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Executives

Mike Bushman – Division VP, Communications and IR

Erik Fyrwald – Chairman, President and CEO

Brad Bell – EVP, CFO and Treasurer

Analysts

Jeffrey Zekauskas – JPMorgan

Laurence Alexander – Jefferies

PJ Juvekar – Citi

Jason Weiner – Deutsche Bank

Rob Koort – Goldman Sachs

Mike Harrison – First Analysis

Mark Gulley – Soleil Securities

Brian Drab – William Blair

John Quealy – Canaccord Adams

John McNulty – Credit Suisse

Mike Judd – Greenwich Consulting

Richard Eastman – Robert W. Baird

Nalco Holding Company (NLC) Q1 2009 Earnings Call Transcript April 29, 2009 10:00 AM ET

Operator

Good day everyone and welcome to the first quarter 2009 earnings call hosted by Nalco Company. This call is being recorded.

At this time, I would like to turn the call over to the Division Vice President for Communications and Investor Relations of Nalco; Mr. Mike Bushman. Please go ahead, sir.

Mike Bushman

Thank you, Nicole. Good morning and thank you for joining us for our conference call to discuss first quarter 2009 results. Joining us today to present are Chairman, President and CEO, Erik Fyrwald; and Executive Vice President and CFO, Brad Bell.

Some of the information discussed today constitutes forward-looking statements that are subject to certain risks and uncertainties. Our statements describing the risks associated with forward-looking information is found on our website and on our press release, which may also be found at www.nalco.com. Further background on our risks is available in our 10-K.

The information discussed today will include data that does not conform to generally accepted accounting principles. Management believes that the presentation of non-GAAP measures such as adjusted EBITDA and free cash flow provides investors with additional insight into the ongoing performance of our operations. When necessary, accompanying schedules for reconciliation of such non-GAAP measures to the closest GAAP equivalent have been provided as attachments to our earnings release.

After comments from Mr. Fyrwald and Mr. Bell, we will open the call up to questions. In order to allow for as many participants as possible to ask questions, we will restrict participants to one question with a clarification follow-up if necessary. We will then ask that participants re-queue in order to ask additional questions.

We'll start with Mr. Fyrwald.

Erik Fyrwald

Thanks, Mike and good morning. In the fourth quarter of 2008, we adjusted our priorities to reflect what has turned out to be a very difficult recession. For 2009, we established a five-part action plan designed to drive the best results we can in 2009, while also strengthening us for 2010 and beyond.

Three of our five priorities will drive short-term and long-term financial results and they include gaining a step change in productivity, delivering focused profitable growth, and improving cash flow. Our other strategic priorities are driving strong safety performance, and strengthening our future through technology, brand and customer service gains.

After a first quarter that was the most challenging business environment in my life, with many industrial producers shutting down operations and many companies going bankrupt, I am pleased to say that we delivered what I consider solid results against our key objectives. We are still not firing on all cylinders, but we are making good progress and using the economic crisis to rally the troops to drive needed change faster.

So let us go through some of the results.

First, we announced last year that we are going to step change our ability to drive cost productivity to help offset some of the volume and currency headwinds and support our growth investments. We are on the right path with our cost control efforts. In the first quarter, we generated $27 million in cost savings towards our $100 million productivity full year commitment. This more than doubles our first quarter savings rates in recent years. I believe we are getting better each month in getting people across Nalco engaged with better processes and better resources to help them drive improvement in a way that we realize the savings today and hold the gains for the future.

Our productivity efforts include both large-scale projects, focused on areas like increasing sales timing for our customers, installing world-class sales and operations planning with demand and production planning, and a step change reduction in non-value adding product complexity. We also are pursuing medium-scale projects to drive operating efficiencies in every support function and making individual decisions such as saving dollars through using Internet conferencing in place of travel or taking on extra work ourselves that used to be done by contractors.

Every Nalco employee is contributing to our success with this initiative, which we have branded internally as Get Fit. If you ask any Nalco employee about Get Fit, they can tell you the overall goals and specifically what they are doing to help make the total program a success. In addition, we have recently engaged a leading consulting firm to help drive faster implementation of several large transformational projects.

Another one of our key objectives is delivering profitable growth that is more focused on the right geographies and market segments and technologies to succeed in this economic environment. We said we want to bring more value to customers and thereby grow our share in our water, energy, and air markets through better technology, better service, and higher impact resource allocation, while holding share in the paper market. We are not using price to gain share.

Now against our brick plus strategy, we continue to invest in emerging global geographies, with most of our people adds in India and China. In the quarter, we brought on 19 employees in these countries, even as our net global employment across all of Nalco decreased substantially through workforce reduction that we started last year.

Brazil continues to be a good growth market and contributed on par with double-digit organic growth in Latin America. In Russia, where the economy took its hardest hit over the last six months, we are using this opportunity to hire strong Russian talent that we were not able to recruit last year, while lowering operating costs by returning expats to their home market. The Russian market will recover and we will be better positioned when it does.

