LSB Industries, Inc. Q3 2008 Earnings Call Transcript

| About: LSB Industries, (LXU)

LSB Industries, Inc. (NYSE:LXU)

Q3 2008 Earnings Call Transcript

November 6, 2008, 5:15 pm ET

Executives

Carol Oden - IR

Jack Golsen – Chairman and CEO

Tony Shelby – CFO

Barry Golsen – President and COO

Analysts

Eric Prouty – Canaccord Adams

Rick Hult – Roth Capital Partners

Dan Mannes – Avondale Partners

Steve Denault – Northland Securities

Ali Motamed – Boston Partners

Bruce Geller – DGHM

Operator

Good day everyone and welcome to the LSB Industries, Incorporated Third Quarter 2008 Conference Call. At this time, I would like to inform you that this conference is being recorded and that all participants are currently in a listen-only mode.

I will now turn the conference over to Ms. Carol Oden. Please go ahead, ma'am.

Carol Oden

Thank you. Welcome to the LSB Industries, Inc. third quarter 2008 conference call. Today, LSB’s management participants are Jack Golsen, Chairman and Chief Executive Officer; Barry Golsen, President, and Tony Shelby, Chief Financial Officer.

This conference call is being broadcast live over the Internet and is also being recorded. An archive of the webcast will be available shortly after the call on our website at www.lsb-okc.com and will be accessible for one month. After comments by management, a question-and-answer session will be held. Instructions for asking questions will be provided at that time.

Information reported on this call speaks only as of today, November 6, 2008, and therefore you are advised that time-sensitive information may no longer be accurate as at the time of any replay. We do not intend to and undertake no duties to update the information contained in this conference call.

Comments today may contain certain forward-looking statements. All statements other than statements of historical facts are forward-looking statements. Statements that include the words expect, intend, plan, believe, project, anticipate, estimate and similar statements of a future or forward-looking nature identify forward-looking statements, including but not limited to, starting up our Pryor, Oklahoma chemical plant, obtaining our long-term offtake agreement for the production at the Pryor plant, cost to activate the Pryor plant, production plans at the Pryor plant at approximately 120 million annual sales, we are in a strong position to finance operations, as well as growth opportunities, capital expenditures for expansion, optimistic about the long range potential for our geothermal products, demand for our acids and ammonium nitrate, emphasize cost reduction while developing products and customer mix that will allow us to operate our chemical plants at full rate, the outlook for commercial construction for this years and future years, prospects for growing the Climate Control business, outlook for a strong ag market, the general level of future activities positions LSB to improve and grow its economy, allow liquidity as a company, impact of gas hedged contracts in the fourth quarter and future quarters, effect of economic slowdown in our Climate Control business and construction industry, sections under the Economic Stability Act of 2008 and effects on our Climate Control business, long range growth of geothermal products, cost reductions, outlook for our chemical business is good, and prospects regarding our Climate Control business is good.

The term EBITDA as used in this presentation is net income plus interest expense, depreciation, amortization, income taxes, and certain non-cash charges unless otherwise described. You should not rely on forward-looking statements because actual events or results may differ materially from those indicated by these forward-looking statements as a result of a number of important factors.

These factors include but are not limited to decline in general economic conditions, interest rate changes, competitive pressures, changes in working capital and the risk and uncertainties discussed under the heading Special Note Regarding Forward-Looking Statements in our Annual Report on Form 10-K for the fiscal year ended December 31, 2007. The Form 10-Q for the quarter ended September 30, 2008, and the reports we filed from time to time with the Securities and Exchange Commission. We do not intend to and anticipate no duty to update the information contained in this conference call.

The term EBITDA as used in this presentation is net income plus interest expense, depreciation, amortization, income taxes, and certain non-cash charges unless otherwise described. EBITDA is not a measurement of financial performance under GAAP and should not be considered as an alternative for GAAP measurement. We will post on our website a reconciliation to GAAP of any EBITDA numbers discussed during this conference call.

Now, I'll turn the conference call over to Mr. Jack Golsen, the company's Board Chairman.

Jack Golsen

Thank you, Carol. Good afternoon, everybody, and welcome to LSB's third quarter 2008 conference call.

Today, Tony Shelby, our Chief Financial Officer and Executive Vice President will review our overall financial results. Then Barry Golsen, our President and Chief Operating Officer will discuss both the Climate Control and the chemical businesses. Following these presentations, Tony, Barry and I will be available to answer your questions.

With everything that's taking place in our economy, any indications we give you about the markets we serve are subject to the return of stability in the credit and capital markets. Our businesses have continued to have good order levels and our backlogs are strong at this time. We do see indications that the general level of future activity will be less than has been in certain areas.

We are convinced that even if the short or medium term general economy turns out to be negative, we are doing the right thing to position LSB to improve and grow as the economy and our markets allow. We did not anticipate the current financial crisis that our country is experiencing, but fortunately the steps that we have previously taken have resulted in us having liquidity, the need to continue with the investments required for our planned long-term growth. Our general approach is to conserve cash to use to fuel our growth plans.

When you analyze the numbers behind our third quarter results as we have reported them in our new release this afternoon, they were better than they appear. In last year's third quarter, there were tax benefits. This year, our earnings are fully taxed. During last year's third quarter, we recognized income of 4.8 million from a litigation settlement and insurance recoveries. This did not recur this year.

This year's third quarter was a perfect storm of detracting events. Tony will break down the details on these events for you in a few minutes. During the third quarter, our chemical's operating income was adversely affected by $10 million due to unexpected plant maintenance downtime, loss of commodity markets and hurricane related delays. When we discussed the Pryor plant with investors during the prior conference call, we mentioned that we were considering activating a portion of the Pryor Oklahoma plant subject to securing a sales agreement with a strategic customer to purchase or distribute the majority of UAN production.

We believe that we will be able to reach an agreement based on our discussions with several strategic industry customers. Based on that belief and our expectation that we will receive the necessary permit, we have rehired key personnel to operate this facility and have positioned the additional necessary personnel to be hired at appropriate intervals during the preparation to startup.

We have hit an administrative delay with obtaining the necessary permits to operate the Pryor plant. We expected to receive permits last month but it now looks like issuance of the final permit could be delayed up to 90 days due to administrative procedures. Therefore, we are proceeding with preparations to start the plant. Barring unforeseen delays and subject to securing a sales or distribution agreement, we expect production to be implemented by July 2009, which at today's prices, we believe will add approximately $120 million in annual sales. We can expect this sales number to fluctuate according to market conditions.

