed capacity. How do we maximize the margin generating capability of fixed asset capacity? So this is something that is prevalent across every product line and we will continue to focus on that.

Rosemarie Morbelli - Ingalls & Schneider

Okay, thank you.

Operator

And next we’ll go to line of Laurence Alexander with Jefferies. Please go ahead.

Laurence Alexander - Jefferies

Good morning.

James L. Hambrick

Good morning.

Laurence Alexander - Jefferies

I guess first question just on working capital, can you sort of flesh out your current thoughts on your opportunities to reduce working capital over the next 12 to 18 months?

Charlie Cooley

Sure, this is Charlie, Laurence, I will take that. Just I'll kind of go maybe line by line on the balance sheet starting with receivables. As we have been talking quite a bit in this call receivables is heavily driven by our pricing levels and it is our intention to maintain pricing so as to maintaining the material margin. So when you think about the accounts receivable line, I would expect that that is likely to kind of remain where it is and any benefit that might result from unit material margin growth, you will see in the P&L, not in the balance sheet. With respect to inventory, and it is really sort of an inventory accounts payables interplay, if you were to assume that the cost of raw materials were to kind of remain flat or go down, you could think about the impact on cash flow as basically being the absence of the cash flow consumed that we have seen in 2008 as we were building the dollar value of our inventory due to higher material costs. So there is something on the order of $170 million or so of cash flow that, out the door, that we would presumably not see and we would be able to retain in free cash flow if raw materials remained where they are or declined.

And finally, let me just make a point, the opportunity for working capital or inventory reduction in terms of days of inventory is probably not there in that we have been very focused on maintaining inventory levels so as to assure an adequate supply for our customers.

Laurence Alexander - Jefferies

And then I guess to follow up on that, if given your relatively strong balance sheet free cash flow profile possibility to work down working capital potentially if raw materials come back. How are you looking at the M&A opportunities that the current depressed valuations marketplace are giving you?

Charlie Cooley

Well, it’s Charlie again. We remain active looking at opportunities. I will say that they are on the small to medium sized side. We do though need to be very mindful of the fact that valuations in the marketplace today I think clearly have come down and so it often comes to a determination as to whether buyer and seller can come to a mutually agreeable conclusion on things. I would overall characterize though in terms of the outlook of M&A as being probably not particularly active going forward just because of the very uncertain times and our desire to be very cautious with our cash flow on our balance sheet.

Laurence Alexander - Jefferies

And then I guess just lastly, the uncertainty that you have on 2009 appears to extend to the Additives segment as well and I guess if volumes were to come under pressure in Additives and actually be negative year-over-year, what’s your confidence level of being able to manage to the unit margin such that margins don't come under pressure as volumes due to negative fixed cost absorption?

James L. Hambrick

Laurence, I have tried to talk to this a number of times over teleconferences as materials have gone up and I have talked about the pricing being artful as opposed to quantitative, the need to look at both situations, etcetera, etcetera all trying to connect it takes a fair amount of intimacy to manage this on the way up and it is no different on the way down. And again, the way to focus on it is not on one side or the other, but really to stay focused on the margin and there is every reason to believe that we will be able to maintain that.

I do want to go back and just make mention, however, on the comment that you made -- I am not sure that maybe you heard or understood the answer Charlie was trying to give you about working capital. We don't actually see the ability to generate additional free cash flow as a result of working capital coming down. And so the notion that we are going to have some extra money to do M&A, I don't really see that as something that is really in the cards for us.

Charlie Cooley

Other than if you were to see a repeat of our cash flow statement in '09, you wouldn't see that cash going out the door as you saw in '08.

Laurence Alexander - Jefferies

Right.

James L. Hambrick

But it wouldn't be related to working capital. The cash flow would actually be -- as Charlie said, it would come through the P&L.

Laurence Alexander - Jefferies

Right.

James L. Hambrick

Other questions?

Operator

We'll go to line of Saul Ludwig with KeyBanc. Please go ahead.

