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PolyOne Inc. (NYSE:POL)

Q1 2009 Earnings Call

May 6, 2009 9:00 am ET

Executives

Stephen Newlin – Chairman, President and Chief Executive Officer

Robert Patterson – Senior Vice President and Chief Financial Officer

Analysts

Steven Schwartz – First Analysis

Dmitry Silversteyn – Longbow Research

Michael Judd – Greenwich Consultants

Saul Ludwig – Keybanc Capital Markets

Christopher Butler – Sidoti and Company

Rosemarie Morbelli – Ingalls & Snyder

[Roger Spritz] – Bank of America

Operator

Welcome to the PolyOne first quarter 2009 earnings conference call. Before we begin, the company would like to remind you that statements made during this conference call which are not historical facts may be considered forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Forward-looking statements will give current expectations or forecasts to future events and are not guarantees of future performance.

They are based on management's expectations and involve a number of business risks and uncertainties, any of which could cause actual results to differ materially from those expressed and/or implied by forward-looking statements. Some of these risks and uncertainties can be found in the company's filing with the Securities and Exchange Commission, as well as in today's press release.

During the discussion today, the company will use both GAAP and non-GAAP financial measures. Please refer to the earnings release post on the PolyOne website where the company describes the non-GAAP measures and provides a reconciliation of them to the most comparable GAAP financial measures.

Now, I will turn the call over to Mr. Bob Patterson, Senior Vice President and Chief Financial Officer.

Robert Patterson

As always, we welcome the opportunity to speak to our investors and analysts about the recent performance of PolyOne. Joining me today is our Chairman, President and Chief Executive Officer, Steve Newlin. Before I begin, let me preface my comments by saying that unless other timeframes are specifically stated or referenced during today's call, we will be comparing the operating results for the first quarter of 2009 to the first quarter of 2008.

In the current environment, we know our investors and analysts are keenly interested in our cash and liquidity positions and so I will address those subjects first, and we have great news. We ended the first quarter with $122 million of cash on the balance sheet, a $78 million increase from year end, and we are happy to report our liquidity has increased $23 million to $189 million.

While we had no outstanding borrowings on our accounts receivable facility as of March 31, our borrowing capacity under our facility declined during the quarter primarily due to a reduction in receivables resulting from better collections and lower sales. I will also mention, as we did in our earnings release, that our cash and liquidity increased through the month of April and at the end of April we had $151 million of cash and $216 million of liquidity.

The primary driver of the increase in cash for the first quarter was a $78 million or more than 25% reduction in trade working capital. I'd like to recognize the entire organization for their contribution to this success and share a few highlights of this accomplishment with you.

Last November we began working with our suppliers to modify and streamline our payment processing and in January we began paying most domestic suppliers on only one day a month. We adopted these terms because they significantly improve internal efficiency, as well as forecast accuracy. This is but one great example of Lean Six Sigma in action.

These terms also improve the consistency and the liability of payments, which is good for our suppliers. Dunn and Bradstreet rates PolyOne the highest possible credit score reflecting our commitment to our suppliers as well as our underlying financial strength.

Next, we focused our efforts on reducing inventory beyond that which was justified by lower demand. In January and February, our sourcing and supply chain resources took purchasing holidays to participate in Kaizen events aimed at reducing raw material and finished goods. While we achieved modest immediate benefits from our temporary buying suspension, more importantly the holidays created space for our organization to make supply chain improvements, brainstorm and generate ideas.

As you can imagine, one of the most difficult aspects of effectuating change is creating the time to do so. We are pleased the events were successful and led to the identification of seven Lean Six Sigma Black Belt projects aimed at reducing lead times and safety stocks, as well as streamlining supply chain management.

The results of the Kaizen events were immediately observable in the first quarter helping us to reduce inventory quantities by 13.6% since year end. In dollar terms, inventory declined $36 million or 20% since year end reflecting an additional benefit of lower raw material costs.

This is not an inconsequential accomplishment and is even more impressive when you consider we were able to maintain an on time delivery rate of 95% for the quarter. While we're very pleased with these results, we will continue to reduce inventory for the previously mentioned Black Belt projects.

Finally, we focused on customer collections. To some extent, I think we benefited in the first quarter from customer payments that were due in December but received in January. Not wanting to repeat this, we initiated a proactive customer calling campaign to clarify billings, pricing and related terms and conditions with customers prior to payment due dates. We also significantly reduced overdue balances from 23% at year end to 15% at March 31, and in total we generated $16 million of cash from accounts receivable.

I also want to point out that we dramatically reduced our exposure to accounts receivable in the North American auto sector specifically we measure and track our overall insured exposure to North American automotive suppliers. The last time we looked at this, the first time we looked at this from a deep [dire] standpoint was October 31 when we had $25 million of uninsured exposure.

By the end of March, we had reduced our uninsured exposure to $3 million. Obviously, this reflects reduced demand from automotive customers, but also our efforts to minimize risk through proactive collections, expanded insurance coverage and customer selectivity.