We are also considering the addition of industrial products to our production at this plant and are discussing this possibility with industrial users of anhydrous ammonia, nitric acid and solutions. The above sales numbers do not include these additional products.

Before turning the call over to Tony, a few points are worth mentioning. On October 28, our shares began trading on the New York Stock Exchange, we have the same stock symbol LXU. As we announced last month, we renewed long-term supply agreement with two of our large customers, Bayer MaterialScience for nitric acid and with Nelson Brothers for ammonium nitrate solutions. We welcome Northern Securities to the list of firms that follow LSB in research. And finally in the October 27 issue of Forbes Magazine, LSB was ranked number 27 among America's best small companies.

Now, I will turn this call over to Tony Shelby. Tony?

Tony Shelby

Thank you Jack and good afternoon. We made our earnings announcement approximately one hour ago reporting diluted earnings per share of $0.18 for the third quarter of 2008 versus $0.77 in the 2007 third quarter. The details for the third quarter of 2008 compared to third quarter 2007 were:

Sales rose to $210.9 million, up from a $147.6 million. Operating income was 8.7 million as compared to 19.1 million. Net income applicable to common stock was 4.2 million compared to 18.1 million. Diluted earnings per share were $0.18 versus $0.77 for the same quarter. Consolidated EBITDA was 12.8 million compared to 23 million.

Before proceeding to a review of the year to date results, there are some significant unusual items in the third quarter operating income and net income of both years affecting our comparability that require some explanation. First of all, the 2007 quarter including gains totaling $4.8 million pretax from a litigation settlement and a business interruption claim. Second, although new customer orders and market demand were good during the 2008 quarter, pretax operating income was reduced by unusual loss items totaling $10 million that lowered the operating income and income from our Cherokee Facility, primarily the result of volatility in natural gas prices and unplanned maintenance downtime.

Those unusual items, which were included in the third quarter 2008 cost of sales were

Unrealized non-cash losses of $4.9 million on natural gas futures contracts. These contracts secured the profit margin of customer orders with current sales process to be shipped after September 30 of 2008. Approximately 2.6 million of these mark-to-market write downs will be recovered in the fourth quarter if shipments are made in the fourth quarter as scheduled.

Also included in the third quarter 2008 cost of sales were $5.1 million of cost related to unplanned downtime of the ammonia plant at the Cherokee Facility. This cost included losses incurred to purchase ammonia at high prices to replace the loss production for already fulfilled firm sales commitments.

To summarize, operating income before unusual items in the 2008 third quarter would be 18.7 million compared to 14.3 million in 2007, or a $4.4 million increase in the 2008 third quarter. These numbers are reconciled to GAAP operating income in our press release and in our 10-Q. Comparability of net income between the two quarters was also affected by income taxes. Approximately $3.9 million or $0.17 per share of the quarter-over-quarter difference in net income was due to the fact that we had a tax provision or expense of $2.4 million in the 2008 quarter, whereas in the 2007 quarter, we recorded a tax benefit or income of $1.5 million. The benefit in 2007 was a result of reversal of certain valuation allowances and a recognition of the differed tax benefit.

In 2008, we had little or no net operating loss carry forwards going into the year. During 2008, we had accretive paid income taxes at regular corporate tax rates. Income taxes are more fully explained in our SEC filings.

Our Climate Control business performed well during the third quarter. Climate Control sales were $83 million or 10% higher, operating income increased slightly to $9.8 million and EBITDA of $10.6 million was approximately the same as last year's third quarter.

We were disappointed with the reported results of the chemical business for the third quarter although chemical reported sales of 124.5 million compared to 69.3 million and operating income decreased to $1.9 million and EBITDA decreased $4.6 million for all the reasons that I mentioned earlier.

At this point, I will review the year-to-date results for the nine months ended September 30, 2008 as compared to the same period in '07. Sales were $569.4 million, up from million $451.8 million. Net income applicable to common stock was $32.7 million compared to $36.7 million, a decrease of $4 million. However, provision from income taxes in 2008 were $19.8 million as compared to a benefit of $1 million in 2007. The explanation of this $20.8 million increase in tax provision for the year-to-date is the same as I explained earlier this third quarter discussion.

Diluted earnings per share were $1.40 versus $1.67 last year. Consolidated EBITDA was $59.2 million compared to $58.5 million in '07. LSB's trailing 12-month EBITDA at 9/30/08 was $84.4 million compared to $67.7 for the trailing 12 months of 9/30/07.

Over the past two years, we have substantially improved our balance sheet and liquidity. Our current liquidity and capital resources reflect a sound financial position in our opinion. At September 30, 2008, our long-term debt was $123.5 million, the stockholder's equity was $128.5 million. Long-term debt to stockholder's equity was approximately 0.96 to 1, less 1 to 1. We have two interest rates swaps in place fixing three month LIBOR through March 2012 on $50 million of blended interest rate of 3.42.

At September 30, 2008, we had cash on hand of $47.5 million plus borrowing availability on working capital revolver of approximately $50 million. We have adequate working capital to finance ongoing operations as well as organic growth opportunities based on our present outlook.

During the three months ended September 2008, net cash provided by operations were $6.3 million including increases in account receivable inventories of 10.7 and $5.9 million respectively due to raw material cost increases, sales increases and seasonal inventory requirements.

Net cash flow was approximately break even. Cash used for capital expenditures were $7.7 million and cash payments to income taxes were $7.2 million. Capital expenditures for the quarter included $1.1 million for Climate Control and $6.5 million for chemical. Year-to-date capital expenditures for Climate Control and Chemical were $6.3 million and $16.3 million respectively.

Our current commitment for the remainder of 2008 is $7.9 million including $2.4 million for Climate Control and $5.5 for process improvements in chemical. In addition, as Jack discussed earlier, we are considering other expenditures related to the activation of the Pryor Oklahoma facility.

That concludes the financial review. Barry will now cover the operational highlights of the third quarter and outlook for the company.

Barry Golsen

Thanks, Tony. First let's discuss the Climate Control business. As Tony mentioned, our Climate Control business sale during the third quarter were higher than the same period last year by 10%. Total heat pump sales were up 21%. Fan coil sales were down 5% and other sales were down 6%.