Saul Ludwig - Keybanc

Well, good almost afternoon.

James L. Hambrick

Hi Saul.

Saul Ludwig - Keybanc

Charlie, the STAR expenses were up $7 million in the quarter. They were flat, obviously, at corporate. I assume that $7 million would have all been in Advanced Materials. A, is that correct? And B, if you think about STAR expense at Advanced Materials for the full year, how much are they spending for the SAP system and does that end at the end of the year? Thus, whatever you spent becomes a positive delta for next year?

Charlie Cooley

The first answer to your question, the bulk of the STAR increase was in Advanced Materials. And Saul, I don't have a number of the top of my head for you for the SAP component. As we look into 2009, we would expect that there be a decline in SAP spending, but I don't have a number. That would be the kind of guidance I give you in the February conference call.

Saul Ludwig - Keybanc

You gave us $2.5 million of spending increase in this quarter.

Charlie Cooley

In the third quarter, right.

Saul Ludwig - Keybanc

And it had been running up all year if I recall.

Charlie Cooley

Yes, I think at the beginning of the year, our guidance for '08 versus '07 was an incremental $10 million of SAP spending in 2008 versus 2007.

Saul Ludwig - Keybanc

So, if that were the case, would that reverse itself next year and go down to $5 million so to speak?

Charlie Cooley

Yes, it will go down. I really don't have a number for you, but it should go down. 2008 is the peak spending year for SAP. We plan to go live in Europe next spring and so there will be spending related to the go live of the Europe implementation, but that will be less than what was spent in '08 associated with the North American go live.

Saul Ludwig - Keybanc

Looking to corporate expense in the fourth quarter, Charlie, assuming the stock price stayed where it is today, which would be down sharply from its end of the third quarter price, would that result in a reversion of incentive comp accruals and cause corporate expense to be significantly lower in the fourth quarter than it was last year? So, how are you thinking about corporate expense in the fourth quarter?

Charlie Cooley

The corporate expense -- our assumption for incentive compensation going forward is assuming a $35 -- excuse me -- a $43 share price. So that is high relative to where it is now, so there might be some expense released and so some STAR upside in the fourth quarter relative to our guidance.

James L. Hambrick

We are still optimistic though that following this call, we might close that gap.

Saul Ludwig - Keybanc

Okay. And Charlie, how are you handicapping this thing with the Prime Reserve fund. $50 million is a lot of money and a lot of other companies are in the same boat. What are they telling you? What are the potential outcomes here? And granted, whatever you say is your best guess, it is not for sure, but how are you thinking about it?

Charlie Cooley

Yes, I think a lot of the information related to this is public and people can go and look at it directly. We provided our redemption notice before the fund closed and so I feel we are certainly well positioned relative to other people who have yet to receive their distributions.

It is under the control of the SEC. Our understanding is that they are looking to distribute funds from the fund in an orderly way so as cash actually -- as investments convert to cash then the fund will be in a position to pay out distributions. I probably can't go any further than that.

The reason why we reflect the majority of the fund as current is because the majority of the fund's maturities are very short-term and would anticipate those to roll off over the coming weeks and months. The bottom line, Saul, is at this point, it is not something that concerns us. We have sufficient liquidity and so we are just going to wait for the issue to resolve itself. So, the massive fund, we are a small player in that large fund and there is a lot of attention being paid to it by a lot of people.

Saul Ludwig - Keybanc

And finally, for James, in the recent reorganization, the functions of operations and R&D were basically moved to report, I think, directly to you and were not within the different segments. What is it that you are looking at for that to help you with as we go forward and how are you going to be able to assess whether that is really working?

James L. Hambrick

Well, I think the architecture that we have, Saul, have had to this point has been really two reasonably autonomous business units with a set of corporate shared service functions providing capabilities to those business units. Things like finance functions, HR functions, IS functions. We are in the process of a pretty massive and you talked about it in your earliest question -- with a fairly robust SAP upgrade of the Advanced Materials segment that really allows us to begin to look at not two separate business units, but really one overall operating function.

