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Executives

Eric Glover - Investor Relations Manager

J. Neal Butler - Chief Executive Officer, President, Director and Member of Risk Oversight Committee

John V. Sobchak - Chief Financial Officer and Vice President

Analysts

Richard O'Reilly

Daniel D. Rizzo - Sidoti & Company, LLC

KMG Chemicals (KMG) Q2 2013 Earnings Call March 8, 2013 10:00 AM ET

Operator

Good day, ladies and gentlemen, and welcome to the second quarter 2013 KMG Chemicals Earnings Conference Call. My name is Lisa, and I'll be your operator for today. [Operator Instructions] As a reminder, this conference is being recorded for replay purposes.

I would now like to turn the conference over to your host for today, Mr. Eric Glover, Investor Relations Manager. Please proceed, sir.

Eric Glover

Thank you, Lisa. Good morning, everyone and welcome to the KMG Chemical Fiscal 2013 Second Quarter Financial Results Conference Call. I'm joined today by Neal Butler, our President and CEO and John Sobchak, our CFO. In a moment, we'll hear remarks from them, followed by Q&A.

Before we begin, I'd like to remind everyone that the information on this conference call includes certain forward-looking statements that are based upon assumptions that in the future may prove not to have been accurate and are subject significant risks and uncertainties, including statements as to the future performance of the company.

I will now turn the call over to Neal Butler, President and CEO. Please go ahead, Neal.

J. Neal Butler

Thank you, Eric. Good morning, and again, welcome to KMG's Fiscal 2013 Second Quarter Conference Call. John Sobchak and I will take you through the financials and provide an overview of each of our businesses. We will then discuss our expectations for the fiscal third quarter of 2013 and our outlook for the fiscal 2013 year. After our comments, we'll be happy to answer your questions. Earnings release was issued this morning and we plan to file our 10-Q on Tuesday.

The second quarter operating environment was unusually challenging, characterized by year-end slowdown in semiconductor production and reduced customer demand within our Wood Treating Chemicals segment. Generally speaking, it's unusual for us to experience sales weaknesses in both of our Electronic Chemicals and Wood Treating Chemicals business within the same quarter, but that's what occurred in the fiscal second period.

Although we had anticipated and expected a short-term decline in global semiconductor manufacturing, the degree of slowdown in production and associated deleveraging of inventories was somewhat greater than what we had forecasted and communicated earlier. This was true in most geometries, including high-technology fabs. Rail tie treating and pole treating also slowed during the quarter and sales were adversely impacted by unplanned outages at customer plant sites, but demand has since seen significant signs of recovery.

Given these conditions, coupled with the expected demand downturn, we responded quickly and effectively to challenging macroeconomic operating environment, reducing manufacturing expenses where possible and continuing to work within our supply chain partners to achieve greater efficiencies. And as a result, we better aligned our cost structure to the temporary reduction revenues, minimizing the impact to earnings and cash flow. For example, within our Electronic Chemicals business, we have remitted several continual improvement initiatives, including increased utilization of rail freight to reduce supply chain cost for finished goods. We also refined our storage and distribution strategy by relocating certain finished goods inventory, more advantageous geographic locations, minimizing the transport and consignment stock and transporting more inventory by rail to reduce shipping costs.

Within our Wood Treating Chemicals business, we then took several initiatives that will help maintain our margins and position us to take full advantage of expected buying demand increases in the near future. More specifically, some newly restructured supply contracts and recent targeted pricing actions should begin to benefit our Wood Treating Chemicals business starting in the current third fiscal quarter.

In summary, these actions and others like them undertaken in the second quarter were instrumental in enabling KMG to bolster gross margins and reduce operating costs during a particularly challenging period. We believe these optimization efforts will have a lasting positive impact on our business, especially as improving end market demand drives higher manufacturing and shipment volumes.

With our strong balance sheet and robust acquisition pipeline, we remain well positioned to pursue additional acquisitions or other strategic opportunities to enhance our market-leading positions. We are pursuing potential acquisitions in our current businesses, as well as in the establishment of a new platform. By design, our acquisition processes is deliberate and disciplined, ensuring that any acquisition we make will satisfy our regular, strategic and financial criteria. As we noted last quarter, we have a strong pipeline of opportunities. We are actively pursuing these and are optimistic about our near-term prospects.

