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Nalco Holding Company (NYSE:NLC)

Q2 2009 Earnings Call

July 29, 2009 10:00 AM ET

Executives

Mike Bushman - Division Vice President, Communications and Investor Relations

J. Erik Fyrwald - Chairman, President and Chief Executive Officer

Bradley J. Bell - Executive Vice President and Chief Financial Officer

Analysts

Brian Drab - William Blair

John Quealy - Canaccord Adams

PJ Juvekar - Citi

Bill Hoffman - RBC Capital Markets

Mark Gulley - Soleil Securities

Michael Harrison - First Analysis

Laurence Alexander - Jefferies

Richard Hoss - Roth Capital Markets

Jeff Zekauskas - JP Morgan

Operator

Good day, everyone, and welcome to the Second 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.

Mike Bushman

Thank you. Good morning and thank you for joining us for our second quarter 2009 conference call. Joining us today are Chairman and CEO, Erik Fyrwald, who is joining the call from Europe; 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 can be founded at 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 the presentation of non-GAAP measures such as adjusted EBITDA and pro forma EBITDA, pro forma EPS and free cash flow provide 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 participants to ask questions as freely as possible, we will restrict participants to one question with a clarification follow-up to get as many people on the call as possible. We will then ask the participants to re-queue in order to ask additional questions. We'll start with Mr. Fyrwald.

J. Erik Fyrwald

Thanks Mike. While continued strong cash generation highlighted our second quarter results as revenues and earnings were reduced by ongoing weak economic conditions, currency impacts and restructuring charges associated with aggressive actions, particularly in Europe, to permanently reduce our cost base.

Organic sales dropped 6.4% on declines in mining, primary metals, and natural gas drilling services that added to ongoing challenges in paper and manufacturing markets. Foreign currency and net divestiture impacts reduced sales 7 and 1% respectively to leave nominal second quarter sales down 14.4% to $913 million. Compared to the first quarter, second quarter revenues improved 5% nominally. Each of the three segments increased nominal revenues sequentially with Energy up 3%, Water up 8%, on Cooling Water seasonal gains and Paper up 4%.

In 2008, nominal sales increased 7% from the first to the second quarter with price increases supporting that growth rate. Comparing to the year ago quarter, Energy Services increased revenues 2% organically. Excluding Adomite, Energy Services would have been up more than 7%. Adomite is our drilling related business that had been 10% of Energy Services in 2008. It fell in line with the 50% drop in North America drilling rigs from the second quarter of 2008.

Both rig counts generally and our related business fell substantially from first quarter results. Rig counts were down 38% sequentially in North America, and will likely stay at depressed levels through the rest of the year. Mining results also worsened compared to the first quarter and contributed to a 9% decline in Water Services organic growth compared to the prior year. First quarter organic sales had been down just 4%, so the decline in mining markets clearly hurt our overall performance.

Paper Services sales dropped 15% organically compared to the same period of 2008. On a company-wide regional basis, organic sales declined 9.4% in Europe, 7.1% in North America, and 4.2% in Asia, while growing 2% in Latin America.

We expect our European business to struggle the most with weak economic conditions and have therefore taken a $44 million restructuring charge in the quarter that will reduce our employment in the region in line with the smaller market size. We will close several plants in Europe and North America and implement further position eliminations in North America. Some of the plant closings led to a non-cash asset write-off while 24 million of the restructuring charge covers severance costs.

Despite ongoing economic challenges, Paper Services and Energy Services, both maintained direct contribution at slightly above 2008 dollar levels. I should note that we have moved previously reported other segment results into the three primary segments beginning with this quarter.

Water Services direct contribution declined substantially from prior year levels, but was up 26% compared to the first quarter on this restated basis. Operating expense controls, significant restructuring actions, and extensive projects aimed at reducing cost of goods sold contributed heavily to solid, direct contribution achievements in Energy and Paper, holding flat or generating slight increases.

Our cost savings efforts are ahead of our $100 million external target for the year, with additional second quarter savings of 26 million bringing our year-to-date results to 53 million. And we now have in place a very good company-wide capability to drive cost productivity that did not exist one year ago. So, we will drive more benefit in the second half and into 2010.

Turning to price; it played a limited role in results across our businesses as price increases were modestly above product cost increases from the second quarter of 2008. We need to carefully manage to avoid price versus cost being a drain on our margins, particularly in the third quarter. We've done a very good job at internal cost savings to drive margins and now must keep delivering total cost savings to our customers to be able to hold pricing gains.

Cash results remain the highlight of our performance this year so far. Year-to-date free cash flow stands at $241 million more than we have delivered in any full year since the company's 2003 leveraged buyout. Second quarter free cash flow was $94 million, more than triple the level gained in the second quarter of 2008.

A nine day cut in inventory days on hand, compared to December 31, contributed substantially to strong working capital gains this year. With our new integrated business management alignment that includes the line business management accountability for free cash flow, which we did not have in place one year ago. With that we are implementing process improvements to ensure that inventory gains are both sustainable and expandable as we go into the third quarter.