As discussed in prior conference calls, our shipments in the first half of 2007 were unusually high because we were in the process of working off excessively high backlogs. Despite these high sales levels in 2007, our year-to-date sales this year were still higher than last year by 4%.

New product orders during the third quarter were $101 million, 53% year-over-year increase, 34% increase over the second quarter, and the highest bookings quarter in history of our Climate Control business. Year-to-date as of 9/30, our order in take was 247 million, up 31% over the first nine months of 2007. This trend has continued. In October we received new product orders totaling 27.5 million. We ended the quarter with a backlog of product orders of 86 million, up from 54 million at year end. I am glad to report that as of the end of the third quarter, we continue to maintain leading market shares with geothermal and water source heat pumps and for hydraulic fan coils.

Our gross margin during the third quarter this year was 29.9% approximately the same at 29.7% for the same period last year. With regard to raw materials, primarily copper, steel and aluminum, since our last conference call, we've seen considerable volatility. Prices increased through the third quarter. Recently, raw material prices have declined. We continue to watch commodities very closely and to hedge when appropriate.

Even though our gross profit increased by 2.5 million, our operating profit showed only marginal improvement over the third quarter of 2007. This was due to higher variable sales cost associated with sales volume increases, higher legal and insurance costs and higher personnel cost associated primarily with intensified sales and marketing efforts.

A key question that we are asked frequently is, what's the outlook for construction both commercial and residential? Due to the trauma caused by the worst financial crisis in decades, which is still unresolved at this time, the availability of credit to our customers going forward is still a question. So, with the assumption that credit availability will stabilize, I will attempt, let me repeat and emphasize, attempt, to discuss the current outlook.

The vast majority of our Climate Control business sales are to commercial and institutional new construction renovation and replacement. Year-to-date through 6/30, commercial and institutional sales accounted for approximately 84% of our total Climate Control business sales. 74% of our total Climate Control business sales were used in offices, hotels, educational facilities, healthcare and retirement facilities, manufacturing and process plants, apartments and condominiums. McGraw-Hill's current outlook as we reported in the 2008 Ware edition of their construction market forecasting service is that contract awards for these building types in the aggregate will increase by 0.8% in 2008 and will decrease by 9.9% in 2009 followed by increases of 5.3% and 14.3% in 2010 and 2011. These numbers represent an upward revision for 2008 since the last conference call, a downward revision for 2009 and 2010 and an upward revision for 2011.

I would like to emphasize again that McGraw-Hill's forecast is predicated on the credit market stabilizing in the near future. Input from our sales force is that the current pipeline is strong but that certain markets have been hit hard. There is hesitancy by some customers to proceed with new projects and some projects have been put on hold.

The market that seemed to be the hardest hit are New York City; banking and financial industry and office buildings, Las Vegas; large casino hotels and condos, and Florida, primarily condominium. Because it’s an area of interest to many of you, I would like to discuss our residential geothermal sales. It's stating the obvious to describe the dismal situation the single family residential construction market is in. The current McGraw- Hill forecast is for a 36% decline in 2008. This is following a cumulative decline of almost 40% during 2006 and 2007. It’s important to focus on the fact that in 2007, our sales into the single family residential market, which for us is all geothermal heat pumps represented only 11% of total Climate Control business sales.

Year-to-date through 9/30 our residential geothermal business was 16% of climate control business sales. Despite the lagging residential market in general, our third quarter residential geothermal sales increased 149% over the third quarter of 2007. Even more encouraging were bookings for these products. During the third quarter, they were up 261% over the same period last year. Year-to-date, as of 9/30, our residential geothermal bookings are up 150% over the first nine months of last year. To put it another way, both our single family residential geothermal third quarter sales and year-to-date bookings were two and a half times greater than the same periods last year and our third quarter bookings were over three and a half times greater than the third quarter of last year, all in the face of a housing market that in general has been decimated.

Also relating to geothermal, the Economic Stability Act 2008 also known as the $700 billion bailout package included tax incentives in the form of tax credits that should encourage the purchase of residential and non-residential geothermal heat pumps. The provisions of the bill applicable to geothermal heat pumps are up to $2000 of Federal tax credits persistent for private residential systems and Federal tax credits equal to 10% of the total system cost for non-residential systems with no persistent limit for the non-residential part.

Both of these tax credits will remain in effect for eight years and it can offset both regular and alternative minimum tax liabilities. In addition, the bill also provides that any property, which is described as energy property, which includes geothermal heat pumps is depreciable over five yeas.

In addition, many states have incentives at this time and we're hopeful that spurred by the new federal legislation, other states will get on board and the states that currently have incentives will increase them.

We believe that our geothermal products are an important part of the solution to environmental and energy issues facing our country, and we remain very optimistic about the long range growth potential for these products. While our historic business model has not been predicated on any tax incentives, we certainly plan to take advantage of this to the extent possible to promote sales of our geothermal products. To that end, we're in the process of substantially intensifying our sales and marketing programs for geothermal products and are also preparing our manufacturing facilities to handle any increased volume that may result from these efforts.

We have made significant staff additions in field sales, dedicated support staff and marketing. In the past two years, we've doubled our manufacturing floor space and added equipment, and we are in the planning stages for another significant plant addition. We've also increased the capacity of our coil manufacturing facility which supports this product.

Turning to our Chemical business, as Tony reported, this business got off to a great start in the first half of the year but it hit road bumps in the third quarter. During the third quarter, total sales of our chemical products were up 80% over the third quarter of 2007. The increased sales were driven by substantially higher raw material costs that translated into higher sales prices. Gross profits and operating income were down. Gross profit decreased from $11.7 million in 2007 to $5.3 million in 2008, and operating decreased from 11.5 million to 1.9 million. Backing off the impact of the 4.8 million of unusual gains in the third quarter of 2007 that Tony discussed earlier, the balance of this decrease can be attributed to the unplanned maintenance downtime at the Cherokee Facility and to the unrealized non-cash loss on natural gas contracts. Both of these items were discussed by Tony earlier.

