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H.B. Fuller Company (NYSE:FUL)

F3Q09 Earnings Call

September 23, 2009 10:30 am ET

Executives

Steven Brazones – Assistant Treasurer

Michele Volpi – President and Chief Executive Officer

James Giertz - Senior Vice President, Chief Financial Officer

Analysts

Olga Guteneva – J.P. Morgan

Jason Weiner – Deutsche Bank

Douglas Chudy - KeyBanc Capital Markets

Christopher Butler - Sidoti & Company LLC

Steven Schwartz - First Analysis

Eugene [Faerber] - Longbow Research

Rosemarie Morbelli - Ingalls & Snyder

Robert Patrick – Cardinal Capital

Operator

Welcome to the HB Fuller Conference Call to discuss their third quarter results. At the request of the company, this call is being recorded for instant replay purposes. This event has been scheduled for one hour.

Following today’s brief remarks, there will be a brief question-and-answer session. Instructions will be given at that time should you wish to ask a question. Management and attendants on today’s call include Mr. Michele Volpi, President and Chief Executive Officer; Mr. Jim Giertz, Senior Vice President and Chief Financial Officer; and Mr. Steven Brazones, Assistant Treasurer.

At this time I would like to turn the meeting over to Mr. Steven Brazones.

Steven Brazones

Today’s conference call is being web cast live and will also be archived on our website for future listening. In addition, this call will be available for replay approximately one hour after we are finished with the question-and-answer portion of our call.

Before beginning, I would like to inform everyone that certain matters discussed during this call will include forward-looking statements as that term is defined under the Private Securities Litigation Reform Act of 1995. Since such statements reflect our current expectations, actual results may differ.

In addition, during today’s conference call, we will be discussing certain non-GAAP financial measures: specifically operating income; earnings before interest expense, taxes, depreciation expense and amortization expense, or EBITDA; and return on gross investment or ROGI.

Operating income is defined as gross profit less SG&A expense. EBITDA is defined as gross profit less SG&A expense plus depreciation and amortization expense, and ROGI is defined as trailing 12 months gross cash flow divided by gross investments.

Also, during today’s call, all EPS numbers referenced for the third quarter of 2009 will be discussed on an adjusted basis to exclude the Roanoke legal settlement.

All of the non-GAAP measures discussed today should not be construed as an alternative to the reported results determined in accordance with GAAP. Management believes that a discussion of these measures is useful to investors because of the assist in understanding the operating performance of the company and its operating segments, as well as the comparability of results, and it provides into the ability of the company to fund such things as debt reduction, acquisition, and share repurchase programs.

The non-GAAP information discussed today may not be consistent with the methodologies used by other companies. All non-GAAP information is reconciled with reported GAAP results on the last pages of our presentation. For more information please refer to our recent press release, quarterly report on Form 10-Quarter, and annual report on form 10-K filed with the Securities and Exchange Commission, all of which are available on our web site at www.hbfuller.com under the Investor Relations section.

I will now turn the call over to Michele.

Michele Volpi

Thank you for joining us today. In light of the challenging economic environment we continue to endure, we are quite pleased and satisfied with our performance in the third quarter. Let me share with you a few of the highlights. First we started to see the initial signs of an improvement in our organic sales development. Although organic sales were still down nearly 10% in the third quarter, volume declines eased over 250 basis points on a sequential basis, primarily driven by new business wins in several segments of our business. Also our volume development improved slightly during the quarter since in most parts of the company we exited the third quarter with stronger demand than we had at the beginning of the quarter.

Secondly, we did a good job of maintaining our gross margin. Our efforts to reduce raw material costs led to a decline in these costs of about 15% year over year and a little more than 1% sequentially. These reductions combined with our efforts to reformulate our product lines to use less costly raw material components and the efficiencies we managed in the plants principally drove the improvement in margins. For the third quarter, gross margin expanded by 680 basis points year over year and 190 basis points sequentially.

Next, we grew EBITDA margin on a sequential basis by 70 basis points to 13.7%. The improvement was driven by the expansion of gross margin offset somewhat by higher selling, general, and administrative expenses. SG&A expenses were up about 11% versus the second quarter or about $6.8 million. On the surface, this level of increase appears high, but in fact, the increase is explained by several discrete factors. Nearly two-thirds of the increase relates to unfavorable foreign currency translation and the timing and magnitude of compensation costs. About $1.5 million of the increase reflects the investment we have recently made to build up our customer facing and technical organizations, while the balance of the increase is a variety of other smaller items. This step up in spending comes after many quarters of extremely tight cost control and is necessary to support the growth expectations of our business.

The next highlight is cash flow from operations. Year over year, it was up $37 million to $59 million. This is equivalent to over $1.20 per share. Improved profitability and favorable working capital development largely led to the year over year increase.