I'd now like to make some remarks about the results of operations. For the first quarter of 2009, consolidated sales fell $250 million or 35% to $463 million. While volume fell 34% below the prior year and by 7.7% below the preceding quarter, we are seeing some stability returning as demand edged up in March versus the preceding two months. We believe customer destocking may be nearing an end.

We reported a net loss of $0.10 per share for the first quarter of 2009 compared with net income of $6.5 million or $0.07 per diluted share for the same period a year ago. The first quarter results for 2009 include a favorable settlement of a foreign tax audit for $10 million and a tax valuation allowance against deferred tax assets of $5.4 million.

We are drawing your attention to these tax items as similar adjustments were not recorded in the first quarter of 2008. Excluding them, as well as special items in both periods, we reported a loss of $0.04 per share during the first quarter of 2009 versus income of $0.08 per share in 2008.

Before I begin to review the segment results, I will comment on our special items. First, during the fourth quarter we recorded a preliminary estimate of goodwill impairment related to our GI compounds and specialty coatings reporting units within the performance products and solutions segment. This non-cash charge was due mainly to the significant deterioration in the capital markets in the fourth quarter and the corresponding increase in our cost of capital.

During the first quarter of 2009, we finalized our testing and impairment assessment as we said we would and have recorded an adjustment to increase our preliminary estimate by $5 million. As we said last quarter, the fact we are recording an impairment charge does not change our long-term strategy and does not in any way diminish our assessment of PolyOne's value proposition. Further, this is a non-cash item that has no impact on our liquidity.

Finally, special items also include $10.1 million of pre-tax charges related to the restructuring actions announced on July 28, 2008 and on January 15 of this year. Both of these programs are proceeding according to plan and I'll have more to say about them in a moment.

I'll now review our segment performance. Our performance products and solutions segment report a quarterly operating income improvement despite a revenue decline of 39% as volume fell by the same amount. While revenues were down $259 million to $159 million, gross margins improved due to restructuring savings, lower raw material costs, and LIFO reserve adjustments.

Our specialty platform was significantly impacted by the slowdown in Europe and Asia. In total, specialty platform sales declined from $288 million or $190 million. Specialty operating income fell from $13.5 million during the first quarter of 2008 to $500,000 during the first quarter of 2009.

The majority of this shortfall comes from our international color and engineer materials segment, which has been very heavily impacted by the global recession. Certain markets have been hit more than others. Our Asia engineer materials business saw revenues decline 66% principally due to lower electronic exports to the United States.

We see this improving sequentially in the second quarter, but certainly expect it will be down overall for the year. Unfortunately, it is more time consuming, more expensive and administratively burdensome to effectuate cost reductions in Europe. Despite our best efforts to remove costs from the organization, we simply were not able to do so in advance of the precipitous decline in orders we experienced in December, and then into the first part of this year.

For the first quarter international segment sales fell 43% and operating income was roughly breakeven. We expect it will take Europe longer to emerge from the recession than the U.S. However, we believe our international segment will return to profitability in the second quarter. Of all our businesses, this segment will benefit the most in terms of sequential operating income improvement from the previously announced restructuring savings.

Our distribution business delivered another solid quarter. Despite the sales declining 32% from $201 million to $137 million, operating income was nearly flat against the prior year due to significant reductions in SG&A and lower bad debt expense. The distribution business now has an annualized return on invested capital approaching 25%. This was no easy feat and these results illustrate the continued relentless efforts of this team to control spending, reduce costs and working capital without sacrificing customer service.

Speaking of customer service, we consider our 95% on time delivery rate, which is based on the customer request date, to be best in class and we achieved this level of performance again during the first quarter while simultaneously reducing working capital. While our on time delivery metrics might not be meaningful to investors at first blush, it should because we believe this important, competitive differentiation continues to allow our distribution business to gain market share.

Our resident intermediate segment, which consists principally of our Sunbelt joint venture, delivered higher operating income in the first quarter of 2009 versus 2008 primarily due to higher caustic soda prices. Corporate costs include $5.8 million of incremental pension expense in 2009 due to the pension asset losses we incurred in 2008, excluding this pension increase and special items, corporate costs were approximately the same as the prior year.

I'd now like to update you on our restructuring progress. Recall in July of last year we announced our manufacturing realignment to reduce capacity, and in January of this year we announced another phase of cost reduction to improve PolyOne's financial strength and competitiveness. These included eliminating approximately 370 additional jobs worldwide, or 8% of the global workforce, implementing reduced work schedules for another 100 to 300 employees based on demand, closing our Niagara Ontario facility and idling certain other capacity.

Additionally, we announced other actions including freezing executive salaries throughout 2009 and deferring other salary adjustments. For all actions announced, we initially expected to incur one time pre-tax charges of approximately $76 million, of which $28 million would be non-cash asset write-downs and/or accelerated depreciation. Since we made our announcements, we have reduced our cost estimates and now project pre-tax charges of $66 million of which $28 million is non-cash.

We expect lower cash costs due primarily to reduced severance costs for our international operations. We now project total cash costs to approximate $38 million versus the previously disclosed $48 million, of which $12 million has already been spent. For the balance of 2009 and just to be clear, we expect remaining restructuring income statement charges to approximate $18 million and cash costs to approximate $26 million.

