Innophos Holdings Q4 2008 Earnings Call Transcript

Innophos Holdings, Inc. (IPHS)

Q4 2008 Earnings Call

February 10, 2009 10:00 AM ET

Executives

William Farran - Vice President and General Counsel

Randy Gress - Chief Executive Officer

Richard Heyse - Chief Financial Officer

Analysts

Christopher Butler - Sidoti & Company

Jeff Zekauskas - JPMorgan

Frank Mitsch - BB&T Capital Markets

Bill Hoffman - UBS

Richard O'Reilly - Standard & Poor's

Presentation

Operator

Good day, ladies and gentlemen and welcome to the Fourth Quarter and 2008 Innophos Holdings, Inc. Results Conference Call. My name is Erica, and I'll be your coordinator for today. At this time, all participants are in a listen-only mode. We will be facilitating a question-and-answer session towards the end of this conference. (Operator instructions)

I would now like to turn the presentation over to your host for today, Mr. Bill Farran, Vice President and General Counsel of Innophos. You may proceed.

William Farran

Thanks for joining us today for the Innophos Holdings, Inc. conference call to discuss 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 February 9, 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 February 10, 2009. 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.

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

Randy Gress

Thanks Bill and Good morning, everyone. In keeping with the usual approach for use on our conference calls, I will start off with some comments about the full year results and then what we have seen in the business in the fourth quarter, and finish up discussing our outlook generally, then Richard Heyse will give us some of the highlights for the quarter and the full year. Next Bill Farran will give us an update on the outstanding legal issues and then after a short summary from me, we will take the questions.

Full year results can only be described as exceptional. We saw substantial increases in 2008 net sales at $935 million versus $579 million in 2007 or a 61% of improvement as our 83% selling price increases positively impacted revenue and income by $480 million across all product lines.

These changes outweigh the 22% of negative volume and mix impacts on revenue, primarily in STPP and other products. Reflecting the quarter results, the largest portion of the annual negative volume and mix changes took place in Mexico due to reduced demand for Granular Triple SuperPhosphate, GTSP, fertilizer co-product, because fertilizer markets have ground to a standstill and also limited reformulation and detergents using Sodium Tripolyphosphate or STPP.

Meanwhile, in U.S. full year demand for Specialty Salts and Specialty Acids were strong, with a positive volume and mix impact. We had strong performance in this area by focusing on growing the business domestically as well as internationally. This is why you see a positive 6% favorable volume variance year-over-year in the Specialty Salts and Specialty Acids business. We were very successful in achieving our objectives.

However, Purified Phosphoric Acid had unfavorable volume and mix for 2008 compared to 2007 primarily due to lost production from planned maintenance and then unplanned Hurricane driven outage at our Geismar, Louisiana facility, along with the impact of the recession on fourth quarter industrial and agricultural demand.

Benefiting from our raw material supply contracts, which buffered us from much of the 2008 price shocks in sulfur and phosphate rock, and strong product selling price increases, we saw 2008 operating income increased by $248 million for 520% and net income improved by $206 million compared to a loss of $5.5 million for 2007.

These were unprecedented levels of achievement for our business.

Now and switching to the most recent quarter's performance, Innophos delivered solid results in the fourth quarter despite a selling environment that became significantly more challenging through the quarter. Net sales for the fourth quarter were up 50% over fourth quarter 2007, due to average selling price increases of 98% or $141 million across our product lines. Operating and net income for the quarter at $69 million and $52 million respectively, show that we continued to operate successfully in the dynamic pricing and cost environment despite a lack of demand for fertilizer and softening of demand for other products at the lower end of our product portfolio.

One can see this softening of demand in the quarterly volume and mix impacts on revenue, which had a negative impact of almost 48% across all product lines, but most notably in STPP and other products, due to reduced demand for GTSP fertilizer co-product in fertilizer markets that were essentially non-existent in the fourth quarter. Volume was also lowered both in U.S and Mexico in Specialty Salts and Specialty Acids, primarily due to reduced demands in some technical applications.

As one would expect, demand for our other products supporting the food, beverage, pharma and oral care business, held up well. Demand was also lower in the United States for technical grade purified phosphoric acid. Technical grade products are primarily used in the industrial, detergency, and horticulture markets we serve. Accordingly, volumes in the U.S. were lower in the fourth quarter particularly in account exposed to the agricultural and industrial markets, the overall economic slowness and likely correction of inventories across the chain all the way to the final customer.

In addition, competitive pressure from European and Chinese producers increased as they began to try to enter the U.S. market in response to slowdowns in their home markets.

Going forward as result of these pressures, we expect to see downward pressure on selling prices which are currently at historically high levels. In response, we are taking a more aggressive stance to retain our leading market position and keep profitable business going forward. We are responding to the increased pressures in all segments by maintaining a competitive offering. We are prepared to maintain our share using the best business practices we know from many years in this industry.

We will continue to focus on providing the best service, proprietary technology, and improving our supply chain to help ensure the quality and consistency of our customers' products. Our raw material outlook has changed since the fourth quarter and it's continuing to revolve up to today as demand for phosphate fertilizers fell to nearly zero and worldwide economic conditions have pushed the market price of sulfur down rapidly.

We are benefiting from declining sulfur, energy and transportation cost in comparison to 2008 levels. Since there has been very low phosphate rock traded recently, there's simply isn't much data concerning the market prices although a few recent trades have occurred that indicate the market price for phosphate rock has also begun to decrease significantly. As a result, we are currently expecting our overall first quarter 2009 U.S. cost structure to remain substantially unchanged from fourth quarter 2008 levels.

In order to calculate our raw material cost in Mexico, we assume sulfur market prices would remain at current levels. And for phosphate rock price we use the upper end of the range of what we have determined to be reasonably possible outcomes of the arbitration process that we are currently undergoing with OCP.

