Nalco Holding Q3 2009 Earnings Call Transcript

Call Start: 10:00

Call End: 11:03

Nalco Holding Company (NLC)

Q3 2009 Earnings Call

October 28, 2009 10:00 am ET

Executives

Mike Bushman - Division Vice President for Communications and Investor Relations of Nalco

J. Erik Fyrwald - Chairman of the Board, President, Chief Executive Officer

Bradley J. Bell - Chief Financial Officer, Executive Vice President, Treasurer

Analysts

PJ Juvekar – Citi

Jason Weiner - Deutsche Bank

Laurence Alexander - Jefferies & Co.

Brian Drab - William Blair & Company

Michael Harrison - First Analysis Corp.

Mark Gulley - Soleil Securities

Richard Hoss - Roth Capital Partners

Chip Moore - Canaccord Adams

Bob Court (ph) - Goldman Sachs

Richard Eastman - Robert W. Baird & Co.

Bogden Koberfield (ph) - West Elby Melon (ph)

Michael Boam - BlueBay Asset Management

Presentation

Operator

Good day, everyone and welcome to the third quarter 2009 earnings call hosted by Nalco Company. This call is being recorded. At this time I would like to turn the call over to the Division Vice President for Communications and Investor Relations of Nalco, Mr. Mike Bushman. Please go ahead, sir.

Mike Bushman

Thank you very much. Good morning and thank you for joining us for our third quarter 2009 conference call. Joining us today are Chairman and CEO Erik Frywald and Executive Vice President and CFO Brad Bell. Some of the information discussed today constitutes forward looking statements that are subject to certain risks and uncertainties. Our statements describing the risks associated with forward looking information is found on our website and on our press release which may also be found at nalco.com. Further background on our risk is available on our 10-K.

The information discussed today will include data that does not confirm with generally accepted accounting principles. Management believes the presentation of non-GAAP measures such as EBITDA, pro forma EBITDA, pro forma EPS, and free cash flow, provide investors with additional insight into the ongoing performance of our operations.

When necessary, accompanying schedules for reconciliation of such non-GAAP measures to the closest GAAP equivalent have been provided as attachments to our earnings release. After comments from Mr. Frywald and Mr. Bell we will open the call up questions. In order to let as many participates ask questions as is possible, we will restrict participants to one question with a clarification followup if necessary. We will then ask that participants re-queue in order to ask additional questions. We'll start with Mr. Frywald.

J. Erik Frywald

Thanks Mike. Good morning and thank you for joining us today. Let me start my addressing the global economic situation and how it impacts Nalco revenues today and going forward. Media attention is increasingly being drawn to stories about the end of the recession. From what we see, we agree that cyclically exposed customers have begun modest recoveries in several industries. These include metals, mining, paper, and some manufacturing and chemical markets. Other customers, particularly in food and beverage power, and hotel, hospital, and university-type business, did not decline as much, and so will grow more slowly in this recovery.

Geographically, Asia is leading the improving economic outlook, particularly India and China. I should point out of course that economies are referring from very low bases set at the end of 2008 and earlier in 2009. That means production comparisons are showing sequential, but not yet year over year, growth.

Like all companies, we have seen meaningful declines in business activity since the beginning of the year. In the third quarter though, this activity decline showed up fully in our organic growth comparison. It did so because price no longer provided noticeable favorability to the prior year period, an impact that had helped organic growth comparisons in the first two quarters of this year.

The bottom line is that we believe sequential revenue increases are a sign of the early stages of as low recovery. We see the market demand for our services starting to increase and believe we are at least maintaining share as we analyze account level and overall market data. In the fourth quarter we expect a return to year on year growth in Asia with the rest of Nalco following in 2010.

Now looking at our three segments during the quarter, we generated organic direct contribution growth in all three areas, and I am very proud of our team for that achievement. Productivity efforts enabled the success as organic revenues declined by 8% in energy services, 10% in water services, and 13% in paper services.

In energy services, Adomite was down 44% organically, reflecting modest sequential improvement from our efforts to diversity our geographic reach in this business. Both oil field services and downstream were down 3%. Many of our contractual arrangements in energy have a more index-like reaction on pricing to raw material cost moves. In addition, downstream faces declining refinery utilization rates that could hamper our sales progress the next couple of quarters.

In water services we gained good sequential growth in the mining and manufacturing markets, but overall sales were still behind very strong third quarter 2008 results. The rate of decline in paper services is becoming less unfavorable as paper production slowly recovers and it appears that we are gaining competitive share behind offerings such as OxiPro Deposit Control Automation Technology which is highly valued by our customers.

