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Ecolab Inc. (ECL)

Q1 2009 Earnings Call Transcript

April 28, 2009 1:00 pm ET

Executives

Michael Monahan – VP, External Relations

Doug Baker – Chairman, President, CEO

Analysts

Eric Hess [ph] – Citi

Mike Harrison – First Analysis

David Begleiter – Deutsche Bank

Bob Koort – Goldman Sachs

Laurence Alexander – Jefferies

John McNulty – Credit Suisse

Gary Bisbee – Barclays Capital

Mark Gulley – Soleil Securities

Rosemarie Morbelli – Ingalls & Snyder

David Ridley-Lane – Banc of America

Dmitry Silversteyn – Longbow Research

Annie George [ph] – Morningstar

John Roberts – Buckingham Research

Ed Yang – Oppenheimer

Jeff Zekauskas – J.P. Morgan

Operator

Ladies and gentlemen, thank you for standing by and welcome to the Ecolab First Quarter 2009 Earnings Conference Call. During the presentation, all participants will be in a listen-only mode. Afterwards, you will be invited to participate in the question-and-answer session. (Operator instructions) As a reminder, this conference is being recorded. Thank you.

We would now like to turn the call over to Ecolab. Mr. Monahan, you may begin your conference.

Michael Monahan

Thank you, Ashley. Hello, everyone and welcome to Ecolab's first quarter conference call. With me today is Doug Baker, Ecolab's Chairman, President and CEO, who will join us for the Q&A section following our review of the quarter's results. A copy of our earnings release and the slides referenced in this teleconference are available on Ecolab's Web site at ecolab.com/investor.

Please take a moment to read the cautionary statement on slide #two stating this teleconference and the slides include estimates of future performance. These are forward-looking statements and actual results could differ materially from those projected.

Factors that could cause actual results to differ are described in the section of our most recent Form 10-K under item 1A Risk Factors in our first quarter earnings release and in slide #2. We also refer you to the earnings release which includes supplemental diluted earnings per share information.

Starting with slide #3 in the first quarter, we delivered results in line with our forecast, despite very challenging market conditions, unfavorable currency trends and substantially higher year-over-year delivered product costs as we aggressively drove new account gains, new product sales, pricing and cost reductions.

Looking ahead, we expect to continue to outperform our markets and deliver superior growth once again in 2009. Starting with some highlights from the quarter as we move on to slides #4 and #5, reported first quarter 2009 EPS were $0.24. On a pro forma basis, excluding special charges and discreet tax items from both years, first quarter 2009 earnings per share were $0.33 compared with $0.39 last year.

Pro forma earnings per share reflected about $0.10 from higher delivered product costs, $0.03 of unfavorable foreign exchange impact and about $0.03 from the reduction in distributor promotions. These were partially offset by pricing and cost savings, including about $0.02 from our restructuring and the impact of new products.

We also continue to make key investments important to sustain our long-term growth in R&D, systems and people and our strategic sales and growth areas. In the U.S. we achieved strong sales growth from our Kay and healthcare businesses as we worked hard to offset slowdowns in our full service restaurant and lodging markets.

International showed strong sales gains in Latin America and Canada while Europe, Middle East, Africa and Asia-Pacific reported modest growth. To drive results in this more challenging environment, we have continued our aggressive sales efforts by emphasizing our innovative products that provide customers with labor, energy and water savings and using them to help deliver new account acquisitions among our national, regional and independent prospects.

We have also focused on cost savings, emphasizing productivity and efficiency improvements and increased pricing to recover higher raw material costs and offset unfavorable currency exchange.

Looking ahead, we continue to expect our full service restaurant and lodging markets, which represent about 30% of our sales to be off in 2009. However, we expect resilient trends to continue in 60% of our businesses including the quick service restaurant, food processing, healthcare, grocery, government and education markets where forecasts call for growth in 2009.

We expect pro forma EPS for the second quarter to be in the $0.46 to $0.50 range compared with pro forma EPS of $0.47 in the second quarter 2008. The second quarter 2009 is expected to see continued though less severe delivered product cost headwinds that will represent about a $0.05 hit to earnings. We also expect an approximate $0.04 per share hit from currency.

Our full year forecast remains the same. We expect modest fixed currency sales growth over the remaining quarters of 2009. However, less severe delivered product costs and the impact of cost saving actions should provide significant benefit to operating margins. This should yield improving pro forma earnings per share comparisons as the year progresses.

We expect the second half of 2009 to show double-digit pro forma earnings per share growth as these impacts benefit earnings. We continue to look for full year pro forma diluted earnings per share which excludes special gains and charges and discreet tax items to be up 5% to 10% and be in the $1.95 to $2.05 range.

In summary, we expect a strong performance for Ecolab in a very challenging 2009 environment as we leverage our markets with strong sales efforts to gain new accounts and better penetration. We will also implement appropriate pricing and cost reductions to deliver steady growth and shelter returns while continue to invest for future growth.

Turning to the details as shown in slide #6, Ecolab's reported consolidated sales for the first quarter declined 8%. However, adjusting for the change in distributor incentive programs, fixed currency sales were flat.

Looking at the components, volume and mix declined 4%, pricing was up 4% and currency reduced sales by 7%. The change in distributor incentive programs reduced sales growth by 1%, acquisitions and divestures were negligible.

Slide #7 includes growth by segments and by division. Sales for the U.S. cleaning and sanitizing operations decreased 5%. Excluding the distributor change, sales declined 2%. As expected, reported institutional sales declined as we changed the way we implement our distributor's incentive programs. Reported sales were off 8%, excluding the impact of the distributor change institutional sales declined 3%.

Our Apex solids wear washing line finished well ahead of plan and showed terrific momentum as heightened customer demand for cost savings and energy solutions drove interest.