Without these unusual items, operating income would have improved. The unplanned maintenance downtime at Cherokee was unusual in duration and also impacted our most profitable product at that time. All of the supply against demand fundamentals continued to be in our favor during the third quarter. However, we are in a very volatile market as the following information will indicate. During the third quarter, our shipped tonnage of urea ammonium nitrate or UAN was 20% higher than the third quarter of 2007 while our revenues from these sales increased 82%. The published sales prices per ton during the third quarter of 2008 ranged from 418 to $520 per ton, up from 270 to $300 per ton a year ago. However, it is now below $300 a ton.

At the same time, the cost of natural gas, the primary feedstock for producing UAN at our Cherokee Facility increased from a range of $5.33 to $7.19 per MMBtu in the third quarter of 2007 to a range of $6.98 to $13.16 this year. Currently, the spot market natural gas price is approximately $6.90 in the 12 months strip, which changes daily, it was quoted today at approximately $7.35 per MMBtu. Whereas ammonium nitrate sales lagged in both the first and second quarters due to weather conditions primarily, high prices of urea pushed the market towards UAN in the third quarter.

During the third quarter of 2008, we sold 23% more tons of UAN than in the third quarter of 2007. However, our revenues for this product were up 90%, reflecting an increase – reflecting increased sales price per ton. The price of anhydrous ammonia, the raw material feedstock for our El Dorado Facility escalated significantly during the first nine months of the year after being relatively stable during 2007. Published prices at the Tampa price point increased from an average of the mid 400 per metric ton in January to a range of $585 to $930 per metric ton during the third quarter. Since that time, ammonia has tumbled and today's price is approximately $575 per metric ton and is predicted to go lower. The majority of El Dorado sales are to customers who accept the cost of ammonia as a passthrough.

Global grain stocks including corn and wheat are at historic low levels and are driving the demand for nitrogen fertilizers. These favorable supply demand fundamentals were the catalyst for significantly higher fertilizer selling prices and better margins in 2007 and this trend continued into 2008. However, recently, we have seen a sudden price drop for most commodities and the price of fertilizer in the market has also declined. Fortunately, the price of both the feedstocks we use, anhydrous ammonia at El Dorado and natural gas at Cherokee have also declined and we're able to produce our agricultural fertilizer products at possible level at current market prices.

On both the Ag and industrial sides of our chemical business, many of our customers are in an inventory correction mode. This is also affecting current short-term demand. Based on the general economic conditions, we're anticipating some softening in the demand for our industrial products. We believe that many of our customers are in a wait and see mode with regard to their production level. However, we believe that in the long run, there will be steady demand for both our industrial acids and our industrial grade ammonium nitrate used for surface mining.

Summing up, the third quarter Climate Control sales were up but the bottom line only showed marginal improvement, primarily due to our investments in growing the business. We also incurred higher variable selling expenses, leave costs in healthcare expenses. New orders were very strong during the third quarter continuing the trend from the first half of the year. The current outlook for 2008 commercial construction is slightly better than a quarter ago. However, the future of credit availability to our customers is unknown and could virtually affect commercial construction.

We're particularly glad to see strong shipments and new orders of our geothermal products, which have so far bucked the trend of both general residential construction and the markets for conventional residential heating and cooling systems. We believe the recently enacted federal tax incentives will help our geothermal sales. We're very excited about our prospects for growing all of LSB's Climate Control business and particularly our geothermal heat pumps over the long-term.

Turning to Chemical, sales were up but profits were down, primarily as a result of the unusual items that we've discussed. We believe the long-term outlook for our ag market is good because of the continuing demand for product costs that will be strong. Current sales prices and feedstock costs are lower than in the recent past; however, the current sales price results in a positive cash margin. Our industrial chemical business demand has been steady so far with the outlook remaining good but we anticipate softening due to the general economic conditions. This business should remain profitable as long as we run our plants at economic levels as it is sold on a cost plus basis. We recently renewed our agreements with Bayer MaterialScience and Nelson Brothers and finally we should make a decision whether to proceed with the startup of Pryor plant in the next 90 to 120 days.

We will now take your questions.

Question-and-Answer Session

Operator

(Operator instructions). And your first question will come from the line of Eric Prouty with Canaccord Adams.

Eric Prouty – Canaccord Adams

Great. Thanks a lot. And Jack, Barry and Tony, congratulations, good quarter on a tough environment. I guess on the geothermal and Climate Control business in particular, obviously with the real rapid growth in geothermal, we have a mix shift going on, could you maybe get into a little bit of detail about how that revenue mix shift over time might impact both the gross margin and operating margin, both geothermal as a whole grows, and then as residential within the geothermal mix grows at even faster clip than the commercial?

Jack Golsen

Well, these are all products that have good healthy gross margins. And as we grow the business, I think in general no matter how we grow the business, we're going to see some operating leverage and leverage on the bottom line and overhead absorption is what I'm really talking about. And so, as we grow, we expect this to just enhance the overall profitability of the business.

Eric Prouty – Canaccord Adams

Right. So, no significant differential in gross margin between the geothermal products and say the coil product, any other retract products?

Jack Golsen

No they are all in the same range. What you have in our business, I'm going to leave you with the impression that all the products we sell have exactly the same gross profits. I might over explain here but I want to be explicit. In everyone of our products, there's a range of profitability depending on the distribution channel we sell through, the size of the job, the competitive nature of the market at the time. So, there is a range. But generally speaking, we don't see a significant difference in the gross profit levels but what we just see is continued growth of the business and the benefits we get from that growth.

Eric Prouty – Canaccord Adams

Perfect, now understood. And then in terms of booking and backlog and again you gave plenty of caution on the call but I am sure you've gone through and really scrubbed the backlog well, what is your confidence level on that backlog being shipped out in the usual period, or do you believe that there is more risk in the backlog now than there has been in prior periods?

Jack Golsen

I don't believe that there is anymore risk now than there has ever been in prior periods. Some companies report backlog based on prospects and suspects. We report backlog as booked quarters. And to qualify an order as a booked order, we have to have a firm contract in had in terms of a purchase order, which we've accepted of our factory with solid terms and conditions that is being negotiated or standard terms of condition. So, when we talk about a backlog, we're talking about business that we have under contract. Historically, we have had a de minimis level of cancellations in our backlog, and we can't see any of the business that we currently have in our backlog is suspect as far as cancellation. Now, I will say that from time-to-time orders are pushed in the schedule, you have a customer that originally wanted an order at a certain time but if the construction gets delayed and so sometimes we see the backlog push around a little bit, I would say, plus or minus a month for certain jobs, but generally speaking we don't see cancellations and we're not concerned right now about cancellation.