Our savings estimates remain unchanged with $35 million to $40 million of estimated savings achieved in 2009 and annualized run rate savings of $57 million estimated for 2010. Perhaps most importantly in the short-term is our ability to fund our restructuring costs without incremental borrowing. As we announced in March, we have generated more than enough working capital improvement during the first quarter to fund the remaining cash costs associated with these actions.

This may be the most critical near-term statement that we want current and prospective investors to digest. For some time now our equity and debt valuations have been seemingly pricing in a high probability of insolvency. We recognize we are not alone in this regard, and many companies have similar market valuations due to general fears about the current economy and credit markets. We trust that our cash flow performance during the first quarter and our ending cash and liquidity positions help to alleviate those concerns and illustrates the resolve and capabilities of this team.

Given our current expectations, we expect to finish the year without borrowing from our accounts receivable facility. We expect to have adequate cash to fund our limited near-term debt maturities, as well as our pension obligations. Our management team is steadfastly committed to PolyOne's success and to delivering value to our investors, regardless of market conditions. We trust the market will recognize the importance of our near-term focus on cash and liquidity, but at the same time will understand we have not lost sight of our strategic long-term goals.

With that, I will now hand the call over to Steve.

Stephen Newlin

Let me begin by thanking PolyOne employees for their relentless resolve and commitment during the quarter. Most notably, we challenged our employees to significantly reduce inventory and working capital, and they did so with great success and I want to commend them for a job well done. With the additional cash on our balance sheet, our liquidity is greater than it was at year end and our current financial strength allows us to invest selectively in our business with greater confidence.

In doing so, I believe PolyOne has taken a major step toward emerging from this downturn a stronger and healthier organization. That being said, we fully recognize that we have a long way to go before the economy recovers. We've seen small but encouraging signs that destocking may be coming to an end and that demand may be stabilizing. However, we're being realistic about near-term demand, which we expect will be well below the unsustainable peaks of the mid-2000's, especially in housing and auto.

We're making the necessary adjustments to right size and position our organization for profitability and growth, but we are not permanently shaping our company for the current depressed levels, which we believe to be at or near the trough. We are by-passing more drastic steps now that could jeopardize our bright future and we're focusing on our market potential, which exceeds $30 billion. Regardless of the exact characteristics of the new level of demand, our ability to be adaptive is key to our success.

We will continue to be relentless in reducing costs, conserving cash and reducing our breakeven point. The improvements we're making are designed to serve us well, regardless of the change in the external economic climate. As we said during the fourth quarter call, we have not abandoned our four pillar strategy and we continue to transform PolyOne into a specialty company. And while the current recession will delay the achievement of our long-term goals, our plan is the right one.

A great example of the continued pursuit of our strategy is our ongoing expansion into healthcare. Healthcare volumes were down about 5% year-over-year versus an overall volume decline of 34% and gross profits showed a double-digit increase. At $40 million, healthcare comprised roughly 9% of consolidated revenues during the quarter. That's two percentage points better than in 2008 and compares to 4% in 2006.

This story is a perfect illustration of why we're expanding into this market. While not immune to recession, the healthcare market offers greater stability and less cyclicality than certain of our commodity end markets and this clearly is observable in our first quarter results. We've repeatedly stated that we're redirecting resources for markets like housing and auto and focusing on healthcare.

We now have a dedicated corporate healthcare leader with 24 sales, marketing and technology managers from the business working on future customer applications and translating new technology from our innovation pipeline. During our fourth quarter earnings call, we advised our investors and analysts that we would continue to invest in our business, but do so selectively and at a slower pace overall. Our focus on growing the healthcare sector is a great example of investing selectively.

Another example is expansion of our investment into Lean Six Sigma. We are a late adopter of LSS principles and that's the bad news. The good news is abundant opportunities for improvements have yet to be captured. We began implementing lean practices and concepts about two years ago with a narrow focus on improving the efficiency of our manufacturing organization and our production processes. The results were measurable both in terms of reducing waste and decreasing our manufacturing expense.

Recently we broadened the scope of our lean initiatives setting our sights on inventory and working capital reductions. We now intend to build upon the lean capabilities we developed and expand Lean Six Sigma across our broader organization. Twenty-seven of our best and brightest people are now in full time project execution roles for two year assignments, and we expect to double this number during the first quarter of 2010.

We will continue our efforts to improve our manufacturing capabilities, but will place a complementary focus on our commercial processes, supply chain functions and our corporate support systems. These efforts will be directly aligned with our strategic pillars of commercial and operational excellence, the key components of our overall strategy.

Our first wave of projects includes accelerating capture of new accounts. We're also launching projects designed to increase the profitability of our products and our portfolio by giving renewed attention to our product lifecycle management and pricing practices. And although we've made great strides in recent years in our pricing practices, I believe we have ample opportunity for improvement.

In the supply chain area, we've launched a program designed to upgrade our sales and operations planning process on a global basis. This program was launched in January when we conducted a series of Kaizen events designed to improve our response to changes in customer demand. The project has allowed us to dramatically reduce our inventory positions over the last several months.