New business gains were good and helped us mostly offset the recession's impact on our food service and lodging customers. The distributor incentive promotion change implemented in the first quarter went well. While it had significant negative impact on first quarter institutional sales, it should be reversed this year and be neutral to slightly positive to earnings. We believe the change will lead to better efficiency in our distribution system.

We expect another strong year in 2009 for our Apex wear washing system, which provides customers with new standards of performance and cost savings. We are using that strength to help drive the new account growth.

We are also utilizing improved prospecting tools and software and targeting independent accounts and regional chains with additional and redeployed sales people and programs. This includes additional sales people in corporate accounts, distributor sales, regional sales and specialization of sales people in the field. We expect these aggressive sales efforts along with pricing and market share gains to help us continue to outperform our markets in the second quarter.

Kay's first quarter sales grew 7%, primarily reflecting new account gains and new product sales. Business trends remain strong in quick service restaurants with continued good ongoing demand from major existing and new fast food chain accounts.

The food retail business continued to show strong growth with double-digit gain. New products and programs like the introduction of solids for QSR, along with customer wins continue to bolster Kay's results. We expect these initiatives along with continued good end market trends to help drive strong gains in Kay's second quarter of 2009.

Textile care sales increased 1%. New account sales along with pricing offset volume declines from existing accounts. We look for flattish results in the second quarter as the business gains and new markets continue to offset lower customer volumes.

Healthcare sales rose 8% as it compared against a strong quarter a year ago. Continued solid growth for our surgical draping businesses led the results. We launched a new non-aerosol foaming sanitizer for skin care in the quarter as well as Asepti-Wraps for surgical equipment and continue to expand our surgical draping business.

In addition, we acquired a small surgical protection and contamination control systems business to broaden our footprint in the operating room and leverage the growing orthopedic surgery market.

Looking ahead, second quarter sales should show continued good growth led by the surgical business.

Food and beverage reported sales declined 8%, however, excluding Ecovation, sales rose 7%. Good results for the food and beverage and water care businesses were offset by Ecovation, where a large project reported in the last year's first quarter impacted the comparison.

Food and beverage enjoyed strong gains in the dairy, beverage, agri, food and water care markets as better pricing, corporate account wins and new products drove sales. Water care sales experienced good growth in the quarter with a continued focus on our corporate account opportunities, particularly in food and beverage.

As expected, Ecovation sales were down from last year on a comparable basis reflecting the recording of a large project in the year ago period. Customer interest generally remains good and the need for Ecovation's affluent management and energy systems remain strong. However, customers are reluctant to commit to significant projects or make major capital commitments in the current uncertain economy. We expect slow results until market confidence firms up, but remain excited about its potential and the $4 billion market opportunity it addresses.

We expect good sales trends in the second quarter for the food and beverage business as we focus on new account acquisition, pricing and continued expansion of our water management platform. Ecovation is expected to see flattish results when compared with last year.

Vehicle care sales decreased 6%. Soft market demand due to the recession more than offset better pricing and new more sustainable products and programs. Vehicle care continues to focus on new programs and new market opportunities to drive sales.

The division recently introduced an operational cost management program to help car wash operators critically analyze their operations and achieve cost savings through energy and water conservation. This should help boost future sales. We expect the second quarter will be challenging and likely a lower sales environment for the vehicle care division.

Sales for U.S. other services decreased 3% in the first quarter. Pest elimination sales rose 1% as gains in the fast food and food and beverage plant markets continue to offset weak conditions in restaurants and lodging. In response, we are focused on selling the basic programs to new accounts as well as regional and local chain accounts. We are also targeting growth markets like QSR and food and beverage processing. We are enhancing field sales force effectiveness with new training and hires to more aggressively pursue contract business.

We expect pest elimination to show modest growth in the second quarter as it focuses on expanding market segments and emphasizes its high quality and more reliable service results to drive new business.

GCS results decreased 13% for the quarter. Service and part sales were soft as existing customers defer repairs and as prospective customers delay their decisions due to the weak economy. The sales pipeline and chain customer interest remains very good as we are able to demonstrate the value of our service program, which reduced customer downtime and emergency repairs.

However, the current uncertain economy has resulted in longer decision time lines despite the lower sales volume, GCS profitability – GCS profitability improved substantially as gross margins and SG&A ratios improved dramatically shrinking the operating loss over last year and reflecting the elimination of stabilization costs related to new systems in last year's quarter.

The new ERP system is providing the operating information that led to improved customer and market segment profitability, dispatching improvements, better tech utilization, supply chain improvement and improved working capital management. All of these have helped our operating efficiency and improved overall division profitability.

Looking to the second quarter, we expect sales to be off due to the weak economy and decreased customer repair activity, but we expect GCS will again report significantly improved profitability over the prior year period.

Measured in fixed currencies, international sales decreased 3%. Europe, Middle East and Africa sales rose 1% in the first quarter at fixed currency rates. Europe's institutional sales declined moderately as food service and lodging trends weakened. In response, we have dedicated sales resources, targeting new business and emphasized new products and the cost savings we offer customers to drive market share growth.

Food and beverage sales rose modestly reflecting slow markets. F&B is focused on winning new customers by emphasizing the cost savings benefits of our leading products like DryExx and Accelerate [ph] as well as implementing appropriate pricing.

Textile care showed modest sales growth in the quarter. Healthcare sales continued to show good growth led by sales of skin care and clean room products. We also launched our solid products lines for instrument cleaning.

Pest Europe showed better core contract sales. However, these were offset by soft and fill rate program revenues. Europe's business information systems platform work continues to move forward. We have successfully implemented the system in four countries, including our largest country, Germany, and the country with our largest plant, which is Belgium. We'll continue to roll out the remaining system locations over the coming months.

With expected completion in the second half of 2010 sales force training is going well and we are seeing better sales fundamentals by our field people in major countries. However, with weak market trends, we look for Europe's second quarter fixed currency sales to be slightly lower than last year. I may have misstated the international sales; they increased 3% in the quarter.