In this challenging environment we have clearly focused on the right priorities. Those that I outlined at the beginning of the year which include step changing our cost productivity capability, better management of the elements of free cash flow within our control and selective investment in the right geographic, technology, and segment growth platforms.

So let's talk about our productivity, cash flow, and growth results in more detail. Our team is doing a great job driving our Get Fit productivity initiative. There are three levels of impact we are driving: first, individual and small group decisions to control spending at the local level; second, department or larger group decisions to improve unit operating processes or close unnecessary assets; and three, corporate mega projects to transfer the company wide processes and capabilities.

Now, to help ensure the success of all aspects of this initiative, we put in place a productivity success payment incentive for all of our employees in lieu of merit increases this year. In the third quarter these efforts generated solid earnings performance through cost savings that captured $31 million in the quarter. This brings our year-to-date savings to $84 million and puts us on pace to deliver record productivity gains by year end that are nicely beyond our initial $100 million target.

Now we only count and report savings that are ongoing, and in 2009 we also had a serious push to obtain one-time savings. These savings helped this year, but require additional productivity work next year to hold those gains.

Now two mega projects that are just starting to get to the point of value delivery and will be important to how we perform in 2010 are helping us to hold our gains. One of these projects is designed to reduce administrative and other burdens placed on our sales force and free them up to spend more time calling on the right customers.

Twenty-three year Nalco Sales Leader Veteran John Alcorn (ph), who leads this effort, tells me he wishes he had taken this simple approach to improving our commercial efficiency and effectiveness before. Another mega project is in Phase II of our integrated business management effort led by 18-year Nalco Commercial Leader Veteran Al Benanadi (ph). This effort has dozens of individual products that include running our sales and supply chain in a disciplined, cross functional, holistic manner, rather than as separate silos. Another important element for this work is product line consolidation which helps simplify all elements of the supply chain.

Behind this integrated approach, Al is leading work to ensure we keep the right inventory to improve on-time performance at the same time we remove unnecessary inventory from throughout the global system. All of our P&L leaders, Dave Filtman, Steve Taylor, David Johnson, and Eric Melin, are personally accountable and very engaged in driving the success of products consolidation and business integration and translating them into hitting aggressive working capital reduction goals and that's paying off.

I should be clear that with product consolidation we are not eliminating proprietary differentiated technologies. We are instead moving customers off old technology and onto new better products. This obviously has important growth value.

For example, when customers use 3D TRASAR Cooling Water Technology, they are more and more satisfied with the value we deliver, and we benefit from significantly lower attrition levels with our best technology.

In meeting dozens of customers over the past 20 months, 3D TRASAR users all tell me that Nalco's ability to save them energy, water, and maintenance costs by automating control of their system on a realtime basis clearly differentiates us from all competitors.

So productivity efforts are in good shape for 2009 and leading into 2010. Free cash flow results are also outstanding. Generating free cash flow above the $142 million total in 2008 was a key priority this year and we are already way past that mark. Third quarter free cash flow of $134 million brings year to date achievement to a Nalco all-time full year record of $374 million. Working capital management gains continued to be important to our cash success. Year to date working capital controls have helped generate $91 million in cash from inventory and $98 million from receivables.

From a day's perspective, a 2.5 day reduction in DSO contributed $24 million of the $98 million in cash from receivables while a seven day reduction in day’s investment in inventory added $39 million of the $91 million in cash resulting from inventory.

Much, if not all, of the gains from working capital we will receive this year have already been captured and while we intend to make further improvement in days in our base inventory, gains here could be offset by inventory being built for a large energy services transaction scheduled for the first quarter of 2010.

Cash benefit of receivables improvement from a DSO perspective could be offset by further sequential business growth, however, I am confident that we are putting in place the right working capital management processes to enable us to improve 2010 performance in each region from a days of sale and days of inventory perspective.

Growth is a third critical priority so let me update you on the progress of our continued growth investments. In 2009 we limited growth investments to top priorities. We remain fully committed to China and India where we will soon have over a thousand employees, having added 140 employees in those two countries alone so far in 2009.

In the next couple of months we will open R&D centers in Shanghai, China and Pune, India, to increase our ability to serve Asia and strengthen our global technology development base.

I will be in Shanghai in early December to help officially open our new combination office, R&D center, and regional training center. This opening is a major statement to our employees, potential new employees, customers, and government officials, about our commitment and capability to serve this critical market.