Lastly, the North American region’s strong performance continued in the third quarter, while the Asia-Pacific region made progress in its turnaround efforts. North America increased its operating income over 50% year over year, while Asia-Pacific went from a loss of $500,000 in the second quarter to generating operating income of $2 million this quarter.

Although we’re pleased with our strong performance in the third quarter, it was not free of challenges. Most notably, weak end market demand. While it is encouraging that the trend in volumes improved slightly in the third quarter, volumes were still down more than 12% year over year. This clearly continues to dampen the benefits generated through raw material cost reduction and product reformulations as we lost leverage on fixed manufacturing costs.

With that, I’ll now turn the call over to Jim to provide a summary of our financial and operational performance.

James Giertz

Let’s start with a quick review of our financial scorecard which is derived from our 5-year plan. The first key metric is organic growth. Here we have set a goal to grow between 3-5% on a compound annual basis from 2007 through 2012 which is the 5 years of our 5-year plan. In the third quarter, organic growth was down 9.6% year over year. While this is a long way from our target range, we are confident based on our analysis of public data and other anecdotal evidence that we’re performing better than the overall market in this challenging environment. We’re winning new business now and enhanced commercial organizations are being put in place to sustain this growth in the future.

EBITDA margin is our second key metric, with our goal set between 14-16%. For the trailing 12 months ending in the third quarter of this year, we reported an EBITDA margin of 11.4%. However, current performance is tracking much closer to our target range. In the third quarter, we achieved an EBITDA margin of 13.7%. There is still work to be done, but we’ve made great progress this year in restoring our margins.

Our next metric is return on gross investment or ROGI, with a long-term goal of between 10-12%. From the end of 2007 to the second quarter of this year, ROGI declined steadily. However, given the significant improvement in gross cash flow in the third quarter, ROGI inched up 30 basis points to 7.1%.

Our last key metric is based on the growth in diluted earnings per share. For this metric, we’ve set a long-term goal to grow between 10-15% on a compound annual basis. Based on our earnings over the training 12 months, we’re currently running at a 12.2% five-year compound annual growth rate, close to the middle of our target range.

Now, let me provide you a brief update on our cash flow and balance sheet position. The third quarter was another very strong cash flow quarter for us. Cash flow from operations increased $37 million year over year to $59 million and was even up slightly over last quarter’s very strong performance. Growth in profitability and more favorable quarter to quarter net working capital improvements primarily drove the improved cash flow during the quarter. It’s also worth noting that the $18.7 million of cash from our legal settlement was not received until after the end of the third quarter. Consequently, the positive impact of this settlement on cash flow will occur in the fourth quarter. Also, we made a $10 million contribution to the US pension plan in the third quarter and still managed to increase cash flow from operations compared to the second quarter.

As I just mentioned, net working capital favorable contributed to cash flow in the third quarter. In total, net working capital contributed nearly $13 million to cash flow from operations. This compares to a neutral impact in the third quarter of last year. As a percentage of annualized net revenue, net working capital was down 180 basis points versus the second quarter. All three components of net working capital improved as a percentage of annualized net revenue. Continued measures focused on reducing inventory levels and optimizing both payment and receivable terms led to the improved results.

As a result of the strong cash flow generation, our balance sheet continues to strengthen. In the third quarter, net debt was $64 million, down approximately $55 million versus the second quarter.

I’ll now provide a brief regional update. Starting with North America, North America continued to deliver another stellar performance this quarter. On the top line, the region began to see a moderation in the decline of volume driven by adhesives. New customer wins from earlier in the year and the continued expansion of customer relationships were responsible for the majority of the improvement quarter to quarter. On the pricing front, average selling price moderated from the second quarter levels, but still positively contributed to organic sales year over year by more than 4%. Operating income posted strong improvement, increasing more 50% versus the third quarter of last year and nearly 7% sequentially. A lot of hard work was done to drive down raw material costs and improve formulations to capitalize on these lower cost raw materials.

In Europe, Middle East, and Africa, the situation is more or less similar to what it was in the second quarter. On the top line, volume decline eased in the third quarter, building on the trend that began last quarter. On the pricing side, however, we struggled to maintain positive year over year comparisons resulting in average selling price declining slightly in the third quarter versus last year. Operating income improved slightly on a sequential basis on higher volumes and lower raw material costs; however, relative to last year’s third quarter, operating income was down 17%. Unfavorable foreign currency translations depressed operating income by about 13% compared to last year. The remaining decline year over year was driven by weaker volumes.

Clearly, we still have a lot of work to do to improve the financial performance of this region. We took a large step towards this end in the second quarter with the additions of two talented industry veterans to lead the European business. They will be instrumental in driving H.B. Fuller’s transformation to profitable growth in EMEA. Through their leadership, we will be well positioned to capitalize on the many opportunities in front of us and unlock the tremendous potential of our second largest region.