Due to the recession driven Latin American market weakness, competitive factors, phosphate rock pricing uncertainty, and weak global demand for fertilizers, we currently anticipate operating our Mexico plant at significantly reduced levels for 2009. Also, we built considerable raw material inventory at the end of 2008, which will delay the impact of phosphate rock cost increases.

Therefore, the increases in phosphate rock cost will not begin to affect our financial performance until the middle of the second quarter of 2009.

Considering these assumptions, we expect Innophos's first quarter 2009 cost structure in the United States, Mexico and Canada, to be similar to the fourth quarter of 2008.

As most of you already know, we are disputing the interpretation of the pricing clause for our phosphate rock supply deposit focus. Both parties are resolving the disputes with binding arbitration which is specified in the contract.

The three arbitrative panel has been named and we hope to conclude the process as quickly as possible but it could take through the end of the year. Both 2008 and 2009 pricing are being disputed. However for 2008, we do not have any material negative downside to what was reported.

For 2009, we are using for our disclosure and the outlook for overall performance, assuming phosphate rock cost to be at the upper end of what we deem as reasonably possible from arbitration. Results could increase our cost for Mexican production by approximately $40 million per quarter in the second half of the year assuming full capacity operations. However, assuming we continued to operate at current reduced levels, this would result in an increase of roughly half to previously reported, full capacity amount or $20 million increase cost per quarter.

Last quarter, we mentioned that we are assuming limited amounts of the determination (ph) reformulation replaced STPP with alternative chemistries. It appears with this reformulation may gain momentum. In addition, we believe Innophos's largest Mexican customer recently lost a significant amount of STPP business for which Innophos historically supply Purified Phosphoric Acid.

This loss of business triggered the closing of one of these customer's three STPP plans which represented over 50% of its STPP production capacity. This customer's therefore reducing its purchases from Innophos starting in the first quarter of 2009, where we expect to supply roughly a third of historical volume.

We estimate that this loss of business could result in a 2009 revenue loss of between 5% and 10% of the historical total company sales and then annual consolidated operating income reduction of between 6 to $10 million based on pre-2008 historical profitability and management success and mitigation efforts. We are taking a number of actions to address this situation.

First, we are continuing to look what this cost is going to support, its reduced operations and of course, we are focused on increasing Innophos's overall share with the customer if we can do so, in the manner that is mutually beneficial.

Second, because of the reduced operational levels, we are taking the actions to reduce manufacturing cost across the whole site.

Also, we are considering several options for the longer term, including seeking new customers for Innophos's Mexican Purified Phosphoric Acid capacity. We have accelerated plans to increase Innophos's diversification of end-markets and customers in the future.

Additionally, with limited and reasonable investment levels, we are increasing the flexibility to greatly the increase the capacity that can be utilized to supply the U.S. operations and to grow the business.

Because we continue to be focused on finding new customers for our higher margin products, we are investing to upgrade the majority of Mexico's technical grade Purified Phosphoric Acid capacity to food-grade capability. We anticipate the investment will be completed by the end of 2009.

Separately, as for our main U.S. and Canadian raw material supply in the first quarter, Innophos purchases some of its Purified Phosphoric Acid needs from a third party U.S. supplier. While that supplier's (inaudible) North Carolina purified acid unit is being prepared temporarily due to a partial shutdown of their complex due to a lack of phosphate fertilizer demand.

Innophos is responding by operating its Geismar, Louisiana acid purification complex at full capacity. And we expect that we will be able to meet our current operating and supply plans without having to supply purified acid from our Mexican operations.

In the event that our suppliers' outage is extended, we could supply our Mexican produced purified acid to meet our U.S. and Canadian market commitments. We are currently projecting that our full year U.S. Specialties business will perform well in the first quarter of 2009. But we cannot rule out price pressure throughout our portfolio. This portion of business applies much too defensive end markets that we consider our core business; pharma, food, and beverage, which comprises a small percentage of our customers' end product cost.

Our U.S. and Canadian purified acid supply is cost effective in today's marketplace and product selling prices are now at historically high levels.

And turning to our Mexican operations; in the first quarter of 2009, we expect to operate at roughly 50% capacity and pursue the business with solid margins. Our main goal is to operate Innophos's Mexican facilities profitably. A slight benefit of running at reduced levels, it will reduce any contingent liability due to rock price uncertainty caused by our current arbitration of our phosphate rock supply agreement.

We will focus on reducing cost sufficiently to run profitably at lower capacity utilization and we'll take every additional opportunity to gain needed efficiencies. We've also looked hard at our plant capital expenditures for 2009 because we want to focus investment on critical projects that maintain the flexibility and efficiency that we need in the current dynamic market environment. For example, Innophos is continuing with the expansion and upgrade of its Chicago Heights facility, which is critical for the growth of its higher margin pharmaceutical and (inaudible) except in product line.

As a result, we now project 2009 capital expenditures to approximate 20 to $25 million inline with historical levels. This amount also includes the investments being made to upgrade the Mexican phosphoric acid purification plant.

In expecting an outlook for Innophos's financial performance in 2009, we must consider several issues. We cannot now predict how severe the recession will be or the associated impact on industrial and agricultural demand. With the uncertainly around Mexican phosphate rock cost and operating levels, in the while (ph) of greater competitive intensity, we have to conclude that we cannot offer reliable and specific operating income guidance for the year.

We can give you an idea of first quarter outlook. We expect that first quarter 2009 volumes will be up approximately 15% from fourth quarter 2008 levels. For selling prices, with the usual puts and takes from various customer agreements, we expected increased prices in some areas, primarily in the U.S., but this will be offset in our less specialized product areas and should result in overall prices that should remain somewhat similar to those of fourth quarter 2008.

Lastly, our cost structure should remain relatively flat as well.

Beyond the first quarter, volume impacts are uncertain and we believe are recession dependent. We do not expect to see selling prices ... we do expect to see selling prices trending down, while Mexican cost structure increases also start to kick in mid second quarter, again, to some extent affected by operating levels.