Asia-Pacific sales grew 1% in fixed currencies. Institutional's modest sales gains were driven by account wins in catering, mid-scale hotels and restaurants as well as food retail markets. They worked to offset weak occupancy and catering in the high end hotels.

Food and beverage sales reported moderate growth. Both the beverage and brewing sectors continue to show solid growth in Asia due to increased product penetration and account gains. Looking ahead, Asia Pacific expects improved sales growth for the second quarter and the remainder of 2009.

First quarter sales for Ecolab's Canadian operations rose 8% over last year at fixed exchange rates. Institutional sales were strong driven by an increased focus on distributor partnership and price increases. Food and beverage sales and pest elimination also showed excellent gains driven by new accounts.

Latin America reported a solid sales gain rising 9% at fixed exchange rates as all divisions increased. Institutional growth was driven by new account gains, increased product penetration as well as continued success with global and regional accounts.

Food and beverage sales reflected strong demand in the beverage and brewing markets as well as benefits of new accounts. Pest elimination continued its outstanding performance throughout Latin America. Overall, we expect healthy growth trends to continue in Latin America with another strong gain in the second quarter.

Turning to margins on the income statement and slide #8 of our presentation, as we expected, first quarter gross margins decreased and were 47.5% compared with 49.4% last year. Excluding restructuring charges included in our cost of sales, first quarter 2008 gross margins were 48.1%. Higher delivered product costs, especially in Europe and lower sales volume more than offset pricing and cost savings initiatives.

SG&A expenses were 38.3% of sales, 10 basis points above last year. The SG&A ratio reflected strong pricing leverage and savings from our recent corporate restructuring. These nearly offset the lower sales volume and higher costs.

Operating income for Ecolab's U.S. cleaning and sanitizing segment decreased 3%. Excluding the distributor incentive change, operating income increased approximately 9%. Adjusted margins, excluding the distributor change expanded by 180 basis points over last year. The increase was driven by pricing gains in improved cost efficiencies which more than offset delivered product costs and lower sales volume.

Operating income for U.S. other services grew 89%. Growth was driven by pricing gains, close attention to expenses and reduced GCS costs related to the system stabilization work last year.

International fixed currency operating income decreased 52%. The lag of higher delivered product cost increases internationally, primarily in Europe had a dramatic impact on our first quarter international operating income. As a result, the lower sales volume and higher delivered product and other costs more than offset pricing gains. The impact of the delivered product cost increases are expected to moderate in the second quarter and the balance of 2009.

The corporate segment includes special charges which are reported as a separate line item on the income statement. The special charges which are not included in pro forma results including a restructuring charge of $33 million for actions primarily taken to optimize our work force as well as other nonrecurring costs to optimize our business structure.

The corporate segment also includes $5 million of investments in the development of business systems and other corporate investments we are making as part of our ongoing efforts to improve our efficiency and returns in Europe. These investments are included in pro forma results.

Ecolab's reported first quarter consolidated tax rate was 29.4%, about even with last year's reported 29.3%. Excluding discreet tax items and the tax impact of special gains and charges, the adjusted effective income tax rate for the first quarter 2009 was 31.3% and compared with 32.8% in the first quarter of 2008.

The substantial decrease in the adjusted tax rate was primarily due to tax planning efforts involving optimization of our international tax structure and global rate reductions. (inaudible) performance is that reported diluted net income per share for the first quarter was $0.24 compared with $0.41 reported a year ago.

Reported – pardon me, pro forma earnings when adjusted for special charges and discreet tax items were $0.33 compared with $0.39 reported a year ago.

As mentioned in our opening comments, earnings per share reflected about $0.10 from higher delivered product costs, $0.03 from unfavorable foreign exchange and about $0.03 from the reduction in distributor promotions. These were partially offset by pricing, cost savings, including about $0.02 in cost savings from our restructuring and the impact of new products.

Turning to Slide #9, Ecolab's balance sheet and cash flow remains strong. Total debt to total capital was 43% at March 31 compared with 39% reported a year ago and 42% at yearend 2008. Our net debt at March 31 was 41%. We also made a voluntary cash contribution to our pension plan of $50 million at the end of the first quarter.

Slide #10 shows our forecast for the second quarter and full year 2009 and the press release includes line item forecasts for our second quarter P&L.

As previously discussed, we look for slow markets throughout 2009 and are taking appropriate actions to drive both the top and bottom lines in these markets. Deliberate product costs and currency present formidable headwinds in the first half as they compare against the prior year, though we look for better comparisons for both in the second half. We have been successfully using our new products that help customers reduce their costs and improve their efficiency along with our service rates to capture market share and drive growth.

In the second quarter, we look for our U.S. operations to show modest sales gains in the face of challenging conditions. We will continue to emphasize products that provide unparalleled performance and energy and cost savings for our customers. We expect them to provide further differentiation and opportunity and help drive results.

We look for international sales to be similar to last year at fixed exchange rates as good growth from Latin America, Canada and Asia-Pacific are offset by Europe. Net including the estimated $0.04 impact from unfavorable foreign exchange, we expect pro forma diluted earnings per share for the second quarter excluding special gains and charges and discreet tax items to be in the $0.46 to $0.50 range compared with pro forma earnings per share of $0.47 earned a year ago. Please recall last year's second quarter reported earnings of $0.55 per share included a $0.10 gain with the sale of a plant.

Slide #11 shows some detail on our 2009 outlook building from 2008's results. The outlook is consistent with our original forecast. Raw materials, freight and fuel, while generally lower than fourth quarter 2008 levels remain a significant combined headwind on a year-over-year basis in the second quarter before turning favorable in the second half.

We're also seeing the deliberate product cost impact hit our international regions a quarter or two after the U.S. Exchange is expected to be negative through 2009 and the distributor change which hurt the first quarter should benefit the fourth quarter.