We're also increasing our expectations of our suppliers through a series of additional Lean Six Sigma projects designed to deploy a global strategic supplier management program that will improve the value we deliver to our customers and shareholders. We expect our key suppliers to become true partners with us in an effort to lower the total cost of ownership by asking them to raise their level of performance. These are broad fundamental business improvement efforts designed to augment the overall performance of PolyOne.

We expect our improved ability to execute projects in critical areas will lead to a 100 basis points of gross margin expansion during each of the next three to four years providing a significant boost to earnings growth and cash flow generation. And as you can ascertain from Q1 results, we're well on our way.

Another example of our continued selective investment is our expansion in Asia with a new facility in India. We began production in Q1 with our first sales in March. This is initially a modest investment that will serve as a springboard into one of the fastest growing economies in the world. Our strategy for penetrating this market includes providing value based solutions to global accounts and leading local players in selected industry segments and target geographic areas. We expect revenues to exceed $2 million this year and we anticipate this business will be profitable in 2010.

Our corporate vitality index for the quarter was 18%, recall that our vitality index measures the percentage of total sales from products included that were entered introduced in the last five years, and it has included distribution sales. So we think it would be more meaningful to measure our vitality index excluding distribution as this business does no product development work. On this adjusted basis, our vitality index has now reached 26%, this means 1/4 non-POD sales are from new products less than five years old.

Sales from new products have declined at a slower pace than our older products indicating the relative value of our new offerings. With gross margins on new product sales are well above the corporate average, we're seeing our improved pricing practices and new technology launches continue to have a positive impact in driving specialization. We are getting better at selling the value of our products and what they create for our customers.

Last month we introduced new compounds for cables used for photovoltaic solar cells that will support customers looking for global compliance with new safety standards in alternative energy applications. And this is a market we expect will grow rapidly as demand for photovoltaic power generating systems increases abruptly.

During the quarter, we also announced a new joint a Detroit development effort with Zyvex Performance Materials to successfully develop the first nano-enhanced thermoplastics that address both electrical conductivity and mechanical property requirements of specialized product applications. These products could displace metals with favorable economics in applications such as medical packaging, consumer electronics and other high performance products.

Our innovation efforts continue to expand with industry leaders such as Archer Daniels Midland, Eastman, Dow Chemical and others as we leverage our material sides and compounding expertise to develop new applications and products. Our focus and commitment to drive our innovation pipeline plays an important role in our longer term strategic position, as we balance long-term investment opportunities with improving our near-term operating efficiency in the current economic environment.

We remain very cautious about our primary end markets and our actions to date illustrate that PolyOne intends to remain competitive through an economic downturn of uncertain duration and magnitude. We are balancing the near-term goals of improving cash flow and liquidity with our long-term strategic objectives.

The recent economic crisis, the cyclical nature of our traditional end markets, and the price sensitivity of our commodity business only serve to reinforce the need for our transformation and validate our strategy. We are steadfastly improving our mix of sales into higher margin specialty applications and improving gross margins as a result.

Compared to the first quarter of last year, gross margins have improved in all of our businesses despite steep volume in revenue declines that would normally be very dilutive to margins. This reflects not only the mix shift I just described, but also the cost savings from our lean initiatives and the pricing discipline and rigor we have instilled in our commercial organization.

Even in an environment as tough as we're in today PolyOne will not chase volume. This has long been an irrational and failed strategy in our industry, and we prefer to reduce fixed costs rather than take business at unacceptable rates of profitability or even losses. Further, we continue to differentiate ourselves from competition by demonstrating the total value equation of our products and services.

I am confident in PolyOne's leadership team and employees. While we have never experienced such a steep and broad decline as this, we also have never had a better or more capable management team. And our talented leaders are equipped to navigate us through this challenging economic crisis while simultaneously guiding our long-term transformation process. Despite the prevailing headwinds we're winning new business every day by providing our customers with innovative products, services and solutions. And our gross margin improvement indicates we're doing so and accelerating level of profitability.

With that, I'll now turn the call back to [Josh] to open the line for questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Steven Schwartz – First Analysis.

Steven Schwartz – First Analysis

Bob, can you just aggregate the four factors behind the gross margin improvement you called out in the press release? I'm wondering how much was related to the LIFO reserve adjustment?

Robert Patterson

Yes, LIFO was $8 million. If you just look on the balance sheet in terms of how that changed from 12/31 to 3/31 and if you stripped out LIFO, gross margin improvement was about 100 basis points year-over-year. And what that translates to is, it's obviously a mixed effect of both volume declines, which were significant, offset by some price and mix improvement. If you look at the top line volume the total sales are down 35% volume down 34%, FX is about 4% bad guy and so that yields a price and mix change of roughly 3%.

Steven Schwartz – First Analysis

So that's what brings this back down to the goal you have the next couple of years about 100 basis point improvement.

Robert Patterson

Yes, I'm sorry, I may have misunderstood your question as being focused on first quarter results.

Steven Schwartz – First Analysis

Yes, no, no it was, Bob, you got it right, just trying to understand the long-term goal versus this quarter effect. Then my second question as a follow up, the consolidated SG&A on an adjusted basis year-over-year, it looks to be about the same amount. So I'm wondering how much of the pension costs are in there? What effect that had, and how much is in there, but maybe we're not seeing from the restructuring?