Now Richard will take you some more details about the quarter and the year.

Richard Heyse

Thanks Randy. Despite the world economy entering into a severe recession in the fourth quarter, Innophos achieved solid fourth quarter net sales and operating income results of 216 and $69 million respectively compared to 144 and $6 million in the fourth quarter of 2007.

In the fourth quarter, year-over-year selling price increases had a favorable impact on revenue of 98% or $141 million. Volume mix impacts had an unfavorable impact on revenue of 48% or $69 million in the quarter. While in fourth quarter, our favorable selling price variances offset the unfavorable volume variance caused by lack of fertilizer demand, the softening demand for products at lower end of our portfolio and the year-over-year unfavorable impact of increased raw material cost.

For the U.S., year-over-year quarterly net sales increased 55% in the fourth quarter due to higher prices across all product lines, most notably in Specialty Salts and Specialty Acids, which exceeded lower volumes across the... the impact from lower volumes across all product lines, most notably in Purified Phosphoric Acid.

Our technical grade applications accounted for the majority of the volume decline as our technical grade applications are most exposed to the industrial and agricultural markets which are currently in a severe recession.

In Mexico, net sales increased 46% versus net comparable quarter of 2007 due to significantly higher prices across all product lines, which exceeded lower volume and mix effects on revenue. STPP and other products accounted for most of the volume and mix declines primarily due to a reduced demand for GTSP fertilizer and lower sales of STPP due to a number of factors including reformulation.

So, we are seeing a broader recession driven trends and potentially see momentum gain in STPP reformulation that is further reductions in the use of STPP in detergent application.

Diluted EPS was $2.40 for the quarter and 9.23 for the year. As Randy already commented, full year EPS was outstanding. Including in our fourth quarter results was a pre-tax charge of $1.9 million related to the write-down of on-hand GTSP fertilizer inventories to net realizable value.

Also included in the fourth quarter taxes was a benefit of $14.4 million or $0.66 per share due to the use of NOLs in the partial reversal of certain valuation allowances against U.S. Federal net differed tax assets. We have concluded that a full valuation allowance is no longer need due to anticipated future U.S. profitability.

The impact that we experienced (ph) for the full year was a benefit of $24.9 million, or $1.16 per share.

Although we did have an unfavorable impact of increasing inventory on at working capital levels, Innophos ended the year with a cash balance slightly in excess of $125 million as anticipated.

Our March 2009, mandatory free cash flow suite payment on our bank debt will be approximately $54 million.

In the fourth quarter, we made estimated income tax payment as planned and there was no need to use the company's revolving credit line.

Finally, we are targeting to maintaining operating cash balance of at least $60 million during 2009 due to the upcoming expiration of our revolving credit facility. Capital expenditures for the full year 2008 were $18.5 million compared to $28.4 million in 2007, when the company was investing in Coatzacoalcos cogeneration project. This is a bit on the lower side of our targeted 20 to $25 million range.

In 2009, we expect to invest 20 to $25 million in CapEx with a focus on greater production efficiency and growth in our higher margin more stable businesses. On the other hand, some potential investments in Mexican capacity that we previous considered important in a higher demand environment, where we pushed out until its demonstrated there is a strong demand side argument to be made for those projects.

As you know, since 2005 Innophos's stayed focused on strengthening its balance sheet. As a result of our exceptional performance in 2008, we've been able to continue to make significant progress and greatly exceed the de-leveraging goals we set for ourselves in 2005. During 2008, we reduced net debt by 30% from 369 million to $257 million, strengthening our balance sheet, putting ourselves in an excellent liquidity position with a $125 million of on-hand cash at year end.

Our year end net debt position of $257 million, when compared with our peak net depth position of $493 million in early 2005, speaks of the significant progress we have made in less than four years.

In addition, we built $118 million of working capital during 2008 and anticipate recovering a significant amount of this working capital build in 2009 and early 2010.

This recovery of working capital cash combined with free cash flow generated from 2009 operations is expected drive additional increases in our cash balances during 2009. This anticipated 2009 cash flow generation plus current on-hand cash exceeds our current bank debt balance and so we anticipate no difficulties with paying off our remaining term bank debt from on-hand cash as it begins coming due in the fourth quarter 2009.

After our bank debt, our next maturity is our $66 million of Innophos Holding, Inc. or holdco notes placed in 2007 which are not due until 2012. So with our steady multi-year focus on our improving our balance sheet, we've been successful today to navigate Innophos through the current credit crisis.

Now I'll turn it over to Bill for legal updates. Bill?

William Farran

Thanks Richard. In addition to initiating international arbitration proceedings in order to resolve a dispute with our phosphate rock supplier OCP, over the interpretation of the pricing provisions of our supply contract which Randy discussed briefly, we've had several developments in the fourth quarter that I'd like to take a minute to highlight.

First we received confirmation from the United States Department of Justice or DoJ that its investigation into the STPP industry for potential antitrust violations, with which we cooperated fully, was closed as to Innophos. And the documents we provided in response to the DoJ's supplement will be returned to us.

Secondly, remaining claims by the Mexican National Waters Commission or CNA for higher water fees sought for the period 1998 to 2002, from our Mexican plant totaling approximately $24 million for which we are fully indemnified by Rhodia, S.A and its affiliates remained on-appeal in the Mexican court system.

During 2008 we received a unanimous favorable ruling from the Mexican Tax Court, most recently on further appeal by the CNA that ruling was affirmed in part and remanded in part for the stated reason that the written decision below did not adequately explains the Court's rulings on all points raised by the CNA. We understand that a decision on remand should be available soon but we do not have an exact date.

Third, as we explained in the press release, we continue to engage in active discussions with the government parties as the potential civil enforcement with regard to our Geismar, Louisiana plant compliance with or exemptions from certain hazardous waste regulations also known as RCRA regulations.

