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Innophos Holdings, Inc. (NASDAQ:IPHS)

Q3 2008 Earnings Call Transcript

November 4, 2008 10:00 am ET

Executives

Bill Farran – VP & General Counsel

Randy Gress – CEO

Richard Heyse – VP and CFO

Analysts

Frank Mitsch – BB&T Capital Markets

Christopher Butler – Sidoti & Company

Jeff Zekauskas – JPMorgan

Mark Connelly – Credit Suisse

Edward Yang – Oppenheimer

Chris Shaw – UBS

Alec Henry – Corsair Company

Richard O'Reilly – Standard & Poor's

Operator

Good day, ladies and gentlemen, and welcome to the third quarter 2008 Innophos results conference call. My name is Madge, and I will be your coordinator for today. At this time, all participants are in a listen-only mode. We will be conducting a question-and-answer session towards the end of this conference. (Operator instructions) As a reminder, this conference is being recorded for replay purposes. I would now like to turn the presentation over to your host for today's call, Mr. Bill Farran, Vice President and General Counsel of Innophos. Please proceed.

Bill Farran

Thanks for joining us today for the Innophos Holdings, Inc. conference call to discuss third quarter 2008 results. Conducting the call today are Randy Gress, Chief Executive Officer; Richard Heyse, Chief Financial Officer; and myself, Bill Farran, General Counsel.

During the course of this call, management may reiterate forward-looking statements made in our November 3rd press release regarding financial performance and future events. We will attempt to identify these statements by use of such words as expect, believe, anticipate, intend and other words that denote future events. These forward-looking statements are subject to material risks and uncertainties that could cause actual results to differ materially from those in the forward-looking statements.

We caution you to consider the important risk factors that could cause actual results to differ from those in the forward-looking statements as contained in this conference call and in our earnings reports and filings we make with the SEC. We will make a replay of this conference call available for a limited time over the telephone at the number set forth in our press release and via a webcast available on the company website.

In addition, please note that the date of this conference call is November 4, 2008. Any forward-looking statements we may make today are based on assumptions that we believe to be reasonable as of this date, and we undertake no obligation to update these statements as a result of future events. We also note that our release of factual business and forward-looking information in this call should not be construed as an offer to sell or a solicitation of an offer to buy any securities of Innophos.

Now I'd like to turn the call over to Randy Gress, CEO of Innophos. Randy?

Randy Gress

Thanks, Bill. Good morning, everyone. I’m very pleased to be able to talk to you about another successful quarter, the third in a row where Innophos delivered record results. Overall, the price increases implemented to anticipate and offset the movements of raw material cost and attempt to achieve full value for our products resulted in a positive impact on revenue of $165 million across all product lines and produced net sales of $292 million. Operating and net income at $113 million and $79.7 million respectively set new company records, as we continue to operate successfully in an extremely dynamic pricing and cost environment.

Third quarter US volumes remained strong and fourth quarter demand outlook remains firm for Specialty Salts and Specialty Acids as well as purified phosphoric acid throughout all of our segments. However, our Mexico segment sales in the quarter were down 37% on volume and mix impacts due primarily to the slowdown in Latin American phosphate fertilizer markets, into which we sell our co-product fertilizer GTSP. In addition, the limited reformulation we saw in the technical sodium tripolyphosphate or STPP market in the detergency area was roughly at the same level as the second quarter. So while present, reformulation did not increase.

Innophos’ core products are primarily sold to consumer product manufacturers, primarily in the food, beverage, detergency, oral care, and nutraceutical and pharmaceutical markets. In 2007, over 60% of our sales were into such consumer non-discretionary markets. Demand from these markets is very consistent throughout economic cycles. And this holds true even in the current environment, as we see consistent demand coming from our core customer base. In some of our markets, such as leavening ingredients, we actually see an increase in demand during slow economic times as people have a tendency to eat more often at home and therefore home baking increases.

However, as you are already aware, Innophos shares a common set of raw materials with phosphate fertilizer producers, and we market a fertilizer co-product that is made in tandem with our purified phosphoric acid process in Mexico. So the recent rapid collapse in fertilizer markets, similar to those that have occurred in other basic materials markets, is very relevant to Innophos and has both a positive and negative implications for us.

For phosphate fertilizer markets, it appears the demand destruction, due to a number of factors including annual price increases exceeding 300%, normal seasonal demand patterns, high customer inventory levels, tight global credit reducing lending to farmers for working capital, and rapidly falling grain prices, have led to a rapid shift in phosphate fertilizer customer sentiment. This is driving extremely cautious purchasing behaviors.

In the world marketplace, during the third quarter, phosphate fertilizer buying slowed dramatically, particularly in South America where a combination of poor weather conditions, increased domestic production, low sales, and large inventories appears to have caused importing of fertilizer to essentially come to a halt during August.

While we are a specialty phosphate producer and not a fertilizer company, this significantly impacted and continues to impact our volume of GTSP co-product sales from our phosphoric acid purification operation in Mexico. It is expected that once high price South American stockpiles are worked off, probably in January, the markets will begin significant purchases again, albeit at much lower prices. Our expectation is that phosphate fertilizer prices will return to approximately 2007 levels, which will result in Q1 2009 price reductions of more than 45% from their peak third quarter 2008 levels.

