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Ferro Corporation (NYSE:FOE)

Q2 2009 Earnings Call Transcript

August 5, 2009 10:00 am ET

Executives

David Longfellow - Director, IR

Jim Kirsch - Chairman, President and CEO

Sallie Bailey - VP and CFO

Analysts

Mike Harrison - First Analysis

Rosemarie Morbelli - Ingalls & Snyder

John McNulty - Credit Suisse

Dmitry Silversteyn - Longbow Research

Robert Felice - J. Goldman & Co.

Douglas Chudy - KeyBanc Capital Markets

Operator

Good morning and welcome to Ferro Corporation’s second quarter 2009 earnings conference call. All participants will be in a listen-mode until the question-and-answer session. (Operator instructions). This conference is being recorded. If there any objection, please disconnect at this time.

Now, I‘d like to turn the meeting over to your host Mr. David Longfellow, Director of Investor Relations. Mr. Longfellow, you may begin.

David Longfellow

Good morning and welcome to the Ferro Corporation 2009 second quarter earnings conference call. Today, we will provide information about our financial results for the three month period ended June 30th, 2009 and actions Ferro is taking to address the current economic challenges.

Joining me on today's call are Jim Kirsch, Chairman, President and Chief Executive Officer; and Sallie Bailey, Vice President and Chief Financial Officer. Following their prepared remarks, Jim and Sallie will take your questions.

I hope you have all had an opportunity to review the press release we issued yesterday. Copies of the press release are available on the Investor Relations portion of Ferro's website, which is located at www.ferro.com. Also available on our website is a reconciliation of reported results to non-GAAP amounts discussed on this conference call.

Before Jim begins, I want to remind you that statements made on this conference call about the future performance of the company may constitute forward-looking statements within the meaning of Federal Securities laws. These statements are subject to a variety of uncertainties, risks and other factors related to the company's operations and business environment that are listed in our earnings press release and in the company's quarterly report on Form 10-K for December 31st, 2008.

Forward-looking statements reflect management's expectations as of today, August 5th, 2009. The company undertakes no duty to update them to reflect future events, information or circumstances that arise after the date of this conference call except as required by regulations. Any redistribution, retransmission or rebroadcast of this call in any form without the expressed written consent of Ferro is prohibited.

A dial-in replay of today's call will be available for seven days. In addition, you may listen to or download a replay of the call through the Ferro Investor Relations website.

I'd now like to turn the call over to Jim.

Jim Kirsch

Thank you Dave. And welcome to everyone on the call. I will focus my remarks this morning on three key topics. First, a brief review of 2009 second quarter results, concentrating on the sequential improvements from the 2009 first quarter. These improvements provide evidence that our cost and expense reduction efforts are working and give us reasons to be cautiously optimistic that we have passed the trough in the current global economic slowdown.

Second, I will provide our view of the business environment for each of our product groups and discuss the steps they are taking to respond to the current economic challenges. I will then discuss the actions we are taking to address the current economic challenges and further reduce our cost structure.

The Ferro team around the world delivered a significant sequential improvement in our second quarter results compared with the first quarter despite a continued weak global economic environment. Our actions to reduce cost and expense coupled with higher sales resulted in improved gross margins, higher total segment income and a reduced loss, compared with the 2009 first quarter.

While our sales reflect worldwide customer demand that remains sharply lower than in the prior year period, we are seeing evidence of stabilizing demand and some reduction in customer’s inventory destocking.

The actions we have taken to bring manufacturing cost and staffing in line with reduced customer demand are clearly having an effect. Our adjusted gross margins measured excluding charges and sales of precious metals increased more than 300 basis points from their trough in the fourth quarter of 2008.

Our monthly sales breakeven level has been lowered as a result of our cost reduction efforts. In the month of June, we broke even at the net income level, excluding special charges on sales of approximately $125 million, excluding precious metals. We discussed the weakness in European demand during our first quarter conference call, and our team worked hard to reduce our losses in Europe by about 60% from the first quarter to the second quarter. In fact, during June, we broke even at the segment income level on our European operations, excluding charges.

In addition, during the second quarter, Ferro had generated positive free cash flow and increased our liquidity. Even with the sequential improvement in our results, we are continuing to take additional cost out of our business and to make progress on restructuring initiatives that are designed to provide us with improved cost per unit performance around the world.

During June, we accelerated by approximately six months, the closure of our manufacturing operations in Nules, Spain. This action is part of our ongoing European manufacturing restructuring, which began in the second half of 2006. In this latest initiative, manufacturing operations from Nules are being consolidated into our facilities in Almazora, Spain.

The Inorganic’s team in Europe has arranged temporary tolling arrangements which accelerate our cost reductions without bringing forward the bulk of the projects cash restructuring costs. This Nules project is expected to result in approximately $2 million to $3 million in the incremental annual savings beginning in July of this year.

Around the world, we continued to focus on cash generation and expense control. During the 2009 second quarter, we generated cash from working capital, including $29 million of positive cash flow from reductions in inventory. We reduced staffing by approximately 200 positions during the quarter or about 3.5% of our worldwide workforce. This was on top of a 5% reduction that was completed in the first quarter.

Also in the second quarter, we implemented a one-week furlough program for US salaried employees. In addition, approximately 170 salaried employees around the world voluntarily joined the furlough program on their own initiative. I think this is an excellent indication of the spirit with which Ferro employees have addressed the issues brought on by the global economic downturn. Without their engagement and commitment, we could not have reduced our second quarter SG&A expenses by over 21% or $17 million from a year ago.

We continued to see weak demand around the world. Many of our customers, particularly those serving the most challenged markets related to automobiles, construction and appliances are running their production facilities of substantially reduced operating rates compared to last year at this time. In some cases, it appears that customers inventory destocking has been reduced, although the rate of destocking has not uniform across regions, markets or customers. We expect that customers will continue to run with very lean inventories at or near current levels for the foreseeable future.