To really take advantage of that, you really need to line up the operating function and the IS function really as corporate service functions in order to be able to maximize efficiency across the businesses. I have a secondary reason for wanting to make that change and that is to tie the innovation function of corporate research and development function with the day-to-day commercial function of the business enterprises themselves.

So very, very lean, efficient operating infrastructure on the one hand and very customer oriented and innovation oriented work by the business groups on the other and so it is a little bit of a separation of duties here in order to focus better across multiple dimensions.

And I really want to do this right now when we are in the midst of enough economic uncertainty that I don't really know what is going to happen in the outside world specifically, but that is no reason not to take advantage and work inside the Company to improve our overall efficiency and that is the reason I decided to make the change right now.

Saul Ludwig - Keybanc

Okay. Thank you very much.

James L. Hambrick

You are welcome.

Operator

And next we'll go to line of Robert Felice with Gabelli & Company. Please go ahead.

Robert Felice - Gabelli & Company

Hi, guys, most of my questions have been answered, just a couple more. If I remember correctly on the second quarter call, you had pointed to the sequential improvement in Advanced Materials earnings, as a sign that perhaps things were stabilizing, leveling off. Yet this quarter obviously showed both a year-over-year and sequential decline and you did a nice job calling out the higher SAP expenses and some of the items there. I was hoping you could just take a moment to delve a little deeper into how things differed, James, versus your original expectations. What was better, what was worse?

James L. Hambrick

Actually, Robert, Charlie covered that pretty well when he went through his detail kind of product line by product line and so I don't want to repeat all the work that he did, but I would tell you that when I made that statement, I had a view that, one, Advanced Materials' unit margins would follow roughly the same contraction and expansion pattern that additives was going to follow and I missed that a little bit. I also missed, I really thought that we were at the bottom volumetrically and in fact, I knew we were going to continue to shed volume in coatings selectively, but we had some additional contraction beyond that as a result of additional North American and European market weakness that I didn't call out in that earlier assumption. That really is the difference.

Charlie Cooley

And I would just build on that. This is Charlie. The two product lines that came in less than we anticipated in the third quarter, Coatings surely is the largest of those, volume, as well as margin pressure and also higher raw material costs in personal care was a factor and going back to my outlook for the fourth quarter, those are both product lines that we are looking at continued improvement in unit material margins to address those cost pressures.

James L. Hambrick

And having said all of the above, of course, Robert, when I made those comments in our last teleconference, I was really taking a pretty broad view in terms of being able to characterize. I really think we have lined out, we are kind of at the bottom. If I missed it by a quarter, I apologize to you, but I would actually repeat that statement now. I really do feel like we are there.

Robert Felice - Gabelli & Company

Okay. So, I guess, it is not typically your practice to talk about 2009 during this call, but broadly speaking, having just said that you think that this quarter was the bottom, as we look to next year, obviously, there is a lot of moving parts, but should we expect improvement off of this level here? Should we think that despite the economic headwinds and the uncertainties that exist you can deliver earnings improvement?

James L. Hambrick

Yesterday afternoon, actually yesterday morning I sat for the better part of two hours with the Advanced Materials team, Charlie and I and Greg Taylor, Dan Willey, the CFO; Eric Schnur, the President and others and we went through multiple plans, referred to as A, B and C primarily as kind of base cases looking at scenario plans for 2009 by product line, by segment. That work is -- and I've got a half an inch of paper here and spreadsheets in front of me. I am not going to tell you what I see other than the fact that we are doing that work and I feel pretty confident when I tell you I really am optimistic about 2009 that that should suffice for right now.

Robert Felice - Gabelli & Company

Okay, that's very helpful. And then, I guess, lastly, and I am not sure if I am remembering this correctly, but I originally remember you saying that the new facility in China should be on in the first quarter, and if I heard correctly now, it is the second quarter. Any specific reason for the pushback there?