In the scheme of the total market size, our production is not large. And so we will simply stockpile our production and sell our stockpiles in the first and second quarter of next year. The overall impact of this situation on STPP and other products is that we are expecting a volume decline of approximately 30% on a pure tonnage basis for this product line for full year 2008 versus full year 2007. While we did not see significant Chinese competition during the late 2007 and the first half of 2008, that began changing during the third quarter. It appears that specialty phosphate selling prices have reached levels that may make imports from China competitive again in several overseas markets.

We are committed to our markets and believe our high-quality reliable supply gives us distinct competitive advantage against Chinese competition. To date, renewed Chinese competition has not had a material impact on our business. As we have reported previously, we are in negotiations with our phosphate rock supplier to our Mexican operations, OCP, for 2009 pricing, as well as on the interim price we are still paying for 2008.

Our long-term contract, which will renew for a new five-year term as of September 2010, unless a one-year advance notice is sent by other party, contains a price determination provision by which price is adjusted each year. In the current discussions, the parties have had significant differences as to the meaning of the price clause.

In addition, the fertilizer market often drives parallel changes in key raw materials, including phosphate rock, and the current volatile market makes the negotiation environment challenging for both parties. If the parties cannot reach agreement, the supply contract provides for binding arbitration, which could be initiated by either party. As noted below, we believe the most likely outcome in arbitration is within the range of the estimate we used to prepare our market outlook disclosure.

Now let's go over to the positive side of recent events. The current oversupply of phosphate fertilizers has played a significant role in the collapse of the market price for sulfur. Between September and October, the Tampa market contract sulfur price has dropped over 75% to $150 per ton. Currently, Innophos estimates that the favorable cost impact due to sulfur price decreases essentially offsets our estimated unfavorable impact due to GTSP fertilizer selling price decreases. This, in large part, explains why the spread between anticipated selling prices and cost increases contained in our market outlook disclosure stayed fairly consistent this quarter with second quarter disclosure levels.

Our current estimate is that our annual raw material cost will increase by approximately $320 million to $375 million or by an amount equivalent to approximately 55% to 65% of 2007 annual sales by the third quarter of 2009 as compared to Innophos' year-end 2007 cost structure. This is a significant reduction from the 75% to 85% increase that we were projecting last quarter.

Due to the fact that little or no data on phosphate rock market transactions have been made public recently, our 2009 cost assumptions on phosphate rock prices were left unchanged in order to be conservative. We do believe that phosphate rock and agricultural phosphoric acid prices are also falling, but there is simply a lack of transparency to current market price levels.

During the third quarter, Innophos announced a fixed price increase of 2008 to be implemented in the fourth quarter. Our most recent increase is targeted on the US and Canadian markets. These increases are more than offset by the expected decreases in the fertilizer selling prices I previously discussed. When combined, we expect that Innophos' selling prices entering 2009 will on average be 95% to 105% higher than those of the fourth quarter 2007. What this means is that despite all of the rapid changes in the marketplace, we currently expect to enter 2009 with a net margin increase at approximately 40% of 2007 sales, which is relatively unchanged from the 45% of 2007 sales level we presented in our last conference call.

The combination of strong improvement in margins and expected firm fourth quarter demand for the specialty salts, specialty acids, and purified acids should lead to strong fourth quarter financial performance. This is despite the expectation that we will sell little or no co-product fertilizer in the fourth quarter. When all the factors I've discussed are taken into account, including the expectation of very light GTSP sales, Innophos estimates that its fourth quarter 2008 operating income will be at least $65 million better than that of the fourth quarter of 2007. And we expect to enter 2009 with margins dramatically improved from 2007 levels.

Now, Richard will give you some more details about the quarter.

Richard Heyse

Thanks, Randy. Innophos again produced outstanding financial results in the quarter, with improved pricing, increasing revenues by $165 million on a year-over-year basis. However, volume and mix impacts on revenue had a negative impact of 13.4% or $19.5 million, primarily due to lower volumes in our STPP and other product lines. This is due to reduced demand and over-supplied fertilizer markets and limited detergency reformulation, as Randy discussed. Meanwhile, demand remained strong for specialty salts and specialty acids and purified phosphoric acid in both the United States and Mexico. We believe that we did a good job of optimizing volume and mix in both segments in these products during the quarter.

Operating income for the third quarter 2008 was $113 million compared to $18 million for the comparable period in 2007, primarily due to favorable pricing. Net income for the third quarter 2008 was $79.7 million compared to $5.6 million for the same period in 2007.

Capital expenditures for the third quarter of 2008 were $4.7 million versus $11.0 million in the same quarter of 2007 when the company was investing in a co-generation power plant project on our Coatzacoalcos facility. Given the tightness in several specialty sales product lines, we anticipate increasing our rate of capital investment in 2009.

Our investment plans are expected to increase our 2009 capital expenditures to over $40 million. We anticipate a number of projects ranging in size from $300,000 to $5 million.

We will be focused on projects to de-bottleneck plans and increase production line flexibility. Line expansions in the Specialty Salts and Specialty Acids business will be accomplished by implementing projects that allow us to increase production through more efficient drying and packaging.

In addition, we plan to continue our investment to support FDA Q7A standards at our Chicago Heights facility. Our Q7A qualification enables us to access incipient markets, which require pharmaceutical product certification. Finally, we will begin making significant investments to increase both the capacity of our Mexican food grade acid purification unit and the infrastructure that supports it.