The Middle East is also a very important growth geography for Nalco. Steve Taylor, who runs our global energy services business, recently relocated to Dubai to provide closer on the ground senior leadership to the + elements of our BRIC+ strategy. Steve's presence allows us to have the executive level presence needed to call on other leaders of Middle Eastern companies and governments, a critical element in being successful in this part of the world.

From a technology standpoint, our 3D TRASAR Cooling Water Technology continues to perform very well with year to date new unit sales nearly at the same level as in 2008, a strong achievement in these tough economic times. The value proposition for customers is strong. Dowel (ph), for example, a critical customer, has used 3D TRASAR Technology to reduce annual water consumption by 1 billion gallons per year at just their Freeport site, creating significant maintenance and energy savings for them as well.

Technology is also important to paper growth, led by successful sales of OxiPro Deposit Control Automation Technology. OxiPro is helping to attract new business. Nearly two thirds of our OxiPro sales are to accounts earned from competitors making this important technology to help us gain market share and drive margins. In energy services we have a significant number of new offerings coming to the market to support expansion in deep water, ultra deep water, the oil sands, and downstream markets.

Earlier this month, we opened a new integrated research & engineering center and headquarters in Denver for our TIORCO enhanced oil recovery joint venture with Stepan. The key point here is that despite the weak economy in 2009, we continue to invest in growth that will pay off in 2010 and beyond.

Now as we head into 2010, growth is taking a more prominent strategic focus, of course enabled by continued productivity and cash management work. Specifically, we are expanding efforts again tour BRIC+ strategy, our water automation initiative, our enhanced oil recovery technology that is starting to find favor at today's oil prices, our natural gas deliquification technology acquired last year, and our air protection technology from Nalco Mobitech that should return to good growth once clean air interstate and clean air mercury rules, that's CAIR and CAMR, that were vacated, are reissued by the administration.

I should note that we are working to develop advanced mercury control programs which are recently helping a Wisconsin power plant achieve 96% mercury removal from their scrubber wastewater stream. We have now proven our ability to take mercury controls to the low parts per trillion levels that can meet any proposed EPA limits. We are working on all phases of mercury control technology including using technology that recently received the R&D 100 award.

Now we need the clarity of environmental regulations to open markets for these important green technologies. In addition to internally generated new offerings, we continue to look at technology deals that would broaden our ability to deliver against our commitment to provide essential expertise for water, energy, and air. Stay tuned.

So to sum it up, we are maintaining our previously stated medium term objective. First, moving our real growth rate from a historic 3%-4% average up to a 6%-8% level as a run rate by the end of 2011; second, generating at least $100 million annually in productivity gains, and third, taking annual EBITDA margins up to our 20% goal level, and Brad will cover where we stand on that important EBITDA metric in his remarks.

Near term, as I said earlier, we expect continued sales gains as some of our most economically sensitive customers are regaining modest sequential production momentum. For Nalco, Asia should return to year on year growth in the fourth quarter with the rest of the company getting on this path in 2010. We are pleased with our gains in productivity and free cash flow and will continue to drive these in the fourth quarter.

Clearly however, we are working to return the business to delivering strong year on year revenue growth as we help our customers to save energy, reduce water use, increase production, and improve their results.

With those comments let me ask Brad to discuss our financial results and debt financing. Brad?

Bradley J. Bell

Thanks Erik. Well, as Erik said we're quite pleased with earnings and cash flow in the third quarter, particularly given the economic environment. Revenues are not what we would like for them to be, but are clearly expected to participate fully as the economies of the words begin to show improvement. Sales in the third quarter continued the sequential increase begun earlier in the year, but on a reported basis remained 14.2% behind the prior year period including a 9.9% organic sales decline, a 3.5% currency impact, and the balance mainly from the divesture of our finishing technologies business last year.

I would point out that comparisons of organic sales over the course of 2009 are a bit tricky. While the level for business activity has been softer this year than the last, it would not be accurate to conclude that the organic decline is accelerating. Remember that we initiated sizable price increases last year in response to cost pressures and those increases gained the greatest traction in the second half of 2008. As such, organic comparisons in the first half of 2009 are helped by year over year pricing gains, far more so than in the third quarter or later.

Erik spent considerable time on our productivity and cost takeout initiatives and these were evident in the gains we have made in margins in each of the businesses, most notably paper relative to last year, both in the quarter and year to date.

In addition to productivity gains, changes in the price-cost relationship helped to offset the impact of lower sales and the burden of lower production absorption. Despite revenues that were off $159 million nominally and $110 million organically from the same quarter last year, pro forma EBITDA of $190 million was up 4% nominally and 10% or $19 million on a organic basis.