In the context to potential settlement, we are working on technical solutions with a neighboring facility which supplies raw materials to our plant and receives a co-product from our plant and have submitted regular updates to the government parties. We believe it is probable that we will reach agreement on implementation of a technical solution for one of the two significant issues that decide at a cost which would not be material.

A viable technical solution has not been identified for the second issue although we are continuing to work with our neighbor in the hope of finding a viable solution. At this point we cannot determine whether the entire matter with will be resolved by settlement with the government parties or whether the issues surrounding our claimed exemptions from RCRA regulations will require litigation.

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

Randy Gress

Thanks Bill. 2008 was an excellent year for Innophos. And I want commend and thank our employees for their commitment to the goals that we have reached in the past year. Their work has put us in a position to capture opportunities that arise in the current 2009 environment and handle the challenges.

As we face issues in 2009 that we have laid out, we will keep you updated on the routes we take towards resolution. We are prepared to operate aggressively towards our market share, as companies do when they have commodity influenced inputs and are seeing increasing economic and competitive pressures. We will retain profitable business and believe that the historical averages to which we expect the business to return can enable us with continued de-levering and healthy free cash production to continue to offer stable return to our stakeholders.

We will continue to invest in increasing our capability in Specialty Salts and Acids as well as increase food-grade acid capability. Meanwhile, we continue to move towards de-risking the company as we have done since its formation. Our reducing debt, both on overall on a net basis, returning capital through dividends and by choosing capital investment and higher margin product lines, when the demand situation is stable.

We believe the work we have already done to improve efficiency and to move capacity towards higher margin business in 2008, will serve us well. And we are continuing to execute incremental projects that will move us in this direction over the coming year as well as increase our flexibility to be successful in addressing the challenges the future brings.

Thank you for listening. Now we will take your questions. Operator?

Question-and-Answer Session

Operator

(Operator Instructions) And your first question comes from the line of Christopher Butler from Sidoti & Company. You may proceed.

Christopher Butler - Sidoti & Company

Hi. Good morning guys.

Randy Gress

Hey, Chris.

William Farran

Good morning, Chris.

Christopher Butler - Sidoti & Company

Wanted to direct that the first question towards the STPP business. I know one of the concerns during 2008 was the dramatic pricing that that was put in was that there would be demand destruction and concerns about reformulation? It seems that at this point some of those fears are coming to a provision. Could you touch on sort of the, that as far as Innophos versus the industry down there and you also mentioned that pricing in the U.S. would continue to climb, any risks of similar situation in the U.S. business looking forward?

Randy Gress

Yeah thanks Chris. As far as the STPP impacts from reformulation, we have seen some demand destruction there. I think that comes in two areas; one is some reformulation in some of the products and specifically talking about some of the laundry detergent in the Latin America area, some reduction that we see in the actual formulations and the use of STPP. Although they are still used in the formulations and the other may be some introduction of some no-P or a no-phosphate type of products.

So, we have seen some of that but what also we see is, some of the export markets from Mexico that are being supplied or where there is increased competition and not necessarily the demand destruction and increased competition primarily from China. As far as the overall demand, we have seen some but ... and potentially I think in the U.S. just to add to that, there has been the pressure from the dish-wash regulations, although there hasn't been a significant increase in that activity, the time line for that was 2010.

And basically, in response to any kind of demand destruction what we are doing is, I think one for the U.S., we have converted some of our capability in Port Maitland to make food grade products primarily for the baking area. And then in Latin America, we're making some investment here on the acid side to convert to grade of food grade product there, and then our offering.

And as far as the U.S. pricing, the second question there or comment, we are seeing some improvements still into the first quarter. But overtime, would see some further pressure on prices. But the ... any further demand destruction that we've seen has been limited.

Christopher Butler - Sidoti & Company

And help me out here a little bit. I have looked at detergents as being somewhat less tied to the overall economy and everything that I've heard as far as long-term trends for fertilizer demand which still seem to be on the up and up a plant closure as opposed to marked falling (ph) from your customers seems to be a favorably dramatic step. Is this a situation where the competition has come in so hard and have really show no signs of letting up that that becomes necessary?

Randy Gress

As far as the fertilizer, yes. We're in the fertilizer business primarily as a co-product there with our GTSP and we would expect recovery in that market, most likely within the second quarter there. But for the STPP, and the competitor or the customers' decision to reduce the STPP capacity, I believe most of that business was for export outside of Mexico to supply the U.S. as well as Latin America. And with the loss of business, they decided to shut that down. But there is no evidence of dismantling at this point.

Christopher Butler - Sidoti & Company

And looking at the upgrade that you are talking about to food-grade in Mexico, there doesn't seem to be a significant uptick in capital expenditures expected for 2009. Is this a relatively inexpensive event? And if the business were to pick up, say on the fertilizer side again and becomes profitable, can you move ship production back to the lower grade easily or is this a situation where once the migration's taken place it's a done deal.

Randy Gress

I think that, as far as the investment, it is fairly modest that was included in our capital plan there and the 20 to 25 million expenditure. Basically, it does give us a great deal more flexibility to support our growth in the food business as well as support our overall asset backed work. As far as the flexibility, it does allow us to convert back if the need or the opportunity was there.

Christopher Butler - Sidoti & Company

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

Randy Gress

Thanks Chris.

Operator

Your next question comes from the line of Jeff Zekauskas from JPMorgan. You may proceed.

Jeff Zekauskas - JPMorgan

Hi good morning.

Randy Gress

Good morning, Jeff.

William Farran

Good morning, Jeff

Jeff Zekauskas - JPMorgan

I guess a couple of general questions and a couple of specific ones. Your operating margin in the quarter was 32% and if you go back to 2007 and 2006, your operating margin was roughly between 6 and 8%. We've had this very unusual appreciation in raw material costs, having to do with a tightness in the fertilizer industry that's now past. Wonder if magnitude what should your normalized margins pay? That is, should they go back to that say 6 to 8% level, or using that they will reach out a different level because of the change in industry dynamics? Can you talk about that overall?