James L. Hambrick

Yes, sir. Actually, a couple of reasons and just to be kind of full disclosure, the first time I really talked about that coatings plant in China, I indicated that we would start it up actually in the fourth quarter of 2008. It would be near the end. The second time I talked about it I actually -- I hedged a little bit and said, well, we are going to go through the pre-commissioning late in the fourth quarter and I expect it will start up in the second -- excuse me -- in the first quarter of '09. And now we are actually saying we are going to do that pre-commissioning work in the first quarter of '09 and really get it started up and running in the second quarter.

Two reasons for that, that slippage. One, scope change. As we have watched the market evolve and we have looked at the changes in our business plans, as we have revised our coatings strategy to focus on narrower markets and stronger product lines as a result of shedding lower margin volume and closing down plants, we have changed the scope of that plan.

Second reason is, construction costs and delays in China are notoriously prevalent and we have experienced some of that. We have also experienced an inability to get electrical lines laid in. We have had a whole host of engineering and construction related delays, which are just part and parcel of doing that kind of work in that region of the world.

Robert Felice - Gabelli & Company

Now given the fact that you have altered the scope of the facility, have you altered your expectations as to some of the savings you will get out of that? I know you had talked about that once that facility came up, you'd save quite a bit as a result of producing out there and not shipping from other regions of the world?

James L. Hambrick

Actually, Charlie gave a growth rate. I think it was about 13% or 14% growth rate in China in the coatings area. Our business is growing out there and this is about savings, but frankly, Robert, it is really more about competitive position. Frankly, in many cases, we can't get product out that far and so it is less about savings and it is more about the ability to take advantage of the market presence that we are building out there.

Charlie Cooley

A lot of the products that we are talking about have high water content and it is very expensive to ship them distance. So, the profit opportunity is to be able to be in country manufacturing these products and we are off to a great start with the top line and volume growth and so what the plant will do is enable us to sell these products at higher margins.

Robert Felice - Gabelli & Company

Okay, great. Thanks for taking my questions.

Charlie Cooley

Thank you.

Operator

And next we'll go to the line of Dmitry Silverstein with Longbow Research. Please go ahead.

Dmitry Silverstein - Longbow Research

Good afternoon, gentlemen. Most of my questions have been answered, but I do want to touch base again on the Carbopol portion of Advanced Materials. I understand the reasons for the powdered Carbopol volumes to be flat, but I am actually pleasantly surprised that liquid Carbopol is still posting such strong 20% growth in year-over-year volumes. Is this a market penetration driven growth? Is there product substitution driven growth or is there a particular geography or a customer that you are hooked up with that seems to be doing so much better? I would have thought that, as the economy got weaker and your penetration of the market has gotten greater, that the growth would slow down.

Greg Taylor

This is Greg. I will try and take that question. Actually, Charlie commented the Carbopol -- powdered Carbopol down a little bit because of consumer choices. The liquid is a very easy to use product. It is being adopted quite rapidly and in some cases, it is a substitute for the powdered Carbopol. So, we have seen good solid growth there.

Dmitry Silverstein - Longbow Research

Okay. So, this is a newer formulation for you that is cannibalizing the old form, as well as continuing to take market share from other alternatives?

Greg Taylor

Exactly.

Dmitry Silverstein - Longbow Research

Okay. So, we can expect this type of growth to go on for quite a bit and really underpinning the performance of the consumer specialties segment?

Charlie Cooley

That's certainly our goal.

Dmitry Silverstein - Longbow Research

Okay, very good. And then, on TempRite, that business has recovered from first half of the year and actually from, I guess, the beginning or end of last year as you got away from our special construction and more into commercial and sprinkler. This used to be a predominantly North American residential construction type of business. Has the mix changed to the point where residential construction is becoming less of a driver for this business?

And secondly, can you give us an idea of what is driving your ability to get pricing in this business? Is it a fact that copper alternatives are still higher priced than CPVC alternatives or is there something specific about the CPVC market that is allowing you to get these types of price increases?