All other includes business growth, pricing, restructuring and other cost savings actions. The second quarter all other category should be similar to the first quarter. The second quarter all other category reflects the impact of fixed – of expected slower growth and pricing as raw materials provide offsetting cost relief.

It also reflects comparison to the second half of 2008 when significant cost and incentive compensation reductions including bonus reductions as well as lower effective taxes benefited year ago results. We continue to look for full year 2009 pro forma diluted earnings per share, which excludes special gains and charges and discreet tax items to be up 5% to 10% and be in the $1.95 to $2.05 range.

In summary, as noted on Slide #12, we are proud of our accomplishments in the first quarter as we performed effectively against very tough conditions and delivered on expectations while building for our future. And despite the increased challenges from the weekend service – pardon me, from the weekend full service restaurant and lodging markets, increased delivered product costs and unfavorable foreign exchange, we continue to expect an attractive performance in 2009.

A final note on some upcoming Ecolab events. We plan to hold a tour of our booth at the National Restaurant Association show in Chicago on May 19. In addition, we're planning to hold our biannual investor meeting on September 10. We'll be sending more details this summer. In the meantime, if you have any questions, please contact me or Nicole in my office. That concludes our remarks. This conference call and the associated slides will be available for replay on our Web site. Operator, please begin the question-and-answer period.

Question-and-Answer Session

Operator

(Operator instructions) And our first question comes from P.J. Juvekar with Citi.

Eric HessCiti

This is Eric Hess [ph] in for P.J. In institutional, what percent of the business is expected to hold up? Where are you seeing the declines and how much of a volume decline do you expect in 2Q?

Doug Baker

Yes, Eric, Doug. I think the – what we're seeing in institutional is pretty much what we expected, which is we clearly have got the most severe pressure in lodging, food service, which is also under pressure is acting a lot like food service has acted in the past under pressure and we don't really expect either to recover, but we also don't believe that they're going to continue to decline at the rates we saw in the last couple of quarters, that they're semi bottoming and we will continue to look at these types of markets through the balance of the year. Volume, we've got a bunch of things going on in institutional. They're doing a very good job. You've still got a number of restaurant closings. We're having great success selling new business and we expect that to build momentum throughout the year. So while the market is not going to recover, we do expect that our new business results will continue to fuel improved results throughout the year.

Eric HessCiti

Okay. And how many sales associates did you hire last year and how many would you hire this year?

Doug Baker

Let's go look up exact numbers.

Michael Monahan

For this year, I think we're looking to be probably net flat, maybe off a little bit for a total head count. I'm trying to –

Doug Baker

Globally.

Michael Monahan

Yes, globally.

Doug Baker

Of course, it differs by region and by business. We aren't managing each business to the same number because we've got very different market conditions.

Michael Monahan

And in 2008, we were up about 550.

Eric HessCiti

Great, thank you.

Operator

Our next question comes from Mike Harrison with First Analysis.

Mike HarrisonFirst Analysis

Hi, good afternoon. I was wondering you talked a lot about targeting share gains and new accounts, particularly on the food service side. Do you have any metrics that you can provide to show us how you're doing on that front?

Doug Baker

Mike, Doug, we typically don't go out and give specific account wins nor give specific numbers of accounts. I guess I can't share that. We are significantly above our average year in terms of new account productivity and probably are only behind one stand out year at this point in time which was when we had a major competitive change in the market, which is really a one-year phenomenon. So we're above last year metrics, we measure unit gains all the way down to the individual territory manager level. We have gained loss reporting, we measure it to net sales, we know what's happening by region throughout all the countries that we compete in. So I think we've got a very good handle on this and we are achieving the type of successes that we hoped for moving into the year.

Mike HarrisonFirst Analysis

Alright. And then I know that you've had some changes for the better in terms of your relationship with Cisco. I was wondering if you could give us an update on that and maybe if you're able to put some numbers on how many new accounts you've gained through Cisco over the past year or maybe what portion of Cisco customers are buying Ecolab products now versus a year ago?

Doug Baker

Yes, I think (inaudible) what I'll say is you're right, we've got, I think a renewed partnership with Cisco at this point in time and we're working very successfully going after select accounts. What we've basically done is compared databases and understand where they've got what I'll just call preferred customers and we aren't serving those customers nor is Cisco enjoying the cleaning business in any other way and we're targeting those customers together. Our new account productivity as a result of this through Cisco is substantially above any previous year. So this is a much more effective way to go to market. We've added resources to specifically help support this program and we're measuring it together. So both corporations, I think are clearly on top of this issue and pushing it to both of our benefit.

Mike HarrisonFirst Analysis

Alright. Thanks very much, Doug.

Operator

Our next question comes from David Begleiter with Deutsche Bank.

David BegleiterDeutsche Bank

Are you seeing – how much pressure are you seeing from your large customers on pricing, specifically in the United States?

Doug Baker

Well, clearly all of our customers are under pressure as well and so – I don't think there's ever been a year when we didn't have conversations with our customers about price and you might not be surprised to hear that they generally would like our prices to be lower. And it's not different this year. So certainly there's pressure. We work to maintain long-term partnerships the way we handle pricing in the last few years was never to try to recoup what I'll call extraordinary raw material increases that we've seen over a four year period capped by a huge increase in the second half of last year. We've never tried to recoup that in any one year. We've never worked to tie pricing specifically to raw materials. So I think our conversation with our customers is the same, which is, we're in it for the long-haul and we're going to work with them to help them lower costs. That does not mean that you got to lower our price to do it. And in fact, our premium products like Apex delivers lower induced costs to our customers and we have record placements and met our goals on Apex, which is our most premium priced program. So I think the way we're approaching it is working. Doesn't mean that there's not some friction out there what you'd expect given the market conditions.