Richard Heyse

Hey, let me say there is lot of moving pieces right now, it's harder started forecast more than a couple of quarters. As far as the operating margins here again, we've been trying to shift mix towards the Specialty products which had a higher operating margin. But clearly right now we are benefiting from the price increases in excess of raw material cost.

Jeff Zekauskas - JPMorgan

Alright.

Richard Heyse

Randy mentioned there will be some pricing pressure. To try to project out in to 2010, 2011 or we return to kind of historical norms, Randy touched on that and the press release the script is found, (ph) I think that that's very possible but we've got, again a number of moving pieces that and most notably it would be what is the intensity of Chinese competition? They are facing some new pollution control regulations, they are getting the benefit of lower energy prices. Energy dropped pretty dramatically and they use the... enter a different route to making specialty phosphate, as well as very energy intensive.

But to me the biggest single driver probably and what it will be our future operating margins is will be dependent upon the intensity of Chinese competition, on our cost structure which is heavily dependent upon energy prices.

And because they are loosing, but they have been ... if we are really seeing now from product prices are in China, you can see the effect of them loosing the support, the subsidies they have been getting from the government and we are anticipating within pollution control regulations, they're going to have some more pressure. So, ultimately if we can answer, it's hard to answer your questions.

Jeff Zekauskas - JPMorgan

It's hard to know.

Richard Heyse

If you can get something where oil prices are going to be in 2010 and 11 it probably can give us a better answer. If oil prices and energy prices are high I would expect us to have better margins in particularly Specialty businesses if they stay low, it's going to be pretty competitive for the next couple of years.

Jeff Zekauskas - JPMorgan

Okay. Secondly, one of the things that Innophos has really been characterized by over the past two or three years has been the stability in demand. And what's happened is that demand has gotten more volatile. Now part of it is that, it seems that, you've had some difficulties with your customer base in Mexico. But even if we exclude that, I think it seems that the demand volatility now is much greater than it has been.

So, when you look at this down 48% number, is it natural to assume that four quarters from now or three quarters from now you should be up 20% or is demand is the not kind of thing that would spring that ... spring back that way as inventories are rebuilt?

Randy Gress

Let me just comment on the overall demand. I think if you break it into the different major product categories; first, you look at what we were hit in the fourth quarter and what we are seeing now in fertilizers side, with our co-product that's basically been non-existent in the market demand. I think if you look at the acid side, we've seen some decline there because of the heavier amount that's in the technical applications and impacted with some of what's going on with the global recession and what we are facing there.

And then on the Specialty Salts and Specialty Acids, certainly the portion that's in the food, pharma and consumer side and the consumable side, we've always said that we are resistant to any kind of economic downturn. I think in that area, we may be seeing some correction in inventories, because it is a long supply chain from the grocery chain to the manufactures, even into the home of consumers.

So, I think certainly in that area we would expect some recovery in what we have on the supply side. As far as the overall impact going forward with some of the corrections in the chain, I think we would expect to see some more recovery in the fertilizer and in the other products, but just how great that would be is difficult to determine right now with what's going in economy.

Jeff Zekauskas - JPMorgan

That's helpful. Just a couple of small things. How many NOLs do you have remaining or what's the aggregate amount of your tax NOLs remaining?

Richard Heyse

It's very minimal. The little bit we have at the state level frankly and yes about 4 or 5 million.

Jeff Zekauskas - JPMorgan

4 to $5 million.

Richard Heyse

But we've pretty well consumed the NOLs plus the balance in essence that we were... because we are going to remove the valuation allowance. That value is pulled in the balance sheet in the fourth quarter. We'll give some specific disclosure on that when we file our K, but in essence the tax impact is recognized this year.

Jeff Zekauskas - JPMorgan

And then lastly, when you see product substitution because prices have moved up, where is that, in which product lines?

Richard Heyse

Where we've seen it, I think we have commented before, it would be we've seen some modest substitution in the STPP and it's other than that it's been minimum, but it's just been primarily in the STPP area.

Jeff Zekauskas - JPMorgan

Okay. Thank you very much.

Operator

(Operator Instructions) Your next question comes from the line of Frank Mitsch from BB&T Capital Markets. You may proceed.

Frank Mitsch - BB&T Capital Markets

Hi thank you and good morning.

Randy Gress

Good morning, Frank.

William Farran

Hey, Frank.

Frank Mitsch - BB&T Capital Markets

I was curious about assertion that your volumes are going to be off 15% in the first quarter versus the fourth quarter can you give a little bit of breakdown as to which end markets you anticipate those ... that 15% drop off sequentially?

Richard Heyse

The ... you will get it, as we kind of in the script, we are seeing more in the, what we would call our technical grade, if you look grades, in phosphates, agricultural, technical then food, and then finally pharma. The technical grade is getting used in industrial situations, also for agricultural making various components for agricultural fertilizers. And those markets are very much been effected by the recession. But we would also see in the first quarter, and this is similar to what a number of food product companies have commented is that it appears even there is some a bit of fall off in the food categories as grocery stores and the inventory channels reduce inventories.

And I think part of what we're seeing is similar to what other chemical companies are seeing, in that the GDP is contracting very rapidly. There was an inventory build up in the U.S. in the fourth quarter despite a slowdown in production. And I think across the board, companies were seeing that similar kind of follow up. I've heard quotes today as much ... that U.S. GDP may be off anywhere from 6% to 7% in the first quarter, which is year-over-year, which is a pretty staggering number.

So there is definitely a recession out there and I think we're seeing it like most companies are.