Now across all businesses, Latin America organic sales grew rapidly, up 13.6%. Organic revenues dropped 3.2% in Asia, 3.6% in North America, and 9.2% in Europe, Africa and the Middle East. We believe our performance in Europe is due to very weak paper and other industrial markets, rather than a resumed loss of market share. However, it is clear that European industrial production will continue to be at depressed levels and we must take further rapid action to adjust and get back to the growth we achieved in the second half of 2008.

Now looking at our technology growth platforms. Nalco Mobitech's air production technology business grew 44% in the quarter. Now this growth rate might slow through the year as utility customers watch while US air rules are being changed. We believe we will continue to improve our position in this market during 2009 and will continue to see very high growth rates in coming years.

We are particularly excited about three Mobitech demonstration projects in China that are moving along well and will be fully operational in the next several months, as well as progress in opening up growth markets in Eastern Europe. The combustion efficiency benefit of Mobitech's technology in coal-fired boilers has tremendous application across end markets, beyond the power market where we are currently focused. I recently had the unusual experience of a customer from outside the power industry coming to our headquarters, asking to see me so that they could ask that we quickly bring our Mobitech combustion efficiency technology to their coal-fired industrial facilities to help them save energy and reduce emissions.

Overall, water service sales were down 4.5% organically with manufacturing and mining sectors among the hardest hit areas. Direct contribution was $70 million, down $18 million on both lower sales and 0.7% margin reduction from the first quarter of 2008. However, water treatment automation and service expansion are key growth platforms. In addition to continued progress in growing our 3D TRASAR cooling water technology, both with existing customers and gaining share with new customers, we also introduced our 3D TRASAR boiler technology late in the first quarter and it is off to a great start.

We also acquired Crossbow Water in late March to expand the range of water pre-treatment technologies and services our Midwest sales engineers can offer customers. Most of the business purchased line item on our cash flow statement went to this acquisition. Crossbow generated $14 million in sales in 2008 and we believe their technology and service offering can provide a very strong platform for domestic and global expansion located in Nalco.

In energy services, we delivered 4.9% organic growth in the quarter on continued very strong sales in oilfield services, which were up 10% and a 3% growth in downstream refining and petrochemical markets. Downstream growth came despite many petrochemical facility closures in 2008 that carried over well into 2009. Our Adamite business sales dropped 12% organically, but that is better performance than the 19% year on year reduction in global rig counts and 27% drop in North America rigs, where much of our business is located. Direct contribution of $80 million for energy services was just under the prior year's $82 million on flat margins and a modest nominal sales debt.

The paper business dropped about with the overall market decline ending down 16.9% organically. We believe, looking at industry production reports, that we are maintaining share in this market as planned. Direct contribution in this segment drops $12 million to $23 million on the lower sales and a 2.5% margin decline from the prior year. However, direct contribution margins improved sequentially from the fourth quarter of 2008, benefiting in part from operating expense reductions. And although we have worked hard to improve these margins, we are not counting on any improvement in this industry in the near term and so we will be taking more aggressive actions to improve performance, particularly in the very weak European market.

Now our third financial priority is improving cash flow. We generated very strong results in the first quarter, with $146 million in free cash flow against a full year commitment that we had communicated to you of exceeding the $142 million we generated in 2008. Now we have made some initial progress in reducing working capital from a base perspective and as we improve our demand planning and order to cash processes, we will be better positioned to manage inventory, receivable and Accounts Payable positions going forward.

On other commitments, we said we expect to improve gross margins in North America, where our US LIFO inventory method meant we benefited for the full quarter from the lower product cost environment. We achieved this in the first quarter, where gross margins were up several hundred basis points despite the negative effects of volume declines. We expect to see gross margin improvement outside of North America as lower product costs come out of inventory in regions that use other inventory valuation methods. Maintaining strong focus on price retention will be critical to our ability to achieve this objective across regions throughout the year.

After a weak start to the quarter, driven by extensive customer plant closures that reduced water treatment sales and production declines that hurt process-oriented revenues, we began to see some improved water service end markets late in the quarter. We're most optimistic that the stimulus efforts in China appear to be taking hold, driving some plant start-ups after extended closures. And as we said earlier, we saw the negative impacts of this recession first in China.

Even with some positive signs, this will be a very challenging year and one with more volatility likely to come. That, combined with sharply-negative currency impacts, means that we will have discipline and focus execution on cost control to ensure reasonable business performance this year. Now because the outlook for the economy is as ambiguous today as it was three months ago, we are still not providing earnings guidance.

So let me sum it up from my perspective. Although it is very frustrating to not be able to report year-over-year revenue and earnings growth, given the state of the global economy, I see the first quarter as generally solid, given that we delivered strong cash flow growth and took actions to offset some of the headwinds and very importantly, strengthened Nalco going forward.

Now let me turn it over to Brad to talk about our results in more detail and to update our refinancing direction. Brad?

Brad Bell

Thanks, Erik. As Erik said, we are generally pleased with our results for the first quarter, including accomplishments in revenue, earnings and cash flow, despite difficult economic pressures and the reporting impacts of unfavorable currency moves. Key among those results was our free cash flow of $146 million in the quarter, exceeding the amount delivered in the full year of 2008.