Innophos has been a strong free cash flow generator throughout economic cycles due to our stable markets, excellent cost structure, and prudent investment philosophy. This trait is extremely important during the current economic crisis. Our cash flow generation was exceptional in the third quarter. As of September 30, 2008, Innophos had $123.1 million of cash and cash equivalents. Net debt at the end of the third quarter of 2008 was $259.9 million, a decrease of $81.1 million from $341.0 million as of June 30, 2008. There were no borrowings under the company's revolving line of credit as of September 30, 2008.

The estimate of our March 2009 mandatory bank debt free cash flow sweep payment has decreased to $55 million from our second quarter estimate of $83 million, primarily due to the impact of income tax payments whose forecasted timing has shifted from the first quarter of 2009 to the fourth quarter of 2008. Also the impact of increasing GTSP inventory in the fourth quarter will have an effect on working capital. We currently expect to end the year with a cash balance in excess of $125 million and anticipate maintaining an operating cash balance target of at least $60 million during 2009. Our anticipated year-end net debt level is now expected to be close to $250 million.

Innophos does have a number of cash requirements in the next two quarters so the use of cash in excess of our operating cash target is already planned through the first quarter of 2009. In addition to our mandatory free cash flow driven bank debt prepayment, Innophos' results will drive higher tax payment, particularly the US will consume the majority of its operating losses in 2008. If current profitability levels are maintained, we estimate that income tax payments will exceed $80 million in the next two quarters.

Offsetting the tax payments are decreasing expectations around the need to fund working capital growth in the first quarter of 2009, as the impact of dramatically lower sulfur prices have their positive impact on inventory value. We do not anticipate using our revolver in the first quarter of 2009 to fund working capital growth as we did in early 2008.

Innophos is staying focused on the priorities we set before we went public. Our first priority is to fund investments in our business that create value. The second priority is to rapidly de-leverage Innophos through a combination of earnings growth and debt reduction. The third is to return value to shareholders through a sustained return of capital. Currently, our credit agreement blocks us from increasing dividend levels or conducting share repurchases. Given today's crisis environment, banks are completely unwilling to change such restrictions.

Our focus will therefore be to continue eliminating our bank debt as fast as possible in order to remove those restrictions unless market conditions improve sufficiently to allow an economic refinancing under much less binding condition. We do not see such an opportunity as likely in the next several quarters.

Innophos' team has done an excellent job driving profitability and this competence in combination with financial prudence and frugality has put us in a position where we feel confident in our ability to weather the current credit storm without sacrificing our growth initiatives on our own strong free cash flow.

Now I'll turn it back over to Randy for the closing.

Randy Gress

Thanks, Richard. Particularly, in this dynamic and rapidly changing environment, we are pleased to say today that we can stick to the plan that we have told you about before. We believe we can continue to provide results above historical norms with healthy margins while paying off debt, paying our dividend, and investing to improve our leadership positions in the businesses we know through conservative incremental projects.

We will also look at bolt-on acquisitions, although that is still at least a few quarters down the road. Investing in these projects offers a way for us to build our efficiency and positively impact our competitive position by making incremental improvements to the businesses in which we already lead.

Overall, these improvements will help us to optimize volume and mix, making it easier to protect our competitive position should raw material price pressures continue to ease. We have not changed our strategy to deliver high quality specialty phosphate products and customer service and obtain full value for our products and our efforts. For example, we will be making investments to improve the reliability and capacity of our Specialty Salts and Acid business in 2009.

At the same time, we know that we will have to fluctuate with the market for GTSP since in the fertilizer market we are simply a price taker. In the fertilizer market, both price and volume have become more difficult to predict. It has a positive impact on us in the form of lower overall raw material prices, but also a negative impact of lost revenues.

We will also be watching the fundamental things happening with the phosphate industry structure in China since it could directly impact our technical STPP and technical MAP products. However, with our strong cost structure, high quality products, and reliable supply chain, we are in a very strong position to maintain our market position on a profitable basis against our competitors. While we maintain our competitive position in all sectors of our business, our main focus as always will continue to be providing critical value to our customers through a high level of customer service and technical support, reliable product supply and quality, and continuous improvement of the efficiency and the strength of our supply chain.

Now we will take your questions. Operator?

Question-and-Answer Session

Operator

(Operator instructions) And your first question comes from the line of Frank Mitsch from BB&T Capital Markets. Please proceed.

Frank Mitsch – BB&T Capital Markets

Good morning, gentlemen.

Randy Gress

Hi, Frank.

Frank Mitsch – BB&T Capital Markets

Yes. A couple of questions. Randy, you spoke about the negotiations with the Moroccans and the specter of arbitration as a distinct possibility. Can you talk about previous experiences with arbitration? I'm not quite sure if there has been. And in terms of a resetting of the price, when would you anticipate the impact? Is there a potential for a retroactive impact on pricing here? If you could take a couple of seconds here and update us on that.

Randy Gress

Sure. Just on the, I guess, history of arbitration, we haven't been in arbitration in the past with OCP. We are operating under an interim price for 2008. But even though it could be higher or lower, settle on that, we don't think that any accrual is required for the 2008. As far as 2009 and the negotiations there, as far as the settlement, that could take I guess up to eight months in determination if we do indeed go to arbitration. But again, with the expected range of settlement there, it's well within what we've included in our outlook on pricing.

Frank Mitsch – BB&T Capital Markets

Okay. All right. So it might be a situation where we don't know this for -- until the middle of next year, possibly?