In Latin America, the region’s macroenvironment continued to worsen, especially in Mexico and Central America. Although this negatively impacted both businesses, it had a more pronounced effect on the consumer paints business. On the top line, both businesses reported a deterioration in organic sales development versus the second quarter. For the adhesives business, average selling price declines outweighed slightly higher volumes. For the paints business, further deterioration in consumer demand resulted in additional declines in volumes versus the second quarter and a lower average selling price. As a result, organic sales for the region declined at a faster rate year over year than in the second quarter.

Regarding operating profits, there was a clear divergence in performance between the two businesses. While the adhesives business achieved improved profitability both sequentially and year over year, the paints business reported an operating loss for the quarter. Although adhesives grew its operating income more than 80% year over year, it was not enough to offset the significant decline in paints. As a result, operating income declined both year over year and sequentially for the region.

Now finally, on Asia Pacific, we’re pleased to report that Asia Pacific began a turnaround in operating performance in the third quarter. On the topline, the volume development in Asia improved the most of all the regions. The return of certain markets which had all but disappeared in the first half of the year together with new customer wins led to much improved volume versus the second quarter.

As a result, volume declines eased by over 800 basis points sequentially, from down 11% to down less than 3%. Average selling price was down slightly versus the second quarter but up 4.6% year over year. Consequently, Asia was the first region to start posting positive organic growth in the third quarter.

From a bottomline perspective, Asia Pacific began a rebound in operating performance. Pricing actions taken to offset the sharp devaluation of the Australian dollar, the return of demand in certain end-markets, reformulations, new customer wins, and the subsequent rebound in the Australian dollar were all factors leading to the markedly improved results.

Also worth noting this quarter is the strong performance of our joint venture in Japan with Sekisui Chemical. Through knowledge sharing, raw material cost reductions, and the adoption of more disciplined pricing tools and processes, the joint venture has considerably improved its financial performance.

I’ll now turn it over to Michele for some final remarks.

Michele Volpi

I would now like to provide you with an outlook for the fourth quarter of 2009. As you’re all aware, the first three quarters of 2009 has been quite challenging from a demand perspective; however, during the third quarter, we began to see some indications that the worst may be behind us. Looking ahead to the fourth quarter, we’re optimistic that we will continue to make incremental progress on the topline. Clearly, the comparables will be easier in the fourth quarter as we’ll not have dramatic decline in volumes that occurred halfway through the fourth quarter of last year. While this will help, our optimism is based on the fact that we continue to win a meaningful amount of new business in this down environment. As a result, we believe we are on track to generate net revenue of approximately $350 million in the fourth quarter. If achieved, this would mark another sequential improvement in organic sales.

On the raw material front, the landscape is quickly changing. Supplier capacity rationalizations occurred throughout the year as demand fell. Additionally, high energy prices and the market expectation for a resurgence in demand are driving our raw material costs up in the fourth quarter. At this point, we are anticipating low single digit inflation versus third quarter level, but exactly how much and how fast our cost will increase remains uncertain. As a result of this outlook, our sales and marketing teams are already in the process of implementing pricing actions to address this higher cost.

Lastly, regarding our tax situation, we expect our effective tax rate for the fourth quarter to be approximately 34.5%, excluding any significant discrete items. That concludes my prepared remarks, and I would now like to open the call up for your questions.

Question-and-Answer Session

Operator

(Operator instructions) The first question comes from the line of Olga Guteneva with J.P. Morgan.

Olga Guteneva – J.P. Morgan

Did you say that your raw material benefits this quarter were 15% year over year?

Michele Volpi

They were actually 14.9% versus last year and down 1.4% versus Q2.

Olga Guteneva – J.P. Morgan

So, there was a small sequential improvement, you said 1.4% versus the second quarter?

Michele Volpi

Yes.

Olga Guteneva – J.P. Morgan

In your cost of goods sold, roughly speaking, what is the fixed cost component, and what happened with this component over the past two years?

Jim Giertz

Broadly speaking, in our cost of goods sold, about 75% of our cost of goods sold is raw materials, and the balance is everything else, and some portion of the everything else is clearly fixed and other parts are partially fixed and some are variable.

Olga Guteneva – J.P. Morgan

Were you able to reduce your fixed cost component over time or it remained fixed?

Michele Volpi

Olga, you know that we’re strong believers of Six Sigma, and we believe in continuous improvement, so when you really look at our factory labor, manufacturing overhead over the years, we have generated lots of efficiencies. We continue to do that, and whenever needed, not just from an efficiency standpoint but also from a strategic perspective, we also adjust our capacity. I think we have done a pretty good job over the years, and clearly that together with pricing actions, sourcing negotiations, and product line reformations is what is contributing to this gross margin improvement. Jim, do you want to add something?

Jim Giertz

The other thing Olga, I’d just point out, we mentioned in our press release that we had a facility restructuring in North America in the third quarter, and that’s a specific example of actions taken to manage down our fixed cost in our manufacturing operation here in North America.