Organic sales slid 3.6% as part of a nominal sales decline to $868 million from prior year first quarter sales of $1 billion. Currency translation effects reduced reported sales of 8.3% of the nominal sales reduction, with divestitures accounting for the remaining 1.2% of a total 13.1% change.

The euro, our greatest currency exposure, averaged a $1.31 for the quarter versus $1.50 in the first quarter of last year. Year-over-year comparisons will remain tough in the coming quarters, as the euro hovered at the $1.50 range until the fourth quarter of last year. Many of the other currencies to which we are most exposed at the earnings level, renminbi, yen, riyal, pound and Australian and Canadian dollars, have similarly weakened against the dollar.

As we stated, those currency impacts weighed on reported earnings measures as well and masked the performance of the underlying business. First quarter EBITDA, and remember that commencing this year, we have dropped references to adjusted EBITDA, of $136 million is nominally down 13% year over year, but the organic decline was less than 3%. Similarly, reported net income of $23 million was nominally 21% below last year, but organically, 18% ahead. Again, we were pleased with the performance of the business portfolio in this environment.

Earnings were helped in the quarter by lower interest expense, resulting from lower market interest rates, lower average borrowings, and the lower dollar value of interest on euro-denominated debt.

Turning to the balance sheet, great attention was put into working capital management, producing a nice increase in free cash flow versus year-ago levels. As we noted, our first quarter free cash flow attainment of $146 million was $104 million higher than the comparable period of last year and gains were achieved in every region. With the declining revenue, it is not surprising that accounts receivable were a significant source of cash in the quarter. Importantly, our DSO or days sales outstanding was brought in four days from year ago levels as we are closely watching credit exposures in this difficult economy. Inventories were brought down $42 million in the quarter, excluding currency and acquisition impacts, the first progress toward reversing last year's significant bills.

The cash flow benefit of (inaudible), which has not been fully seen since the initial impact of such actions as is the reduction to Accounts Payable as replenishment raw materials are ordered at a reduced level. But the second quarter will see that cash gain as inventory levels are held or improved further, while Accounts Payable begin to build back to normal levels.

Since I'm sure it will come up in questions, let me provide some background on gross margins. Clearly, a number of moving parts went into our gross earnings comparisons for the quarter. Lower sales volumes, prices higher than year-ago levels, even costs that remain higher than year-ago levels as FIFO and weighted average cost methods used abroad overshadowed lower costs here in LIFO-based North America, unfavorable currency impacts and cost savings benefits. We do not intend to provide a detailed breakdown of these elements or specific price cost updates, but I will note that the unfavorable volume variance absorbed into the income statement in the first quarter amounted to $18 million, reflecting not only reduced output to match sales activity, but also further curtailments as we drove the inventory reductions noted.

Net overall gross profit margin was flat to last year. We expect as we gain some volume and a lower product cost hit the P&L outside of North America to be able to drive overall corporate margin improvements.

A couple of other points before we move to your questions.

First, you will see that we have modified our segment reporting, so let me walk you through the changes made to the schedules. As in the past, we have provided 2008 segment reporting information in schedules attached to our earnings release using the same basis on which we are reporting 2009. For one, you will see that despite the fact we merged the paper services division into our newly named water and process services division for management purposes, we are continuing to report paper segment results separately. Further, we have moved the other smaller operations whose revenues previously appeared in the other segments now primarily into water services, the replacement name for industrial and institutional services where they are now managed.

Next, we have discontinued allocating an internal capital charge to the businesses, offsetting that charge in the other segment. We began allocating capital charges to the businesses several years ago as a way of gaining business attention to working capital issues, but believe we can achieve even greater attention to the topic more directly, including making the progress and working capital a regular topic in our weekly executive council meetings. The early experience of the first quarter seems to bear this out.

Finally, just a note on refinancing activities. We are well along in our replacements to the revolving credit facility that matures in November of this year and have seen great receptivity by our banks. Further, if you follow the high-yield bond and the leverage loan markets, you will know that conditions have improved significantly since the first of the year. Those improvements, and the fact that Moody's investor services recently upgraded our credit ratings, including a corporate family rating of DA3, and a rating of DA1 on our senior secured bank credit facility bode well for a new term debt financing we may take on to pre-finance some portion of the term loan B that matures in November of 2010. We are examining alternate instruments and structures and will certainly keep you posted on any meaningful developments on actual activity.

With that, let us open it up to questions.

Question-and-Answer Session

Operator

(Operator instructions) And our first question comes to us from Jeff Zekauskas from JPMorgan.

Jeffrey Zekauskas – JPMorgan

Hi, good morning. A couple of questions. Were your volumes in energy in the quarter up or down year over year?

Erik Fyrwald

We had organic growth in the revenue line for energy services of 4.9%. That is a combination of volume change and price change and we have not broken those two pieces out and that activity varies a bit by region, but obviously, energy was a strong performance for us around the globe.