Randy Gress

Yes, possibly.

Frank Mitsch – BB&T Capital Markets

All right. Richard, you mentioned that your debt dropped down to 260 at the end of the third quarter, and I think you were offering guidance of 250 at the end of the fourth quarter. And I would have anticipated with the higher operating income that it might be a bit more than that. Is it simply the cash tax payments and inventories? Or is there -- can you talk about why your expectation for net debt is perhaps not as high as we would have thought the reduction might be?

Richard Heyse

It's in the script. The main reason is that we're anticipating making an estimated tax payment in the fourth quarter for Mexico, where previously we anticipated that tax payment would be made in the first quarter. So that's by far the largest driver of the change. And the change in expectation that we're going to have to build inventory of GTSP during the fourth quarter and so we won't see the cash flow from that due to shipment until the first half of next year. So those two effects really explain the bulk of the change in our expectation on net debt. And the largest one, the tax payment, is simply a timing issue of a payment that is going to shift from the first quarter of next year to the fourth quarter of this year.

Frank Mitsch – BB&T Capital Markets

If you assume that the balance of your -- with the exception of the fertilizer business and your other businesses altogether, I think you indicated you are going to be monetizing that inventory in fertilizers during the first half of the year. Would that suggest that your debt levels would drop meaningfully? And obviously, lower working capital, if you're selling out of inventory, your debt levels will drop meaningfully in the first quarter of '09, is that kind of how we should be thinking about this?

Richard Heyse

Okay, through that total debt, we're going to make the -- we'll make that mandatory cash flow sweep payment. First quarter cash flow for us, typically we have fairly strong outflow. We're still going to have some working capital build due to price resets in some of our contracts. So I would expect first quarter to be more neutral, as we build working capital similar to the first quarter of this year, make tax payments and make the free cash flow sweep payment. So those are all – there is going to be some significant outflows in the first quarter. I think we expect 2009 pattern of cash to be similar to 2008 where we had net cash outflow first quarter due to working capital build and various payments. Second quarter, there was some working capital build, and then we had very strong cash flow in the third quarter, and expect that good cash flow this year in the fourth quarter except for that tax payment. So I think our expectation is 2009 would have a similar pattern.

Frank Mitsch – BB&T Capital Markets

All right, terrific. And then lastly on the cash flow side, you are indicating CapEx next year of $40 million. When would you anticipate seeing a payback on those investments?

Richard Heyse

Typically, we've mentioned on previous calls that our investment standards, we're looking typically for two to four-year type paybacks. I think that's pretty normal for the investments we select, sometimes five on low risk infrastructure-type projects. So we tend to be pretty financially focused. So I would expect our investments will have good financial payback.

Frank Mitsch – BB&T Capital Markets

Terrific. Thank you.

Operator

And your next question comes from the line of Christopher Butler from Sidoti & Company. Please proceed.

Christopher Butler – Sidoti & Company

Hi. Good morning, guys.

Randy Gress

Hi, Chris.

Richard Heyse

Hi, Chris.

Christopher Butler – Sidoti & Company

You seem to indicate a number of reasons for the weakness from fertilizers being inventory, credit issues and then just seasonality. Can we read into that that looking out to 2009 and beyond that you think that the fundamentals for phosphate-based fertilizers remain strong?

Randy Gress

Yes.

Richard Heyse

Yes, Chris, I would think so. And ultimately the fundamental driver for fertilizer value is crop prices. And crop prices are still fairly strong compared to historical trends. I think what's happening now is simply – again, the channel, the downstream channels are clearing themselves of high-cost inventory with the expectation that they're going to get a reduction in price due to sell-through costs going down for phosphate fertilizers. And I think if you look -- we're not a fertilizer business, but if you look at what various trade letters are reporting, the expectation is, in the first quarter, demand will resume in Latin America once the downstream channels are cleared.

Christopher Butler – Sidoti & Company

And you had mentioned that during the quarter there was an impact from the hurricane. I apologize if I missed it in the conversation, but could you help us out by quantifying what kind of impact we're looking at there?

Richard Heyse

It was – we had had a maintenance outage as scheduled, maintenance outage in our Geismar, Louisiana plant in the second quarter. So that had already made our purification plant, had already made our inventories tight. And then when the hurricane went through Louisiana, we had to take some additional downtime. So it wasn't material, but most of our volume difference in purified acid sales was strictly due to the fact that we had to take some downtime in the third quarter due to hurricane and we couldn't make up that production.

Christopher Butler – Sidoti & Company

And as far as sort of shifting back again with GTSP, is there any -- do you have any alternative uses for that? You had mentioned building for 2009, building inventory for 2009. If the rebound is slower than expected, is there any way to transition that co-product to other end markets?

Randy Gress

Yes. At this point, it is a co-product and it's such a relatively small portion of the overall global GTSP market. We don't expect that we won't be able to sell as things recover in the first and second quarter. As far as other opportunities, we are looking at some different alternatives there. But at this point, we'll sell it within the GTSP markets.

Christopher Butler – Sidoti & Company

Thank you for your time. I'll go back into the queue.

Operator

And your next question comes from the line of Jeff Zekauskas from JPMorgan. Please proceed.

Jeff Zekauskas – JPMorgan

Hi, good morning.

Richard Heyse

Good morning, Jeff.

Randy Gress

Good morning, Jeff.