Robert Patterson

Sure, the pension and costs increased significantly and the effect in the first quarter of '09 versus '08 was an incremental $5.8 million of expense, which is almost entirely contained within our corporate and other align and segment. And the reason for that is, is that if you look at the participants in the PolyOne pension program, only about 10% are active employees, so we have captured those costs outside of the segment results.

So, if you take last year's report at SG&A of $72 million, you've got a bad guy of $5.8 million, you'd expect it to be roughly $77 million this year and we reported $69 million, the items going the other way, Steve, are restructuring benefits of about two, lower bad debt expense, favorable FX of about two as well as incentive accrual adjustments downward of about $2 million. So, hopefully that helps you reconcile year-over-year SG&A.

Operator

Your next question comes from Dmitry Silversteyn - Longbow Research.

Dmitry Silversteyn - Longbow Research

Just wanted to confirm, you had a 30% plus decline in the distribution volumes, but my understanding is that the raw material prices or the plastic prices that you're distributing have come down quite a bit as well. Did the margin to gross margin at business improve despite the volume loss, or was it too much to expect that?

Robert Patterson

Dmitry, well thanks for that question first of all. Yes, gross margin did improve in the distribution business. Last year, first quarter we reported 8.6% and first quarter '09 was just over 10%.

Dmitry Silversteyn - Longbow Research

Okay, but that didn't have anything to do with the, kind of the one-off's, it was just literally a gross margin, I mean a raw material benefit or did gross margin also get impacted by things like LIFO adjustments and foreign exchange and whatnot?

Robert Patterson

Our distribution business is on FIFO so there's no LIFO benefit. The year-over-year improvement is primarily driven by a mix. And our distribution business is leading the way in terms of expanding our healthcare sales and so that's one of the reasons why you're seeing that improve year-over-year. To some extent, there has been a benefit of lower raw material costs, but largely those are passed through to customers.

Dmitry Silversteyn - Longbow Research

Okay, so you had to pass those through to customers. Okay. The second question is, you mentioned seeing signs of the inventory correction being over particularly in the Asian and electronic business. Can you give us a little bit more color and what you're referring to and then kind of what gives you the modest confidence to say that? What are you seeing in terms of sequential improvements? What are you seeing in terms of customer order patterns that lead you to believe that the inventory correction phase may be over?

Robert Patterson

Well, I'll just make an initial observation about order of magnitude. And if you look at our Asian business being roughly 5% or 6% of total sales, last year electronics was about 50% of that. This year, it's actually about 1/3 or slightly less. So that gives the order of magnitude. In terms of what's happened from an electronic perspective, and that again as I mentioned in my comments earlier, is principally driven on exports to the United States. Steve, is there any observation you want to make?

Stephen Newlin

Well, I think it's really difficult to distinguish the temporary decline in demand that's due to the inventory liquidation from a more persistent decline in final and market demand, but I believe based on what we're hearing from our management teams around the world and from our sales force, is they're believing we're through the majority of the destocking that companies have been going through.

And we don't have unfortunately, we don't have a scientific process full of data points to determining that, so it's sort of a intuitive, instinctive call that you make. And we could be off, but we're seeing some signs that we're seeing more stability in order pattern, there's more consistency. The expectations for order, the cancellation of orders, the rate of cancellations is subsiding. So we feel like a lot of this destocking that we know has been going on is getting to a point where it's minimized now. And that's probably about the best we can do to answer that, Dmitry.

Operator

Your next question comes from Mike Judd - Greenwich Consultants.

Michael Judd – Greenwich Consultants

I just had a sort of follow-up to Dmitry's question about demand, because I guess that's really the million dollar question here is volumes, not only in the second quarter, but in the second half of the year. And I think we're all hoping that the inventory destocking basically is coming to an end here.

The question is, you move into a period seasonality where typically there's a pickup in demand. And then I guess the jury's kind of out on the fourth quarter in terms of what happens during that time period. So, this is sort of a longwinded question here, but as you think about some of the things that are going on, like Chrysler and GM and the impact of that during the summer and the seasonality, which those are sort of counteracting trends there.

And then you think about the second half of the year, what are you telling your organization? What sort of guidance are you providing them from a management perspective or for planning purposes?

Stephen Newlin

Mike, let me take a stab at that. First of all, what we're telling our organization is we have two primary priorities right now. And the first one is to collect more new business that's profitable business, good business that will be business we will want to have after we get through this period. That's profitable, that makes sense, where we can differentiate and add value to our customers.

So we're putting a lot of pressure on our sellers to spend more time being more efficient. We've given them a lot of tools to do that and we're changing those expectations. They need to be out there with our customers frequently and with prospects.

Second thing that we're telling all our employees is we are on cash in a very intense way. Looking at everything we can do to improve our cash flow, to reduce our working capital, and you're seeing evidence of that. Those two things aren't changing. If anything, they're just being fortified with a greater degree of intensity.