Jeffrey Zekauskas – JPMorgan

All right. But it was also an area where you had very strong pricing towards the end of 2008, so I guess I am interested in what has been the general level of change in your prices or the general trend in the change in your volumes.

Brad Bell

Well, clearly, throughout 2008, and not just in energy, we brought price increases meaningfully across the whole portfolio. You might remember that in 2008, our full year pricing attainment was $159 million against costs of $170 million, but over the fourth quarter, we were beginning to right size that with prices overtaking cost increases in the period and as Erik pointed out, key to this year's result will be hanging on to that kind of pricing activity. So everybody got price last year, everybody is working to hang onto price, is going to be a meaningful part of our 2009 attainment, but we would have definitely broken out pricing actions this year.

Erik Fyrwald

Well I would just add to the volume question in energy and that is that our business held up strongly in energy both in the upstream and downstream refining, the petrochemical and Adamite volumes were soft.

Operator

Thank you. And now we will go to Laurence Alexander from Jefferies.

Laurence Alexander – Jefferies

Good morning. First of all, with respect to this metric on – you touched a little on organic EBITDA and net income, are you running the business on an organic basis or on a nominal basis, and how are you judging people internally?

Brad Bell

We are judging people on organic basis and where there is opportunity to adjust our business to push harder to take advantage of some currency situations, we will adjust goals, but we are setting goals and measuring performance based on organic performance and that is when the exchange rate is in our face or in our back.

Erik Fyrwald

Clearly with David Johnson running Europe, can't run a US dollar portfolio, he has to think local currency, but when you get back to consolidated Nalco, our incentives systems et cetera are our nominal results for EBITDA, et cetera. But the people in the field can really only run that which is under their control.

Brad Bell

So when foreign exchange like this year is a headwind, that does us to push harder on productivity. So there is a two-part answer; the business is run on organic. We set objectives for people that are driving the revenue and earnings organically but we look at the results on a nominal basis, and if the headwinds are against us on a nominal basis, we try to push harder in other ways to make up for the foreign-exchange headwind.

Laurence Alexander – Jefferies

And secondly, just with respect to the free cash flow targets, what is your current perspective on how much of a tailwind you can get from raw materials this year, and given your strong performance in the first quarter, have you set a new internal goal that you can share for a benchmark for free cash flow for the rest of the year?

Erik Fyrwald

Lawrence, we really haven't come up with a forecast that we are going to put out in the public realm, obviously, we are pleased with some of the start we got in the first quarter, both in the cash earnings sense and certainly in a working capital sense. Obviously, we have got some costs that hit us later in the year, semi-annual bond interest, pension funding, things like that, so we have not yet converted that into a new goal for public dissemination. You know the economy is still a bit ambiguous to say the least, I just saw that first quarter GDP was revised this morning. So, not ready for publication of something new but obviously we are not putting our feet up having achieved what we have achieved in first quarter, we are going after this.

Brad Bell

Let me just add to that on the inventory piece of it, such an important element that we strengthen our inventory controls that we have gone from last year having supply chain corporately managed inventory and a way that we really talked about it monthly I would say before last year to where we have the four P&L leaders with total accountability for inventory, they have goals by months and by quarter and we report on their progress towards those goals at our weekly executive committee call that starts at 6.30 every Monday morning and we go through not only working capital, but where we are on revenue and where we are on cross productivity. So, we are managing this much more aggressively than we have in the past with very clear accountability and resources to be able to strengthen how we drive total working capital and particularly step change how we do inventory.

Operator

(Operator instructions) Our next question comes from PJ Juvekar from Citi.

PJ Juvekar – Citi

Yes, hi, good morning. Erik, for many years now, Gus struggled in Europe and then you moved David Johnson there and you clearly saw improvement about a year ago. Now that European manufacturing is falling off, are there new priorities for Europe in your mind?

Erik Fyrwald

Well, it is very important that we continue to finish what David and his team have started in terms of fixing the back office, getting people out selling more, getting us position to be able to be at the right force commercially, and I think we're continuing to make progress there. People are getting their selling time up, there's more focus on being out with customers, and winning in the marketplace.

At the same time, we have to look at where the true opportunity is in the future when we look at deploying our resources and certainly, although Russia is down a lot right now, we think Russia will come back as energy prices come back in the next few years. So we're strengthening our capability in Russia by hiring strong local talent and being ready for that turn, strengthening our market position, strengthening our share.

The Middle East we think will continue to be a growth engine for us, so we are actually strengthening our capability there also and there are parts of Africa, Turkey continues to grow for us for example. So within the EMEA geography, we are redeploying resources to where the bigger growth opportunities are and away from the lower growth opportunities very aggressively like paper in Western Europe, for example. So yes, we are re-looking at our priorities, but being very good at the basics is important for us to continue to work on throughout Europe.

PJ Juvekar – Citi

Thanks for that. And just quickly, secondly, on the deepwater platforms, so that business would be the last one to get impacted by oil prices; so what is happening there? I know you had some new platforms starting up this year, are there any delays on there, can you just give us some sense of what is happening in that business?