Pro forma EBITDA margin in the quarter expanded to 19.9%, reflecting the strong productivity push across the company and around the world. As we noted in our earnings release, the quarter's result included a pension settlement loss in the amount of $20.6 million that we removed in deriving pro forma EBITDA.

This is an abnormally high non-cash charge associated with a couple changes we made in the quarter to the company’s US defined benefit plan. Briefly, the cash contributions made to the plan resulted in a funding status of 73% which is below the 80% threshold required by law in order to continue providing complete lump sum payments for the present value of pension benefits. With this change we saw an acceleration of some nearer term retirements tripping the threshold for which this settlement charge is required under the relevant accounting regulations.

The charge is non-cash in nature and represents the recognition of a pro rata portion for unamortized actuarial losses carried in the accumulated other comprehensive income component of shareholders equity. This settlement loss is included in our administration expense line of our income statement and explains the vast majority of the year over change in that line item.

The aforementioned 73% funding level results from our contribution $32 million to the US defined benefit plan in the quarter bringing year to date contributions to $50 million and completing our funding to that plan for 2009. As noted in our release, funding for all pension plans globally is expected to total $71 million this year, and through the third quarter we have completed $68 million of that amount.

In a second change we announced that we are transitioning those employees still in the US defined benefit program that was closed to new entrants in 1999 over to the company’s defined contribution plan for all service beginning January 1, 2010. Our pension plan changes reduce our risk profile and allow Nalco to establish more reliable funding programs for employee retirement needs. As we made these changes we carefully balanced our goal of incenting employees to contribute to our profitable growth goals while bracketing our ongoing cash exposures.

Moving down the P&L let me take a moment to explain what's going on in income taxes. Our tax rate in the quarter for book purposes was 45.3%, impacted by valuation allowances against deferred tax assets prompted by our European restructuring actions. At the risk of oversimplifying, when a restructuring charge produces an overall loss in a given country, you may have to take such valuation allowances and match tax benefit continuing losses until such time that it is clear the entity will return to profitability and be able to utilize such net operating losses.

As you're aware we've taken significant steps to improve our cost structure in Europe including major revisions to our manufacturing footprint there and headcount in both supply chain and sales organizations earlier in the year. We are further streamlining and standardizing work processes and fully expect a much improved profit position for the region.

As we do, those profits will show up effectively tax free by virtue of reversing the valuation allowances. Again, all of this is for book purposes and doesn't affect cash taxes.

This tax rate of 45.3% was 2.6 percentage points higher than last year's third quarter, the impact of which was about a penny a share in the current period. Last year's book tax rate reflected tax on the sale of our finishing technologies business unit which carried significant goodwill not deductible for tax purposes. We expect the rate in the fourth quarter of this year to be several points lower.

Bottom line, pro forma EPS amounted to $0.31 in the quarter as compared to a comparably computed $0.36 in the same period last year. Adjustments in rising pro forma EPS are the same as those for pro forma EBITDA and are individually quantified in attachment seven to our earnings release.

We were also pleased with the results of our focus on free cash flow producing $134 million in the quarter and bringing the year to date accomplishment to a historic high of $374 million. Cash on the balance sheet at quarter end exceeded $240 million and we plan to pay down a portion of our debt in the coming months.

Currently we are evaluating opportunities among the debt we have maturing in 2010 and in 2011 and we'll come back to you when we have finalized arrangements on the amount and specific timing of such repayments.

Presently net debt is down $247 million since the start of the year, despite a $29 million increase in the US dollar value of euro denominated debt. This year's cash generation gives us the ability to de-lever and to reduce our interest expense.

Year to date, sales are down 13.9% nominally to $2.74 billion, including declines of 6.7% organically, 6.2% due to currencies, and the remainder mainly from the September 2008 sale of our finishing technologies business.

Declines in paper, mining, primary metals, manufacturing, and well service business units over nine months largely drove this result.

Pro forma EBITDA stands at $469 million as compared to $508 million in the prior year period. Viewed on an organic basis, this EBITDA was flat to last year as our productivity efforts offset the negative impact of lower organic sales.

Year to date our pro forma EBITDA margins have increased by 110 basis points to 17.1%. Our year to date productivity achievement stands at $84 million against an annual goal of greater than $100 million, putting the company in position to exceed its previous annual productivity record by year end.

Pro forma diluted earnings per share of $0.61 are below the $0.89 achieved on a pro forma basis in the first three quarters of 2008. Restructuring charges, pension settlement accounting, costs for early extinguishment of debt, and a substantially higher tax rate incurred in the first nine months of 2009 drove down reported earnings per share to $0.16 through the first nine months this year compared to $0.92 in the divesture aided year ago period.