Let me now review the performance of our three business groups. Our Inorganic Specialties Group, including the Performance Coatings and Color and Glass Performance Materials segments made a great deal of progress from the first quarter to the second quarter of 2009. Both segments were profitable in the second quarter and together contributed over $8 million in segment income compared with a loss in the first quarter. The units also combined to generate more than $20 million in cash flow during the second quarter as they continued to reduce inventory to reflect lower manufacturing volume.

Our Porcelain Enamel operations within Performance Coatings have been a bright spot in our results this year. Last year, we completed the consolidation of our main European Porcelain Enamel manufacturing operations from Rotterdam, Netherlands to Almazora, Spain. As a result of this change as well as additional efforts in North America and Asia, operating margins in this product area have improved, despite a reduction in sales volume.

Pigmented inks used in digital tile printing applications are also performing well as this new technology continues to be adopted by more customers. Our long-term involvement in this technology and our experienced product development team have made Ferro the leader in pigmented inks for ceramic applications. Demand for our core tile coating products and auto glass enamels while improving remains well below 2008 levels, which is challenging our European operations.

We continue to reduce costs as we are doing with the Nules and Limoges restructuring programs and look for ways to expand our sales penetration throughout Europe, the Middle East, and North Africa.

Our Electronic Materials business also generated sequential improvement from the first quarter to the second. During the second quarter, sales of metal paste to solar cell manufacturers in China recovered somewhat from weak performance in the first quarter, although reduced demand in Europe, partially offset the volume improvement. However, the aggregate sales mix was improved reflecting higher sales of silver pastes.

Our pasting facility in Suzhou, China is now operational and we are engaged in a number of qualifications of a little bit on pace with Chinese solar cell manufacturers. Successful completion of these qualifications will broaden the penetration of our solar products in Asia.

Demand for our dielectric materials is still well below the prior year period. So customers resume more normal manufacturing after extended plant shutdowns in the first quarter. Although one significant customer has changed the business model and their demand is not expected to return.

Our chemical mechanical planarization slurries have been qualified by an additional customer which led the increased sales as the customer’s state-of-the-art 32-nanometer technology ramps into production over the next several quarters. This qualification is for both shallow trench isolation and inter-level dielectrics which represents increased penetration for our CMP products and validates our belief that ceria-based products provide an increased value as integrated circuit line widths decrease.

Visibility to near-term customer demand in Electronic Materials remains limited. Demand for solar paste has been positively impacted by stimulus spending in China, but future orders may be uneven as Chinese firms compete for business. Other solar markets around the world continued to be impact by tight credit market conditions and volatility in government spending. Demand for surface finishing materials appears to be on a modest upward trend.

Results in our Organic Specialties Group also improved in the 2009 second quarter compared with the first quarter. The Group’s performance reflect in the combined results of the Polymer Additives, Specialty Plastics and Pharmaceutical segments, shows sequential increases in sales in segment income.

The Group generated positive cash flow with a substantially reduced inventory during the quarter. Raw material cost generally declined across the Organics Group compared with the prior year period. And since product prices decline more slowly, this contributed to the segment income results.

Our product mix is also improving, helping to mitigate effects of lower sales volume. We continued to diversify our sales away from commodity PVC related markets into a wide variety of value-added applications, including home power tools, oilfield drilling mugs, gel coats for wind turbines, and specialized plastic films used in a variety of applications.

As in our other product groups, the near-term visibility of customer demand for the Organics Group remains limited. While demand appears to have stabilized at this time, it is too early to know when the end market demand will show signs of a sustainable recovery. We will continue to focus our efforts on managing costs, positive cash flow and maintaining strong customer relationships.

I have discussed a number of positive developments in our business, especially with respect to the sequential quarter improvements we reported in the second quarter. The 12% or $41 million increase in sales from the 2009 first quarter to the second quarter generated improvements in gross profit at an incremental $16.5 million of segment income during the quarter.

Our results provide evidence that we have lowered our breakeven sales level and now we are poised to generate excellent operating leverage as worldwide customer demand begins to recover. However, we certainly under a continued improvement is essential for our future success. We are not counting on a quick economic recovery. While we can respond quickly to improvements in customer demand, we remain focused on cash management, cost and expense control and staying on schedule with our restructuring initiatives.

Consistent with the last two quarters, we will not provide specific third quarter sales or earnings per share because of the uncertainty and near-term customer demand. However, we currently expect the sales trend to be relatively flat from the second quarter to the third. This is somewhat better than our normal seasonal pattern. We’ve generally recorded a decline in sales from the second quarter to the third, driven by a slower demand in Europe, particularly in August which is a traditional time for vacations in the region.

However, we remain cautious, as the timing of the resumption of normal manufacturing activity in Europe during September is quite difficult to predict. In addition, our customers around the world remain very cautious as they want to keep tight control of their channel inventory.

Finally, I would like to say a few words about the response of our worldwide team as we go through this difficult period. We’ve asked a lot of our employees around the world during the past year. We ask them to make hard decisions related to restructuring, consolidation of facilities and reductions in expenses. We’ve asked them to share in sacrifices related to compensation and benefit programs. And we have challenged to manage all of the business more closely, especially in those areas related to cash management.

Through all of these challenges, our team has performed with exceptional professionalism and genuine engagement. I believe a number of factors have led to this. First, we have leveraged the win from within culture that has been established over the past three years. The tenets of win from within stressed personnel accountability and continuous improvement which have been essentially elements of our response to the economic challenges.

Second, our managers around the world have worked hard to communicate with employees in a way that is direct and transparent. Armed with the facts, our employees are making the right decisions to respond to the needs of the business. And third, I am continually impressed by our employees’ commitment to the collective success of our business. I have seen this commitment as I have travelled around the world during my years with Ferro.