Brad Bell

Yes, in that business, the major projects that were headed towards completion continues. I have just recently been with our team and visited several customers and project teams; I have got to tell you that it is wonderful to hear our customers tell us how much they value what we are bringing and the technology and the confidence that they have working with us in these new areas, going deeper than they have ever gone before. So we are still very bullish on that part of the business and you saw the 10% growth in upstream in the quarter. What I would say though is that every oil company is looking at what CapEx that they are going to start the new CapEx and there are a number of cutbacks that we are concerned about impacting our business in 2012, 2013 and beyond. On the other hand, our sense is that when the economy starts to turn, that there isn't enough increased oil production to make up for what will be stronger demand; oil prices will come roaring back and we will be well-positioned for that, don't know when.

PJ Juvekar – Citi

How many new projects are starting up? Thank you.

Brad Bell

We haven't given that number, but we will refresh that view because we are also looking out a number of years and giving an update on the next call.

Operator

Thank you. And our next question comes to us from Jason Weiner from Deutsche Bank.

Jason Weiner – Deutsche Bank

Thank you, good morning. Just to linger on energy services for a moment, you have seen sort of a sequential decline. If we think about the rest of the year, what would you view as the most likely drivers of sequential earnings improvement through this year if we were to see it?

Brad Bell

Are you talking only about energy services or –?

Jason Weiner – Deutsche Bank

Energy services earnings.

Erik Fyrwald

Well, I think that the positive drivers there are we continue to commercialize some CapEx projects, we continue to gain some share in both downstream and upstream, upstream through the CapEx projects, downstream by continuing to bring to the customers more value creation. We are working on cost productivity throughout the company and that is benefiting energy services as well as the other divisions. And those are the major focus areas for us.

Now the headwinds for us are continued very weak market for drilling activity, impacting our Adamite business and that is a tough business, it is proportional, the sales are proportional to the rig count. You have seen the rig count numbers that decline significantly and we see those probably continuing to decline and we are suffering from that now. Adamite is 11% last year of our energy services business, this year clearly it will be less than that. So it is a small piece, but that is a big challenge. Also like the rest of the company, the raw materials will continue to flow through and benefit us for the year and I can tell you our key is working very, very hard with customers to bring more value to customers, to bring more total savings to customers, to protect our pricing as best as we can.

Jason Weiner – Deutsche Bank

Thanks, that is helpful. And just on FX, since it was such an impact and you were helpful enough to give us the organic profit impact of all, could you talk a little about the segments? I think you did, but perhaps some more specifically, can you tell us what the organic profits would have done ex-FX, by segment?

Brad Bell

Jason, this is Brad. We will have that in the 10-Q detail on the DC margins and DC year over year changes by market segment. On average, the currency impact in the year-over-year change was about 9%, yet some small impact in the year-over-year change from acquisition and divestiture activity and the rest of it was really organic. You will see that in the Q and we expect to have the Q filed this week.

Operator

Thank you. Our next question comes to us from Rob Koort from Goldman Sachs.

Rob Koort – Goldman Sachs

Thank you, good morning. I was wondering if you could comment on the price rise delta; I know that has been a major focus in the fourth quarter, it finally turned positive, can you give us some sense where that stands today and what the expectations might be for the year?

Brad Bell

We won't share specific numbers but I will just tell you that we continue to have a very strong effort to one, make sure that we are quantifying for the customers how much total cost that we're saving them; and our programs to do the same this year. So characterizing our value in dollar terms so that they see that it is more important than the price issue is the value that we are bringing them and through that, trying to hold onto price as best as we can, obviously there is pressure everywhere for all companies and everything to reduce prices and we are not immune to that but we are defending or we are explaining our value as best we can to preserve that price as best we can.

At the same time, on raw material costs, we are taking advantage of the market tailwinds, but at the same time, our sourcing group is working very hard to structurally benefit and see where we can have more opportunity to drive cost reductions. A good example of that is we have a very clear list of all the sole source products that we buy and we are going through every one of them with our technology team and we are qualifying new suppliers, where there is any potential pricing cost benefit. So we are working both on the price line and the cost line, and as we said last year, we are making progress there, but we're just not prepared to quantify at this time.

Rob Koort – Goldman Sachs

Erik, can you talk a little bit about customer behavior and how that might have changed given the severity of this economic recession? I know that in most instances historically, your customers just turn the dials down instead of turning them off. You think we're past the low watermark in terms of facility closure by your customer base so that while you don't want to give a forecast for 2009, can we be constant that the trough has been reached or no?

Erik Fyrwald

Well, I think that there is so much volatility out there I can't be overly confident on anything that is not within our control, but I will say that we are encouraged by what we have seen in China for example, some plants starting out that have been shut down for quite a while and that is across industries. We are encouraged by some petrochemical plants that have started up again. You have heard the chemical companies I'm sure last year – at the end of the year talking about how many plants they had shut down. Some of those are coming back online. That has been very encouraging to us.