I would say the answer to the rest of your question, we don't have any additional insight beyond the primary public documents that you all have with regard to auto and housing. Our guess is probably 550,000 housing starts for the year 2009. I'll give you a couple of data points, with averaging over $1.9 million in '04, '05, and '06. Housing starts were $1.34 million in '07. So it is a dramatic decline.

Even from last year where we saw, kind of a shut down in the second half, still we were over 900,000 housing starts. So, we see that very soft for this year.

Auto, we're probably looking at close to 10 million units versus an average of 16.5, 17 million units in the 204 to 07 range. So still, dramatically lower production rates than what we've seen in the past. And that's sort of the bases upon which we're running the company these days until we have some data that suggests otherwise. You're absolutely right about the seasonality. That a lot of, with the re-tooling and changeover what's going on in auto, summer is very soft for auto. Usually offsetting that to some degree is housing has a pickup then.

Whether those two dynamics will have some mitigating affect on one another this year or not, I think it remains, it just has to play out because I personally think all bets are off right now on seasonality when you talk about these two markets. It's not predictable, it's moving daily. You see a new report every day in the journal or some other document that you look at.

We saw some good news yesterday about construction, but I would say that a lot of that was more on the commercial production side that it is general housing. So, there's some encouraging signs, but sure not enough for us to call it a reversal at this point.

Michael Judd – Greenwich Consultants

And just a follow-up because you guys do have somewhat of a unique perspective because you have plants in China and also a plant in Poland, can you talk about specifically those two regions in terms of what your, again, a similar type of question, but just framing it more from an international perspective?

Stephen Newlin

Well, Mike, China has gone through the same downturns that we've seen everywhere else and with five plants there it's a very important market to us. And certainly the domestic consumption in China is accelerating again from what we see. The exports, we think that they've hit the trough. I think Bob mentioned this earlier we're beginning to see some signs of improvement.

We expect things to get better this year, as we go through the year, but we're certainly not going to reach the highs and the peaks of the past several years by any means, so some optimism in China, GDP growth again in China. But I mean 5% or 6% GDP growth in China is a steep fall from where they were. But I guess at this point we're going to take it, and we're going to continue to penetrate more markets there and more accounts to offset the decline in our existing base business, but we think China is coming along, one of the bright spots around the globe.

Eastern Europe not quite so robust, we're still, we're seeing progress but there's more caution there and of course the connectivity to the Central and Western Europe economy is linked a little more closely, and I think there is not this powerhouse of numbers of demographics and numbers of people to create the same degree of demand that we're seeing in some place like China.

Operator

Your next question comes from Saul Ludwig – Keybanc Capital Markets.

Saul Ludwig – Keybanc Capital Markets

When you kind of simplify it, you see that the inventories from the end of the year fell $40 million and you let your payables extend by $20 million and that pretty much explained the $64 million cash generation from working capital. If we sort of fast forward to the end of the year, you think that the $64 million that was generated from working capital in the quarter will be about what it will be for the full year, or do you think when we get to the end of the year that $64 million will be a higher number or a lower number?

Stephen Newlin

Well, first I would just add it was about $78 million for the first quarter because receivables were actually done about $16 million, and I do believe that performance will hold and improve through the balance of the year.

Saul Ludwig – Keybanc Capital Markets

So, the net of $64 million, which is all the numbers in the [Poly] fund statement that should be a little higher by the end of the year?

Robert Patterson

I believe so, and I think you might be including in that the $14 million payback for those receivables, so that's correct and we don't believe we will have any outstanding borrowings on our AR facility at the end of the year.

Saul Ludwig – Keybanc Capital Markets

You didn't have any in the first quarter?

Robert Patterson

Correct.

Saul Ludwig – Keybanc Capital Markets

Okay, good. What do you see for cap spending for the year?

Stephen Newlin

Well, we did just under $7 million for the first quarter, which really does reflect a concerted effort on our part to pull back on spending. At the beginning of the year we said $40 million to $50 million, I think $40 is a top end number so we should be there or there under.

Saul Ludwig – Keybanc Capital Markets

Okay, would you think about the cash that you build up, and a lot came as you said from the very good job you've done working capital, when you sort of think out the next year or so, do you think some of this cash is going to sort of revert back in to working capital. I'm trying to get an idea of how much cash you really have, you might say temporary cash versus permanent cash you could use for other purposes.

Robert Patterson

Well, with respect to working capital, we do believe that we're going to continue to improve upon working capital through the balance of the year, and so I see that as an incremental cash flow, a good guide for us for the next three quarters.

If your second question there, Saul is what we do, we end up doing with that cash, I mean for now we are actually very happy to just have that on our balance sheet. As you know, we do have some near-term debt maturities, as well as pension funding obligations, and those are our first priorities as well as capital appropriations.

Saul Ludwig – Keybanc Capital Markets

Okay, great, next question related to the income statement the $8 million then of LIFO probably all then and apply to the performance products and solutions segment.

Stephen Newlin

That's right.

Saul Ludwig – Keybanc Capital Markets

Are we done with that or is there any more LIFO gains that we're going to see subsequent to the first quarter?

Stephen Newlin

I think we'll see continued LIFO benefit as a result of reducing inventory. I mean we're at a point now where I don't think the influence of price will be as significant as the influence of decrement, so as we get inventory quantities, we'll see a continued benefit from LIFO through the rest of this year.