Our employees are engaged with customers each and everyday. They genuinely believe and know that Ferro products and our application know-how can make a real difference for our customers.

I am confident that Ferro will continue to respond aggressively and positively to the challenges we face over the next several quarters. We do not know the timing or the extent of a recovery in the end-market demand. However, we don’t expect the demand to rebound quickly to the levels seen a year ago.

We may not be able to forecast the new normal level of worldwide demand, but we are preparing for an extended period of modest recovery. Our reduced cost structure and the expense control discipline have put us in a position where we expect to generate improved operating leverage as we move through the coming quarters driving a faster recovery and profitability with incremental improvements in sales.

Now, I’d like to turn the call over to Sallie, who will review the financial results in more detail, before we open up the call for your questions. Sallie.

Sallie Bailey

Thanks Jim. This morning, I will discuss the 2009 second quarter results in comparison with both the 2008 second quarter and the 2009 first quarter. The sequential comparisons are particularly important as we determine where we are in the global economic downturn and as we evaluate the effectiveness of our costs and expense reduction efforts.

Reconciliations of non-GAAP results discussed in this conference call are available on our website in our Supplementary Financial Results package. Please note that the prior period results in our press release, SEC filings, and on the call today have been adjusted for the sale of our fine chemicals business. The fine chemical results for the 2008 second quarter are included in discontinued operations as a result of the sale of the business in the fourth quarter last year.

Ferro reported a loss from continuing operations of $0.27 per diluted share for the second quarter of 2009. Included in the results were pre-tax charges of $6.4 million, primarily related to manufacturing, rationalization activities and other cost reduction activities. Net sales for the quarter were $399 million, a decline of 37% compared with net sales of $632 million in the 2008 second quarter. Net sales increased by 12% from the first quarter of 2009.

The sales decline from the prior year period was drive by reduced sales volume, resulting from the global economic slowdown. Lower precious metal cost pass-throughs contributed approximately 6 percentage points to the sales decline and changes in foreign currency exchange rates accounted for approximately 3 percentage points of a decrease.

Cost of sales declined by 35% from the prior year quarter to $334 million, primarily as a result of the lower sales volume. Manufacturing related staffing reductions and other cost takeouts also contributed to the lower cost of sales.

Gross profit declined to $65 million or 16.3% of sales as a result of the lower volume. The gross margin percentage in the 2008 second quarter was 18.8%. Gross profit in the 2009 second quarter was reduced by $3.7 million by special charges, primarily for accelerated depreciation related to our manufacturing rationalization projects in Europe.

Adjusting our 2009 second quarter gross margins for precious metal sales and special charges, the gross margin was 20%. The equivalent adjusted gross margins were 17.2% in the first quarter of 2009 and they were 16.7% in the fourth quarter of 2008. Adjusted gross margins were 22.3% in the prior year period, when we had the benefit of significantly higher sales.

SG&A expense for the second quarter was $62.5 million, a decline of $17.2 million from the second quarter of 2008 and a decline of $5.6 million from the first quarter of 2009. The SG&A decline was driven by reduced staffing, suspension of annual and incentive compensation programs and reductions and other benefits, a furlough program and other expense control initiatives. Partially offsetting the lower SG&A expense was an increase of approximately $5 million in pension expense.

The 2009 second quarter SG&A also included approximately $3 million in special charges, primarily due to expense reduction efforts of another manufacturing rationalization related expenses. The 2008 second quarter SG&A expense included net charges of $2.4 million primarily related to corporate development activities, asset write-offs and employee severance expenses.

Restructuring provided net benefit of $309,000 in the second quarter compared with charges of $9 million in the prior year period. The 2009 second quarter amount was largely due to a $3.7 million reduction in an environmental reserve related to a closed manufacturing site in Europe.

Offsetting most of the benefits from the reserve reduction were the other restructuring charges primarily related to our European manufacturing rationalization. We expect to record additional charges in coming quarters we continue our previously announced restructuring project in Limoges, France, as we complete the manufacturing, consolidation Jim discussed in Nules, Spain, and as we undertake additional restructuring projects to our ongoing costs.

Total segment income for the 2009 second quarter was $19.3 million, down from $52.2 million in the prior year quarter, but an increase of $16.5 million from the $2.8 million of segment income that was recorded in the first quarter of 2009. All of our segments were profitable during the 2009 second quarter.

The decline in segment income from the 2008 second quarter was primarily the result of lower manufacturing volumes, partially offset by savings from cost and expense reduction action.

The sequential improvement in segment income from the first quarter of 2009 was driven by improved profitability in the Performance Coatings and Color and Glass Performance Materials segments, each of which recorded a loss in the 2009 first quarter. Electronic Materials, Specialty Plastics, and Pharmaceuticals, also recorded increased segment income from the 2009 first quarter to the second quarter.

As part of our reconciliation of segment income to income from continuing operations before taxes, we reported unallocated corporate expenses of $16.6 million for the 2009 second quarter, including non-restructuring special charges of $6.7 million. In the prior year period, unallocated corporate expense was $12.9 million. The primary driver of the increase in corporate unallocated charges was approximately $5 million in additional pension expense. Excluding the special charges of $6.7 million, the additional pension expense of $5 million, the corporate unallocated expense was $4.9 million for the second quarter of 2009.

Interest expense was $17.2 million for the second quarter, up from $12.8 million in the 2008 second quarter. The increase was driven by higher borrowing levels and higher average interest rates on our borrowings. The increased rates were primarily as a result of an amendment to our credit facility that was signed in March 2009. Interest rates also increased due to an amended receivable securitization program that was put in place in early June.

For the quarter, our loss from continuing operations was $0.27 per share including charges. Excluding the $6.4 million with special charges from our second quarter performance would result in a pre-tax loss of $9 million. Applying a tax rate of 36% would result in a loss $0.16 per share on an adjusted basis.