Eric Prouty – Canaccord Adams

Excellent. And then finally, on the natural gas hedges, it sounds like about half of the rate, the loss from this quarter can be made up in the next quarter. Can we assume over a then six or one year time period that all of that business more or less gets shipped out, sooner or later you do recoup all of that losses that was taken, noncash charge that was taken during the quarter?

Jack Golsen

Eric, I think that the majority will work itself off through 2009. The other reason we have this fairly significant issue is because, as Barry mentioned, in the second and third quarter, you saw gas back way up to $13. We had firm orders with customers that had a margin in addition to the $13 gas, we locked those in unfortunately. We had to take that write-off in the third quarter, we’ll recover in subsequent quarters, you're exactly right.

Eric Prouty – Canaccord Adams

Right, we can thank the regulators for mark-to-markets of hedging contracts. Any --?

Jack Golsen

The important thing to remember here is that these are all associated with specific firm sales process orders and we don't really expect any hedges.

Eric Prouty – Canaccord Adams

And then anything on the copper side that we have to keep an eye out for, or you pretty much unhedged from a copper standpoint?

Jack Golsen

Actually, we are hedged from a copper standpoint, but we are hedged in a favorable position.

Eric Prouty – Canaccord Adams

Okay. Fantastic. I will jump back in the queue. Again, congratulations during a tough time.

Jack Golsen

Thanks.

Operator

Your next question will come from the line of Rick Hult with Roth Capital Partners.

Rick Hult – Roth Capital Partners

Good afternoon, gentlemen. Thanks for taking my question.

Jack Golsen

Good evening, Rick.

Rick Hult – Roth Capital Partners

Starting off with the Pryor facility, can you give us an update on the offtake partner, and that's really in regards to the supply glut that we're seeing. How does that affect negotiations? Has there been any effect of that, are they advanced enough where we’re really just waiting for permits at this point?

Jack Golsen

Well, we are waiting for permits; that's the fact. We've indications from the regulators that we will get those permits. There's nothing really holding them up except on their end. They have certain administrative procedures that they have to go through which take – each procedure takes certain amount of time according to them. So, we expect to have the permits. As far as the customers are concerned, the economics of starting up have changed since we first began. But they're still very good based on current conditions. And we believe that we're going to conclude the uptick agreements with a customer. I'm not at liberty to tell you who it is but we believe it will happen.

Rick Hult – Roth Capital Partners

Okay. And if you can jump around a little bit, I apologize, and this is I guess more for Barry. With the sales price increases have been passthrough on the Climate Control business, it looks like most of the year-over-year growth came from those price increases rather than a growth in shipments. Assuming that…

Barry Golsen

There's actually two things there. There is – excuse me for jumping in because that wasn't entirely correct.

Rick Hult – Roth Capital Partners

Okay.

Barry Golsen

Some of it was with sales price increases and some was in a shift of mix to the products that sell at a higher price per unit.

Rick Hult – Roth Capital Partners

Okay, okay. So, the actual number of shipments would be down but in this case because of a higher average sales price then obviously the revenue would be up?

Barry Golsen

That's correct. Higher average sales price plus some price increases.

Rick Hult – Roth Capital Partners

Okay. Now, I don't know if it’s a normal thing to keep the prices stable or to actually give concessions, but assuming that commodities continue their slide, can we expect to see – assuming stable pricing, can we expect to see some gross margin expansion?

Barry Golsen

That is usually a portion of what's going on in the selling price. Historically, we've seen a fluctuation – you've seen – looking back to other times than we are in right now, what we have seen is that there is a slight disconnect between raw material price increases and our selling price increases, and it’s more of a timing issue. So, there are times when our gross margin decreases until we can get cost increases out there into the field, selling price increases and then other times, when you see slight decreases in materials, where we pick up some gross margin and that's true. Historically, that's what it’s been and I believe that's probably what's your question is based on. I think right now, we're in times where we don't really know what's going to happen, we don't know what's going to happen as far as how competitive things will get out there in the field. People are talking about unusual economic scenarios out there and we don't have any better crystal ball than anyone else. So, although I would hope to get some pickup as material prices – raw material prices decrease, I certainly won't be betting on it right now.

Rick Hult – Roth Capital Partners

Okay. So, concessions aren't completely out of the question?

Barry Golsen

When you say concession –

Jack Golsen

I'll step in. Really not concessions but just more competitive bidding.

Rick Hult – Roth Capital Partners

Right. Okay.

Barry Golsen

I agree with what Jack just said.

Rick Hult – Roth Capital Partners

Can you describe the phasing of the most recent Climate Control shipments versus building and the construction phase are in, in other words, can we think of the – the shipments that we're seeing go out now or in the past quarter, can we think of those being installed in buildings that were funded a couple of years ago and construction had been started several quarters ago?

Barry Golsen

Yes.

Rick Hult – Roth Capital Partners

Okay.

Barry Golsen

For the most part. I don't think – that's not – dealing with our commercial side of our business, the answer to that is yes. And you're dealing with the residential side of our business, the answer to that is no because there's a much shorter duration when someone breaks ground on a house and new construction or does retrofit in commercial – let me start over, there's a much shorter life cycle on residential construction than on commercial construction. So, the answer to your question is yes for commercial, not necessarily for residential.

Rick Hult – Roth Capital Partners

Right. Okay.

Jack Golsen

And on renovation and replacement, it would be shorter.

Rick Hult – Roth Capital Partners

Okay.

Barry Golsen

Correct.

Rick Hult – Roth Capital Partners

And then assuming that energy prices continue to decline, obviously, it extends economic pay back of geothermal and that's been somewhat offset by tax credits in the U.S., correct?

Jack Golsen

That's correct.

Rick Hult – Roth Capital Partners

Okay. And then again on the Climate Control, it looks like a nice jump in SG&A and that's really just getting more aggressive on the selling and the marketing piece of it?

Jack Golsen

That's a good chunk of it right there.

Rick Hult – Roth Capital Partners

Okay. And then lastly, have you considered a stock buyback at current levels?

Jack Golsen

Well, we've talked about a stock buyback and as you know our Board authorized a stock buyback.

Rick Hult – Roth Capital Partners

Right.