Now we recently added two outstanding supply chain leaders to our team to help us further enable these gains and have some additional outside support helping drive progress as well.

Now in addition to inventories, modest gains were made in receivable and payable days outstanding. Capital expenditure control also aided free cash flow as our year-to-date spend is $21 million less than in the first half of 2008. CapEx will end the year less than the 120 to 130 million range we had initially communicated for the year even as we continue to put in new or expanded plant operations in Alberta, Canada, the Middle East and Russia.

One of our key objectives this year is to strengthen our future with the right actions today. A couple of highlights in making this happen include, we hired very strong people into new leadership roles in Russia and China, and already had high level discussions with leaders in both countries about the role Nalco can play in providing solutions to industry that are economically and environmentally sustainable. An example of the benefit already is access to Chinese state-owned enterprises that we have never had before. This will start to pay-off in 2010 with new revenue generation.

We made strong progress on three Nalco Mobotec projects in China as part of our efforts to rapidly expand its air protection, combustion efficiency business in China. To-date these projects are moving forward successfully. We also have added 80 people to our China and India operations so far this year as we ramp up our capability to drive significant growth in these critical markets.

We increased our year-to-date R&D spending 8% organically as we see tremendous growth opportunities, particularly in energy, water markets and air that will be driven by new technology to help us gain share and continue to improve margins. We started up servicing the world's first ultra deepwater platform as part of our 11% organic growth in our oil field services business in the second quarter. Good growth in this market continues as we open new platforms that are starting production, penetrate existing accounts with new applications, and take some share to our technology advantages.

The recovery in crude oil prices to the $60 level is also encouraging producers in Canada's oil sands to reintegrate some expansion activities in that important region. We continue to have good success with an OxiPRO deposit control technology in paper that leverages our technology automation platform and helps secure our paper margins.

We also purchased a small environmental engineering firm in the UK that expands our air expertise and dust suppression. And we are working on programs to help ignite Nalco Mobotec air protection platform, which we expect to struggle for the rest of the year. The business grew 14% organically in the second quarter but this is the lowest growth rate we have delivered so far.

The combination of legislative uncertainty around two air quality regulation rules in the United States that's Care in Camer, soft pricing for NOCs and SOCs credits and the weak economy are likely to restrain growth in this business for the next several quarters, absent additional action. However, given the success we are demonstrating with projects to come online with this technology, we remain very positive about the three to five-year potential of this business to really help drive Nalco growth.

Also our Crossbow business has established a very robust project pipeline and is running ahead of our acquisition business case despite the tough economy as it expands our service offering in the important water treatment market.

Now as we look to the remainder of 2009, we have several priorities. First, we need to keep up the pressure on our cost savings and productivity initiatives. My understanding of Nalco's history is that when the company becomes comfortable with its performance, unexplained spending increases creep into our results, and I can tell you that we are focused on making sure that we continue to maintain pressure and drive productivity initiatives while also maintaining discipline around short-term cost savings.

We must retain price to ensure that price cost changes do not become a drag on our price... on our business performance. There is clearly pressure from customers to reduce pricing and we are arming our sales force with the data that is showing costs swinging backup in some areas, especially going into the future quarters. We have also increased training of our service engineers to make sure that we create more value and quantify that value to our customers, and training our key account managers and marketers on strategic negotiations to make sure that not only we are delivering the value, but we are keeping Nalco's fair share of that value.

We will also continue to invest for growth in China as well as in countries that have continued to deliver double-digit growth this year, including India, Saudi Arabia and others. Growth will return to the economy at some point or we do not know exactly when inflection point will be, we are driving our capability to gain share through technology and better trained sales engineers that will increase our growth performance regardless of economic conditions.

And finally, we are continuing to push aggressively with our integrated business management model and our process changes to drive substantially lower inventory requirements and faster collection of receivables.

While we do not know when business growth will resume, we do know that this growth would typically pull from cash for working capital needs. And our days investment in inventory is at 61 days and our days sales outstanding for receivables is at 70 days, and we will drive further reductions in both metrics with the fastest progress likely to be in the inventory category.

So with those comments, let me turn the call over to Brad to walk through our results in more detail. Brad?

Bradley J. Bell

Thank you. Erik gave you good a run through of revenue trends in the businesses and regions, and I will expand the discussion of earnings, cash flow and related matters. Clearly there is some noise in the quarter and we want to ensure everyone understands how the underlying businesses performed over the period.

Our gross margin in the quarter expanded by 80 basis points year-over-year to 45%. As our foreign entities are not on LIFO they are slower to see any benefits from lower raw materials, so that is coming as inventory levels are looked down aggressively and will absent another up tick in costs increase in impact over the second half of the year.