Frank Mitsch - BB&T Capital Markets

I am trying to get a handle on the 15% breakdown. It sounds like you'd put some in the food and beverage camp, some in the detergents camp, some in the industrials camp and some in the fertilizer camp?

Richard Heyse

Yeah it's probably the ... two-thirds of it are, two-third is probably in the, the technical applications which would be detergency, industrial and in fertilizer we said it's just been the market is non-existent its still ... it's just barely starting to functionalize couple of weeks.

So that market that we didn't shipped much product in the fourth quarter, so relative to that 15% is more in the detergency and the tech and industrial.

Frank Mitsch - BB&T Capital Markets

I see okay. And then you, you obviously mentioned about the Mexican client so that's going to continue to be a volume ... negative volume impact as far as you can see, is that correct?

Richard Heyse

Correct.

Frank Mitsch - BB&T Capital Markets

All right, great. And with respect to the environmental litigation that you are currently ongoing, you see pretty much issue one, is not material however issue two, it sounds like an open ended liability with an in-determined cost. When might we get clarity on that issue?

Randy Gress

I'm going to ask Bill Farran to answer that.

William Farran

Yeah, thanks for the question. Yeah I think we are sort of working with the technical teams on that and with the government parties, I think we regularly update the government and so they are familiar with this issue. And I know it's hard to predict just when a technical solution to something will be found. I consider we have some very capable teams of both companies working on this and I would expect this issue to be better known in the summer.

But the talks with the government are continuing and as I mentioned briefly in the presentation, it's difficult now to determine whether the whole matter will settle or whether we're going to have to get the help of a court on the interpretation of the exemptions for the whole site for both matters that we've been claiming. But we now think it's probable that we are going to reach an agreement with respect to the first issue with the government won't have the cross swords on that.

But the second is both a legal and a technical head-scratchier right now. So, if I would discuss, we will have more insight into it this summer.

Frank Mitsch - BB&T Capital Markets

Your engineers' best guess on the amount of funds that might be required for the second solution, technical solution, I mean it's just, are you just trying as to put this in a breadbox, if you will, I mean how large could this be?

William Farran

Well as I said, it's something that can't be resolved by agreement. We'll litigate the exemption. But I can put a number on a technical solution, it really hasn't been identified. I mean this is side and others have long claimed we think rightly, a mineral processing exemption from the hazardous waste loss which is the matter that is in dispute across the country.

So, we aren't alone in this. It's not sort of remote sort of claim we're making. It's in fact something that there is a reason there is an exemption. We have large volume materials that have to be handled.

So, I mean, if we don't have the technical solution to handle it as the government wants us to, I can't put a number on that. I can say that to become something that the companies are not willing to underwrite we will engage in litigation.

Frank Mitsch - BB&T Capital Markets

Alright, terrific and while on a top litigation and arbitration if you will, the Moroccan phosphate rock situation is one way to think about that is that as everyday goes by, it appears that phos rock prices are coming down. Would it not be in the Moroccan favor to trying to get this to get a ruling sooner rather than later on this that or am I thinking about this wrong?

William Farran

No, I think you're thinking about it correctly and I think that parties are both in agreement generally that it ought to move forward expeditiously. I don't know whether you're familiar with international arbitration. This is at the ICC in Paris, that will require an agreement and there are some issues that are flying back between the parties right now, if you will, to frame on that.

But I am optimistic about the companies both agreeing to do this on an expedited basis.

Now, what that means though isn't something it'll happen tomorrow afternoon, its litigation. You have to sort of start counting back from, you've got three world-class arbitrators, so they'll need some time to make a decision. You've got the presentations to the parties. So when you start to do that on a calendar basis, you're probably at best in the middle of the year.

But to answer your question, yes, I think it's in the interest of both parties and we're hammering out what we hope will be an agreement on expedited basis.

Frank Mitsch - BB&T Capital Markets

Terrific, thank you.

Operator

Your next question comes from the line of Bill Hoffman from UBS. You may proceed.

Bill Hoffman - UBS

Hey, good morning.

William Farran

Good morning, Bill.

Randy Gress

Good morning, bill.

Bill Hoffman - UBS

I just wanted to, Richard I just want to run through the working capital cash releases as you go through the period, you talked about one having built a lot of inventory in fourth quarter. I am just trying to get a sense on how that starts to flow out in first half and you also mentioned that your cost structure is pretty well locked in for that first half of the year. So can you explain a little bit more about the cash release?

Richard Heyse

Well, we said we increased working capital inventories in particular and somewhere it didn't make sense before the annual price resets unless some pre-buying occurred. Also, one of the things we did is we paid all of our bills, so unlike most parties in the fourth quarter, we were receiving inventory and paying off bills and though the jest of that was $118 million. I think as our unit inventories drop and as we get down to kind of normal levels of on-hand inventory which should happen in the first and second quarter, we'll see some of that value come out, working capital gets changed to cash, but the balance will have to wait till 2010 until some of our unit prices drop further.

Likewise, on receivables we're seeing that drop a bit, as sales drop so we're getting some recovery there. But I think it's reasonable that between now and say first quarter 2010 we should recover maybe about half of that working capital. And again you throw that in with we expect to have positive operating cash flow in the year and we feel pretty good about our cash position for the year.

Bill Hoffman - UBS

Great, that's very helpful. The second question is just given some of the color that you guys provided certainly about the Mexican facility, I think the thing that I am still questioning is thinking about the margins the domestic U.S. business and how that may trend back down towards more normal levels? Just because I guess I ... the one thing I really question is, your costs are up because you got the inventory on hand and will stay at these kind of elevated levels yet demand seems like its softening and I would have expected prices to start to come down.

Can you just talk about that dynamic and when you start to see your margins getting compressed?

Richard Heyse

Yeah again I think as we said in the press release that we would expect there is going to be pressure on pricings through the year. In the past we identify these situations, we when we're ... we respond to competitors, we know which customers we served long term and we're clearly going to maintain overall competitiveness with those customers.