Capital spending was $20.3 million in the second quarter or $23 million for the first half. We continue to expect the full-year capital spending to be approximately $35 million or about half of our spending in 2008.

Depreciation and amortization was $22.7 million for the quarter, including approximately $3.4 million in accelerated depreciation related to our manufacturing rationalization programs.

Total balance sheet debt on June 30th, 2009 was $650.7 million. In addition, we had net proceeds of $16.3 million from off balance sheet international receivables factoring. Total financing was $667 million on June 30th, including the receivables factoring and increase of $79.8 million since December 31st, 2008. The increase was driven by a requirement to collateralize our least precious metals. Total financing declined by $6.3 million from March 31st, 2009 despite an increase of precious metals collateralization on deposit during the second quarter.

On June 30th, we had $80.4 million on deposit of cash collaterals for precious metal leases, up from $65.5 million on March 31st. We have received request for approximately $15 million in additional precious metal collateral and we expect to satisfy these requests during the third quarter as metal leases are renewed.

Our quarterly results continued to see a significant impact from reduced sales level, resulting from the worldwide economic slowdown. However, sales increased from their low point in the 2009 first quarter. The increased sales in the effects of companywide cost and expense reduction resulted in a sequential improvement in gross margins, lower SG&A expense and higher segment income, compared with the first quarter of 2009. Offsetting some of this improvement was higher interest expense.

We are continuing to execute on our restructuring programs and to reduce staffing to bring our cost structure more in line with current customer demand. We believe our reduced cost structure puts us in position to generate improved operating leverage when end market demand begins to recover. And we will continue to focus on free cash generation and maintaining our liquidity.

Thank you for participating in this morning’s call. And I’d now like to turn the call back to Dave, to begin the question-and-answer session.

David Longfellow

Thank you, Sallie. Operator, we are now ready to begin the question-and-answer session. Can we have the first question please?

Question-and-Answer Session

Operator

Thank you. (Operator instructions). Our first question comes from Mike Harrison from First Analysis. You may ask your question.

Mike Harrison - First Analysis

Hi, good morning, everyone.

Jim Kirsch

Good morning, Mike.

Mike Harrison - First Analysis

I had a couple of questions on Electronics to start with. On the dielectric side, what is the strategy going forward there, now that your largest customer has decided to make those materials in-house?

Jim Kirsch

We are running the business for cash basically. We are supplying – if you look at the dielectrics business, there is two pieces broadly in the segments of commodity and specialty segment. We are continuing to support technically and with excellent sales and application technology to specialized segment.

On a more commoditized segment, we are running the business for cash, taking out cost and expense where we can, when we can. And the modest volume increase that we saw during the second quarter is certainly up with absorption in our major facility there which is in Uden, in the Netherlands.

Mike Harrison - First Analysis

Do you view that business, Jim, as a potential divestiture candidate?

Jim Kirsch

I will tell you, Mike, that on the commodity side of dielectrics, all options are on the table.

Mike Harrison - First Analysis

All right. Then, in terms of the solar conductive paste demand levels, have those demand levels dipped at all from Q2 levels, and also wondering how much pushback you are getting from customers on pricing?

Jim Kirsch

You say the demand levels have been dipped from Q2 – do you mean from Q1 to Q2 essentially – sequentially or from Q2 this year to last year?

Mike Harrison - First Analysis

From – I am talking about from Q2 levels to what you are seeing maybe in July of the medal conductive paste side.

Jim Kirsch

The volume has actually been increasing modestly month by month as we have gone through the course of 2009. And my expectation would be, it’s going to be lumpy where we are going to continue to see some modest increase. The dilemma has been that it’s – it’s kind of like a car firing on not quite all cylinders.

Europe started out very strong early in the year on relative basis and China was quite slow. That’s transitioned as I mentioned in my comments, the good news for us is we are selling higher margin products on the Chinese front and the Chinese stimulus plan is helping.

Our July – I just got to look at our July revenues, and we have seen a slight improvement in July over June. And as I said, we expect to give the – at this point, our third quarter to be pretty flat with our second quarter in terms of our demand side.

Mike Harrison - First Analysis

And then, last question I had is maybe best for Sallie. For the purposes of the covenant calculation, I know there are a lot of puts and takes on EBITDA. But what was EBITDA for covenant purpose is for the quarter and for the trailing 12 months?

Sallie Bailey

Yes, Mike, we don’t disclose that information publicly.

Mike Harrison - First Analysis

What about the – where you were on your leverage ratio for the covenant calculation?

Sallie Bailey

Again, the only information that we provide publicly is our compliance with our covenant.

Mike Harrison - First Analysis

Maybe I can ask a slightly different question then, in terms of the covenant, you’re allowed to add back the non-cash pension expense to EBITDA, but I know you’re a subject to a limit of $14 million in 2009, how much of that limit have you used through the first two quarters?

Sallie Bailey

We’ve used about half of it.

Mike Harrison - First Analysis

Okay. Thanks very much.

Sallie Bailey

But Mike, just, there are other non-cash items that are also added back to adjusted EBITDA for covenant purposes. So for example, asset impairments – so goodwill for example is an add back for covenant purposes and other types of asset impairments.

Mike Harrison - First Analysis

And presumably any of the other special items that you are calling out in your supplemental EBITDA?

Sallie Bailey

That would be a good assumption directionally, yes.

Mike Harrison - First Analysis

All right. Thanks very much.

Operator

Thank you. Our next question comes from Rosemarie Morbelli with Ingalls & Snyder. You may ask your question.

Rosemarie Morbelli - Ingalls & Snyder

Jim, you talked about the trend during the quarter and said that you expected the third quarter to be reasonably flatter with Q2. I am assuming you are talking about revenues or are you talking about volume and is there – are they both actually one of the same really more or else?