Olga Guteneva – J.P. Morgan

So I take it that this restructuring charge is reflected in the cost of goods sold line on the income statement. Is it correct?

Jim Giertz

That’s correct. One hundred percent is in the cost of goods sold line.

Operator

The next question comes from the line of Jason Weiner with Deutsche Bank.

Jason Weiner – Deutsche Bank

On the raw materials, I sort of thought that thing was up sequentially looking elsewhere, so can you elaborate on what basket of raws you saw helping your earnings sequentially?

Michele Volpi

It’s been to be honest, Jason, all over the place. I think we have a team now that is more experienced and is more able to partner with the suppliers and drive down continuously but also collaboratively the raw material prices, but more than that, we have a very good connection between the sales, marketing, and technology teams to address reformulations and making sure that we need to get together with our customers on the impact of inflation, so from that perspective, I think we are generating a lot of good momentum. We’re taking advantage of this situation, and we are doing that with a clear idea of long-term growth in mind, and therefore not putting volume at risk, and as I told you, based on what we have seen in the first half of the year based on positive results, we think it’s working.

Jason Weiner – Deutsche Bank

Okay, let me look at the volumes for a minute then. On some of these new wins, are you gaining market share in North America in a significant way?

Michele Volpi

Well, I think that we are winning new business both with new accounts and existing accounts, but I also think that we’ve got much better at also perfecting our current business and at building customer loyalty, so it’s both new accounts and existing accounts, and I think some of the changes we made in the organization and some of the training we have been investing into that are already paying back.

Jason Weiner – Deutsche Bank

Can you characterize if it’s in more specialized products where you’re winning business or more commoditized products?

Michele Volpi

It’s in all the points of the product line are clearly the marketing and the business directors are pushing really far new product lines and new market segment entry, and we are getting some inroads there, but I think we’re getting more and more effective in terms of managing also our business and making sure that we have prices that are aligned with the complexity and the cost of service.

Jason Weiner – Deutsche Bank

If we look at your guidance for $330 million next quarter, can you talk to how much volume improvement versus price improvement? You mentioned you’re implementing price increases. How much might be assumed in that?

Michele Volpi

I will tell you directionally and then maybe Jim can add content to that. I can tell you that through the third quarter, there was a positive trend within the quarter of volume, so we started basically at minus 15% and we ended up at minus 10. Clearly from a pricing perspective, remember that we started raising prices in the third and even more in the fourth quarter of last year. So clearly what you can expect in the fourth quarter even if clearly we are going to do whatever it takes to maintain our margins or get close to the third quarter level, there is going to be clearly a more difficult comparison year over year in terms of price increases. You will see more of volume and less of pricing compared to the third quarter.

Jim Giertz

I can give you more specific numbers to back up what Michele said. On the $330 million of revenue, the volume would be down about 6-7%, and all the other factors would be fairly small, so price may be up slightly. I think currency would be a slight positive in the fourth quarter for us, but the other factors are pretty minor. About 6-7% down on volume would correlate to the $330 million of revenue forecast.

Jason Weiner – Deutsche Bank

I thought I heard you say there was sequential easing in prices in the third quarter. Did I hear that right?

Jim Giertz

Did I mis-speak on that one? Price will a slight negative year over year.

Jason Weiner – Deutsche Bank

I thought I heard something about sequential, price moderated from Q2 levels, so I just wanted to make sure that that’s what you said and is that going to continue sequentially?

Jim Giertz

It’s going to be down sequentially in Q4 slightly.

Operator

Your next question comes from the line of Douglas Chudy - KeyBanc Capital Markets.

Douglas Chudy - KeyBanc Capital Markets

You’ve certainly done a nice job in North America on the profitability front. Can you give us a sense about long-term operating margin potential for the various international segments and maybe do you see these other segments having the potential to get on par with North America at some point?

Michele Volpi

I think that really the margin enlargement first of all that we look at we clarified that in 2007. It’s EBITDA margin and ROGI margin, because it is clear that we need also the volume to come through and we need to have profitable growth, so yes, let’s talk about gross margin, but let’s understand that our key metric in terms of profitability are ROGI and EBITDA margins. As far as North America, I think that Jim Owens and his team have done a terrific job specifically in the current environment, specifically with very weak volume, and it’s been a combination of really managing well the negotiations with the suppliers, aligning pricing with cost to serve economics, reformulating raw materials, making sure we had the right sweet spot of capacity utilization in the plants, but is also a team that is driving to realize their profit margin segmentation. I can tell you that a lot of that has started also in the other regions, both in Europe, Latin America, in Asia-Pacific, and clearly it is one of the areas that is going to help us maintain gross margins, as much as we can, taking into account that the margin that we look at is EBIDA and ROGI.

Douglas Chudy - KeyBanc Capital Markets

You have cited some pretty good new product win momentum here heading into the fourth quarter and I guess into 2010. Can you quantify what level of wins you have seen or some way to frame that up for us?