Saul Ludwig – Keybanc Capital Markets

Do you think that $8 million is going to be repeated in say the second quarter?

Stephen Newlin

No, I don't think it'll be that significant because a big chunk of the $8 million was price and so we're at a point now where if we assume flat pricing and that could go up or down, as you know. I think it will come more from the decrement side in terms of just getting quantities out.

Saul Ludwig – Keybanc Capital Markets

On your final compound business, how much did your selling price change let's say on a cents per pound basis versus your costs for PVC resin on a cents per pound basis?

Stephen Newlin

I'm probably not going to be able to respond to that with as much detail as you're looking for. I will just tell you that volume was down 39%, total sales down 39%, there's a little bit of an affect downside there of about 3%, so I think price mix is a positive for us for the quarter of about 3%.

Saul Ludwig – Keybanc Capital Markets

And did your resin cost go up or down?

Robert Patterson

Resin costs were trending down through the first part of this quarter and we see them flattening and really stabilizing towards the end of the quarter.

Saul Ludwig – Keybanc Capital Markets

So you had some favorable price versus raw material, let's say variable margin.

Robert Patterson

Yes, I believe that's true.

Saul Ludwig – Keybanc Capital Markets

Okay, great, and then next question is Sunbelt, which had a very, very strong first quarter. We're all aware of what's happening with pricing on chlorine and caustic, particularly caustic. What do you see the Sunbelt contribution being going forward?

Robert Patterson

I mean well, first of all just in terms of projecting ECU netbacks everyone seems to believe and Olean is in the same camp that they won't be as high in the first quarter and they're trending down. I think that their outlook is a little bit more positive than CMAI, and so it would be a stretch to say that we're going to replicate the first quarter Sunbelt earnings and I expect it will be down in the second quarter into the balance of this year.

Saul Ludwig – Keybanc Capital Markets

You think it will be down in half?

Robert Patterson

I don't know if it will be done in a half, but I would say we don't see any real changes in volume so it really is an affect on pricing.

Saul Ludwig – Keybanc Capital Markets

To clarify, [inaudible] $8.8 million was what you showed as your tax benefit in the quarter and that $8.8 million had several components to it. Some related to….

Stephen Newlin

Saul, sorry to interrupt you here.

Saul Ludwig – Keybanc Capital Markets

….what are the different components of that $8.8 million?

Robert Patterson.

Saul, maybe we can have some one-on-one dialogue. We're trying to keep this to a couple of questions so that we…

Saul Ludwig – Keybanc Capital Markets

Okay, that was my last question.

Stephen Newlin

All right, thanks Saul.

Operator

Your next question comes from Christopher Butler – Sidoti and Company.

Christopher Butler – Sidoti and Company

First question, is there any business that you're looking at right now that's really dropped off that you particularly don't want to have back?

Stephen Newlin

Well, we like most of our business these days, but of course some accounts are better than others and we're making a really concerted effort. We try to take care of all of our customers, but we certainly have customers that are very prime and we spend time giving them extra attention.

I would tell you that we had to excuse ourselves from some business in a couple of end markets that was shaky, that we didn't feel was credit worthy and we won't go back into that business unless and until they become stable, that they show some signs of prosperity and growth, and that their credit risk is deminimus.

So I would say that there are indeed some accounts that we just had to steer in directions for other people to take care of just because we were unwilling to take the degree of risk relative to the reward available to our shareholders.

Robert Patterson

I would say the most significant change in our mix Q1 over Q1 has been away from transportation and into healthcare. Q1 transportation was about 14%, now it's about 10, and as Steve mentioned earlier in the call, we picked up two percentage points on healthcare. So all things held equal, that's a trend we'd like to see continue and that's not to say anything disparaging about our transportation customers, but just in terms of overall mix we would like to see it move in that direction.

Stephen Newlin

We have some automotive customers where we have critical applications and it's a very good business relationship, it's a mutually beneficial business relationship. We just have to have the internal discipline not to go after some of these applications that are purely price-based commoditized we're not any different than anyone else.

And because of that and perhaps because of the final end product they're producing, it's a very risky proposition, and one that doesn't' serve anybody real well long-term. So there's a big distinction there between the types of, we aren't just saying automotive is a bad business. It can be a very attractive business in certain applications.

Christopher Butler – Sidoti and Company

Going back to cash flow I guess here a little bit, have you given us an idea of what you think any contribution might be to the pension plan here in 2009.

Robert Patterson

Publicly we said that we would make our minimum funding requirements and that's for our qualified plan, or not qualified plan, that's $5.5 million this year. There is always an opportunity to fund in advance of that. If you've seen our 10-K, you know that our funding contributions over the next five years are fairly significant. So there may be a move by us at the end of the year to fund greater than the $5.5 million level. I just can't say at this point how much that would be.

Operator

Your next question comes from Rosemarie Morbelli – Ingalls & Snyder.

Rosemarie Morbelli – Ingalls & Snyder

Could you give us a better feel for the areas where demand you feel has stabilized? In other words, has stopped declining and may even be showing some signs of life.