Jim Kirsch

They’re more or else one and same in my comments, Rosemarie. The thing you have to watch is our mix is pretty – can be pretty volatile. But from what I am seeing right now in the real profit drivers in the company, we’ve seen slight improvement, as I said, kind of month over month.

In our Glass business for instance, if you look at the CGPM numbers, you see some pretty substantial revenue improvement. And as driven primarily by volume improvement, somewhat supported by things like the CARS, cash for clunkers program that started in Europe, significantly earlier than the one that started here.

But as I look at my comments about the third quarter, we’re really expecting a relatively flat volume and revenue quarter. But the uncertainty here is, people come back to work as scheduled in September or people extends shutdowns from August.

And right now, I don’t have a good answer for that. Fundamentally, our customers haven’t made that decision as I understand it.

Rosemarie Morbelli - Ingalls & Snyder

Do you get any feel – and you said, the customers haven’t made any decisions, do you get a feel as to what their frame of mind is, what their expectations are, are they more positive than they were last quarter, are they getting more depressed? Could you give us –?

Jim Kirsch

It’s clearly an anecdotal question, Rosemarie. But the information that I’ve received and from the people I have spoken to, I think people feel better about the economy in general today than it did in the first quarter. There is a lot of concern about the lack of visibility all the way through the supply chain. People have, including ourselves have done a great job of reducing inventories.

I would expect that all of us are going to keep a very tight handle on inventories and continue to try to reduce them as we go through the third quarter. And then as you get into the fourth, which is for the holiday reasons and so on, typically a slower quarter. I think we are going to see more inventory destocking going on in the fourth quarter. So I think it’s going to be a second half of the year people feel better, but I think we’re all going to be managing very, very tightly.

Rosemarie Morbelli - Ingalls & Snyder

Did I understand properly that the destocking you expected to continue at your customers’ level through the end of the year, some companies are saying that what they are seeing is that inventory destocking is just about done. But you seem to have a different opinion.

Jim Kirsch

What I am saying is that, I think we are seeing a much reduced level of destocking than what we saw in the first six months. What every opportunity a company has to take inventory out, I believe they are going to take advantage of that.

The other thing I was suggesting is that, during the fourth quarter, which is typically a slower quarter and a shorter quarter because of holidays. If companies have the opportunity to take out more inventory and to build cash reserves, I think they will do so. That’s just one guy’s opinion.

Rosemarie Morbelli - Ingalls & Snyder

No, no, that is helpful. And if I may ask one last question, given all of the steps you have been taking in the additional cost cuttings that you are in the middle of with flat revenues Q3 versus Q2, is it reasonable to expect continuing margin improvement?

Jim Kirsch

Well, we have had a substantial margin improvement, obviously since the – I am talking about gross margins now – since the December timeframe. If we can maintain the volumes we have, I would expect our margins to be maintained. A lot of that will depend on what happens in raw materials over the next six months and our ability to convert the – I am very confident in our ability to convert product at increasingly – in increasingly efficient ways. I am not as confident that raw materials will stay as low as they have and particularly with some of the pressure on commodity pricing.

Rosemarie Morbelli - Ingalls & Snyder

And if raw materials go up, do you expect that you will be able to get some price increase and get back what you had to give up in the second quarter?

Jim Kirsch

Historically, we have been able to do that. So my expectation would be that we will be able to cover raw materials. It’s the margin side that I am more worried about.

Rosemarie Morbelli - Ingalls & Snyder

Okay. Thanks a lot.

Operator

Thanks. Our next question comes from John McNulty with Credit Suisse. You may ask your question.

John McNulty - Credit Suisse

Yes, good morning.

Jim Kirsch

Good morning, John.

John McNulty - Credit Suisse

I have a couple of questions. With regard to the cost saves and how we should be thinking about them going forward, can you give us some color in terms of how we should think about the third quarter sequentially relative to the second?

Jim Kirsch

It will – we surely expect from a roll-forward standpoint, I think continued improvement in our cost structure. Quantifying, that’s a little bit difficult. I haven’t done that in terms of units. But I can tell you, as I look at our manufacturing rollup of our data, what I continued to see is that our cost structures in our operating facilities are still in a declining mode. So my expectation is that, we have talked a lot about breakeven levels in the last couple of calls. We’re going to continue to grind away lowering that breakeven level, John.

John McNulty - Credit Suisse

Okay, but not a specific number for it that you can give us.

Jim Kirsch

No. Let me – I will give there some thought and if there is something we want to publicize, we will do that.

John McNulty - Credit Suisse

Okay. And then the furlough impact that you had, I believe you said it was for the second quarter when the furlough happened. What was the – what were the savings tied to that?

Jim Kirsch

Roughly in the $1.5 million to $1.7 million range.

John McNulty - Credit Suisse

Okay. $1.5 million to $1.7 million. And then, one another things that we noticed was the inventory has dropped a lot sequentially from the first quarter to the second, and I am assuming that that hit you on the operating leverage side where you probably took a little bit more on the cost side, per se, unit than you might normally? What was that hit if you know it?

Jim Kirsch

First off, the reason it dropped more and the second and the first was actually catch up. Secondly, it feels like for the most part we are there.

Sallie Bailey

Yes. I think, John, the way that we really look at it, I think we took most of the absorption hit in the first quarter and that’s really part of the margin improvement that you see, first quarter, second quarter is coming from running albeit into lower capacity utilization, sort of running more for our customers. So I think we are really for our customer demand. So I think the impact from an absorption point of view in the second quarter is not as significant just the inventory reductions. Is that helpful?

John McNulty - Credit Suisse

Yes, no, it definitely – it just looks like it was such a big reduction. I think there might be some in the quarter, but –

Sallie Bailey

Yes.