The benefit that is there, primarily in North America, and the productivity gains that are reflected in gross profits have been largely offset by volume variances, that is the under-absorbed plant costs that have totaled $30 million year-to-date. Of which, 12 million was in the second quarter, including $3 million emanating from our drive to reduce inventory where we have been extremely successful. That $12 million volume variance diluted gross profit margin by 130 basis points.

Actions prompting the restructuring charge we took in the quarter will go a long way in eradicating those costs as we move to a more optimal manufacturing footprint addressing seven facilities around the world. Perhaps this is a good place to mention that under the accounting rules for this, there is a $20 million asset write-off which is non-cash but it also prompted incremental depreciation in the amount of $3 million in the second quarter, $8 million in the coming third quarter, and $1 million in the fourth.

Cost savings from our restructuring activities have already begun. And by the time we enter 2010, we expect to have annualized reduction in people costs that comfortably exceed the severance charges we have incurred in recent quarters.

As stated in our release, EBITDA in the quarter amounted to $82 million compared to $167 million a year ago. Looking at this without the $44 million restructuring charge and $16 million of early debt extinguishment costs, pro forma EBITDA was 142 million versus a comparable $169 million in the year ago period, a decline of over 15%.

Somewhat more encouraging is the fact that Q2 was modestly up 4% from the comparably computed $136 million in Q1 of this year and we believe things should continue to improve from here.

All this is spelled our in Attachment 5 to our earnings release, and I'd like to note a couple of items here. Again, of the $44 million restructuring, just under half was non-cash asset write-offs and the other portion will be extended as severance in related over the next several quarters.

Similarly, the charge for early debt extinguishment includes both the $9 million call premium paid in cash and $7 million of unamortized issuance costs from 2003. These amounts are recorded in the other income, other expense line.

Two other one-offs that we don't believe properly fit the definition of pro forma EBITDA are also shown on our Attachment 5. A $5 million non-cash software write-off and $8 million in charges for some consulting assist for elements of our productivity program. We note them on Attachment 5 so you can understand this $13 million of noise here in the quarter not expected to be repeated and not to be confused with weak operating performance.

Income taxes in the quarter were unfavorably impacted by the recognition or valuation allowances that offset some of the tax benefits that were created due to foreign losses. Restructuring expenses, primarily in Europe, were significant cause of those losses.

Attachment 7 to our release details the after-tax earnings relevant to each of our restructuring and early debt extinguishment to drive pro forma EPS of $0.11 in the quarter and $0.28 year-to-date. Our effective tax rate, excluding those two items, was more than 40% in the quarter driven largely by valuation allowances in countries beyond those with restructuring. In the second half of the year, we expect that rate to be closer to 35%.

Finally, I'll note that in both the quarter and year-to-date EPS figures is about $0.06 per share of friction from the non-recurring consulting expense in software write-off stated earlier.

Moving to cash flow, the actions we've taken around the world for working capital management, productivity, and just plain simple cost management all showed up in free cash flow. Though cash earnings are running behind 2008 levels, that was more than made up for in working capital to drive free cash flow to $94 million in the quarter and $241 million year-to-date multiples of last year's level as shown on Attachment 6.

We've achieved significant and sustainable reductions in inventory through the programs that Erik touched upon. Year-to-date, the contribution to free cash flow from inventory reduction has totaled $90 million with the days investment in inventory metric of 61 days, down nine days from prior year-end. Not only do we see this improvement in days as sustainable, we see continuing progress in the quarters ahead. Accounts receivable reductions have contributed $108 million to free cash flow year-to-date.

Our days sales outstanding or DSO remained under good control around the world at a global weighted average of 70 days. Granted we will see a build in receivables as a kind of this economic recovery arrives but that impact will certainly be blunted by continued inventory improvements underway.

These strong cash results left us with more than $200 million of cash on hand at mid-year, accelerating our ability to de-lever our balance sheet as this is largely applied to our debt reduction in the second half of the year.

As you probably saw, we completed a major refinancing in May of this year that addressed our debt maturities of 2009, 2010, and elements of 2011, giving us greater flexibility going forward.

The $250 million revolver that was maturing in November of this year was replaced with the new instrument of the same size with the five-year maturity. Term loan A maturities of 2009 were retired in full. All but $167 million of the November 2010, term loan B maturities were replaced with the new seven-year term loan B in the amount of $750 million. It would be our plan to extinguish that remaining $167 million from free cash flow.

A new senior note offering in the amount of $500 million is maturing eight years out was used to call $475 million of the 7.75% notes, otherwise maturing in 2011. Going forward, we see internally generated cash flow being used for additional built-on acquisitions as appropriate opportunities are identified for dividends and for continued de-levering of our balance sheet.

I believe we have addressed the main topics. Let me turn this back to Erik for the closing comments and then take your questions.

J. Erik Fyrwald

Thanks Brad. Just to summarize three important takeaways from our second quarter. First, we are putting in place the best capability Nalco has ever had to drive working capital and free cash flow. The results so far are very encouraging but we have further to go, and for the second half, we will continue to increase our free cash flow although at a much slower rate than the first half.