I'll now turn the call over to John who will discuss our financial results in greater detail.

John V. Sobchak

Well, thank you, Neal, and good morning, everyone. Before I begin I'd like to remind everyone that due to the sale of the Animal Health business in March of 2012, this former segment is now classified as a discontinued operation. Prior year information has been reclassified to conform to the current period presentation.

Second quarter sales declined 15% year-over-year to $57 million from $67 million in the same period a year ago. By business segment, Electronic Chemicals sales declined by 7.8% year-over-year to $35.6 million and Wood Treating Chemicals sales declined by 25.4% to $21.2 million. These quarter-over-quarter declines were primarily volume related, as pricing generally was maintained and average gross margins increased.

Consolidated gross profit for the second quarter of 2013 was $15.7 million or 27.6% of sales. That compared with gross profit of $17.1 million or 25.6% of sales in the second quarter of fiscal 2012. The year-over-year increase in gross profit margins reflect the improved price in the Electronic Chemicals segment and a reduced percentage of Creosote sales in our total revenue mix.

As the distributor for Creosote

[Audio Gap]

From $5.8 million or 8.6% of sales in the year-ago period. Most of our distribution expenses attributable to the Electronic Chemicals segment, which was a greater percentage of total revenues in the second quarter of fiscal 2013 relative to the year-earlier period. SG&A expenses were $6.6 million or 11.6% of sales in the second quarter versus $6.5 million or 9.6% of sales.

[Audio Gap]

$683,000 primarily involving consulting and other services in advancement of our consolidation strategy. We anticipate these project costs will decline significantly in our fiscal third quarter. Our consolidated operating income was $3.2 million, down from $4.9 million in last year's second quarter. The year-over-year decline in operating income was due to lower sales and the associated impact on profitability, as well as additional project costs, as I mentioned previously.

Diluted earnings per share were $0.14 in the second fiscal quarter of 2013, down from $0.21 in last year's second quarter. Our effective tax rate for the quarter was 39.3%, which actually turned out to be a bit higher than we had earlier anticipated. Electronic Chemicals segment operating margins after corporate allocations improved by 30 basis points to 6.8% from 6.5% in the same period last year. The improvement in electronic

[Audio Gap]

We anticipate that segment margins will rebound in our fiscal third quarter driven primarily by higher manufacturing volumes, but also by targeted pricing action trying to recapture raw material cost increases. We also look to realize incremental gains in operating efficiency from our ongoing continual improvement program.

Wood Treating Chemicals segment operating margins after corporate allocations were 10.5% in the second fiscal quarter, down from 11.4% in the same period last year. The margin decline reflected lower sales due to seasonal factors, unexpected shutdown of customers' Wood Treating facilities and competitive pressures from alternative processes and materials in the rail tie treating market. We anticipate that segment margins will improve in the third fiscal quarter as sales improve on a seasonal basis and customers production facilities come back online in conjunction with targeted pricing actions that have been implemented. We also continue to work to build and strengthen alliances with strategic market participants.

Our balance sheet remains in excellent shape with working capital of $52 million and long-term debt of only $22 million as of January 31, 2013. We have $58 million of availability on our revolving credit facility and $5 million of cash, providing ample resources to help further our consolidation strategy. Despite the challenging operating environment we experienced in the second quarter, we generated $2.3 million of cash from operating activities, bringing our fiscal year-to-date operating cash flow to $8.6 million.

And now I'll turn the call back to Neal

J. Neal Butler

Thank you, John. I'll now provide some additional commentary and our outlook for the fiscal third quarter and the fiscal 2013 year. Assuming no major disruptions to the global economy, we anticipate that both our Electronic Chemicals and Wood Treating Chemicals businesses will strengthen in the second half of fiscal 2013 relative to the first half. We are encouraged by the sales uptick we've seen in both of these segments in the first part of calendar 2013 and believe that an improvement bodes well for our fiscal third quarter. Regarding our Electronic Chemicals business, market research suggests global semiconductor production will increase between 4% to 6% on a year-over-year basis in calendar 2013 as the semi-conductor industry rebounds from a disappointing finish to calendar 2012.