Jack Golsen

But we believe right now that probably the best thing that we can do is to conserve cash. We have several opportunities for the company to grow and expand. We have the Pryor opportunity, we have the growth in our heat pump operation. We have other growth opportunities in other areas in the business. Those require capital to do that growth. As long as we think that we can put the money to use better to grow the operations than to buyback stock, that won't be our number one priority. I am not ruling that out and our position might change. But in this kind of a general economy, it’s not something that we are automatically going to do.

Rick Hult – Roth Capital Partners

Okay.

Tony Shelby

A good example of people who did that is the investment community. Now the government is criticizing them for buying back the stock and losing that capital, reducing their capital.

Rick Hult – Roth Capital Partners

Okay. I appreciate the additional insight. Thank you.

Jack Golsen

Thanks Rick.

Barry Golsen

Thanks Rick.

Operator

Your next question will come from the line of Dan Mannes with Avondale Partners.

Jack Golsen

Hi, Dan.

Dan Mannes – Avondale Partners

Hi, good afternoon everybody. A couple other questions for you guys. First just briefly on Cherokee, I believe you guys had an outage just to fix some of the issues that occurred in Q3. Is that completed and is it back running at sort of normal capacity now?

Barry Golsen

Dan, we had planned to take the plant down on October 1. We ran into some problems in the third quarter and we didn't quite get to October 1. That's how we lost so much time in the third quarter. We did begin the turnaround in October and so about ready to come back up.

Dan Mannes – Avondale Partners

So, is that – but it’s been down for the entire month of October?

Barry Golsen

That’s correct.

Dan Mannes – Avondale Partners

And that was planned?

Barry Golsen

That was planned.

Dan Mannes – Avondale Partners

And is that the normal cycle for Cherokee, just looking at Q4 results from last year, that looks like the case?

Barry Golsen

We don't necessarily do this (inaudible) turnaround every year. Sometimes it will be every 24 months. But we've been down, the duration has been a little bit longer than we planned, but we're pretty close to coming back up.

Dan Mannes - Avondale Partners

And given what you know, you believe whatever it was that you ran into the third quarter you’ve solved that?

Jack Golsen

When we come out of the turnaround, we should be in great shape.

Dan Mannes - Avondale Partners

And just briefly on Pryor, you talked about it in a couple of different ways. First you talked about sort of bringing up a portion of it and then bringing up in pieces. Assuming you get the offtake contract and permitting work is expected, could you sort of walk us through what would be the schedule of it coming online and what pieces at what point?

Jack Golsen

Well, I can tell you that we plan to be on full production on the original process we planned by the first of July. First, will come up the ammonia plant, that will probably come up by April, May. And then a few weeks later, probably will come up the nitric acid plant, and that will probably May, June. And lastly will come up the rest of the ammonia, then the acid, then the urea plant. And that will come up before the end of – very end of June and we should be producing by July. Now those – that schedule could slide because it depends on some of these things on outside vendors. It depends on the electric companies that supply the electricity and the gas company to have their pipeline and meters in place et cetera. So some of the timing is not within our control, but we think that these are relatively conservative dates.

Tony Shelby

Dan, in our recently filed 10-Q, on page 46, there's a complete rundown of what Jack just told you.

Dan Mannes - Avondale Partners

Got you. Sorry, I didn't get a chance to read that before the call.

Jack Golsen

By the way, we just filed that today.

Tony Shelby

Just a few minutes ago.

Dan Mannes - Avondale Partners

That's fair. And then just talking briefly, you mentioned $120 million of theoretical annual revenue. If memory serves, this was 300,000 tons of UAN or a little bit more than that?

Jack Golsen

This is 325,000 tons of UAN.

Dan Mannes - Avondale Partners

Okay.

Jack Golsen

And this does not – that amount, as of today's pricing, that does not include other products that we make – that we might make at that plant, that we think we’re probably going to make.

Dan Mannes - Avondale Partners

Sorry, I thought Barry said earlier – he was saying UAN was close to 300. So, 300 –

Jack Golsen

325 is what we're targeting.

Barry Golsen

What we are hearing Dan from our marketing department in the Dallas- Texas area is that nobody really knows what the real price is right now because you are currently off season. People are pretty full. It will take a while for it to settle down. Most of – if you read most of the pure ag guys, they're talking about low prices to start picking back up in the spring.

Jack Golsen

Dan, were you talking about the volume that we're going to produce or the tonnage or the price?

Dan Mannes - Avondale Partners

Well, you confirmed that tonnage at 325, so I was confirming the price there.

Jack Golsen

Okay.

Dan Mannes - Avondale Partners

So, it sounds like you guys are assuming a price in the 300 to 350 range based on what current – what you think today?

Jack Golsen

Yes, that 325 includes some additional anhydrous ammonia, about 35,000 tons.

Dan Mannes - Avondale Partners

Okay. And theoretically, again this is full year and given where current gas prices are, that's still a pretty healthy margin even at 320 – at 350 per ton?

Jack Golsen

There's a pretty good cash margin in today's – if you compare today's natural gas cost to what we think the sales prices of UAN. But as – let's just be a little careful. We don't really know what the sales price of UAN is right now. We will see as the spring starts, as the spring gets here.

Dan Mannes - Avondale Partners

Understood.

Jack Golsen

The reports on the market price are not reliable at this time of year. It’s an annual situation plus you're in a very strange situation for global – for the global economy.

Dan Mannes - Avondale Partners

But you guys do have some visibility. You're selling UAN from Cherokee today and may be not to the same exact market. The current distributors of UAN are the people you sell to, do they have access to credit or are they sitting there with completely full stocks?

Jack Golsen

No, no, they're not. They don't have completely full stock.

Tony Shelby

I would say – let me just throw this in. Let me give you an analogous situation that everyone can relate to. If a 5 or 10 or 100 shares of a major company stock fell at some price, is that particular price meaningful on a small scale basis? It’s not really. And what we have is the – we're in the off-season. In the off-season, you are not selling, so the price is not meaningful based on the last sale.

Dan Mannes - Avondale Partners

Okay. Now I completely understand. Just a couple of quick questions on Climate. First, if you can say – you mentioned some of the markets that are obviously are in some difficulty, New York, Las Vegas and Florida. Can you give us some color on maybe what percentage of your business historically goes to that market or give us some idea of what your exposure is?