Jeff Zekauskas – JPMorgan

A few questions. If it turns out you have to -- if it turns out there is an issue with the definition of the prices for rock with OCP, is there also an issue with the definition of prices for rock with Potash Corp.? Or does it turn out that those are entirely different events?

Randy Gress

It's completely different events.

Jeff Zekauskas – JPMorgan

Okay, so you and Potash understand your relationship whereas this one is a little bit more problematic? Second question is having to do with GTSP volumes. So, Mexico for the first three quarters has been running, call it, negative 38%. And what you said was that in the fourth quarter you expected to ship little or no GTSP, and in your release you say that you'll be down 30% on a pure tonnage basis for STPP and other products. So, is your GTSP volume down a lot more than 30%? Is that the right deduction to make?

Richard Heyse

No, I think our disclosures -- we disclosed the volume and mix impact on revenue. And so sometimes -- especially with the rate the prices are increasing, when you run those calculations you can get a pretty large number when prices go up on volume and mix. So why we made that disclosure on pure volume was just to clarify the actual year-over-year change in physical volumes. And I think that's pretty much about what we're looking at for GTSP shipments 2008 versus 2007, that they will be about 30% lower shipments for the full year.

Jeff Zekauskas – JPMorgan

So how much are you running for the first three quarters?

Richard Heyse

I think we discussed before, a typical quarter for us would be 40,000 to 50,000 tons. I don't -- first and second quarter, we're probably consistent in that range. Third quarter was a little bit under that, somewhat under that. So the – in the fourth quarter, as we said, it will be pretty light.

Jeff Zekauskas – JPMorgan

Okay. And now just two last questions, if I may. When you look at your operating income, it was roughly $113 million in the third quarter. And if you take your $65 million improvement versus the fourth quarter of last year, you should be at about $71.5 million. So the sequential change is negative $41.5 million. And I guess obviously your sulfur costs are coming down and your rock costs haven't changed. So, is all of that change GTSP and the underlying business is improving, or is the underlying business not improving and only part of that is GTSP?

Richard Heyse

I think on the sulfur costs, as we explained before, we are a FIFO. We use FIFO inventory accounting. So even though the incoming price of sulfur will be going down or has gone down as of October, that effect will take two to three months to work through our costs. So our fourth quarter costs will essentially be based on third quarter incoming sulfur prices, which were very high. So we won't -- we don't expect -- you shouldn't expect to see the benefit of lower sulfur costs until the first quarter. Also, typically our fourth quarter volumes are seasonally slower. So if you're looking at sequential analysis third to fourth quarter typically, again, consumer product companies take shutdowns around Christmas time and Thanksgiving. So we do have some seasonal sequential volume that's fairly normal for us. But all that aside, yes, the -- if you look at third quarter profitability of GTSP shipments versus fourth quarter, then that's clearly going to be a significant decline. But again, we expect to take the volume we produced and ship it early in the first half of next year, albeit at lower prices. As Randy noted, again, this is a compelled product for us, so our cost structure is fairly low. So we anticipate that those sales next year still will be profitable.

Jeff Zekauskas – JPMorgan

Okay. And then lastly, you guys are always so kind as to provide us this price and cost data. And in your outlook, essentially you have that $550 million to $605 million improvement on an annualized basis, which is about $144 million, $145 million in revenue improvement on a quarterly basis. And then you give us the cost increase of $115 million to $135 million. So basically if you take, call it, $145 million and you subtract $125 million, you get a $20 million operating profit as the difference between price and raw materials. But what you say is that your operating profit should be up $65 million, which implies something like $75 million or $78 million in increase in raw materials, not $115 million to $135 million. So can you give us some kind of bridge that links that $65 million number to your pricing number to your cost number, because I can't get the three numbers to really add up?

Richard Heyse

Okay. Well, I think the first thing and the cost number where we say the range is approximately on an annualized run rate about $320 million to $375 million, again, a fair amount as we try to get our disclosure occurs on January 1. We still do have raw material contracts and the prices are going to reset. As far as fourth quarter and the guidance, there are a number of moving pieces. We are -- the cost structure should be relatively unchanged from third quarter. However, again, we're having significant volume falloffs from the GTSP shipments. And we did have -- we are implementing some price increases in our specialty products in the fourth quarter. So it does -- the $65 million is a true guidance, including fixed costs and everything else. Because of the number of moving pieces, we just felt it was easier to provide that overall number. But as I said, the main driver of the falloff is simply the lack of GTSP volume in the quarter.

Jeff Zekauskas – JPMorgan

So maybe another way of reading that $115 million to $135 million cost number is that one has to take that and adjust that for the missing GTSP volumes to get the numbers to work.

Richard Heyse

Yes. And I think that has been occurring throughout the year. So to take that evenly across four quarters, the sulfur costs were -- have been ramping up through the year. And so you simply can't take that $120 million average and divide it by four and say that's the amount in each quarter. Sulfur prices really shot up in the third -- third quarter was the peak at $650 a ton. And so the incoming sulfur prices were high in the third quarter, which will hit our fourth quarter costs. So to really give you an accurate quarterly model, we'd probably have to walk you through how the incoming costs have changed by quarters for sulfur and sulfuric acid.