Given our strong presence in both the U.S. and European markets, we are well positioned to benefit from this projected increase. Already, we're starting to see a recovering demand for our web process chemicals driven by rising semiconductor production. Additionally, we continue to benefit from growing market demand for our highest purity products. As semiconductor process and technology advances and production moves to even finer geometries, the purity requirements of the chemicals used to edge and clean silicon wipers continues to increase. KMG is at the forefront of this trend, supplying a range of ultra high-purity chemicals that can meet the demanding purity levels required in the world's most advanced semiconductor fabs.

Within our Wood Treating Chemicals business, we look for sales to improve in the third quarter relative to the fiscal second quarter as railroad crosstie production is expected to remain high relative to average historic levels and the utility pole market replenishes inventories, which had depleted during Hurricane Sandy or following Hurricane Sandy. We believe the demand environment for rail tie treating will improve, but anticipate sales will remain somewhat below the levels we saw on the third quarter of 2012. In addition, as John mentioned earlier, we should begin to see benefit from targeted pricing actions, which have been implemented in this third quarter.

Meanwhile, as mentioned, we continue to pursue acquisition or other strategic opportunities that will enhance our leading positions in our Electronic Chemicals and Wood Treating Chemicals businesses. Additionally, as noted in previous calls, a strategic initiative is the establishment of a new platform prior to the end of fiscal 2014. We have nothing specific to announce on this front at present, however, we are assessing solid opportunities in key material additive sectors. While we cannot provide more specific details at this time, we continue to work diligently to identify, evaluate and close on transactions that will enhance our earnings and cash flow and generate long-term value for KMG shareholders in line with our growth strategy.

I'll now turn the call over to the operator for questions.

Question-and-Answer Session

Operator

[Operator Instructions] Your first question comes from the line of Richard O'Reilly.

Richard O'Reilly

John, when you were talking about the gross margin, you kind of faded a couple of times, you started talking about the distribution impact. Can you just repeat that, I think I know where you're going, but I just don't know how big those distribution adds up as a part of your 2 segments are?

John V. Sobchak

I had mentioned that distribution expenses had increased by a rate of $5.9 million from $5.8 million in the year-ago period, and most of our distribution expenses attributable to the Electronic Chemicals segment, that's because in those Wood Treating Chemicals segment, generally, we're selling our product that would be the planned [ph]. So Electronic Chemicals, as it becomes a bigger portion of the total revenues ends up increasing the distribution expense as a percentage of sales.

Richard O'Reilly

Versus the gross margin, okay.

John V. Sobchak

I'm sorry, I should mention that other companies sometimes include a distribution expense in cost of goods sold. KMG does not. We separate it out as a separate operating expense item.

Richard O'Reilly

Fine. Okay, fine. So we would see it in the growth -- we would see your numbers in the SG&A line versus the gross line, okay. Okay, but do you think the overall impact on the operating margin for the segment works out to be about the same?

John V. Sobchak

Yes. There is -- in the Electronic Chemicals business, just because of timing of the movement of some products, there can be a small shift in distribution expense from period to period. In general, the distribution expense has been holding, I think, very well. There's been upward pressure from the cost of freight, so trucking costs have increased. The offset to that is that our operations team has been very diligent and effective at driving greater efficiencies into our distribution channel.

Richard O'Reilly

Okay. If I can ask a second question on your expectations longer term for margins in the Electronics business segment. I know that, that includes some unallocated -- the unallocated cost, so how do you see your margins in that longer term? I think in the last few quarters, the Wood Treatment has been higher. So if anything, the sexy business doesn't look like it has the sexy margins.

John V. Sobchak

The Electronic Chemicals business actually has more fixed cost overhead. So the facilities are more expensive and so because of that, it's more volume sensitive. And we'll see operating leverage through higher volume throughput that will improve margins. With the expansions that our customers have on their horizons in North America and some additional business that we expect to come our way through these organic growth opportunities, as well as just a recovery from what's been a downturn in the semiconductor production industry we expect volumes to increase through the fiscal year and as a result, margins will improve as well.