Stephen Newlin

Well, I don't know what signs of life are these days, but I think just general across the board we're seeing, particularly I will start with Asia. We are seeing that some of the destocking that was just resulting in no orders is beginning to show up in terms of some orders and some repetitive business that's going on. That would be one area that we've seen.

This has been a hard hit and abrupt decline that has affected virtually every market that we serve. And, again, I mentioned healthcare a lot less than others. I don't think we saw the same degree of destocking in healthcare. We saw a reduced normalized run rate. So that would be another area. I can tell you that in where we aren't seeing a lot of changes are in auto and housing right now.

We do not see much different going on in those. I think part of this I still the amount of build that goes on in those two marketplaces relative to the past. I mean you can't stock to build products for a million houses when you're only putting 500,000 of them out of the ground. So, I think when those numbers plateau and we think they're getting close, then we'll see the destocking in those two segments pretty well eliminated.

Rosemarie Morbelli – Ingalls & Snyder

Following up on this, as you see the plateauing in auto and housing essentially lower than it has been for years, do you think that you have eliminated enough capacity for products going into those markets? Are we going to see additional plant closing or without closing a plant can you still shutdown some lines for products going into those two and, therefore, lower your manufacturing cost.

Stephen Newlin

We can, we do have the ability to close lines without closing plants and it's a strategy that we have in fact deployed and, yes, we can always take out additional capacity. We want to be very careful that we don't get ourselves in a predicament where we can't capture some good demand as it returns, but at the same time it allows us and enables us to be even more selective about the business that we pursue.

Rosemarie Morbelli – Ingalls & Snyder

Again, this is still part of the same question, there have been a lot of houses changing hands and I grant you at foreclosure houses but that is kind of irrelevant to my question how much people pay for it. That would translate into remodeling. If that remodeling part of the housing world were to pickup, do you have enough going into that market in order to be helped or is that almost irrelevant to your business?

Stephen Newlin

No, it's not irrelevant at all, Rosemarie, it's a good question. Actually, remodeling typically has been an offset to slowdowns historically in new construction. That has been a disconnect during this last downturn. And remodeling, certainly, if they're replacing windows, which often happens, there is a lot in it for us. So we like activity, we like construction. We don't care if they're building new large or small, frankly, the percentage of our program our components of houses in smaller homes often is a higher percentage than in larger homes.

So we like to see activity. We like to see starts and we like to see remodeling and we benefit from both. The problem with remodeling is there just haven't been a lot of home equity loans available, etc., which drives a lot of that remodel. But, I think you're right, we're hopeful that the turnover of homes. When people buy something, especially when they but it at distressed pricing, it gives them a little more room to put some money into it. And if we get a pickup in remodeling, we'll be delighted.

Robert Patterson

Thank you, Rosemarie, for your question. We're going to take one more question, [Josh], and then we'll conclude.

Operator

Your next question comes from [Roger Spritz] – Bank of America.

[Roger Spritz] – Bank of America

It looked like SG&A increased $10 million to $70 million in Q1 '09 from $60 million in Q4 '08 after trying to adjust out for some non-recurring items and such. Can you comment on this change and what a normalized quarterly run rate SG&A might look like?

Robert Patterson

The first thing I would just tell you, and I didn't hear your question that well, but I think you said Q4 '08 versus Q1 '09. If that's the case, one of the biggest changes that we had was that previously we had been accruing for incentives under our long-term incentive program for programs initially awarded in '06 and '07, for which there was not a subsequent payout. That was trued up at the end of last year and so I would say that you see an incremental amount of SG&A reduction in the fourth quarter versus what you'd see in the first quarter.

Secondly, the biggest delta is the increased pension expense in the first quarter, which is about $5.8 million over fourth quarter of last year. And I think that in terms of what we're looking at for the remainder of the year, is that it's not going to be appreciably different from where we are right now, although I would just say that there is some timing difference in terms of how our incentive accruals are booked against operating income over the course of the year. Beyond that, we're not going to make much more in a way of projections for 2009.

[Roger Spritz] – Bank of America

That was excellent. Thank you very much, guys.

Robert Patterson

I do have a couple quick closing remarks I'd like to make and I want to clarify that the gross margin improvement from Six Sigma that we talked about, that is incremental to gross margin recovery that we expect as a result of economic recover.

And while we know we've had some benefit from LIFO, you should also understand that, as we build less inventory in terms of utilizing the equipment and covering the overheads, there's also a negative adverse offset to that. So as we return and get some recovery, we're going to see I think a nice improvement in gross margins on more than one front here.

I want to thank you for joining us today. We're confident we can balance our near-term objectives during this downturn with our long-term strategy and deliver shareholder value. And we look forward to talking with you again next quarter.

I'd just like to remind you that we have an Investor Day. It's going to be held June 25 beginning at 7:15 am central time at the Hyatt Regency McCormick Place in Chicago, and we're hopeful you can join us to experience the National Plastics Exposition NPE and to see our transformation in action. Thank you everyone.

Operator

Thank you for your participation in today's conference. This concludes the presentation. You may now disconnect.

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Source: PolyOne Inc. Q1 2009 Earnings Call Transcript
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