So we are seeing some examples of encouraging signs, but at the same time, we are concerned about overall level of unemployment and consumer confidence issues and how that all filters through. So our view is of course we hope for the best, but we're going to drive the things that we can control, continue to work on getting market share without sacrificing price, continue to drive productivity very aggressively, and flow through the $100 million commitment that we have made, continue to do all we can around free cash flow, so that we can continue to strengthen the elements of inventory and accounts receivable and do those things well, so that in any economic scenario we can continue or still deliver a strong year in free cash flow. So we're seeing some encouraging signs. I don't want to get overly optimistic and do anything other than keep the foot on the accelerator for the things that we can control that we know that will benefit 2009 and strengthen us for 2010 and beyond.

Operator

Thank you. And Mick Harrison from First Analysis has our next question.

Mike Harrison – First Analysis

Hi, good morning. In the energy business, I don't want to harp on the pricing of volume question but I do know that you have a greater proportion of contracts there that are indexed to raw materials or where the pricing is indexed to raw materials. I was wondering of those contracts worked against you in the quarter and then have you seen an increase overall in the number of customers that are interested in moving to indexed contracts across all three segments?

Erik Fyrwald

We haven't really seen a major change in customer interest in contracts indexed but of course those that are indexed with raw material prices coming down, we're starting to see those decline and there was some impact, but at the same time, we are seeing the benefit of raw materials falling through and that is a bigger benefit when you look at overall Nalco.

Mike Harrison – First Analysis

All right. And then, I was wondering if you could give us some more details on the Crossbow acquisition, can you give us a sense of the size of the pretreatment market and where are those customers getting those products now, are there Nalco offerings that actually might be cannibalized as you roll this out or are they giving those products services from third parties now? And then also maybe a sense of the timings for a roll out beyond the Midwest into the rest of the US market?

Erik Fyrwald

First of all, it is a small company that we've purchased. They had $14 million in sales last year, very geographically focused in the Midwest. They are located not far from Chicago and service Chicago, Indiana, Michigan, Illinois and some of Wisconsin, but they're very focused around the Chicago area. The service is largely around reverse osmosis systems, including they manufacture some specialty RO equipment and ion exchange resonant regeneration and they have mobile equipment as well as regeneration facilities at a very large facility they have that by the way has a lot more capacity in the Chicago area. Top-notch outfit, very highly regarded by customers. As soon as we bought it, and were able to explain it to our people internally, I think 50 sales engineers representing 50 of our customers today said that they had great opportunities for this offering as their customers that they wanted to bring the Crossbow people into and that is happening.

So I think that the market for pre-treated water is substantial globally and I think we will be able to demonstrate very quickly a high growth rate off a very small base in this geography and then within the next year, we will start significant geographic expansion. You know, I look at this as like a number of our other acquisitions, like Mobitech, like Geo OneSource, small company, very limited geographic scope, but very good technology, in this case it is service technology but also some specialty equipment technology that we can very quickly globalize. So I think we will take this $14 million to hundreds of millions of dollars in the next few years like we're doing with Mobitech and some of the other acquisitions that we've done.

Operator

Thank you. And our next question comes from Mark Gulley from Soleil Securities.

Mark Gulley – Soleil Securities

Good morning, guys. With respect to interest expense, a very sharp sequential decline; Brad, you went through some of that. Is that the right number for the rest of the year or could currency or other factors drive the number back up again on the interest expense line?

Erik Fyrwald

Probably less likely currency, Mark. I think what you're seeing is the very low level of interest rates in the marketplace, I mean three months LIBOR is currently hovering around a 1% kind of a level. So I think you know the bigger impact on interest expense would be more a function of what we do on the refinancing front because unfortunately, the instruments that are maturing carry lower rates of interest than their replacement vehicles and that is something that we are in the midst of right now.

The debt maturing in 2010 has been front of mind for a lot of investors, lot of encouragement from people, some of whom are on this call, so I trust that proactively. You know, the markets have improved, our ratings have improved, we got great receptivity to the rollover, the revolving credit facility. So I think we're looking at ways to address part of that $887 million maturity to fall through next year. As we have said before, it is not our intent to replace that fully, because free cash flow will be strong and we will de-lever as we go into that instrument. So, things we are looking at, but unfortunately, rates in the market space, while greatly improved, are still higher than the kinds of things you could do in 2003.

Mark Gulley – Soleil Securities

And then secondly, with respect to the fundamentals, I was surprised that your decline in the petrochemical area downstream was not greater, given tales of what we have heard in the chemical industry. Can you talk a little bit about why perhaps you weren't down as much as perhaps I would've thought?

Brad Bell

I don't think we've broken it out between downstream refining and petrochemicals. Whereas the petrochemicals was very challenging, we did continue to expand our share position in downstream refining and I would say that we have done well in sharing petrochemicals also that helped offset some of that challenge.

Mark Gulley – Soleil Securities

Thank you.

Operator

And our next question comes to us from Brian Drab from William Blair.

Brian Drab – William Blair

Good morning. I know you said that toward the end of the first quarter, you started to see some rays of light here in the water services business in terms of factories coming back online in China in petrochem. Can you make any comment on what you are seeing in the general manufacturing area, if you haven't already and also the trend in the auto market and the expectation for large-scale factory shutdowns coming this summer in the auto market a concern?