Jeff Zekauskas – JPMorgan

See, it's funny because when I read that paragraph, I thought that that really had to do with the fourth quarter because I thought what you guys do is you project out four quarters. So you said 35% is supposed to happen in '08, which is really the fourth quarter of '08, and then the balance is going to happen in the first and second of '09 with I guess little change in the third quarter of '09. I didn't read that number as going back into 2008. Historically, I thought it sort of started in the fourth quarter. I guess that's –

Richard Heyse

What we've tried to do is anchor our disclosures starting from the fourth quarter of '07 to be a constant yardstick. And so we're saying relative to fourth quarter '07 cost structure and the SEC, the format disclosure, the guidance they gave is to reach out 12 months forward when you have these types of raw material contracts. So we're trying to say relative to the fourth quarter '07 cost structure, by third quarter of 2009 here's what we see our annualized run rate changing. And then we try to give an indication of how much of that occurred in '08 versus '09, but it's not -- it's not -- you can't take that '08 number and simply flatten it across the whole '08. It's more back-end loaded towards the second half of the year.

Jeff Zekauskas – JPMorgan

Okay, thank you very much. Thanks for your patience.

Richard Heyse

Thanks, Jeff.

Operator

And your next question comes from the line of Mark Connelly from Credit Suisse. Please proceed.

Mark Connelly – Credit Suisse

Thank you. Two questions. If my memory is right, in past quarters you had told us that STPP out of China had declined as a competitive issue and now it looks like STPP is back. Can you give us a sense of what you think is happening over there and whether we should be thinking of China, which does have export tariffs on phosphate and might be moving towards quotas, is going to remain a competitive problem in that market for you?

Randy Gress

I think a few things, Mark. One is from the past there have been here-and-gone type of issues and issues with the reliability of supply for the Chinese products, some of that driven by availability of energy. But also what we have done is increase our prices within the marketplace where we are seeing Chinese exporting STPP in our export markets where there has been some impact, although certainly not material at this point. I think where we have certainly provided a lot of value to our customers is certainly in the reliability of supply where we've been able to meet their needs and also help support them when there have been some disruptions. I think what is going on with China is, one, the reliability of energy supply; and then two, some of the rationalization that has occurred more recently with some of the environmental pressures on the P4 supply situation there. Richard, I don't know if you –

Richard Heyse

I think overall, Mark, the Chinese supplies with time have become less competitive as the government's pulled away their subsidies. But what's been happening is we've been -- especially phosphate prices have been rising and essentially in the third quarter in some regions the Chinese supply was essentially cost-effective again because of rising prices. So I think, as Randy mentioned, we saw it in some of the export markets, South America, et cetera, that the Chinese supply was starting to be cost competitive and more because prices were going up and they could afford to compete again.

Mark Connelly – Credit Suisse

Okay. Okay, that's helpful. A question on the rock side. I mean, we've talked about the contract issues, but can you walk us through conceptually what a decline in rock prices would do to your earnings stream? I mean, you've got long-term contracts. I presume the benefit wouldn't be immediate. But we've seen the benefits of passing through higher rock costs. Are we going to see the negative benefits, if you will, of lower rock costs if that's where we head?

Richard Heyse

I guess as far as rock costs, again, our contract is a bit delayed – has delayed from market prices. And in our disclosure, we've got our expectations on what our rock costs are going to be next year, and we feel pretty comfortable that, as we said, our selling price increases have more than offset those costs. Clearly, we would be benefited if rock prices started trending back down. That would be reflected in our costs, as our contract price resets each year.

Mark Connelly – Credit Suisse

So you don't see any vulnerability to pricing as your costs come down?

Richard Heyse

I think the critical value for us is more market MGA and relative to -- for acid purification. And if you look at purified acid, there tends to be some correlation between market acid prices and purified acid. But also purified acid capacity in the world is getting fairly tight. And so as far as the pressure on purified acid price is due to weakening of agricultural acid prices, we think there is in essence a counterbalance of that simply because there isn't much purified acid capacity in North America or Europe available at this point.

Mark Connelly – Credit Suisse

Okay, that's helpful. Thank you.

Operator

And your next question comes from the line of Edward Yang from Oppenheimer. Please proceed.

Edward Yang – Oppenheimer

Hi. Good morning, guys.

Randy Gress

Good morning, Ed.

Richard Heyse

Good morning, Ed.

Edward Yang – Oppenheimer

Just a clarification. Is the Chinese competition limited to STPP? Or are you also seeing that in salts and acids as well, which I would think is much more differentiated?

Randy Gress

Yes. For the most part, Ed, it's been limited to the technical grade products. I think again just to reinforce some of our strengths, certainly in the food grade and specialty salts, one, it has been a reliability and certainly what we bring in value with the tech service; and two, I think in talking to customers there's still some strong negative sentiment out there against some of the quality issues that the Chinese products have seen especially in the food grade side.

Edward Yang – Oppenheimer

Regarding contamination, you mean?

Randy Gress

Yes.

Richard Heyse

Correct.

Edward Yang – Oppenheimer

And on contamination, even within STPP, do customers care about that? I know the product is mainly used for detergent, but is contamination also a factor there as well?

Randy Gress

For the STPP technical grade, it's more of a reliability issue rather than the quality issue.

Edward Yang – Oppenheimer

Okay. And your last plant outage in Coatzacoalcos was fourth quarter '07. Looking into '09, are you planning one in the second half of '09 or is that going to fall into 2010?

Randy Gress

Right now it's scheduled for the second half of 2009.