David BegleiterDeutsche Bank

Doug, just on Europe what were the margins in this quarter and where do you stand on the structural improvement in that business relative to your expectations?

Doug Baker

Yes, the margin story in Europe, I mean the margins were terrible in Europe in the first quarter. Really had nothing to do with the restructure, it was really a phenomenon of the raw material run up and now the raw material run down. I mean if you want to go back to the metaphor of there is a big rat moving through a snake and it is almost through but if you – Europe is just on a one quarter lag and the raw material peak was in first quarter in Europe and the increased year-on-year raw materials in Europe was greater than last year's Europe profit. So, that's going to have an outsize effect. Now we already know the raw material prices we're paying now in Europe are substantially lower. As they work their way through the system, we know that proper recovery is in front of us at constant or even slightly lower volume.

David BegleiterDeutsche Bank

Why does the lag occur in Europe?

Doug Baker

I mean, there's – there's – I don't have all the structural reasons. We're not the only guys seeing a lag in the raw material performance. There's a few differences in our raw material supply situation there. One, we don't have the same type of caps in our contracts in Europe, so we're going to see more dramatic swings up and frankly more dramatic swings down in that type of situation, which is what we're seeing here as well. It just took longer to work through the European supply situation. We certainly have more inventory in Europe, so that's going to have some impact on it as well. But it's not a unique situation to us. But we also are very clear on what's going to happen with raw material prices there. We're already seeing it on the products we're buying today.

David BegleiterDeutsche Bank

Thank you very much.

Operator

Our next question comes from Bob Koort with Goldman Sachs.

Bob KoortGoldman Sachs

Thanks. Got a couple, but Doug, I almost fell off my chair. I want to make sure I heard you right. Did you say your raw material inflation in the first quarter in Europe exceeded your profits in all of last year?

Doug Baker

Not all of last year, first quarter profits last year.

Bob KoortGoldman Sachs

Okay. I'm back on my chair. I was wondering, could you just describe a little bit the distribution, the logistics of taking a deep – I guess an inventory destock in the first quarter and a restock in the fourth quarter? Refresh my memory; didn't you guys do this a couple of years ago?

Doug Baker

Nobody told me. No, we – we have not done this in the past. What our past practice was is we would incent distributors to raise inventories moving into the heavy season, which for us is second quarter and third quarter. We would then typically maintain those incentives to maintain that inventory level throughout the second quarter and third quarter and then we would not have an incentive in the fourth quarter vis-à-vis and inventories would therefore come down to a more normal level during the fourth quarter. What we did this year is not incent the distributors to build inventories. We have (inaudible) don't believe this is efficient spending anymore and as a result you're going to see a decrease – because inventories aren't going to be built in the fourth quarter – or the first, you see a decrease in sales in the first quarter, but that's going to be offset by, if you will, a year-on-year increase in the fourth quarter because they won't be destocking in the fourth quarter this year because they never up their stock. It's a very – exactly what outs are, we know exactly what ins or to distributors, we've got a very firm handle on this and we've been managing – so our confidence level here is quite high and how our distributor ends behaved, if you will, in the first quarter was exactly as we anticipated.

Michael Monahan

Bob, referring to history, in one particular quarter, may be a little above or a little bit below what it may have been in another quarter. So it's not – it may vary just a little bit, so we may have been referring to that relative to the prior period, little bit higher, little bit lower, but this was a fundamental change than the way we were approaching it and a much bigger number than ever before.

Bob KoortGoldman Sachs

Got it. If I may follow-up, in the key institutional area, I think you said you're done 3% ex of the distributor program and I would guess we haven't seen that number in 10 years or 15 years outside of 9/11. Do you think this is also sort of a one-off destock across the customer base and you'll get that back in the back end of the year assuming the economy behaves or is that just for whatever reason an anomaly that you won't make up later?

Doug Baker

Well, I mean, I wouldn't say that we've got built in our numbers a restock this year. I mean certainly there's no doubt that inventories have declined. It always happens as business declines and as business increases, we know inventories will increase as well. We are – we aren't projecting that that's going to occur this fiscal year.

Bob KoortGoldman Sachs

Okay. Thanks.

Operator

Our next question comes from Laurence Alexander with Jefferies.

Laurence AlexanderJefferies

Good afternoon. I guess first question on Europe, if you look at the sequential decline in margins, do you think you can recoup most of that decline to margins in Q2 and Q3 given the raw material profile or has there been other changes in Europe as well?

Doug Baker

No, I – what I would say is we expect margins to increase every quarter and by Q4, we're going to be back to normalized margin rates.

Laurence AlexanderJefferies

And secondly, just further on Europe, can you discuss a little bit of what you're seeing in terms of competitive landscape, particularly, how your larger competitors are holding up in this environment?

Doug Baker

Yes. I'd say Europe is – remains our probably toughest geography from a competitive standpoint and that hasn't changed unfortunately and so we're seeing the same, I would say, aggressive activity that we've always seen in Europe. I think all – every person in this business is feeling the market contraction that we're describing here. I'm almost – I'm also certain that we're handling it and managing it better than virtually all competitors as we move through. I suppose you can find some small regional who is outperforming us, but I would say, by and large, I know we're doing much better than the market and I would suspect much better than our larger competitors.

Laurence AlexanderJefferies

Thank you.

Operator

Our next question comes from John McNulty with Credit Suisse.

John McNultyCredit Suisse

Yes, good afternoon. Just a couple of questions. With regard to the lack of an incentive program for the distributors, is that something that should be – or was helping the margins and might explain some of the strength in the cleaning and sanitizing margins given the weak environment that you're in right now?

Doug Baker

I think there's a couple of things. I mean we said we expected that this whole program of re- – I guess, focusing the distributor incentive program would be profit helpful. I would say though, on the larger story, we have been taking a long steady course of price increases and we said always that over time those would continue to help rebuild the margin that we've lost over the years as a result of a four year steady raw material increase and we've had very tight discretionary expense control put in place as well. So I think it's a number of factors that have led to this, but it's also not, we don't believe a one quarter story.