Erik Fyrwald

Well, the mining and metal market globally has been very weak and if you follow some of the mining companies or the steel companies, I think we are all being impacted by the lower industrial production to lower demand downstream, not only for autos but other things. So that is a tough sector. The paper sector is also very tough, particularly in Europe. It has been challenging for a number of years, continues to be challenging, some stabilization in North America but still challenging. It was very down in Asia at the end of last year and going into this year but we're seeing some pickup in countries like China. We have seen continued paper production growth in Latin America, that has been one bright spot, but I would say that overall industrial activity continues to be very challenged. You know, there are some bright spots, food and beverage continues to – people continue to eat and drink, but overall it is still a very challenging situation, the decline has certainly slowed but I'm not sure how fast we will see a ramp-up.

Brian Drab – William Blair

Okay, thanks, and one question for Brad. Do you get the sense from your discussion with your lenders that it’s more likely that you’re going to be able to refinance a portion of the 2010 term loan that you expect to – with either another term loan or do you expect you might have to go to the public debt market?

Brad Bell

Quite possibly, do a balance of each and then obviously the high yield bond market has rallied greatly since the first of the year. Interestingly, we are starting to see some improvement in the leverage loan market as well, term loan these days; and in bank because were not looking for new money but a rollover of existing; and the fact that we are looking for a less than a complete replacement, my sense is – just from comments we’ve had and some of the reversed inquiry, we will have – we have great opportunities in front of us.

Operator

Thank you. And John Quealy from Canaccord Adams has our next question.

John Quealy – Canaccord Adams

Thank you. Good morning. First, on paper – excuse me – in Europe. Erik, I think you mentioned some other additional optimization activities. When should we look for those to hit the P&L moving through ’09?

Erik Fyrwald

Well, in Europe, many things take longer than they would in the United States, but we’ve been taking actions there for a lot of last and are continuing this year, so there will be a combination of shifting resources to higher growth opportunities that I talked about before. You know, Mobitech is growing great guns in Europe and we are taking some very talented folks and putting them on Mobitech to help drive that. There will be some natural attrition and there will be some positions eliminated, so it will happen through the year and there won’t be one big sudden spike that will happen through the year; so in the second half, we will start to see some benefit but the biggest benefit will be in next year.

John Quealy – Canaccord Adams

And back to the growth platforms if I could for a minute. Your expectations for ramping 3D trace are on the particular side. Is this a multiyear opportunity to get that water cooler penetration or – how do you look at that?

Erik Fyrwald

Yes, it’s multiyear. We are in our fifth year for cooling tower water and what I would say is we did a good job with cooling tower water, but we stepped up the resource in last year and grew it 40% last year in the fourth year, so we’re trying to learn from the good and the bad in cooling tower water, and have a new approach for 3D boilers that we think will allow us to ramp it up faster than we did in cooling tower water in terms of percent of opportunity each year; and we’re off to a good start, but the real significant impact will start to happen next year and into the future. But there’s a big opportunity here. We’re going after it aggressively and we’ll get there as fast as we can, but I think we can go faster than we did with cooling tower.

Operator

Thank you. Our next question comes to us from John McNulty from Credit Suisse.

John McNulty – Credit Suisse

Yes, good morning, just two quick questions. With regard to your cash flows normally in the second half of the year, you normally see a pretty good step up is – is that still likely to be the case or you’ve got somewhat borrow a little bit or a benefit in the first quarter where it may reduce the positive impact you normally have in the second half of the year? How should we think about that?

Brad Bell

Let me answer that a little differently. I think nothing we have done will offset the normal seasonality of the underlying business, so that fundamental trends remain in placed in second half cash flows on the base of business coming from the P&L will be stronger. I think what you’re seeing in the first quarter is we didn’t wait for that to go after the balance sheets. The inventory surge that we took on last year is something that we were quick to redress in the first quarter, further gains to come. So that patterning could be a little different than what you’ve seen historically.

John McNulty – Credit Suisse

Okay, great. And then, just a second question on the 3D boiler ramp up. Are there any sizeable incremental costs that should be coming in or is it pretty much – you’ll manage it well enough where we shouldn’t see a big ramp up in the cost or maybe the margins to take a little bit of a hit in the next couple of quarters?

Erik Fyrwald

We’re doing a lot of training and a big chunk that is behind us, and putting some additional resource just focused on this; but they’re coming from other parts of Nalco. We’re not hiring into that. I think that you will not see a spike in costs.

John McNulty – Credit Suisse

Okay, great.

Erik Fyrwald

It will more than pay for itself this year, but the real big positives will start next year and beyond.

John McNulty – Credit Suisse

Great. Thanks for taking my questions.

Operator

Thank you very much. (Operator instructions) And then, our next question comes to us from Mike Judd from Greenwich Consulting.