Michele Volpi

As I said before to Jason of Deutsche Bank, we are really winning both in the new market segments and in new products. I don’t think we have yet something in terms of breakthrough platform. Barry Snyder and his technology team are working on that and are making good progress. Therefore, a lot of that has been more product tweaks, but there is very good collaboration between technology, manufacturing, sales and marketing, and also in making sure that we have the right product suite and we don’t just have over-engineered products.

Operator

Your next question comes from the line of Christopher Butler - Sidoti & Company LLC

Christopher Butler - Sidoti & Company LLC

You had mentioned along with some of your new business wins you talked about how demand seems to have improved during the course of the quarter. Could you touch on whether this was a continuation of what we’ve seen from your second quarter, that the supply chain inventory levels have really depleted at this point and that things are flowing through or if you’re actually seeing end customer starts to get out and buy more?

Michele Volpi

I think that some is clearly beginning to an end of the destocking levels. That’s what most likely when everybody else is reporting the third quarter you will see also from the others. Still, I think we are over-performing the market as Jim said in his script, and when you look at the first half published results from our most direct competitors, specifically the industrial adhesive segments of these competitors, you will see that there has been several point difference in terms of revenue and volume evolution. So clearly, a component is the destocking that is broad-based and is going to affect everyone in the industry, and that’s a positive. I don’t see yet a resurgence in demand, and hopefully we’ll see that in 2010, and I’m getting more on the optimistic side than two years ago when we prepared for the downturn, and because of that optimism, that’s why we have been investing for growth and really making sure we’re ready for that, but I think when the market does start picking up, we will be in a better position than some of our competitors.

Christopher Butler - Sidoti & Company LLC

You made in distinction in Latin America as to the adhesives business versus the paint business and how they’re shaping up. Are you seeing similar differences in adhesives versus more construction related adhesives here in North America as well?

Michele Volpi

As Jim said, adhesives have been performing relatively better than our specialty construction brands even if also there is a lot of good work being delivered in spite of the Roanoke story that finally now we’ve put an end to, but also there you see a North American team that inherited not necessarily successful story with Roanoke and to get with our legal team for what we were owed, and they ended up with a very good settlement. So construction is still down. Adhesives have very good momentum, but we’re committed on both our North American construction business and our consumer paints business in Latin America to improve performance.

Operator

Your next question comes from the line of Steven Schwartz - First Analysis.

Steven Schwartz - First Analysis

With respect to Asia, Jim gave a nice commentary on what’s happening there, but can you give us an idea of what part of that business is exposed to the Chinese stimulus because I know you do a lot of business in New Zealand and Australia as well?

Michele Volpi

To be honest, pretty limited because we’re not really into infrastructure which is where the majority of the money has been spent. We’re not into capital equipment. We’re not in really the basic materials, so a lot of this has been us doing a better job in the region, and let me say that’s not just on the top line nor on the margin enlargement. It has also been on the net working capital side because we’re also very happy and very proud of the cash generation that the corporate team has done, but also of the amazing work that has been done from an inventory standpoint and receivable standpoint in this tough environment, and Asia-Pacific which had hiccups in the present second quarter has really started hitting the ball right and getting very good inventory numbers and cash flow generations, so that means we can invest in the business.

Steven Schwartz - First Analysis

That is mostly being done then through like New Zealand and Australia, some of your larger end markets for that region?

Michele Volpi

No. We have grown in China, but it has been in the packaging and woodworking market that are really not benefiting a lot from the stimulus money of the Chinese government.

Steven Schwartz - First Analysis

Second question is on pension Jim. You mentioned making a $10 million contribution. What is your current position going into 2010 from an expense standpoint?

Jim Giertz

Just recall that our measurement date for pension was August 31 last year, so at the end of our third quarter, we measured all our pensions and then the next measurement date is the end of our fiscal year this year so it’s November 30th. We’ll measure at the end of the fourth quarter, so the first part of the answer is that we really don’t know because things are going to change between now and end of the fourth quarter in terms of the market value of our assets and discount rates that we have to use to assess the liabilities and so forth, so we’re not going to know for sure where we stand with our pension expense until after the end of the fourth quarter, and our intention would be therefore when we come out with our fourth quarter conference call in January that we will give you many more specifics about what’s going on with our pension plan in terms of funding but also the expense level that we’re seeing as we go into 2010. Now with all that I said as background, we were nearly fully funded in our US plans at our last measurement date. Clearly, we’re going to be less funded absent any other funding activity, we will be less funded when we re-measure at the end of the fourth quarter, and so on the face of it, that would indicate that our pension expense will increase somewhat in 2010 versus 2009. Part of that though I think you have to appreciate is that in 2009 in the US plans, our pension expense is actually an income item still due to other factors from prior year, so when I say our pension expense will be increasing, part of that is that we’ll actually be returning more to a normal condition where we actually be returning more to a normal condition where we actually have the pension expense in a year as opposed to an income item, so we’re working on various strategies for funding and how to manage the pension expense, and we are going to just have to roll all that together and give you more details when we come out with our fourth quarter in a couple of months.