Second, we now have in place the strongest cost productivity capability we have ever had. Here again, the results year-to-date are encouraging but more to come in the second half 2010 and beyond as we get better and one-time costs go away. So for the second half for cost productivity we expect to exceed the $53 million that we delivered in the first half.

And third and perhaps the most important, the same leadership team that is aggressively driving free cash flow and cost productivity is putting even more effort into getting our revenue growth capability really firing on all cylinders.

We started to see some of the benefits of our actions here in 2008 with our BRIC plus efforts, new technology acceleration like 3D TRASAR, and shifting of resources to higher growth market segments from lower growth areas.

In 2009, the large economic headwinds have knocked us back a bit, particularly in North American natural gas drilling and global mining, metals and paper. However, our strategy is still right on and you will begin to see the benefits in coming quarters as the global economy stabilizes and then it will lever up overtime as the global growth resumes.

So in the second half, we will continue to strengthen our market share position across our businesses, and by the fourth quarter, one indication of improvement will be that our revenue year-to-year in Asia we expect to get back to being ahead of prior year.

So with those closing comments, let me turn it over to Mike for our Q&A. Mike?

Mike Bushman

We can open the call up to questions now. And again, let me just remind you that we're going to try and allow for as many people to have a chance to ask questions as possible. So, restrict yourself to one question and one clarification if needed.

Question-and-Answer Session

Operator

Thank you. (Operator Instructions). And our first question will come from Brian Drab with William Blair.

Brian Drab - William Blair

Good morning.

J. Erik Fyrwald

Hi, Brian.

Brian Drab - William Blair

Just wanted to ask a question on SG&A. SG&A came in at 306 million in the second quarter, and of course included the 13 million related with consulting fee and the software write-off. So if we took those out, it will be at 293 million, that's still up sequentially from the 278 that you reported in the first quarter. Could you talk about why we're seeing up tick sequentially in SG&A of about 15 million given your ongoing focus in cost cutting?

J. Erik Fyrwald

Brad, why don't you take us through some of the items there.

Bradley Bell

Sure. Well, what you're going to see is a nice up tick in revenue from Q1. We are watching our operating expenses in the business as extremely tightly both on a one-off basis, across-the-board kinds of things and more importantly the structural takeouts. With that, we're still driving DC margin, and I think the biggest pieces that you'll see fall away are the $13 million that you just cited. But as we get into this part of the year, commissions are up [inaudible].

Brian Drab - William Blair

Okay. So, mainly commissions.

Bradley Bell

And Commissions, and you got a currency impact on a year-on-year basis.

Brian Drab - William Blair

Yeah, sure. Okay. And then, Brad, a question for you on gross margin. Could you just repeat your comment that you made regarding what your expectations were for gross margin directionally for the second half for 2009, given the dynamics there in the international business?

Bradley Bell

Sure, we should continue to see gross margin expansion with a good part of our world that hasn't fully shown the benefits of lower raw material costs, because they don't operate on LIFO. Europe is essentially FIFO and we've got weighted average systems in place for South America and Asia.

Asia indicated that in the month of June they saw a turn in the raw material costs. So they should see margin expansion in Q3 bolstered further by volume expansion in Q4 as Erik referenced, and we're working to get costs out of the system, hence the restructuring charge of getting assets, volume, variance issue as well. That by itself as I said was a 1.3% piece of drag on our gross margin.

Brian Drab - William Blair

So do you expect sequential improvement from the 45% level or are you talking about year-over-year improvement?

Bradley Bell

We would continue to... we would expect to see continued sequential improvement as we saw from Q1 to Q2, they will again -- will get more global in the improved by the cost takeout actions we have made.

Brian Drab - William Blair

Okay, great. Thank you.

Operator

And our next question is from John Quealy with Canaccord Adams.

John Quealy - Canaccord Adams

Hi, good morning. With regards to the organic growth across the businesses and the growth across geographies, can you talk a little bit more about price versus volume characteristics making up that organic growth?

J. Erik Fyrwald

Brad, you want to take that or Mike?

Bradley Bell

We are operating remotely her, so a little more formal in our reply to question. Very little price sequentially from Q1, all right? So we're seeing a benefit of cost showing up in more places and good benefit of cost takeout productivity actions are getting traction leading to the $53 million as cited.

Mike Bushman

And as we said, compared to last year only modest benefit from price compared to the second quarter of last year.

J. Erik Fyrwald

But also I'm very proud of how we've driven the training and how our people out with customers, delivering value, quantifying that value, and holding on to price generally well. And that's one thing that we're putting high focus on to make sure that continues in the third and fourth quarters.

John Quealy - Canaccord Adams

And then as a follow-up, I get your point about gross margin sequential improvement, but from a direct contribution margin percentage, should we look for bottoming right here in the Q2 period or how do you think the direct contribution margins will shake out as we move forward in these several depressed quarters moving forward?