So, as but as Randy said in the script, its beyond the first quarter it's very difficult right now to predict the competitive environment besides that we know the intensity is going to be high. But we'll be dynamic in our response and we'll stay competitive at the customers that we have served long-term.

And we will just simply as if the year evolves and each quarter we'll just have to get everyone update. But at this point we know what the first quarter, the good feel for the first quarter, but we're still not ... we don't know what things we have to respond to in the second quarter as competitors take action.

So, wish will give you better clarity this we said in the script, it's a very, very difficult time right now and I don't think many companies are able to pierce through the second, third, fourth quarter and predict what things are going to look like.

Bill Hoffman - UBS

Do you have any sense even in the first quarter here maybe what the cost inventory position is of your competitors i.e. do they have a lot more flexibility in having lower raw material costs coming into the year than you might...

Richard Heyse

Again, it depends on the competitors. There are several our European competitors are not integrated back to phosphate rock like similar to Innophos. So, we don't have ... we cant ... we don't know what their purchasing arrangements are, so we can't guess and say what their cost structure is. We do have one competitor, is really chemicals and that is integrated back to rock, and in is real. And so, they clearly have got a good cost structure. But generally we've had a reasonably good cost structure also with our contracts and have been able to compete profitably.

I think the flipside if you look at the lower end of our portfolio where the competition is more based in what we're seeing particularly for Mexico is based out of China, part of what ... due to some actions by the Chinese government their phosphate rock cost is somewhat below market levels, global level. So they have had some advantage due to effect of the regulations in China and into regulated economy.

And so, there ... until the cost of phosphate rock in China gets back to normalized with world levels they do have somewhat of an advantage right now.

Bill Hoffman - UBS

Great, thanks that's helpful.

Operator

(Operator Instructions) Your next question comes from the line Mary Ananthakrishna (ph) from Nomura (ph). You may proceed.

Unidentified Analyst

Hi. I was wondering how much do you think prices would have to fall in order to, to invite competition and basically return to the competitive environment you've seen early in '08.

Randy Gress

As far as ... can you repeat the question?

Unidentified Analyst

Basically how much do you think prices of the finished products would have to fall in order to put the market back in the position it was early in 2008 where you then you, then you will describe the market as being super tight and brutally very little foreign competition?

Randy Gress

If I can make some comments, I am not sure if I'll get it directly. I think as far as the ... there was some global tightness in the overall supply demand balance in the beginning of '08, but at that time also there was a significant run up in cost. And throughout the year, we had implemented a series of price increases throughout the year. I think some of that is capturing some of the value and use of the products, especially on the Specialty Salts, Specialty Acid side and some of the critical functionality that those products provide.

And going into this year, we are still seeing at the high end here, some still improvement in the price, in the value we're giving on those products. It's in the lower end on the portfolio where we're seeing some more competition and pressure on prices right now.

Unidentified Analyst

And regarding your raw material costs are going to be up for you and you mentioned that in second quarter you would expect raw materials to be higher by $20 million if the Mexican plant is running at 50% and by $40 million per quarter, if the Mexican plant is running at 100%, is that, would that be kind of where they would peak or would we expect to see more increases after that, given your contract positions?

Richard Heyse

Let me explain in our disclosure as Bill touched on. What we've in our disclosure is the worst possible outcome of the arbitrary, with the correct language. The high end of retail (ph) competitive outcome, using the language correct. So we are trying to box the range of what we think is possible out of the arbitration and in that case in the event, it go that way be roughly about $10 million and assuming we stay at roughly 50% operation and the impact on Mexican cost is $10 million in the second quarter and $20 million each quarter after that.

As we said U.S. cost structure, sulfur has dropped pretty dramatically in the last two quarters. So the decrease in cost related to sulfur prices dropping in marketplace has offset some of the other increases for some of our contracts in net and net, it's pretty much going to be a wash. So our cost structure we are looking at for the U.S. business for all of 2009, we expect to be pretty similar to the unit cost structure that we had in the fourth quarter of 2008.

But clearly the biggest single issue that we have as far as the cost structure 2009 is the outcome of the arbitration and those will have to be patient and work through that process and drive through best possible outcome on that front.

Unidentified Analyst

Would you just clarify what do you just, Bill you said you said in Mexico it would up $10 million in second quarter and then $20 million each of the following quarters?

William Farran

Correct as we basically we're in a fight for inventory basis...

Unidentified Analyst

Okay.

Richard Heyse

So as that new rock feeds there (ph) and start to hit our cost of sales that would be sometime in the middle of the second quarter based on we had to deal with fairly high inventory levels in 2008 in Mexico. That's going to take a while to rotate through the on-hand inventory and for that cost to rock to show of in our financials.

William Farran

That yeah -- just let me clarify again that's based on the disclosure and that's based on high end of what's reasonably possible in the results on the arbitration where our expectation would be significantly and materially below that on the outcome.

Randy Gress

As far as a challenge for us, it is essence a legal case, so we can't go in to specifics. We have to respect that process and so the ... from a disclosure point of view we simply only can disclose that reasonable possible downside.

William Farran

May need your help. Let's just take a quick minute on this. While any kind of litigation, including this arbitration is confidential, the financial accounting industry has long ago determined well how do you begin to box something like this. And we evaluate that under the financial accounting standard board's table number five. Where management's required to make a determination as to whether contingent liability and that would be the requirement in this case to pay more than what we're going to be paying for an interim price in 2009 once that agreement has reached.

And figure out whether that probability, whether that likelihood is either probable or reasonably possible or remote. And is there a range with respect to that determination and if so, is there any number that is more probable than another. We could have used in our disclosures, the number that we believe is probable, which is the number we have calculated under our determination of the interpretation the contract clause.