Operator

(Operator Instructions) The next question comes from the line of Eugene Faerber - Longbow Research.

Eugene Faerber - Longbow Research

Just following up on raw material cost, you mentioned you expect low single digit increase sequentially in the fourth quarter. What are you expecting in terms year over year? You saw 15% decline in raw material cost in third quarter. You expect that to increase being more than 15% decline in fourth quarter or do you expect that decline to be lower on year over year basis?

Michele Volpi

Basically we would expect still a decline year over year, but clearly that decline to abate from third quarter level, so if we were at 49, 15% in the third quarter, we would end up being a bit lower than that number based on what inflation will do and also based on what our teams will be able to do in terms of monitoring that inflation both through negotiations and through reformulations, but it is clear that we will strive to maintain our margins at this high levels, but we will make sure that we do that without compromising customer relations.

Eugene Faerber - Longbow Research

Could you also provide what’s happening with raw material cost sequentially in different regions in Europe versus North America? I know last year when raw materials were increasing, they were increasing more rapidly in North America versus Europe. Is that something you’re seeing this time as well?

Michele Volpi

What I can tell you is that somehow there is not a major difference between the regions. We’re speaking of plus/minus one percent variance between the regions expected in fourth quarter. We’re speaking of the same, actually even less than that of what happened in Q3, so dynamics are pretty similar. Also because the process to address the raw material inflation has been similar, and there has been a lot of global knowledge sharing and collaboration, so I’m pretty happy with the grasp that the teams are starting to have on this, how they fight together with the sales and marketing guys and collaborate with the customers as well.

Eugene Faerber - Longbow Research

If I understand you correctly, currency is expected to be positive in fourth quarter for topline. Are you expecting positive benefit on the margin from currency as well?

Jim Giertz

I don’t think. Typically, there wouldn’t be any significant impact on margin from currency, but we would expect that year over year the currency effect for us will be positive in the fourth quarter just as it was slightly positive for us in the third quarter.

Eugene Faerber - Longbow Research

You announced leadership changes in Europe. What is your strategy there? What are your expectations from new leaders and also on Latin America and European business, what is it that you’re doing to turn that business around?

Michele Volpi

I think that with the new leaders we brought in from several companies in the last year and a half, we have gained a lot in terms of experience. We have found them to have the same values that we always had at Fuller, which is a very important heritage. Plus we have found very competent people. We have empowered them, and we’ll empower them even more. They have responded with a lot of accountability, and they have shown great leadership abilities in terms of building, developing, and growing teams below them, so the entire cultural change and the talent upgrade that we were speaking about and committing to in October ’07 at our investor conference here in Minnesota is happening, and clearly these people starting for instance with Jim Giertz, with Jim Owens, Barry Snyder and the individuals we have hired in Europe brought together with a wonderful development of talent we had already internally at H.B. Fuller is starting to give results in a very tough environment, so that’s why we are optimistic even if maybe the market is still down and that’s how we’re performing in this environment.

Operator

(Operator Instructions) The next question comes from the line of Rosemarie Morbelli with Ingalls & Snyder.

Rosemarie Morbelli – Ingalls & Snyder

Michele, you are making a point of concentrating on the EBIT margin which I’m assuming is more or less the operating income at the different region level. In the third quarter, North America hit 15.4%. First of all what is the outlook for North America, what is a reasonable goal for that particular business alone in terms of margin? What do you think you’re going to accomplish given what you have done in restructuring and in changing more or less the way you’re operating when the economy actually turns around?

Michele Volpi

First of all, let me clarify one point. I meant EBITDA instead of EBIT and that’s what we published in October ’07 because we want to make sure that we do what is right in terms of investments for growth, so that’s why we talked about EBITDA and not just EBIT. With that said, I think North America clearly so far this year has done a very good job at basically strengthening the profitability profile, getting back and even exceeding the 2007 levels when we met in Minnesota. Rosemarie, you remember that, and clearly the challenge for Jim and his team which is also what we committed to in October ’07 is to grow from the higher profitability profile achieved because it is clear that also growth will give us the leverage to manage better and more efficiently the assets we have, so clearly the focus is on growth. The commitment is on growth, and our intention is to post positive organic growth next year, absent any major turmoil in the economy, but I think we have started putting in place a machine that it is starting to hit on all cylinders.

Rosemarie Morbelli – Ingalls & Snyder

So are you saying that you are planning to invest in the North American business in such a way that you’re going to grow the topline, but the margin, the profitability is just about at the top? Is that what I am hearing?