Bradley Bell

Again, I think if you're going to see the gains that we anticipate at the gross margin level through costing methods and cost control that should flow to DC. Our business leaders have very good control on their operating expenses with their businesses. And I think you should... we saw nice gains Q1 going to Q2, productivity should lead gains in the second half of the year as well.

John Quealy - Canaccord Adams

Thank you.

Operator

And our next question is from PJ Juvekar with Citi.

PJ Juvekar - Citi

Yes, hi, good morning.

J. Erik Fyrwald

Good Morning PJ.

Bradley Bell

Good Morning PJ.

PJ Juvekar - Citi

In Europe it seems like we are taking two steps forward and one step back. We have seen some progress earlier, is the downturn masking the progress, and can you talk about the European fixed cost and what happened in the quarter?

Bradley Bell

Yeah, what's happening in Europe is, we expected a slowdown as part of the global economic slowdown. But as we got into the year, it's been more pronounced than we have expected, and therefore we are taking more aggressive actions on cost cutting, especially in Europe itself.

Now, we still see growth opportunities in the Middle East and several other geographies, parts of Africa, parts of the Caspian region. So we're actually adding some resources there, but in Europe itself we are taking substantial additional cost actions to lower the cost base.

Now, we continue to do the back-office work to free up time for sales reps, to do what it takes to improve our market position, and I believe through this we have not lost any market position, we gained some. What we want to do is get things streamlined, get the costs... the non-essential costs out, and be in a position to have better margins and be able to more aggressively grow our market position in Europe while we strengthen our capability to grow in the Middle East, the Caspian, and in Africa.

And in Russia, we have not expanded our head count there. We've been reducing it to some extent but there we have taken the opportunity to strengthen our leadership and have brought in some very, very strong talent to complement our existing talent in Russia.

So overall, a more realistic view of lower growth, lower economic vibrancy in Europe itself, and we're adjusting the cost for that. But we are going to stay on track to expand our market position and then we're selectively strengthening in the other geographies where we can drive growth.

PJ Juvekar - Citi

Okay. And then, next you used LIFO in the US, FIFO in Europe, and weighted average cost in Asia, so when you put all that together, what was the raw material tailwind in the second quarter? And then what do you expect in second half? Thank you.

Bradley Bell

PJ, on a global basis, it's still a bit of a headwind when you look at costs, gross of all of the productivity steps that we have taken internally. North America is again, LIFO-based as in the first quarter, is seeing favorable year-on-year raw costs comparisons, and rest of the world is not although I indicated that in Asia they turned in June and they will be turning a bit later in Europe with expansion over the balance of the year.

PJ Juvekar - Citi

So net-net, do you think it's a positive in the second half?

Bradley Bell

Yes, yes.

PJ Juvekar - Citi

Okay.

Bradley Bell

So we're seeing the high cost period going into Q3, Q4 last year, we've made tremendous stride getting that inventory out of the system, but much of it is still resident in the foreign locations, and their costing methods are slower to recognize the decline just as they were slower to recognize the cost increase in 2008.

J. Erik Fyrwald

PJ, also I would add that it's taken us a while because of the complexity of our manufacturing system, because we were making unique products in certain plants to get our manufacturing footprint right-sized, and therefore the continued high volume variances.

We have been taking aggressive actions in the first half of this year to get setup for making sure the products are qualified in the plants that will go forward, also reducing the number of products we have substantially that will start to benefit us in the late second half of this year. And those actions will start to get meaningfully at this volume variance that we have been saddled with in the first half.

PJ Juvekar - Citi

Right.

J. Erik Fyrwald

Starting towards the end of the year but much more into 2010.

PJ Juvekar - Citi

Is it fair to say, Brad, that your raw mag commodities by maybe two to three quarters?

Bradley Bell

I don't think you can generalize. It depends on the economic cycle that we're in and capacity utilization desires that those upstream of us... their inventory adjustments, and I don't think there is a norm. I think we... I think at the troubled economy... we have some background here.

PJ Juvekar - Citi

Hello.

Mike Bushman

We can move to the next question.

Operator

Our next question is from Bill Hoffman with RBC Capital Markets.

J. Erik Fyrwald

Hi Bill.

Bill Hoffman - RBC Capital Markets

Good morning. I wonder if you can talk a little bit more about this restructuring, one of the things that I'm sort of curious about is some of the end markets like on paper sector just as an example where demand is down 25, 30% in certain segments, how you're balancing your production capabilities manufacturing for this much lower benchmark demand which may be years to recover?

Bradley Bell

Right. So that's what I was talking about in terms of the resetting the cost base in Europe the most. But certainly we've been doing the same in North America, and will continue to take further actions that have been accrued for already through the rest of the year to get that manufacturing base, but also our selling base, and then our back-office support base in line with where that market is today and what we're now expecting going forward.

The aggressive actions that we've taken paper which have already been significant or a good part of the reason why our DC was up slightly in the second quarter in paper, despite the tremendous fall off in revenue. So, we're going to take further actions in paper and the rest of the company to get right-sized in costs for the outlook that we have today, but at the same time continuing to invest in the areas where we can drive the growth and accelerating that.