But we've done something different than that. We've said, let's look at the reasonably possible range and let's make our disclosures and our outlook on the basis of the high end of what we think is reasonably possible. We think that's fairly conservative. That's ... its not specific numbers because of the confidential nature of it. But work through of the FAS 5 evaluation, that's where we came out and that's sort of how we build our outlook and our disclosures in this situation.

Randy Gress

This was the consistent approach that we've been following all along.

William Farran

Okay and aggressive approach and more aggressive approach if we just say, just check our number because our evaluation has that is the most probable, but that's not what we would use.

Unidentified Analyst

And then when you estimate this worst possible outcome for the rock price?

Richard Heyse

Reasonably possible.

Unidentified Analyst

Reasonably possible, so how does that price compare to the current rock prices for phosphate rock?

Richard Heyse

There is I mean ... one, it's just tough to comment about. It's within the range of market prices from last year. Right now there isn't a phosphate rock market that's functioning if you look at any trade magazine that reports on that, they're all saying that there is no effective market to quote. So, really no one ... the market hasn't restarted. So we really can't comment to how does that compare to current market because there is no current market.

Unidentified Analyst

Okay, thank you.

Operator

Your next question comes from the line of Richard O'Reilly from Standard & Poor's. You may proceed.

Richard O'Reilly - Standard & Poor's

Okay, thank you. Good morning, gentlemen. Two questions, the OCP rock price for '09 that is determined by price changes in '08. So, what you are looking at is based upon '08, so whatever the today's rock price is, market price is, really that sets for 2010. Am I correct with that thinking?

Richard Heyse

There are actually a number of moving parts on that. One, you take at any point in time; you take the then current contract price. And then you determine what has been the variation between, if we're trying to find out the 2009 price, you would take the variation in the market between first half '08 and first half '07.

So, it's not a simple matter as looking at any current market condition or broad average for a particular period of time. You have to know the starting point and then you have to know the variation. Now, I think folks begin to box this. We are just constrained on confidentiality, but folks can begin to box some of this with some probably available information.

Randy Gress

I think to its question 2009's market price doesn't feed into our 2009 price for rock and OCP.

Richard Heyse

Right, the 2009 price would begin to feed into the determination for 2010.

Richard O'Reilly - Standard & Poor's

Okay. Great that was my broad understand. Okay thanks. Second, you give price and volume change for your products and for STPP and other it's a negative 125%, can you explain that?

Richard Heyse

That's an accounting artifact. If you ... what we report is the price variance and then the combined volume, mix impact upon revenue. And when you, when one's doing the variance calculations, at the end one of the three has to be a plug. And we just gave the numbers that are so large that it's forcing and it happens to be not quite meaningful.

I think the way to look at volume is as we said, volumes in Mexico are roughly 50% of capacity levels overall when you look all the product lines there. And in the fourth quarter the U.S. was more kind of normal levels would have been of fall off of the technical side.

But we are just ... with the magnitude of our price increases combined with no fertilizer sales and fertilizers are high-volume low-priced item, it drives some very strange calculations unfortunately. But we have to stick with our methods and report that way.

Richard O'Reilly - Standard & Poor's

Okay, fine. Is it correct to assume that overall for the Specialty Salts and Acids that is generally the high up margin product category?

Richard Heyse

Correct, one way we have described if you look, say historically 2006, 2007 margin percentages between STPP, Specialty Salts and Purified Acids might be similar, but the Specialty Salts sell for much higher prices per pound. So when you look at a profit per pound, it's significantly higher than the other products.

Richard O'Reilly - Standard & Poor's

Okay. Fine. Okay, thank you for that.

Operator

This concludes the question and answer portion of the call. I would now like to hand it over to Mr. Randy Gress, CEO. You may proceed.

William Farran

No, operator this is Bill Farran. And I had one additional clarification question, Randy about the expected impact of reduced sales to the customers that you've mentioned in Mexico, in connection with the closure of its Mexican STPP plant, both in the press release and the earnings call presentation, you mentioned a range of annual operating income reduction.

Could you go over that one last time, because I may have misheard you there?

Randy Gress

Yes. Thanks, Bill. As far as the impact on the companies based on a historical basis, we're actually looking at an operating income reduction between 6 and $16 million based on pre-2008 historical profitability. And also based on management's success that the mitigation efforts and again we're focusing on offsetting those sales, continuing sales, with the customer offsetting some additional sales and then also investing to increase our food grade capability within the side to support our other growth initiatives.

William Farran

Okay, great, sorry for the interruption.

Randy Gress

Thanks. Yeah, in closing I want to thank everyone for participating in the call and thank you for your questions and look forward to updating you in the next call.

Thank you.

Operator

Thank you for your participation in today's conference. This concludes the presentation. You may now disconnect and have a wonderful day.

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

THE INFORMATION CONTAINED HERE IS A TEXTUAL REPRESENTATION OF THE APPLICABLE COMPANY'S CONFERENCE CALL, CONFERENCE PRESENTATION OR OTHER AUDIO PRESENTATION, AND WHILE EFFORTS ARE MADE TO PROVIDE AN ACCURATE TRANSCRIPTION, THERE MAY BE MATERIAL ERRORS, OMISSIONS, OR INACCURACIES IN THE REPORTING OF THE SUBSTANCE OF THE AUDIO PRESENTATIONS. IN NO WAY DOES SEEKING ALPHA ASSUME ANY RESPONSIBILITY FOR ANY INVESTMENT OR OTHER DECISIONS MADE BASED UPON THE INFORMATION PROVIDED ON THIS WEB SITE OR IN ANY TRANSCRIPT. USERS ARE ADVISED TO REVIEW THE APPLICABLE COMPANY'S AUDIO PRESENTATION ITSELF AND THE APPLICABLE COMPANY'S SEC FILINGS BEFORE MAKING ANY INVESTMENT OR OTHER DECISIONS.

If you have any additional questions about our online transcripts, please contact us at: [e-mail]. Thank you!