Charlie Cooley

I'll take a stab at it. It's Charlie. First off, on the relative importance or dependence on the US housing market, the proportion of TempRite volumes that have gone into particularly single family North American residential housing has declined consistently almost quarter-to-quarter. It is now below 30% of total TempRite volumes that go into that market. And that has been replaced by international growth in general, as well as the expansions of fire sprinkler and commercial applications that we have talked about before.

In terms of pricing, this is a product, whether you are talking about residential housing or commercial or fire sprinkler, the value proposition of chlorinated PVC is relative to competing steel and copper applications remains very strong and so that would naturally lead to some decent pricing power that the TempRite products should have. So that is what you're seeing.

Greg Taylor

And even a stronger value proposition, as you get into commercial size applications over residential.

Dmitry Silverstein - Longbow Research

So obviously, the value proposition is the combination of product pricing, as well as installation speed and ease. As pricing for copper and steel comes down potentially next year, how resilient do you think your pricing will be for CPVC in that environment?

Charlie Cooley

I think it is still going to be very resilient because there is actually a third element too. It is lower cost material, it is cheaper to install, but also in many of its applications, it is higher performing than the competing metal application. So, all of those should help increase penetration over time.

Dmitry Silverstein - Longbow Research

Okay. Thank you very much.

Charlie Cooley

Thank you.

Operator

And next we'll go to line of [Jeffrey Strong] with QVT Financial. Please go ahead.

Jeffrey Strong - QVT Financial

Hi, thanks for taking the question. I wanted to come back to the currency and just make sure I properly understood what you said. The sensitivity to currency is $0.02 per share in earnings versus a $0.01 per share change in the Euro?

Charlie Cooley

Sorry. 1% change in the Euro on an annual EPS basis was $0.02.

Jeffrey Strong - QVT Financial

Okay. So, if the Euro changes by 10%, we are looking at $0.20?

Charlie Cooley

Yes.

Jeffrey Strong - QVT Financial

In EPS? Perfect. Thank you. And are there any other currencies that you are particularly exposed to, any of the Asian currencies?

Charlie Cooley

That is the main -- the main currency is the Euro. We are exposed to Sterling, to Yen, to a number of other currencies, but primarily Euro.

Jeffrey Strong - QVT Financial

Okay. Are the products that are sold into Asia denominated in euros as well?

Charlie Cooley

No, no. A lot of our -- is in dollar pricing or local currency. A lot of our international sales in Additives are dollar priced.

Jeffrey Strong - QVT Financial

Okay, great. And then on the -- earlier, you referred to a couple of things that explained the difference between the volumes in the US and Europe. I guess it broke down into -- there is somewhat of a lag, but there is also the secular impact. Is there any way to quantify what the share or how much more of the diesel you sell in the Europe market versus what you sell in the US? Is there any way to quantify kind of the secular component?

James L. Hambrick

There is. His name is Mark Sutherland. You can call him for a follow-up call. He'll be glad to take you through all the details.

Jeffrey Strong - QVT Financial

That sounds good. I will do that. Thank you, guys.

Mark Sutherland

And thank you, James.

James L. Hambrick

You are quite welcome, Mark.

Operator

And there are no additional questions in queue at this time. Please continue.

Mark Sutherland

Yes, well, Gloria, we have given the time and everyone's patience in waiting for us to get started today, since there are no other calls, I would like to thank everyone for dialing in and provide two telephone numbers for follow-up. One is my direct line for clarifications and the second will be the dial-in number for telephone replay. My telephone number is 440-347-1206 and Gloria, could you please provide the replay telephone number?

Operator

Yes. Ladies and gentlemen, this conference will be available for replay starting today at midnight through November 30. You may access the AT&T teleconference replay system at any time by dialing 800-475-6701 and entering the access code 963371. International participants may dial 475-800-475-6701 and entering the access code 963371. That does conclude our conference for today. Thank you for your participation and for using AT&T Executive Teleconference Service. You may now disconnect.

James L. Hambrick

Thank you. And I would like to thank everyone and conclude the call.

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Source: Lubrizol Corp. Q3 2008 Earnings Call Transcript
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