So we've already taken some costs out, that have helped paper specifically since that was really what the question was, but there is more to come to continue to strengthen the paper performance. We are not expecting in North America or Europe any quick up tick in the paper business, we expect it to stabilize close to where it is today in North America, and maybe some continued weakness in Europe, but our cost adjustments are going to be faster than what the market is doing there to help drive our margins... continue to drive our margins.

Bill Hoffman - RBC Capital Markets

All right. Thank you. That was helpful. And just a quick follow-up. And I wonder if Brad could just help us from a working capital standpoint. How much, if you try to quantify what you think in the second half assuming that we don't see much economic growth from where we are but how much more working capital cash you can take out?

Bradley Bell

Let me answer it, may be by item here. Receivables, we've certainly seen the harvest there with the slower economic growth around the world, and then we pulled out a fair amount of receivable dollars in a growth sense of the world. We've tightened up our DSO... DSOs varies by region in the world, but the weighted average for the company was about 70 days as we sat here at mid-year. For that part, I think it's largely behind us.

Inventory, we've gotten the easier, lower hanging fruit. And I think those have been involved in this effort and might take umbrage of my word of easier. But we are now seeing the S&OP processes kick in. We are going to continued challenging and reduction of the number of SKUs that we keep around.

There is further inroads to be made in inventory. I think the lion's share of the progress has been had to-date. But I think that the continued inroads that we do have in front of those Q3, Q4, even going in the 2010, will offset much of the receivable build once that comes back with business activity.

So it's kind of one of the reasons why we cautioned in Erik's remarks that free cash flow will continue to grow in the second half of year is our expectation, but don't look forward to continue with the pace at which we did in Q1 and Q2.

Bill Hoffman - RBC Capital Markets

Great. Thank you. That's helpful.

Operator

And our next question is from Mark Gulley with Soleil Securities.

J. Erik Fyrwald

Hi, Mark.

Mark Gulley - Soleil Securities

Good morning, guys. Hey, if my premise is correct that you cannot save your way to prosperity, I want to ask you a little bit about sales growth initiatives. Erik, in the third element of your wrap-up, you talked about revenue growth. But still a lot of your business is in mature economy, so what are you doing there to perhaps recover some of the growth that we expect to see?

J. Erik Fyrwald

What... we are doing a lot, we're doing what I would say is the core part of our effort is analyzing the growth opportunity by segment, making sure that we understand very clearly how our sales reps are lined up against the growth opportunity by segment, but then getting it down specifically to customers, and then realigning the sales force to make sure that we match up the opportunity with the capability. We call that program commercial excellence. We're well underway in North America and I think it will start to have an impact in 2010 and we're leveraging that to other parts of the world. And the goal there is two-fold, one is to make sure that our sales force is lined up absolutely correctly against the right opportunities and away from the low growth opportunities.

And secondly, looking at how to free up additional sales time, additional reps to go more aggressively after new business. Part of that whole effort is to make sure that we are fully taking advantage in the Water Services area and in energy downstream of 3D TRASAR technology. And continuing to accelerate the penetration of existing accounts and new accounts around the world for cooling tower waters and driving the boiler launch very aggressively, which is off to a good start, but we expect to continue to lever that up around the world and drive 3D TRASAR very aggressively. So, those are the more mature market areas.

So even where we believe that we can reduce the amount of reps we have, for example, paper in Western Europe, which we've been doing, and refocusing those efforts on higher growth opportunities and reducing some costs. What we're doing there with the remaining people that we have is further securing that business by making sure we're selling the best technology that we're focused on the right customers, and getting more out of what we have left to drive our position.

So I guess the short answer is, we're doing a lot there and we're not standing pat, and our goal is to gain market share... continue to gain market share across the businesses while we look to drive continued growth in our margins across the businesses. But the bulk of the resource increase... the shift in resources is going to be in the growth geography segments and technologies.

Mark Gulley - Soleil Securities

It's my follow-up, that's a good segue way... I mean, a lot of people when they talk about BRIC or BRIC plus as you pointed out in earlier calls, Caspian and other select markets, they've taken the 'R' out of BRIC because of some uncertainties about the economy, about government that sort of thing. Can you elaborate a little bit on why you're so confident that Russian still offers good opportunity for you that you follow through on the commitment you made earlier?

J. Erik Fyrwald

Yeah, so we're keeping our eye in BRIC. We are adding the head count in China, India and Brazil, where we absolutely see the growth happening now and need to be able to take full advantage of that. I think the Russian economy not only is in bad shape right now, it will struggle for a while, but our belief is that the Russian economy where we have a fairly low share. As the global economy starts the pickup and whether that's in six months or whether that's in a year, whenever it is, there will be tight supplies of energy, again oil will be tight, prices will come up, and Russia has a lot of world's oil and natural gas.