John McNultyCredit Suisse

Okay. And with regard to pricing, I know you came in up 4%. It seems like that was a little bit higher than what you were guiding to. I also know you were looking for 1% in the second half. Do you have expectations that you may be able to do better than that in the second half given the traction you got in the first?

Doug Baker

I think, by and large, I would stick with a pricing story, which is this isn't going to be a great – this is not the right environment to go out and get substantially more or incremental pricing. At the same time we don't expect prices to erode. So you're going to see, if you will, a declining benefit as we progress through the year from pricing.

John McNultyCredit Suisse

Okay. And then just the last question, with regard to Europe, I know the fundamentals are extremely difficult right now for you, but you're also – you've been involved in the sales force training or retraining. When would you expect to see some traction coming from that or are you and it's just not necessarily showing up just because of the difficult environment?

Doug Baker

Yes, I think if you look over the last few years, look, we've accelerated our European business on organic sales growth each of the last three years. Even now, I think you're going to see Europe's pricing benefit this year is going to be substantially higher than any of the previous years and while it came later than that management team and that we had hoped, they did secure it and it's going to have a real benefit this year as they move forward. So I would say we're already seeing the benefits of the sales focus and the additional sales fire power that we put in there. I wouldn't say we're done realizing the benefit, but I agree with your other point that it's going to be difficult to read in this environment.

John McNultyCredit Suisse

Okay. Great. Thanks for the help.

Michael Monahan

A number of other metrics we can look at for the sales force and see that the various behaviors they've got underway are improving, their sales disciplines improving, so we think all the things are forming around that such that as the environment improves, you're going to start to see better reported results as a result of that.

Doug Baker

Every business in Europe had positive net competitive gains in the quarter.

Operator

Our next question comes from Gary Bisbee with Barclays Capital.

Gary BisbeeBarclays Capital

Hi, guys, good afternoon. I think you just tried to tackle this, but can you give us a sense, given the falling year-over-year revenue, how you got the operating margin in the U.S. cleaning business up? I take it there wasn't as much as benefit or gain yet from the restructuring effort you initiated earlier?

Doug Baker

Well, we got – we didn't get the full benefit, but we certainly did get, probably I don't know – in some of the field organizations, two-thirds benefit because we – we implemented the program in January and so we realized the benefits of the back two months in some of the moves we did SG&A wise. The other is tight expense control, continued pricing gains and starting to see at least sequentially quarter to quarter reduction in raw material prices, although year-on-year there's still a problem.

Gary BisbeeBarclays Capital

Okay. And then on the U.S. other service margin, can you tell us what the GCS loss was and it looked to me like it had to go to zero unless the pest business also had improving margins in the quarter any other comment on how you got such a big increase in the operating profit there? And I guess also is that sustainable as we look to the next couple of quarters? Thanks.

Doug Baker

Well, the GCS last year lost $6 million and this year we lost $2.8 million. It was a substantial improvement in spite of obviously real top line challenges. All the moves that we had talked about that we're implementing in GCS I think Mike referred to them in his upfront comments, have taken hold or if you will, the water line above which we got to rise to get to profitability on GCS has been substantially lowered over the last two years and as a result you're – we're seeing some dramatic improvement in – at least its loss profile. If you had any kind of normal business conditions, I think you would have seen break even for sure or better.

Operator

Our next question comes from Mark Gulley with Soleil Securities.

Mark GulleySoleil Securities

Good afternoon, Doug. I got two questions for you. First of all, is there anything like this distributor thing in the U.S. that's in the Ecolab system where you may have to smooth things out; is there an encore to this whole thing?

Doug Baker

No, there's nothing at this level. I mean, this is institutional, which is by far our largest business. No. So this isn't going to be a recurring theme. It's a little bit of a one off, we spent a lot of time working this and identifying it. I think this has been a great move for our business.

Mark GulleySoleil Securities

Okay. And secondly, my impression was that pest elimination would be a little bit more resilient this recession. Turns out that sales gain was pretty modest. Was my premise incorrect or is there something else going on in pest that maybe we should be concerned about?

Doug Baker

No. I mean, it's the market. And I would say I think in past – clearly pest has been impacted. Traditionally though when things get tight, if pest is doing a good job, there are no pests, therefore, people start questioning whether they actually need the service. They will walk away from the service for a period of time and Mother Nature reappears in the form of cockroaches and mice and we usually end up getting called back. So I'd say we've gone through these cycles before and we expect this business to strengthen throughout the year.

Mark GulleySoleil Securities

That's helpful. Thank you.

Operator

Our next question comes from Rosemarie Morbelli with Ingalls & Snyder.

Rosemarie MorbelliIngalls & Snyder

Good morning, all. Could you – when you talked, Doug, about the fact that you could go back to the traditional margins by yearend for Europe, when I look at the margins in Europe, that doesn't seem to be a real traditional margin. So, are you looking at the 9% that you – that you had last year for the full year, is that what you would think of as a traditional margin?

Doug Baker

Yes, in that range, yes.

Rosemarie MorbelliIngalls & Snyder

Okay. So by the fourth quarter, you could be back and have a 9.4% margin flat with that of last quarter?

Doug Baker

Well, already you're pretty specific.

Rosemarie MorbelliIngalls & Snyder

I know.

Doug Baker

I agree with the – that is the range I'm referring to. I'm not going to get down to the decimal point.

Michael Monahan

Rosemarie, for the full year last year, Europe's were about 7%, so let's make sure you got that line right.

Rosemarie MorbelliIngalls & Snyder

You're right. I was looking at full international. But full international in the first quarter is only at 3.5%. So, let's link that question to the full international, can we go from the 3.5% of Q1 back to around 9% by year end?