Jim Kirsch

It was the – John, if you look at the first quarter results in Organics, Performance Coatings in particular and the big change, a lot of that change hit them in debt absorption issue, hit them in the first quarter. So you had about $10 million or $11 million swing in segment income in that business. And there they’ve had some improvement in revenues.

If you look at Performance Coatings, it had about $8 million or $9 million improvement in revenues, but they had a pretty substantial movement in their segment income. And a significant portion of that was due for the fact that the absorption it was taken in the first quarter versus the second.

John McNulty - Credit Suisse

Okay, that’s helpful. And then the last question, for the quarter, the CapEx of $20 million looked actually a little bit higher given kind of what you I believe you had forecasted for the full year. So can you give us some colors to what happened in the quarter and kind of what your thoughts are the full year now?

Sallie Bailey

Yes, I think, John, we continue to confirm that we think our CapEx will be in that $35 million. We – the CapEx in the – for the first half of the year really relates to the continued look at a building of our plants in – our Color plants in Spain and so it’s just turned out that when those accounts were paid, they were paid in the second quarter and we had a high number at the second quarter. But we are still sticking to the – trying to manage the CapEx to $35 million for the year.

John McNulty - Credit Suisse

Okay. So that would be like $6 million give or take a little bit per quarter for the rest of the year.

Sallie Bailey

Yes.

John McNulty - Credit Suisse

And then in terms of maintenance CapEx versus growth CapEx and kind of how we think about it going forward to 2010, 2011, I mean what is your maintenance level like or normalized maintenance level?

Jim Kirsch

Let me give – I will give you two different sets of numbers, John. The normalized maintenance has been in the rough numbers, $12 million or so, okay? This year, it will be fairly close to that, it will be in the $7 million, $8 million range.

John McNulty - Credit Suisse

Okay. Okay great. That definitely helps. Thanks a lot.

Operator

Thank you. Our next question comes from Dmitry Silversteyn with Longbow Research. You may ask your question.

Dmitry Silversteyn - Longbow Research

Good morning. All of my questions are already been asked in a way by Rosemarie, so I'll just move on to the next one, maybe come back later. Can you talk about – and you talked about the mix shift playing a role in your margins and in profitability, can you talk about some of the new products that may be hurting you with that mixed shift in a positive direction, or, is it just a question of which divisions do better in relative volume terms one versus the other?

Jim Kirsch

It’s the former versus the latter. Let me explain that Dmitry. Let me – for instance, if you look at our plastics business, it’s had a terrific year. We don’t tend to talk a lot about it. But they have been very engaged in penetrating in the coloring side of the plastics business.

It’s higher value, it is – there are a variety of niche markets that are available to us. It moves us away from what I would say a commoditized materials. And while we have seen a very severe reduction in volume as many plastics players have, we have seen very nice improvement in operating margins at the segment level in that business and that’s a significant reason why.

In our Polymer Additives business which has been a historically driven very much by PVC related activities, we’ve talked for a couple of years now about the fact that we’ve moved about a third of that business away from PVC related applications into some of the applications I mentioned in my earlier comments like down hole mugs and more what I would call environmentally friendly applications in personal care.

In our Glass businesses and in our Tile business, I mentioned pigmented inks. And pigmented inks are significant because it allows essentially inkjet style of printing on a tile line as opposed to roller type application of Color. What that means is tile applicator can now create tiles that can compete with woods and natural materials like stones, granites, et cetera. They are high value and rapid growth as application as customers adopt that new technology into their places of business.

And I started to mention glass, because we typically talk about our inorganic colors, but there is also organic materials that have allowed us to create more value and to penetrate markets where certain types of raw materials or colors are less favored, if I put it that way, from an environmental standpoint, it allowed us to move into again higher value.

So a little bit of innovation going on in businesses that traditionally aren’t considered as innovative. Our Tile business, our Glass business, our Plastics business, Polymer Additives and we have talked quite a bit in the past about Electronics, so I will leave that out.

Dmitry Silversteyn - Longbow Research

Okay. All right, that’s very helpful. But actually I want to follow-up on the Electronics. We’ve seen – I think your comments were fairly conservative for the expectation in the business, particularly in the dielectric and capacitor area once in a year. We’ve seen quite a bit of a recovery in the June quarter versus March quarter and things like wafer starts and semiconductor sales. Would that eventually caused your revenues to up sequentially. I understand that there is a lag because of the supply chain, but would you expect to see similar levels of recovery in terms of volumes in the second half of the year, given what happened in the semiconductor land in the second quarter?

Jim Kirsch

We’re not as tied to the semiconductor side of the world as we used to be. If you think about our mix, it is clearly dominated by photovoltaic and by polishing materials for everything from contact lenses, eye glass lenses, military applications and high-end aftermarket automotive applications in fact. So we have really repositioned the business more into what I will broadly call clean technologies over the last several years. So while that will beneficiary, we don’t think we will – A, be the victim of some of the larger swings that they have in their – in that side of the business. But we also won’t have the advantage of some of the upswings that they have in business as well. The dielectric side will certainly benefit as that trend continues.

Dmitry Silversteyn - Longbow Research

I understand. On the photovoltaic side, is the biggest challenge for that business right now, volume or pricing?

Jim Kirsch

The biggest challenge was overbilled in 2007, 2008 in the world’s largest market which was Spain. And so the challenge is primarily volume. There is a lot of pressure on pricing more in the panel modular silicon side. And yes, we have lots of pricing discussions, but our ability to continue to deliver higher efficiency producing product to our customer, which enables them to increase yield and gain savings out of their production lines, so far has kept us in good step vis-à-vis our margins there.