And we believe that our technologies... our service capability is a great set for what Russia needs. So it increased our leadership capability in Russia without adding head count. We started to connect better I think to the Russian oil companies themselves as well as other Russian customers to the government to be able to... without expanding our cost base to work ourselves better into the opportunity there so that we get that position over the next year and be able to take advantage when the economy turns... the global economy starts to turn and the Russian opportunity becomes green again. We want to make sure that we're there and not wait until that happens.

Mark Gulley - Soleil Securities

Thank you.

Bradley Bell

I may be add one comment to something Eric said a moment ago, and that's the important of technology here. And I think since we have gone through the bit of the reorganization in pretty more of the business under broadminded general management here. Our technology effort is far more selectively aimed at key market segments, key customers, more so than in the past. I mean, you see it with ultra deep, you see it with the enhanced oil recovery et cetera. I think we're getting a very good traction on that, and one of the reasons we felt comfortable expanding the spend on R&D because it's much more business driven... are entitled to link between what the marketplace is clambering for and we've shown back to your mature market's question where we do well is we can deploy technologies that our competitors just simply don't have.

Mark Gulley - Soleil Securities

Thank you.

Operator

And our next question is from Mike Harrison with First Analysis.

Michael Harrison - First Analysis

Hi, good morning. Wondering if you could talk a little bit on the Energy side, you're coming up against some pretty difficult organic growth terms for the second half. Can you give us a sense for how much contribution you guys are expecting to see from new projects in deepwater, and maybe a little bit on oil sands as we see some improvement in oil prices? And then whether those new projects can in fact prevent that segment from showing organic revenue declines in the second half?

J. Erik Fyrwald

All right. Let me start and Mike or Brad, you can sign in here any time. But first of all, we are not forecasting any near-term turnaround in the Adomite business. We've already talked about it being directly proportional to rig count. The natural gas prices continue to be very low and until there is some firming of the natural gas pricing we don't expect rig count to start to recover. Obviously it's a small part of the energy services businesses. It was 10% last year and with the sales being down substantially this year it's a lot smaller part of the overall Energy Services.

On the OFC and the refining side, refining slower growth in OFC has been delivering in the first half but still significant growth as we've been gaining share, as we've been driving new technologies into the market place. OFC as we've been also driving new technologies into the marketplace and winning more than our fair share, a large portion of the CapEx projects.

We do foresee some of those CapEx projects that started up in the first half to continue to ramp up in the second half and some additional CapEx to come on in the second half. So we expect continued growth, but I think it would be a challenge to keep up with the same types of growth rates we've seen so far. But I believe that for the full year we will see in both our upstream OFC business and our refining business for the year solid organic growth performance.

Michael Harrison - First Analysis

All right. And then, I was hoping I could get some detail on the $30 million in consulting and software write-offs, how were those split across the segment in terms of the DC impact?

Bradley Bell

It's really all-in admin expense. So you wouldn't look for it. And we're trying to keep the DC measurements pure year-on-year both last year to this year, and then this year to next year, so those were held at corporate.

J. Erik Fyrwald

And let me just expand a little bit on why we did, what we did... why we believe that was the right thing to do for the company both to have the consulting support but also writing-off the software. We've worked hard to really woke up from a very weak productivity process a year ago to try to get running start to have very strong productivity capability, and also add back to Mark's question earlier to our commercial capability.

So, we brought in a leading consulting firm to really help us get in place the right processes, the right approach, make sure we could get the right data together to really figure out how to get going quickly with our get set productivity initiative, and our commercial excellence capability. I'm very, very pleased with the progress that we've made there. I think the money that we've spent and the money that we've incurred was very, very well spent and will pay off many times over for the future.

On the software side, we brought a new leader of IT. Somebody that I have great confidence in and he has already helping us to make IT much more of a powerful tool for us to not only streamline cost but also support growth. And as he and the team have gone through a rigorous evaluation of all of our project activities and all of our software activities, there were some projects, some software that needed to be stopped were not going to be adding any value in the future, so we dealt with those and now we're moving on. So, it's a lot of money, $13 million, but I think you will see that creating many times that value going forward.

Michael Harrison - First Analysis

All right. Thanks very much.

Mike Bushman

Next question.

Operator

And our next question is from Laurence Alexander with Jefferies.

J. Erik Fyrwald

Hi, Laurence.

Laurence Alexander - Jefferies

Good morning. First question, on the Water segment, initially... originally the former INIS, it looks as if the... you've now settled in around direct contribution margins around 18 to 20%. Do you think that you have the right leverage in place to maintain that range? And what would it take to get margins back to the historical levels?

J. Erik Fyrwald

Well, first of all, let me start and then Brad add in here. I think that the Water team is doing absolutely the right things to drive cost reduction but balance that very much with the programs that are going to drive market share improvement, to drive the technologies into the marketplace, to drive margins not just from a cost reduction standpoint but also from a... will bring more value and services, whether its Crossbow services, the services that we have historically had, by training our people better and getting the models of where... customers we do at the best leveraged across more customers. So, do the best of Nalco in more places.