Michele Volpi

Well, the truth is that we already started investing in the last 12 months, and that’s why you heard Jim speaking about the SG&A inching up is because there has been investment, and the investment has not been just in upgrading the organization. You know there are costs for important people, but a lot has been on training and on providing tools through the sales and marketing and to the technology team to deliver long-term sustainable growth which is what this company needs and it is what we are committed to.

Rosemarie Morbelli – Ingalls & Snyder

So it sounds as though the 15.4 is something that you guys are happy with and will probably stay there, if I am translating what you’re saying correctly. Now looking at Europe, Latin America, and Asia-Pacific, obviously the level is substantially lower. What would be a reasonable expectation when those businesses, and I understand you’re investing there as well, but when they go on all cylinders, is it reasonable to expect that it will reach the North American level or the expenses are such that it cannot reach the 15%?

Michele Volpi

Let’s separate Europe from Asia-Pacific and Latin America. I think in Europe, we have some of our best opportunities. Clearly on one side, it is much more complex from a geographic standpoint, cultural standpoint, regulation standpoint than North America because it is a collection of separate countries. We all know that, but I think that complexity is also a great opportunity. I think we’ll be able to address that in a very successful way. On top of that, in Europe, or call it EMEA as a region, we have also fast growing developing economies. We have Eastern Europe. We have North Africa and the Middle East which are part of that region, so I think great opportunities there, not only to improve the topline but also to improve the profitability, and I am extremely confident based on what our people are going to bring. Now as far as Latin American and Asia-Pacific, on top of what we said for Europe, there is clearly a critical mass point that we need to keep into consideration, and it is clear that those are two regions where even more than in the others we have to grow to really be effective to be profitable, so can we get? Looking really long term, I would like to have four regions that are of comparable size and are of comparable profitability. Now, how long it will take to get there is the real question, and we’ll talk about that over the next quarters.

Rosemarie Morbelli – Ingalls & Snyder

You talked previously about the growth being helped by new products being sold into new customers and with your old customers. What is the percentage of the new products revenues as a percentage of revenues, and you said you were not really happy with that particular level yet. Could you remind us where you’re last year, where you’re this year and what the goal is?

Michele Volpi

We’re always in the mid-20s. I think that in the last year because of the emergencies on the raw material side, the need to reformulate, a lot of focus has been on the tactical side to make sure that we were really having the right formulas, but I know that Barry Snyder is working a lot on the breakthrough innovation on platforms on new stuff. Clearly that takes time, and that requires investment which is what we have been doing, and that again is replacing the SG&A. What time they will take, I really cannot tell you at this point in time, but I am also very positive.

Rosemarie Morbelli – Ingalls & Snyder

Regarding the competitive landscape, now raw material costs are going up, you have been gaining market share. Do you feel that the competition has not become particularly disciplined in that there could be some kind of a price war as they do not raise pricing in order to get back the share you took away?

Michele Volpi

I can tell you what I have seen and what I have so far has been more disciplined behavior than in the past. As far as what will happen in the future I don’t know, but what I always tell my team is that we have to manage our own destiny and make sure that we don’t depend on competitors, and we have several levers to pull. I’m very happy that the teams are pulling all of them, and that’s why I’m confident.

Rosemarie Morbelli – Ingalls & Snyder

What do you mean by pulling leverage?

Michele Volpi

It means working on pricing and price is not just price increases, it’s alignment with cost to serve, it’s working on raw material negotiations with suppliers, it’s working on raw material reformulations, it’s working on efficiencies in the plant, so all of that is making sure that we get good gross margins but also that we balance the volume and price equation, and we don’t lose customers, and actually we grow with them as we see that we are gaining new business.

Operator

The next question comes from the line of Robert Patrick with Cardinal Capital.

Robert Patrick – Cardinal Capital

As you think about the capital on your balance sheet, the $180 million, how much of that is likely to be needed to support the growth that you’re expecting in the coming year?

Michele Volpi

First, I’m going to give a directional answer and then maybe Jim can maybe add something to that. When we spoke in October ’07 of investments for growth, we spoke both of capex, we spoke of acquisitions, and we spoke of investments in SG&A, and that’s exactly what we are doing. You look at the capex year to date, I think it’s around $15 million. We’ll end up maybe at $25 versus the original forecast of $30, but we’re doing all the needed investments, we’ll do more, but it is always going to be prudent, commensurate, and making sure that we invest. We don’t spend. We have really made a lot in terms of changing the culture here, making sure that everybody is accountable, and we’re pretty happy about that, and investment is not just capex, it is also in M&A. We all know the story of Roanoke, and I think everybody here is committed to make sure that when we make acquisitions, they are going to work better, and as I can see, the Nordic acquisition and the other acquisition are working pretty well so far.