Jack Golsen

No, I really would rather not do that. We don't really release the percentage of our sales on a market-by-market basis. We consider that to be really confidential. We wouldn't want our competitors to know that information.

Dan Mannes - Avondale Partners

Okay.

Jack Golsen

Those are important markets to everybody and they are markets that were hard hit, and that's why I mentioned them.

Dan Mannes - Avondale Partners

Understood. And then just one last question.

Jack Golsen

I'll just say this in general. We have a very good representation all across the United States in all the major market areas. So, typically, there are few exceptions to this but typically our exposure is proportional to the general size of the market.

Dan Mannes - Avondale Partners

That makes sense. Just one last thing, we talked lot about residential, geothermal, and obviously that's doing quite well. Have you had any material uptick or any different experience in the commercial geothermal business?

Jack Golsen

Yes, our commercial geothermal business is doing very well this year. I don't have any numbers to give you right now, but it’s also doing very well. It has not increased the same level of the residential but has definitely picked up.

Dan Mannes - Avondale Partners

Okay. Great. Thanks a lot for the color.

Jack Golsen

Dan, I think that when people catch onto a new law on commercial geothermal, the 10% tax credit on the whole cost of the system are unlimited, there's no limit. I think that we'll start seeing more.

Tony Shelby

And the depreciation benefit also enhances that. The five-year depreciation period on it really enhances that as well.

Dan Mannes - Avondale Partners

Understood.

Operator

Your next question will come from the line of Steve Denault with Northland Securities.

Steve Denault – Northland Securities

Good afternoon, everyone.

Jack Golsen

Hi, Steve.

Steve Denault – Northland Securities

I would love to get a better understanding of the 21% growth in the heat pump business. How much of it was kind of volume versus what sound to be maybe some mix or pricing, and in fact to also put it another way, how much of it was geothermal related?

Jack Golsen

Let me think. We said – let me see if I've got that information here.

Tony Shelby

Steve, would you –

Jack Golsen

I'm looking at some numbers I have. You're asking me for some pretty detailed numbers. Why don't you ask another question and I'll come back to that.

Steve Denault – Northland Securities

Okay. Tony, I'll ask you this question. When you came out with your update regards to the third quarter and the Cherokee downtime, I think at that point in time you talked about a unfavorable non-cash charge of 5.5 million for nat gas, recognized or realized this $4.9 million, you had natural gas down since that point in time.

Tony Shelby

The answer is since then we’ve shipped some of the product that we had hedged.

Steve Denault – Northland Securities

Got you. So, you recognize it against the actual cost of goods sold.

Tony Shelby

Right.

Steve Denault – Northland Securities

And so when you make reference to being able to go the other way on nat gas, a favorable impact in the fourth quarter, you're not – nat gas prices really haven't changed but we're talking the recognition of really the contracts rolling off essentially?

Tony Shelby

Yeah, in other words you have firm sales orders that were shipped – that are scheduled to ship in the fourth quarter, they are matched up with certain future contracts that will be settled here in the fourth quarter.

Steve Denault – Northland Securities

Okay. That makes sense.

Tony Shelby

So, you're looking – what you got left at 12/31/08 and value those when you do your fourth quarter.

Jack Golsen

Those numbers though would include any new hedges that are added if they happen in the fourth quarter, that's rolled into the future.

Steve Denault – Northland Securities

Okay. That makes sense. Do you remember what the percent of – when you report your second quarter results, what the percent of residential or geothermal sales were as a percent of mix for the overall Climate Control. You said --?

Jack Golsen

Would you ask that question again please?

Tony Shelby

What's your geothermal mix?

Steve Denault – Northland Securities

You were 16% geothermal year-to-date, 50% of the Climate Control…

Jack Golsen

That's right.

Steve Denault – Northland Securities

You know what that was in the second quarter?

Jack Golsen

No, I really don't have that as a percentage and I have to go back and do that calculation. I don't have that number.

Steve Denault – Northland Securities

Okay.

Jack Golsen

And as to your first question, there is a lot of variables there and I don't – those are some pretty detailed and specific numbers you asked for. I don't really have them available to me right now, sitting here at the table.

Steve Denault – Northland Securities

Okay. Fair enough. And final question, you referenced based on where natural gas is and ammonia prices at this point in time, the fertilizer cash margin is healthy. Can you give us directionally what healthy means?

Jack Golsen

If you take UAN, for instance, we normally assume that including bore house gas [ph] about 14.3 MMBtus of gas for a ton of UAN.

Steve Denault – Northland Securities

Yeah.

Jack Golsen

And so you have more planned [ph] gas tons left, and you have a gas cost, you had 80 to $100 conversion cost, probably more close to $80 side, and compare that to the sales process of UAN.

Steve Denault – Northland Securities

Okay.

Jack Golsen

That's what we would call cash margin.

Steve Denault – Northland Securities

Okay. Thank you. That's it.

Jack Golsen

Thanks.

Tony Shelby

Thank you, Steve.

Operator

(Operator instruction). Your next question will come from the line of Ali Motamed with Boston Partners.

Ali Motamed –Boston Partners

Hi, I was wondering if you could talk about the percent of residential, geothermal that was in your orders for the quarter? I think you mentioned 16%, it was in sales for the quarter?

Jack Golsen

You know what, that's a good question. Boy, percent of orders, I’ll have to calculate that, jut a minute. Ask another question while we calculate that.

Ali Motamed – Boston Partners

That's the most important question. That business should be large next year right? Residential geothermal at this point should start becoming with the massive growth you're putting up should start becoming a substantial business approaching triple digit million, is that fair?

Jack Golsen

Three digits.

Tony Shelby

(inaudible) about the market.

Ali Motamed –Boston Partners

100 million-ish range for residential geothermal as you keep up the execution coming into mid point of next year?

Jack Golsen

Oh, yeah.

Tony Shelby

More than that I think.

Ali Motamed –Boston Partners

More than that. And you're putting up rapid growth there and people are just figuring out the tax credit. And I guess the orders, percent of orders was sort of – it’s my way of trying to figure out how big that may be.

Jack Golsen

Let's see what Barry comes up with.

Barry Golsen

We have an unusually, incredibly high geothermal booking quarter, although I would say – it was really about – we booked about – it’s at 101 million. I think that totaled – I think we probably had about – in the range of about 20%.