Those types of activities plus new technologies and getting 3D TRASAR out there with much, much broader coverage. Those things are going well and are going to continue to pay off in terms of supporting our DC margins going forward. So I think we are making good progress there and I think that we will be able to drive growth at these higher margins without sacrificing those margins.

Bradley Bell

Erik, I might add to that. The restructuring actions that we just took in the second quarter probably have the water businesses as the biggest beneficiary. I think we dealt structuring the paper earlier on. This is largely around water, as I mentioned in my remarks, we are taking seven plants out of the system, getting rid of specialty plants if you will and making the remaining plants in the network far more flexible and their capability set.

And I think as those implementations occur, you will see the additional improvements to the water margins. So Laurence, you opened your comments that you have settled in at 18% I think we have settled in anywhere I think pushing this forward.

J. Erik Fyrwald

Our goals stated previously is 20% EBITDA margins and aggressively drive growth with those margins.

Operator

And our next question is from Rick Hoss with Roth Capital Markets.

Richard Hoss - Roth Capital Markets

Hi. Good morning, gentlemen.

J. Erik Fyrwald

Hi, Rick.

Richard Hoss - Roth Capital Markets

If you could just focus on China from a regional basis, if you could give as an appreciation for the current penetration in these markets, and really the opportunity for additional penetration with some, I guess, some color on timeframe to capture this potential revenue stream?

J. Erik Fyrwald

Yeah, China historically, we have focused on markets that were largely export-oriented, and often Western companies operating in China. A lot of our business has been in the alumina, mining, metals area, food and beverage, and other markets, where export was a key part of the opportunity. We want to keep our position in those markets and continue to expand it, but we're looking at expanding even more aggressively for the China market opportunities.

So for example, in the past we have not had a lot of business with the Chinese state or owned enterprise whether its oil companies or power companies, petrochemical companies, a big opportunities right in the real half of Nalco's capability, but not areas that we've largely penetrated. We've had very minimum penetration in China. So that's a big part of the reason why we brought on the additional leadership that we brought on in China. People that are very well connected to the government, a lot of experience with state-owned enterprises, know the China market itself, the internal market very well, and has gotten us connected to the right companies that worked a lot with our people to plan on where the best opportunities are, and have already started to get connected to the customer... the target customers in a significant way.

I think that this will take until next year, sometime a year from now to have start to just have a significant impact on our China business. But the overall China beginning to recover opportunity is going to start to pay afterwards in the second half of this year and into next year as well. So you have that combination of overall recovery in China plus us penetrating some very new, very core areas from Nalco, but new to us in China opportunities.

So we're very bullish on China, that's why we're putting more people, more capability in China. That's why we started up our Nanjing plant, that's why we are putting in place significant research capability to develop products not only for the China market but for the Asian market and global opportunities, but sitting there in China close to this huge opportunity market. So a very important market for us and we're going after some new areas for us in China that will start to benefit next year.

Richard Hoss - Roth Capital Markets

Okay. And then just follow-up. So the assumption would be fairly try to make that growth rate would exceed the GDPs number that you've seen out of region based on, one, just maintaining market share, then two, additional opportunities and increased penetration et cetera?

J. Erik Fyrwald

For 2010, that will be the case. Yeah.

Richard Hoss - Roth Capital Markets

Okay. Thank you very much.

Mike Bushman

We're coming up on 10 o'clock. So let's just take one more question.

Operator

Thank you. And our final question will come from Jeff Zekauskas with JP Morgan.

J. Erik Fyrwald

Hi, Jeff.

Jeff Zekauskas - JP Morgan

Hi. How are you? In your water business, your organic growth in the first quarter was negative 4.5, and then this quarter was negative 9.1. And I assume that your prices are deteriorating a little bit sequentially. So, all things being equal should we expect comparable lower price volume comparisons or organic comparisons in the third and the fourth quarter versus the second?

Bradley Bell

We're not making any projection at this point. All I can tell you is that a big chunk of the decline was in mining and metals, paper obviously continues to be soft, and manufacturing is continuing to be soft. I don't foresee any significant turnaround in mining and metals near-term, but I do think that there has been some segments that have shown some improvement in some parts of the world but I'm not forecasting any macro big list from economies.

But I do think by the fourth quarter we'll start to see a year-over-year growth in China, and I also think that some of the these other efforts that we're making to drive growth in the other segments, we will start to see some benefits. So I'm not going to give you any projection, all I can tell you is that I believe that when we look back on the second half that we will be able to say that we gained the market share in our target markets.

Jeff Zekauskas - JP Morgan

Okay. Thank you very much.

J. Erik Fyrwald

Mike?

Okay. Well, thank you all everyone for joining us and be happy to take any follow-up questions individually for those that we were not able to get to today. Thank you for joining us.

Operator

That concludes today's conference call. And we thank you for your participation.

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Source: Nalco Holding Q2 2009 Earnings Transcript

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