Dmitry Silversteyn - Longbow Research

Okay, that’s helpful. And then switching gears a little bit, talking about the Organics business, we have seen quite a bit of a nice improvement there in operating margin certainly on year-over-year basis in Specialty Plastics, although Polymer Additives seems to be a little bit weaker. How much on the lower volume dictating a lot of the profitability, but obviously raw materials helped at least to some extent in the quarter. As you move look forward into 2009 second half of the year, just looking at the slopes of raw material pricing and some aggregate basis it looks like your positive delta should increase in second half of the year. So my question is around pricing, are you seeing more pressure from customers to lower prices, even though sequentially raw material prices are going up or are customers – or are you able to use the sequential increase to kind of forestall pricing discussions even though your year-over-year raw material delta is getting more favorable?

Jim Kirsch

We certainly are not able to forestall pricing conversations. Virtually every customer meeting starts somewhere very earlier in the discussion with pricing in that particular area. And yes, we do use raw materials as part of the rationale. But again, we’ve moved pretty hard to buttress our commoditized type materials with applications that range from applications in energy such as the wind turbines I mentioned and the colorings business which are little more price resistant I will say because of the value sell. So our track record has been very good in that business of managing the price-raw material relationship and I would expect it to continue to be so as we move forward.

Dmitry Silversteyn - Longbow Research

Okay. All right. And then one final question, on just if you could care to provide any strategic updates on your divestiture plan. I think you were talking about the Organics business perhaps not being barred up fair ago in the longer term. Is there anything changing in the credit market or appetite from investors for some deals that gives you some confidence that this can be accomplished in the near to mid term or is completely on the back burner and you’re not being thinking about it?

Jim Kirsch

Given the multiples and the reduction in EBITDA, the value of those businesses are much more valuable to Ferro in terms of their cash generation than they are outside of Ferro. So the team is doing a great job of managing of the businesses well. They’re improving their margins, they’re managing and delivering cash. So there is no intention at this point in time to get engaged in those types of conversations.

Long-term, we will see where this goes. Clearly, in my mind, the strategic intent of this company is going to be built and will continue to be built around its core competencies of particle engineering, and our advantages of application technology in the energy sectors like photovoltaic and alternative energy like wind turbines and also in the inorganic sectors that we’ve talked about particularly in Glass and Color.

Dmitry Silversteyn - Longbow Research

Okay, okay. That’s helpful. Thank you.

Operator

Thank you. Our next question comes from Robert Felice with J. Goldman & Co. You may ask your question.

Robert Felice - J. Goldman & Co.

Hi, most of my questions have been answered, just one or two more. Jim, I think I heard you correctly before, but I wanted to double-check that Ferro was breakeven on a net income basis in June. Is that correct?

Jim Kirsch

Yes it was – I am glad you brought that up. We are breakeven on a profit before tax basis in the month of June.

Robert Felice - J. Goldman & Co.

And did that trend continue in July?

Jim Kirsch

We are – I am not going to forecast where that will be in July as the numbers are rolling in as we speak, Rob. I have seen the revenues and we haven’t seen all other puts and takes as you work your way through the statement. But my expectation is that, as I have looked, as I have mentioned, we think we are through the worst of this. Our cost reduction work continues, our operating leverage continues to be improving. So if we stay on the track we are, it can maintain the kinds of volumes and revenues, we should maintain a position where we are breakeven or slightly better.

Robert Felice - J. Goldman & Co.

Okay. I guess taking it a little broadly. You mentioned that you don’t expect or at least you are not banking on a sequential improvement in volumes in the third quarter versus the second. So assuming that’s the case and given the cost saving actions you have taken, in fact you lowered your breakeven level, how comfortable or confident are you in Ferro’s ability to maintain covenant compliance in the third quarter and beyond?

Jim Kirsch

You and I have had this dialog once or twice in the past. And I am not going to make a prognostication on the compliance or lack of compliance on the covenants. But I will tell you this, I think a lot of people bet against us in January, February in terms of our ability to be compliant. I think that happened again in April and May in terms of our ability to be compliant. I said then at the time, we are taking all the steps necessary to run the company as efficiently and effectively as we can. We are focused on cash and liquidity.

And as of the end of June, our liquidity was in excess of $150 million for instance. We’ve already talked, both Sallie and myself about cash flow and the positive nature of that. If we continue to do while when we get a little bit of help on the market side, then, we got a good shot or a reasonable shot at being compliant. And if the market doesn’t help us and we continue to do our jobs well, we are going to – it’s going to be a struggle. So we will kind of see what happens in the markets in the next six weeks.

Robert Felice - J. Goldman & Co.

Okay. In relative to where Ferro was three months ago, is the company tracking below, above or in line with your expectations?

Jim Kirsch

We are about in line with my expectations. I knew in November, December, how ugly the first quarter was going to be and then it got uglier than what I thought I knew, which I don’t think is unusual. The second quarter, we worked so hard and took out so out so much cost and expense in the three and four months from that November-December timeframe through that first quarter that I knew we would see improvement at the bottom line as a consequence. I was a little surprised at the strength of June frankly.

And I am gratified that we seem to be at or through the bottom of this thing and the July revenue numbers as I have said looked a little better than June, so that’s encouraging. But I remain concerned about the lack of visibility that our customers have in the August and September months. And I think I said at second quarter, we need to get through a quarter or two before we at least declare – I don’t want to say victory, but at least declare we’re through the worst of this thing. So let’s get through this third quarter and see what it looks like.

Robert Felice - J. Goldman & Co.

Okay, great. So it sounds like the next four to six weeks will tell a lot.

Jim Kirsch

I think so.

Robert Felice - J. Goldman & Co.

All right. Thanks for taking my questions and good luck.

Jim Kirsch

Thank you.

Operator

Thank you. Our next question comes from Rosemarie Morbelli with Ingalls & Snyder. You may ask your question.

Rosemarie Morbelli - Ingalls & Snyder

Just quickly, looking at the operating profits by segment and we sequentially every single line of business improved versus the first quarter, except for Polymer Additives and yet you didn’t have anything negative to say about it. Could you give us a better feel for what is going on there and whether you are confident that that margin will improve over the next couple of quarters?