Doug Baker

Yes, I think, internationally, you will see a similar type recovery throughout the year and we will be at those margin rates by yearend.

Rosemarie MorbelliIngalls & Snyder

Okay. And given the – the raw material cost environment, the pricing, which I am sure is not going to be easy to get in Europe as everybody is feeling very poor, do you feel that in terms of restructuring you are doing enough and fast enough or is there something – some additional steps that you are going to need to take?

Doug Baker

No, I think what we've always said is I think we size our restructuring program appropriately when we went after this and – but the moves if you're referring to Europe, we also stated even when we announced the restructuring, weren't going to all occur at the same timing that, if you will, our North American and Latin American, much of our Asia-Pacific did because of rules, regulations and others and we are seeing those occur throughout the year and I think Europe's also got the appropriate targeted restructuring in mind.

Rosemarie MorbelliIngalls & Snyder

Okay. And then if I may ask you a question regarding the swine flu, which everyone, I have already seen people with a mask, face mask in New York on the subway, do you think that the potential positive in terms of people particularly in hospitals and other areas like that and even in restaurants and hotels I am guessing, do you think that that positive potential will be large enough to offset the potential negative from people not going out as much, not traveling as much? Do you have a feel for what that could be?

Doug Baker

Rosemarie, it's such a hard question to answer because really depends how this evolves and specifically, look, if this is going to be a pandemic, meaning, it's going to be widespread, but it's going to be a highly contagious flu, but not a flu that kills at a high rate, the risk is we get a flu for a few days, I think you got a very different situation, one that, I don't know, you might argue might be beneficial. Clearly, if this is highly contagious and also highly lethal, I don't think there's – I think that's a very different situation. And time is going to tell. I would say the odds are it's going to be the former not the latter, but we're going to have to let things play out and understand what the facts are.

Rosemarie MorbelliIngalls & Snyder

Okay. Thanks.

Operator

Our next question comes from David Ridley-Lane with Banc of America.

David Ridley-LaneBanc of America

Sure. Just a quick one. On the – I heard you speak earlier in first quarter about how great the acquisition pipeline is. Just wondering is that still the case; do you still think you're going to get some deals done in 2009?

Doug Baker

Yes, my assumption – I believe we're going to get some stuff done in 2009. But I guess what we've always said is we're going to do this at the right price and it's still taking a while for – let's say the things that we like, the current owners must still like too, although they say they're (inaudible). It's going to take a while for multiples to come down and if they come down as fast as we think, we'll end up closing them. If they're going to hold out for high price or a price higher than we think the property is worth, we're not going to buy it just to close something.

David Ridley-LaneBanc of America

Okay. Sounds great. I'm going to put my mask back on. Thanks.

Operator

Our next question comes from Dmitry Silversteyn with Longbow Research.

Dmitry SilversteynLongbow Research

Good morning, gentlemen. Couple of questions if I may. You talked about the European market having about a 1% growth in real – or in constant dollars in the first quarter, but then you talked about expecting a slightly down quarter in the second quarter. What has changed between the first quarter and second quarter? Are they going through their version of inventory correction later than the U.S. or is there also an out of phase shift in Europe versus U.S. that you observed in the raw materials situation?

Doug Baker

Yes, I would say, Dmitry, I mean what we've witnessed is Europe – Europe, if you will, kind of lagged the U.S. in particular, in its decline economically and so what I think you're seeing is just that lag kind of rolling through.

Dmitry SilversteynLongbow Research

Okay. Okay. Well, I mean, they started later, but I think they kind of raced us, I think they beat us to the bottom little bit here, but maybe I'm wrong. You also expect Asia-Pacific to do better if I understood your comments correctly on a year-over-year basis in the second quarter versus the first quarter. Was there something specific about the first quarter in Asia-Pacific that, that caused the results to be a little bit weaker or is something changing now that you expect results in the second quarter to be stronger?

Doug Baker

Dmitry, it's principally China, which is – our China business continues to do quite well. But if you also recall last year in the second quarter, there was blizzards, floods, earthquakes, I guess were later. I mean they had a lot of challenges last year particularly in the first half and so the – somewhat of a base issue.

Dmitry SilversteynLongbow Research

Okay. So if you say challenges in the first half of last year, wouldn't that – wouldn't you have already seen the benefit in the first quarter of this year?

Doug Baker

No, it's principally second quarter, where it showed up in our business.

Dmitry SilversteynLongbow Research

Okay, Doug, and then one final question. You talked about adding sales people about half a thousand or so in 2008, but you're looking to be flat to slightly down in 2009. One of the ways that you're able to grow above market growth rates and gain share and have some control over your destiny is through sales force additions, so I'd just like to understand the rationale behind keeping the sales count flat in '09 versus '08 or is it a matter of adding it in some places and taking them out in others so that net-net you're flat?

Doug Baker

It's clearly the latter. We've got clear sales additions in a number of our businesses. We're adding corporate account, head count throughout the globe on all of our major businesses because we have targeted that we want to gain outside share in the largest account in food and beverage and institutional in all regions, health care and the like, but look, we also took out a number of what I'll call sales support positions as a part of central that weren't, if you will, directly customer facing, which are going to be offset by some adds in some sales positions. So there was – I mean, central was a genuine restructure in terms of how we've organized our manpower around the world to make sure that we can capitalize on the growth that's out there and also become more efficient in other businesses.

Dmitry SilversteynLongbow Research

Okay. Thank you very much.

Operator

Our next question comes from Annie George [ph] with Morningstar.

Annie GeorgeMorningstar

Hi, thanks for taking my call. I just want to get a little more color on GCS. What do you think this business will look like two to three years out? I mean what when are we going to see some growth here?