Edward Yang – Oppenheimer

And will the dollar impact be fairly similar to what you experienced in 2007? I think there were some one-time issues in '07 that affected the price as well.

Richard Heyse

I think in 2007 there was the terrorist action that blew up the natural gas distribution network in Mexico, which caused wild story, but caused sulfuric acid to get short. So we had to take more downtime simply because we couldn't buy replacement sulfuric acid. That was a terrorist-driven event and we wouldn't expect that to happen again in 2009. So we would expect our 2009 outage to be more routine and the costs more in line with historical numbers.

Edward Yang – Oppenheimer

Okay. And as you know, the currency markets have been extremely volatile. How much of your sales are dollar denominated? And in terms of just geographical distribution, what percentage of your volumes would also be affected by dollar strength, so outside of currency translation as well?

Richard Heyse

Most of our -- phosphates, especially phosphates globally are primarily sold in US dollars. So the vast bulk of our sales are invoiced in US dollars, including our sales out of Mexico. So there's not a lot of exposure to exchange rates as far as the US dollar in a revenue line. We do export, and we're working to expand our exports to Asia and Europe, but those are primarily also invoiced in dollars. Probably the one area where it might have some impact is on some of our marginal export sales where the customer -- in essence, the expense to buy in dollars is perhaps a bit higher. But overall, we don't expect the strength in the dollar to have a significant impact on our business.

Edward Yang – Oppenheimer

Okay. Thank you very much.

Operator

And your next question comes from the line of Chris Shaw from UBS. Please proceed.

Chris Shaw – UBS

Hey, good morning, guys. How you doing?

Randy Gress

Hey, Chris.

Randy Gress

Hi, Chris. Good.

Chris Shaw – UBS

So for your – the GTSP volumes, do you expect them to make up some of it in the first half of '09, or do you still think they will be down? I mean, is it just getting pushed back or do you see actual deterioration?

Randy Gress

Yes, we think we'll be making it up in the first half.

Chris Shaw – UBS

All of it or just most of it, do you think?

Randy Gress

Yes. I think most of it, if not all of it. However, it would be at a lower price, we'd expect.

Chris Shaw – UBS

Right, okay. That makes sense. Do you -- the guidance you were giving I guess both for -- I guess specifically for fourth quarter, sort of, is that including – are you factoring in the new price increases as of October, or are you still waiting to see if those are implemented?

Richard Heyse

Those are factored in our expectation on pricing. So that's based on what our expected realization of those price increases.

Chris Shaw – UBS

Okay. And then I get a little confused the whole -- with your free cash flow and the required amounts of cash. But are you -- would you be able in the -- above and beyond the cash flow sweep for the credit facility, would you -- could you pay that -- given the restraints you gave yourself earlier in the call, could you pay down the full amount of that facility in the first quarter?

Richard Heyse

Would we have cash, the cash on hand to pay it down? It would be pretty close. But as we mentioned, we think it's the right approach for next year is to keep our operating cash levels around $60 million. In the past, our target had been $15 million, and cash in excess of $15 million we'd use to pay down the bank debt. Given today's environment, we think it's better to be prudent and keep at least $60 million of cash on hand. But during 2009, will we have sufficient free cash flow to consider paying the bank debt off, the answer is we believe so.

Chris Shaw – UBS

Okay. And I think someone else might have been trying to get at this, but maybe I'll ask it again. Given your current expectations for more maybe rock prices settle for your contract for 2009, where would then like spot market rock pricing have to go or drop below for you to see decline, say, in your contracts for 2010? Do you know?

Richard Heyse

If you look what's relevant for us is more prevailing market prices in the first half of the year. So if there was significant trend in rock prices in the first half of 2009 over the preceding year, that would drive our -- again, it's a market-based pricing mechanism. So that would indicate that our prices would start moving down.

Chris Shaw – UBS

Can you give us any idea where we should be looking for where that inflection point is, where the market prices in the first half of '09 would have to go to?

Richard Heyse

I think that's part of where the -- we mentioned on our call, there's not a lot of transparency to the rock -- what is prevailing rock market prices and what's being reported at times is the very high spot prices, prompt spot prices, not overall market prices. I think the overall true market prices are significantly lower than those spot prices. But I think the simplest way to look at it is if there is -- I think like fourth quarter, we're hearing reports that prompt rock prices are dropping upwards of $100 a ton, and if that continues in the first half of next year, that would be positive for us.

Chris Shaw – UBS

Okay. Thanks a lot.

Operator

(Operator instructions) And your next question comes from the line of Alec Henry from Corsair Company. Please proceed.

Alec Henry – Corsair Company

Good morning.

Randy Gress

Yes.

Alec Henry – Corsair Company

Two questions. First, how far along are you with your 2009 order book for specialty products? And could you give us some commentary there? And then the second question, when you assume GTSP pricing will be back to 2007 levels, are there different dynamics between that product and, say, the DAP or MAP market? Or is your assumption there consistent with DAP prices going back to 2007 levels as well? Thanks.

Richard Heyse

As far as the process for our order book, I think we're just starting that process, the dialog with customers and what orders and pricing. I think we’ve told people in the past that we have better insight once we get into the year-end conference call in February and March and where things are going to land. So, as Randy said, the demand is still firm. We don't see a falloff in demand, again because we're selling into primarily consumer non-discretionary products. So we don't have anything to immediately believe that it would be significantly different than this year. As far as the second part of your question, GTSP tends to -- it moves with both DAP and agricultural grade acid. And so we think our assumptions are consistent with what we're reading in various trade journals as their expectation of 2009 DAP prices. And we typically try to be conservative in our assumptions and so feel pretty comfortable with our disclosures.