Jim Giertz

The only thing I would add is that, Rob I think you remember that our balance sheet, our excess liquidity is typically offshore, so our excess cash is sitting offshore outside of the United States whereas our debt is in the United States. Hopefully, I’m also answering part of your question. That causes us some issues. Our balance sheet looks a little strange sometimes because of that. I think the good news is though that a lot of the capital expenditure plans that we have and some of the more aggressive growth plans we have are outside of the United States, so our excess liquidity that we have offshore does align with our growth strategy. For example where are we spending capital right now? It’s in China where we’re building a new facility. We’re adding capacity in Egypt for example and places like this. That’s where we are easily able to access our excess liquidity to fund projects like that.

Robert Patrick – Cardinal Capital

Michele, perhaps you could comment on how you see the M&A environment playing out over the next year generally within the industry in which you operate.

Michele Volpi

I think that lots of people got scared because of what happened in 2008 and 2009. I think some players are starting to understand that consolidation has its benefits, but I think it still requires some time, but I can tell you we’re working very actively on our pipeline and making sure that we have our relationships on the ground and we’re ready to capture what is right at the right price.

Robert Patrick – Cardinal Capital

Have you seen a narrowing of the spread between bid and ask for the properties that have come around or is it more that you have seen more properties coming around after a dearth of them being available for a year or so?

Michele Volpi

I don’t think we’re there yet, but discussions are starting to be a bit more rational, but I think it will still take one or two quarters to make sure that people come to that conclusion.

Operator

The next question comes from the line of Eugene [Faerber] - Longbow Research.

Eugene Faerber - Longbow Research

Could you provide a little bit more color on your main end markets and what are you seeing in those markets both in Europe and North America and whether stimulus is playing any role there, and your expectations for fourth quarter for those markets?

Michele Volpi

So far what I can tell you is all the stimulus money that has been really pumped into the market, some is still unfortunately into the books, and we have heard that both in Asia and in North America has been mainly into the infrastructure side. There has been some money that has been kicked into the automotive side, but as you know we divested our automotive presence two years ago, so really not a lot that has been hitting our business, so I would really call it as performance growth, the volume development of H.B. Fuller.

Operator

The next question comes from the line of Rosemarie Morbelli with Ingalls & Snyder.

Rosemarie Morbelli – Ingalls & Snyder

Is the $68 million in SG&A a new base in dollar terms on a quarterly basis going forward?

Jim Giertz

Let me take a step back and try to look at SG&A for the full year because there’s a lot timing issues in SG&A expenses which we referred to in our press release, but last year for the full year, our total SG&A spend was $255 million, and year to date, we’ve spend $192, so let’s just say that in the fourth quarter we again spend $68 so it remains at the level of Q3. That will put our SG&A for the full year at $260, so under that scenario, that’s a hypothetical scenario, we’ll be at $260 million for the full year versus $255 for last year, that’s a 4% increase.

Rosemarie Morbelli – Ingalls & Snyder

But it was really a lot lower in the first half.

Jim Giertz

Yes, and again a lot of that is timing. It’s how currencies play out, how the timing of our compensation accruals work and other factors. Now, is our spend level higher at the end of this year than it was at the beginning of the year? Yes. That’s because of what Michele referred to. It’s the active decision to invest in customer facing organization, but the sequential increase that we saw in SG&A looks more dramatic than what’s really happening in the core. First take a look at the year over year numbers for the full year which is a great comparison and then we’ll give you some more guidance at the end of the fourth quarter about what our SG&A spend will be next year as we finish laying in all of our plans for next year.

Rosemarie Morbelli – Ingalls & Snyder

Are you satisfied with your new inventory level? Is that getting low, do you think you can get it down some more? I know Michele made some comments, but I didn’t catch them all.

Michele Volpi

I think we had major hiccups in the first and the second quarter. I think we are correcting those, but I think that if we work well in terms of market segmentation and service level with customers, inventory still has some room for improvement, and I believe the actions we have put in place specifically in some areas are achieving fruition and will continue to be.

Rosemarie Morbelli – Ingalls & Snyder

My last question still links to the inventory, but this time as your customers, you have seen the demand growing, do you have a feel as to whether they are rebuilding their inventories to a certain degree or are they ordering by small amounts and actually selling them? If the demand is coming from their customers or are they just getting ready for when things pickup? Can you tell?

Michele Volpi

Actually, I think that this recessionary environment has given a good inventory management lesson to everybody, and I think that yes some inventory will come back, but some is gone forever because I think that companies out of necessity have learn to become more efficient.

Rosemarie Morbelli – Ingalls & Snyder

So you’re guess is that whenever you get an order, your customer is actually selling that amount as opposed to putting it back into inventory?

Michele Volpi

On a broad basis, yes.

Operator

It appears there are no further questions at this time. I’d like to turn the conference back over to Steve Brazones for any closing or additional comments.

Steve Brazones

Thank you everyone for joining us today for our third quarter conference call.

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Source: H.B. Fuller Company F3Q09 (Qtr End 08/29/2009) Earnings Call Transcript
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