Richard O'Reilly

Do you ever talk about a long-term goal for margins for the business?

John V. Sobchak

We have. And frankly, we kind of exceeded our goal and I think it was the fourth fiscal quarter of 2012. So we've done well versus what our initial targets were for the business when we first got involved in it. And now what we're working on is setting new goals and new opportunities through expanded production and organic growth of those facilities.

Richard O'Reilly

If I can ask another question, on the Wood Treating, your customers for the utility pole, what was the nature of their problems because I would have just thought they would have been wanting to at least running full out?

John V. Sobchak

Yes. I wish I had greater insight into this. One of the issues, of course, is that there's -- the ultimate customer of the utilities and there's thousands of them across the United States. What we have been able to determine is that the inventory of utility poles that are treated and ready to be installed is at a low level. We don't think that there's that serious a concern about it right now because for the most part, we're out of the high storm season, we're out of the hurricane season. Most of the poles that we lost this year in the United States were in the Northeast part of the country as a result of Sandy. Unfortunately, that's kind of the home turf for our competing product, which is chromated copper arsenate, CCA. However, when it comes time to replace inventories across the country, and during Hurricane Sandy and the aftermath, utility poles are brought in from all over the country, and so there are plenty of Penta poles that were installed in the Northeast. There was a Penta pole installed across my mother's house in Queens, New York.

Richard O'Reilly

Probably, where I'm in, in New Jersey, too.

John V. Sobchak

It was good to see. So we were frankly surprised by the downturn we saw around the holiday season in pole treating. We are seeing now a pickup of that. And why that occurred, it could be for a number of reasons. Sometimes it's as simple as weather prohibiting the harvesting of the wood for pole treating because pole treaters don't need to let their wood dry out and cure as long as rail tie treaters to do.

J. Neal Butler

Yes. I think that one of the things we did see was that's just what we believe to be a delay in the replenishment. Some of the -- as John said, some of our treaters actually shut down their systems and did maintenance during -- particularly, during the month of December and part of that was driven by just the lack of available wood or the ability to get into the woods and harvest. And as a consequence, they shutdown and do their maintenance work. So that was a component of it. But to his point a while ago, we see the replenishment coming back now and we see the uptick in demand coming back.

Operator

Your next question comes from the line of Daniel Rizzo.

Daniel D. Rizzo - Sidoti & Company, LLC

Do you think additional pricing action is going to be necessary in the Creosote business or is it more of a wait-and-see?

John V. Sobchak

In the Creosote business, the issue has been primarily volume related. So there's been tension in the marketplace between the supply side of the equation and the demand side equation due to, generally speaking, higher energy prices and what the industry is now coining as carbon inflation. But for the most part, there's been some stability there. We've seen some erosion of prices in certain areas. As a whole, we've been able to maintain the profitability of the segments fairly well.

J. Neal Butler

Yes, Dan. I think just one -- just as a bit of a caveat, the impact in Creosote has been a consequence of demand environment, it has been a slowdown in just actual shipments in demand.

Daniel D. Rizzo - Sidoti & Company, LLC

So that would -- do we expect it to pick back up as the summer rolls in?

J. Neal Butler

Yes.

John V. Sobchak

There's one thing I would like to point out, and I'm glad you kind of bring some of these up. The impact of borate dual treatments that we've been watching very closely over the last several quarters, we had anticipated that there would be some erosion in the demand for Creosote. Because of this process, we weren't expecting it to be as widely accepted as it has been. And while certain industry trade groups do not support the reduction of Creosote usage per tie, that in fact is what is happening in the industry and it caught us a bit by surprise. At this point, we are looking at it as a structural change to the industry, how wood is being treated, and we're working to reposition ourselves in the business given the current market realities.

Operator

There are no additional questions at this time. I would now like to turn the presentation back over to management.

Eric Glover

To all audience, we sincerely appreciate your participation today. We thank you for supporting KMG. We look forward to speaking to you at our third quarter conference call. And with that, we bid you all a goodbye. Thank you.

Operator

Ladies and gentlemen, that concludes today's conference. Thank you for your participation. You may now disconnect. Have a great day.

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