Doug Baker

Annie, it's kind of a – the business always had a no problem top line, had a problem bottom line, while it's still losing money, clearly we've done a lot of stuff to start improving its ability to generate money. I would also point out that the business was cash positive last year and is projected to be cash positive this year, so if you will, the work on GCS isn't a cash drain at this point in time for the corporation. What do we expect in a couple of years? I guess, we need a little projection then on the – I expect the economy is going to be better a few years out than it is today and I think this business will respond quite well to top line improvement.

Annie GeorgeMorningstar

And how far are your customers pushing out their decisions in this business? You mentioned that earlier.

Doug Baker

It depends. I think everybody starts looking at all decisions more thoroughly in these times of economic environments and, it happens in every business, it happens in ours. How long does that last? Probably until they start seeing signs of recovery.

Annie GeorgeMorningstar

Is this your most economically sensitive business?

Doug Baker

It's one of the most economically sensitive. The most, maybe I'd give that award to Ecovation and vehicle care.

Michael Monahan

The other thing I'd add, Annie, and this is Mike, that for a lot of our customers this is a fundamental change in how they would do the repairs, in the sense that historically many of them were having it done locally, it was a local decision and this would be one that's a corporate decision where they're using one provider. So it's a cultural change in is it a local decision or a corporate decision. So you've got to go through the machinations of that in the current environment and as you can imagine in the current environment, there's a lot of other things that we're worried about and concerned about. The way we see it, the concept is being well accepted, this is more a deferral of a decision than a cancellation of a decision. As Doug says, we do think when things recover, we'll see decisions made.

Doug Baker

We've got plenty of – the interest remains, we're confident in the interest. I also, say you're going through – somebody has three fryers and one goes down and you don't have a full house, you do not fix that fryer right now. So we've got a lot o just fundamental deferral of repair, this is throughout the industry in other equipment repair businesses and the business will come back. Ultimately the fryers will get fixed.

Annie GeorgeMorningstar

Okay, thanks a lot.

Operator

Our next question comes from John Roberts with Buckingham Research.

John RobertsBuckingham Research

Can you hear me?

Michael Monahan

Got you, John.

John RobertsBuckingham Research

On Slide #11 where you show the all other, which is the productivity improvement and so forth, the first half is $0.18 to $0.22, the second half is slightly lower, $0.13 to $0.19. Wouldn't the benefits be picking up momentum as you finish the year or are you just starting to lapse some of the programs from the fourth quarter that you don't have as much from the second half?

Doug Baker

John, Doug. It's really a couple of factors. One, you've got pricing, which as we said we're going to have a diminishing benefit throughout the year as we start lapping the pricing that we realized second half of last year. Second, you've got tax. We started realizing partial benefits of EBS in the second half of last year and we're realizing them on a full year, but we will start lapping tax benefits in the second half as well, which would also be included in there. And then there's also some variable pay components which also has an impact.

John RobertsBuckingham Research

And then secondly, when you talk about the European raw material and fuel increase, are you talking about fixed currency rates or public currency rates cost because they'd be up a lot more in fixed rate than they would be in public currency rates?

Doug Baker

Well, when I talked to them and compared the raw material costs to the profit, for instance, it was – it works in both fixed and frankly, public rates, but I was talking in fixed.

John RobertsBuckingham Research

Okay. Thank you.

Operator

Our next question comes from Ed Yang with Oppenheimer.

Ed YangOppenheimer

Hi, all my questions have been answered. Thank you.

Operator

Our next question comes from Jeff Zekauskas with J.P. Morgan.

Jeff ZekauskasJ.P. Morgan

Just a couple of quick things at the end. Are all of your special charges in corporate, that is the $34.5 million or is only $26.5 million in corporate?

Michael Monahan

Are you referring to the segment profitability?

Jeff ZekauskasJ.P. Morgan

Yes.

Michael Monahan

Yes. All of them are in there. So you've got the $34.5 million plus the other $5 million from the investments we've made.

Jeff ZekauskasJ.P. Morgan

Okay. And you said in a previous press release that you intended to reduce your headcount by a thousand people. How many are gone so far?

Michael Monahan

About 90%.

Jeff ZekauskasJ.P. Morgan

90%. So that's how you got your SG&A down. And in terms of your pricing, you said your average prices were up 4%. In which regions was it up more than that?

Michael Monahan

Price – I'm sorry, Jeff, what was the last part of the question?

Jeff ZekauskasJ.P. Morgan

In your slides you said that your average pricing for the consolidated entity was up 4%. In which major business units that you have – which major segments was your price up more than that?

Doug Baker

Yes, well, regions, we have more pricing in North America, last year and we had strong pricing in institutional and F&B.

Jeff ZekauskasJ.P. Morgan

Okay. So North America –

Doug Baker

Jeff, you asked that question on the headcount. 90% sitting here today, but we just announced a plant closure earlier this month. We weren't at a run rate at 90% throughout the first quarter.

Jeff ZekauskasJ.P. Morgan

Right. And then lastly, your Latin America local currency growth was plus 9 and I think in your annual you talked about some diminution of business in the Caribbean and in some other south – I think in Mexico. What turned around Latin America in the first quarter?

Doug Baker

Well, I'm not sure turned around. I mean, Latin America, if you go back to our history, has been a double-digit sales growth region for a number of years. So, what we've been talking about is it has still been – it was still impacted last year by slower – slowdown in Caribbean and Mexico and I would expect with the recent news, we aren't anticipating a turnaround in our Mexican business any time soon.

Jeff ZekauskasJ.P. Morgan

Right. Okay. Thank you very much.

Operator

That concludes the question-and-answer portion of our conference. At this time we will turn the call back to Ecolab for some closing comments.

Michael Monahan

Well, thanks, everyone for your participation today and have a good one. Take care.

Operator

Ladies and gentlemen, that does conclude our conference for today. You may all disconnect and thank you for participating.

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Source: Ecolab Inc. Q1 2009 Earnings Call Transcript
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