Mike Judd – Greenwich Consulting

Yes, good morning. You’re sales engineers have a unique perspective since they’re operating in a lot of these plants and other petrochemical plants but all kinds of plants throughout the industrial world. What are they saying in terms of inventories at the customer level? And do they see any green light there? In other words, is their perception that the inventory levels have been work down? So, therefore, there’s an opportunity for business to pick up here even if it’s just a seasonal pick up? I understand your comments earlier about the petrochemical industry. How things – you have some plants that have been down and are back up and running. But that’s a little different than the question I’m asking. Thanks.

Brad Bell

Yes. I think what we’re hearing both from our folks and from what we read is that there’s been a lot of inventory destocking across many industries. And at some point, that’s got to end, and so we’ll see what the real demand is when that stops being part of the decline. Then, hopefully, if things start to improve from our end-use demand standpoint, that that’ll be levered up with additional inventory build at some point. But what I would say is that the way I would characterize is there’s less massive inventory decline at this point and, therefore, less reduction, a slower rate of reduction, but we haven’t seen people start to rebuild inventories yet. So, we haven’t seen that leverage yet, but –

Mike Judd – Greenwich Consulting

So, this is a second derivative issue in the sense that the decline, the rate of decline is decreasing. Is that essentially what you’re saying?

Brad Bell

Yes, I would say that. And we’re seeing some areas of stability and some areas of plants restarting up like I described, so we’re seeing some positive signs, but there are also some negative signs out there. There are still – you hear about companies having trouble or some bankruptcies or plant closures, not necessarily specific to us but – and somebody mentioned the automotive industry in North America extremely challenged. And that challenge is the steel and aluminum industry, and that challenge is the mining industry; and that impacts all of us.

Erik Fyrwald

I think we have time for one more question. We’re coming up at the end of the hour.

Operator

Thank you. Our next question comes to us from Richard Eastman from Robert W. Baird.

Richard Eastman – Robert W. Baird

Hi. Just – really, just two related questions; one on the paper margin, contribution margin in the quarter. You had alluded to some additional cost reductions there as well, I think both in Europe and US. Would you envision having the ability to hold margin, added cost reductions, tough environment? Do you think you can hold the contribution margin percentage in that business at this point?

Brad Bell

Yes. This is Brad, Richard. It’s a tough industry space. Our business is performing well, but you got a customer set certainly in Europe, certainly in North America, that’s still finding bottom, if you will. Business grew in Latin America as Erik pointed out. We’re getting tremendous benefit from having rolled that business into the new water and process services division, so we took a lot of cost out of this, which isn’t obviously helping our margin. This business, like the others, is going at the same kind of productivity improvement and I think we just need to be careful about right-sizing the investment and right-sizing the dedication of resources to the health of the business. So, again, outside of North America, this business, like the others, will begin to benefit from the flow through of lower raws as it finds its way through FICO and weighted average costing systems. I think it’s not too much different other than the underlying health of the customer’s set.

Richard Eastman – Robert W. Baird

Okay. And then, can I just roll that into a broader question on gross margin for Nalco overall? Did the gross margin in the quarter come in below plan for you? I realize there are lots of puts and takes here, everything from currency volumes down. Sales mix probably is flat going forward, but the gross margin suggests that you’re giving back enough price to offset the lower raw material cost. And I’m trying to figure out where does the gross margin go from here for the balance of the year.

Erik Fyrwald

Okay. Let me try to explain. As we said before, we expect it and this is what happens; that gross margin would improve in North America where we’re on FICO accounting. And it did because it reflected the lower cost of raw materials, our ability to do a reasonable job maintaining price, and that margin improvement of hundreds of basis points occurred despite the volume variances that we incurred, as Brad referred to the $18-million global volume variance. We expect in the second quarter for us to start to see gross margin improvements in the other regions that are on FICO or other accounting methods that we’ll start to see that raw material flow through. So, whereas our gross margin for the first quarter was roughly flat; North America was up, the rest of the world was down. We expect North America to stay positive and for the rest of the world to start to improve in the second quarter.

Brad Bell

And I mentioned earlier – this is Brad – that we’ll file the Q this weekend. And in there, you’ll see that at the direct contribution line, about 9% of the year-over-year change was currency, essentially of the same thing going on at the gross earnings line. So, I think, maybe, what you’ve interpreted as price gives back against lower raws or something. Don’t forget that the sizeable currency component in that gross earnings number as well.

Richard Eastman – Robert W. Baird

Okay.

Operator

And that concludes the question-and-answer session today. At this time, Mr. Bushman, I will turn the conference back over to you for any additional or closing remarks.

Erik Fyrwald

Okay. Let me just make – this is Erik. Let me just make a quick closing comment. Just to reiterate what I said at the beginning, I am pleased with the effort across our company and the progress that we’ve made both in terms of our focus growth efforts, step-changing cost productivity in the company, and in really step-changing our ability to drive cash flow. Clearly, not satisfied with year-over-year declines in revenue and earnings, but we are absolutely committed to continuing to do, to drive the things that we can control to strengthen this company’s ability to drive growth, profitable growth, to drive cost productivity, and to drive cash flow. And we expect that to continue through the year and show continued improvement in those areas.

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Source: Nalco Holding Company Q1 2009 Earnings Call Transcript
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