Ali Motamed –Boston Partners

Of that being the residential?

Barry Golsen

Yeah.

Ali Motamed –Boston Partners

And then at some point going into the next year, this is something obviously people had spoken of before with splitting the two businesses, but it’s starting to become – did you jut stop thinking about that or are you kind of just focusing on execution here for a little bit because that residential business has massive potential?

Jack Golsen

That's a really good question and it’s a question that we've discussed several times. We've been asked before on conference calls and in between conference calls. Quite frankly, there are some investors who feel, we should split the companies because they believe that we would be more focused and we’d get a higher multiple for the business if we separated than together. And then there are also other investors that we've talked to, significant investors to see a benefit in diversification, and the possible kind of cyclicality of these businesses from time-to-time. So, this is a topic of discussion for LSB management and the Board of Directors. We are continually looking at ways to get higher shareholder value. However at this time, we don't have any plans for a fundamental change. We do not think that this would even be feasible at this time given the state of the economy and the financial markets right now.

Ali Motamed –Boston Partners

I guess the one thing that I would just add though is as residential starts to become a bigger and bigger part of your business, that's not counting the past here, that generally doesn't follow the economic cycles to the same degree of commercial construction. So, I can understand diversification to offset different cycles, but at some point here as we stabilize, that should become just a growth business with a secular growth driver. And so that's why maybe the diversification strategy doesn't necessarily apply to the value –

Jack Golsen

At this time, it’s still – although it’s an area of the business that we have – we think has a huge amount of potential and it’s an area of the business that we're very optimistic about in investing to grow, still a small part of the overall business. But as time goes on and our situation changes, as I said, it’s something that our management and our Board of Directors looks at and considers, and we are not ruling out that at some time in the future, we might have a different outlook and we might not think that it’s advantageous, but at this time, we don't have any plans.

Tony Shelby

Well, I would like to add to that. We do not have a bias about keeping the companies together or separating. We have practical considerations and we're always looking at those and what's involved and what the consequences would be. And so up until this last financial crisis that we are all in, we were looking at that again and we do it almost continuously, because we get these questions. But at this time, the financing that would be required to do the deal would probably not be available, and in fact we know it’s not available, and so we're just saying we have to wait till things settle down before we give a real serious consideration again.

Jack Golsen

So I guess the bottom line of that whole thing, going back to your original question, which was something along the line is, are you focusing on execution right now? At this point in time, the answer is yes.

Ali Motamed – Boston Partners

Thank you very much.

Operator

(Operator instructions) Your next question comes from the line of Bruce Geller with DGHM.

Jack Golsen

Hi, Bruce.

Bruce Geller – DGHM

Hey, good evening guys. Great job in a tough environment out there. I had one question. I glanced through the 10-Q that you filed, and the operating cash flow year-to-date is down year-over-year, maybe there's some seasonal aspect to that. But it looks like relative to last year, you had some build up in receivables and inventories that have kept the operating cash flow, has held it back a little bit this year. Can you give us some insight going forward if you are going to be feeing that up in the fourth quarter?

Jack Golsen

We had very significant cost increases in the third quarter. So, your receivable – your sales price – we had a $55 million increase in sales in the Chemical business, most of that was sales process increase. We have inventories are higher, our receivables are higher, plus we’ve had some pretty significant sales seasonally. So, that will come back now in the fourth quarter probably. And keep in mind the net cash provided by continuing operating activities is that we pay about $16 million in income tax whereas last year we didn't have that. And we've had, of course, the build up in receivables inventory. But we've been very, very careful with our receivables, our inventory, and they're all in great shape. It’s just a matter of being – having the additional working capital to take opportunities of growth in sales.

Bruce Geller – DGHM

Okay. Great. And then you gave an estimate in the press release of the sales that could be expected from the Pryor facility and I know it might be a little premature to give some guidance on what kind of earnings might be attributable to those sales, but can you give any type of metrics to kind of give the investment community higher sense of confidence in the start-up of that facility, what kind of return on investment, what kind of pay back period are you intent to get?

Tony Shelby

Bruce, I think that would be contrary to our stated policy of not making forward-looking projections. I think that you could look at some of the other pure ag people and get some dynamics of that and what their average selling prices are and that sort of thing, but we are not comfortable doing that.

Bruce Geller – DGHM

Well, you gave an estimate of the sales so that that in itself is forward-looking. I'm trying to help you I think and have you help the investment community just – because there's probably some uncertainty that the analysts are going to have regarding how to model this out and there may be some concern over near-term earnings pressure. But I just – I get the sense that this is a very positive step and that it is probably very high return on investment that you're undertaking, but I just think it might be helpful to try to convey some of those metrics to the investment community so that people have a proper degree of confidence as you embark on this?

Tony Shelby

We just gave you some metrics in terms of industry statistics as far as gas content, the conversion cost. I think we probably did the conversion cost hopefully from our side, and the sales process is also probably acknowledged. You got distribution cost that you can look at the industry itself. We don't – we don't have offtake sales and distribution agreement at this time. I don't think we would be comfortable in commenting on the sales process.

Jack Golsen

Bruce, I know that it might sound arbitrary, the fact that we have such a firm stake in the ground on this. But we've really considered this many, many times as to whether we should give guidance. And the primary reason we don't give guidance is that because the current market conditions we're operating in are subject to too much change to be able to give really good reliable guidance. In the Chemical business, since most of our industrial sales fluctuate with raw material feedstock prices and since those prices are impossible to forecast, we can't give guidance on the top line, because we don't know what raw materials are going to do. On the ag side, both raw material prices and sales price fluctuate, but not necessarily at the same rate. So, there's always – and there's always the weather factor, which can also have an impact on ton shipped regardless of the price. So, we just don't feel comfortable in this business giving guidance. We just don't feel that the factors are reliable enough to where we can – we are not prescient enough to be able to tell what the future is going to be. But we do have a range on the top line based on what the current market price. And at this particular in time, taken a snapshot, we feel comfortable saying what that is.

Bruce Geller – DGHM

Thanks guys. Good luck.

Jack Golsen

Thank you.

Tony Shelby

Okay.

Operator

There are no further questions. I will now turn the conference back to management.

Jack Golsen

Thanks everybody.

Operator

Ladies and gentlemen, this concludes our conference for today. Thank you all for participating and have a nice day. All parties may now disconnect.

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