Jim Kirsch

Yes, the difference between first quarter and second quarter in Polymer Additives was all completely related to FIFO calculations. And as that rolls through our organization, it had that kind of an impact on the second quarter results. So it’s that simple.

Rosemarie Morbelli - Ingalls & Snyder

Okay. And so going forward, that particular impact disappears.

Jim Kirsch

Yes. It should work its self through. That is correct.

Rosemarie Morbelli - Ingalls & Snyder

Okay. And then just looking at the different weak industry or weakest industry as in construction, auto and appliances, could you give us a feel with particularly on appliance giving the sale of existing homes vis-à-vis are foreclosure are not, I don’t think makes a difference. Are you seeing some kind of light at the end of that tunnel? Could you pick those three areas and tell us what kind of trends you are looking at?

Jim Kirsch

Well in appliance, it’s interesting. It’s actually improving pretty substantially in Asia and we have some very significant appliance customers in Mexico. And they’re adding shifts, adding workers. They are running longer. So we are seeing some gradual improvement in the appliance market both whether that’s hot water tank washing machine drivers, et cetera. So I am modestly encouraged by that.

Automotive is really tough Rosemarie with all this government funding. (inaudible) aren’t they another month, another two months? Is this a bubble? Is there – we will see what happens. I don’t – I am seeing so many different numbers on automotive prognostication that I am not going to take a guess personally. I would just tell you that it represents globally 9% or 10% of our total revenues exposed to the broad automotive markets.

And as there are enhancements to production, we should see a gradual improvement in the businesses that are attached to that if you will. And people like Toyota, Honda, Ford have all announced production increases going into these summer months and there is a lot of discussions about how low inventories are on the car lots and in the automotive producers.

On the other hand, you have got the GM’s new Board saying we want to be number one. And so I am a little concerned about what’s going to entail in terms of their production, pricing and so on. So that’s a very difficult one to prognosticate.

You asked about building and construction in general, I am encouraged by the new home starts and the numbers that are being put out. Some of the housing companies are starting to show little bit results. Spain remains dismal, that’s an important market for us. Fortunately the export markets out of Spain are strengthening slightly. So we are seeing a little bit enhancement there.

In general, as I said a little earlier, clearly anecdotal, we feel a little better now than we did two months ago. And if the third quarter plays out like we’ve hoped as well, then we will feel a little better in the six or seven weeks than we do now.

Rosemarie Morbelli - Ingalls & Snyder

Okay. And then last – thanks, that was helpful. And then last, if I may, SG&A level in volume terms was really very low. Now you did have that one week furlough helping, is that furlough gone, are you going to have another week in the third quarter and in other words, that to dollar terms of SG&A is not sustainable going forward?

Jim Kirsch

Yes, we are not having a furlough in the third quarter. We haven’t made that decision about the fourth quarter at this point in time. We are – in terms of sustainability, we have shown a remarkable propensity since 2006 to grind away and take out expense on the SG&A line. And we are going to continue to do that. So if we stand still, the answer is no, it’s not sustainable. But we are not going to stand still and we are going to continue to work hard to take expense out at that level.

Sallie Bailey

And if I could add something to that, in terms of – for your modeling purposes, if you think about it, in the first quarter, we had S&A as a percent of sales of 19%. This quarter it’s gone down to 15.6%. Given the work that we have done and in modeling for the second half, I would be looking in the 16% to 17% of the – for S&A as a percent of sales. So it depends on the sales level that’s relative to the 13% to 14% that we were posting last year.

Rosemarie Morbelli - Ingalls & Snyder

You have 15.6% of sales in Q2 though includes the $3 million on non-recurring charge. So if you take it out, you’re really only at 14.9%.

Sallie Bailey

That’s right. I am doing it off of the public numbers that’s complete SEC numbers, Rosemarie.

Rosemarie Morbelli - Ingalls & Snyder

Okay. So if I take out that 9%, I mean the differential is similar to what you are talking about out of the public numbers?

Sallie Bailey

That’s correct.

Rosemarie Morbelli - Ingalls & Snyder

Okay. Thanks a lot. That will be it. Good luck.

Jim Kirsch

And we will just try to squeeze in one final question, please, operator.

Operator

Okay, thank you. Our last one comes from Douglas Chudy with KeyBanc Capital Markets. You may ask your question.

Douglas Chudy - KeyBanc Capital Markets

Hi good morning. You showed nice sequentially improvement in Electronic Material operating margins ex-precious metals during the quarter. With demand appearing to be getting a little bit better, should we expect further sequential improvements in margins in the back of the year?

Jim Kirsch

Very dependent on mix. But if we get demand a little bit in the European photovoltaic combined with continued improvement in dielectrics and maintain where we are in China, my expectation of that would be, yes.

Douglas Chudy - KeyBanc Capital Markets

Was mix the main driver in sequential improvement or maybe if you can breakout the components between mix and cost savings or just the sequential demand improvement?

Jim Kirsch

It was primarily mix.

Douglas Chudy - KeyBanc Capital Markets

Okay. And then just finally one other thing, should we expect a similar expense in third and fourth quarters hitting the corporate expense line?

Sallie Bailey

Yes.

Douglas Chudy - KeyBanc Capital Markets

Okay. All right thank you very much.

Jim Kirsch

Welcome.

David Longfellow

All right, that concludes our conference call today. For copies of our press release, replays of this call, or access to our SEC filings, please go to our website at www.ferro.com and click on Investor information. Thank you and have a good day.

Operator

Thank you. And this does conclude today’s conference. We thank you for your participation. At this time, you may now disconnect your line.

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Source: Ferro Corporation Q2 2009 Earnings Call Transcript
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