Alec Henry – Corsair Company

But just so I understand, so that's sort of consistent with DAP prices going back to 2007 levels?

Richard Heyse

Yes, yes. Correct.

Alec Henry – Corsair Company

Okay. Thanks.

Operator

And your next question comes from the line of Richard O'Reilly from Standard & Poor's Company. Please proceed.

Richard O'Reilly – Standard & Poor's

Good morning, gentlemen. Thank you. Can you discuss your tax rate? It's moved around this year and I think it's 24%. How should we be thinking about it for the fourth quarter and maybe for '09?

Richard Heyse

Okay. Hey, Richard. Our tax rate, we've got – our Mexican subsidiaries are fully taxpayers and the corporate tax rate in Mexico is about 28%. When you translate that over into a US GAAP basis, that gets you into the low 30%. What's more challenging is our US business has net operating losses, so our effective tax rate is zero. So what happens is as the mix of profit shifts between Mexico and the US, our corporate tax rate moves around a lot. So we really tell people to look at the two entities separately. What would be happening in this fourth quarter is we're working through our US net operating losses. We have accumulated net operating loss of about $90 million from previous years. And we will hit our 382 limitation in the fourth quarter. So we will have some taxable income in the fourth quarter, and then would expect in 2009 that our US businesses are pretty well fully taxable and a typical corporate rate of about 38% is probably right. So overall, when you're looking at the company blended rate between Mexico and the US, it's probably about 34%. It isn't a bad one going forward for assumptions on corporate tax rate. But that rate will move with the mix of profits between Mexico and the US.

Operator

And your next question is a follow-up question from Jeff Zekauskas from JPMorgan. Please proceed.

Jeff Zekauskas – JPMorgan

Thanks very much. In your commentary, you had discussed some possible price declines in price of phosphate rock for '09 on a contractual basis. But I thought your contracts were very much lagged. And so if anything, maybe you would see those benefits in 2010 and 2009 would really reflect sort of the run-up from, I don't know, the early part of '07 to the mid part of '08 or something like that or the early part of '08. Or is that not correct?

Richard Heyse

Well, I think in our outlook, I mean if you look what we said, our costs are going up and that's primarily due to the rock price reset. So rock costs will go up in 2009. But I think what we're trying to answer is, if rock prices trend down from 2008 to 2009, we would see that as a benefit in the 2010 reset.

Jeff Zekauskas – JPMorgan

In the 2010 reset. So in other words, if they trended down so far as to I guess go below where they were at the beginning of '08? Is that the --?

Richard Heyse

And market conditions in earlier 2008. And again, it's a fairly complicated formula. So again, that's why we're having, as Randy mentioned, the discussion with OCP on how to interpret it. But again, we feel that our market outlook disclosure, our calculation of our cost structure for 2009 covers the credible scenarios conservatively of what the outcome is for next year. And again, if the rock prices are trending downward, clearly that would have a – significantly in 2009, that would have a benefit for us in 2010.

Jeff Zekauskas – JPMorgan

And then lastly, I know the toothpaste market isn't the largest market for you, but it's one of those areas where there is some sort of tradeoff between phosphates and silicas. Sort of how has toothpaste reformulation evolved? That is, do you continue to sell more specialty phosphate volume or less volume? Can you give us an idea of how your prices have made a difference to volume, if they have made a difference to volume?

Randy Gress

I think if you look at what we've commented about reformulation, and what we've seen is just really in the STPP and the detergency side and any other markets, really haven't seen anything much in the way of any kind of reformulation and demand has been solid. I think even if you look at just our performance overall in the Specialty Salts and Specialty Acids business, we have shown some good growth in that area with our increased focus. And that's certainly an area that we've targeted to continue to grow and perform well.

Jeff Zekauskas – JPMorgan

And then I guess lastly, I mean, with so many of the companies that we follow as the economies slide into recession, there has been a step-down in demand growth. And for you guys, your specialty salts demand growth has held on very, very well this year. I mean, it seems to be up a few percent. Do you see that being impacted by the recessionary environments in the US and Europe? Or do you think that you'd actually grow volumes next year?

Randy Gress

I think a lot of certainly the base demand and the growth there is because of the heavy concentration, especially in the specialty salts and acids in the non-discretionary purchases. And that's that food, beverage, nutritional and pharma, oral care and detergency area that is pretty solid. And I think you add to that some of what we've done in some of the focus areas, as you've followed us over the years, with the in-sourcing of the pharmaceutical business that we did at the middle of last year, we've shown some real good performance growth as well as taking some of these unique products into the export markets to really strengthen that area.

Jeff Zekauskas – JPMorgan

Okay. Thank you very much.

Randy Gress

You're welcome.

Operator

You have no question at this time. And I would now like to turn the call over to Randy Gress for closing remarks.

Randy Gress

Well, thank you. I really appreciate you joining us for the third quarter results call and look forward to again updating you on our progress in the next quarter. Thank you.

Operator

Thank you for participating in today's conference. This concludes the presentation. You may now disconnect. Good day.

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Source: Innophos Holdings, Inc. Q3 2008 Earnings Call Transcript
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