With that as background let's open up the call to questions.

Question-and-Answer Session

Operator

(Operator's Instructions) And at this we have a question with PJ Juvekar with Citi.

PJ Juvekar – Citi

Hi, good morning. Erik, it's refreshing to see such a strong focus on internal productivity improvement. My question is on Europe, with all the restructuring that you guys have done in that region, how is it paying off? Can you talk about where margins are today compared to where they were before and how do they compare with North America?

Bradley J. Bell

PJ, Europe has got its work cut out for it. We took a good size restructuring charge there in the fourth quarter of last year and another charge in the second quarter of this year. These got at our manufacturing footprint in the region, they got at resizing our sales force, and they got at the commitment we're making to paper or not making to paper and in various customer segments.

The plants that we provided for closure really are still operating and wont' be physically down until the end of this year. As you know that's a lengthy process with works counsels, et cetera, in that part of the world. So we are really not yet seeing the full benefit of this activity. You certainly saw it in the paper results. They were a contributor in that part of the world, but the manufacturing supply chain reorganization, et cetera, really is the 2010 implementation step.

J. Erik Frywald

But I think to add to that PJ, it's very important to understand that in Europe, as we talked about earlier in the year and last year, have cleaned up the back office issues that faced us. We've got a stronger leadership team in place and I believe poised to not only successfully get this restructuring behind us and get to the better margin position, but also to drive our market share position.

In fact, in the third quarter our sequential nominal sales growth in Europe was 8%. So we are starting to see not only some market lift, but I think our position is strengthening in Europe. So I am very pleased that we're getting our costs right sized for the market opportunity in Europe, but also our capability to deliver against the market benefits that Nalco can bring to our customer base is very strong and I think you'll see some very good performance from Europe going forward.

PJ Juvekar – Citi

Okay. And then just quickly on pension funding, Brad, you said it was 73% below the required by law which is 80% —

Bradley J. Bell

No, no. We have a US defined benefit plan which allows lump sum payments to retiring employees. The Pension Protection Act says to be able to do that you must have an 80% or better funding level. We are only at 73% so we're seven points shy and until we trip over the 30% funding level — the 80% funding level once again, lump sums are curtailed to only a portion of that person's benefit. They take the rest of the form in an annuity. So we're almost three-quarters funded, we've got a plan laid out we'd rather have a consistent $50 million or so ongoing contribution rate than subject the plan and Nalco's cash funding to the kind of whipsaws it has seen over the years, really since Suez bought the company and through private equity and then going public — we want something more predictable and obviously maybe one of the bigger impacts is the predictability of cash funding now that those participants are over in the defined contribution plan that the rest of us are in.

PJ Juvekar – Citi

Okay well, I'll follow up later on pension.

J. Erik Frywald

And just to be clear, that 73% funding was as of what date?

Bradley J. Bell

The funding date is a beginning of year number required by IRS and DOL.

Operator

And moving on we have a question from Jason Weiner with Deutsche Bank.

Jason Weiner - Deutsche Bank

Thank you, good morning. The clarification on some of the organic growth stuff is very helpful, thanks. I wonder just to further clarify; can you address maybe companywide volumes sequentially?

Bradley J. Bell

Volumes are a tough thing to think about in a service company because our customers typically get a bundled invoice that is chemical, it is services rendered on site, it is not the chemical company model where you're counting kilograms one period in compared to the next. We'd have significant mix shifts as we bring out better technologies. It might use less chemical, but bring more value to a customer. Even internally we haven't found that to be helpful in managing the company.

So I think the organic numbers we gave to you both year over year, et cetera, are a better way to look at what's going on inside Nalco really in any one of the segments.

J. Erik Frywald

But as Brad and I both referred to in our comments, when you strip out price, which was more favorable in the first than the second quarter, our organic level of business activity which is kind of a combination of service and volume declined year over year and were similar in the first three quarters. So we haven't seen a year over year drop, but what we have seen is the sequential beginning to improve in the third quarter.

Jason Weiner - Deutsche Bank

Okay, that’s helpful, thanks. Just to focus on paper for a moment where there was good improvement quarter to quarter in margins, I wonder are some of the new products you mentioned commanding better pricing and or are these margins a new level that's somewhat sustainable? How should we think about this 20% margin?

J. Erik Frywald

Certainly the new technologies come out with higher margins and we've focused on some of the higher margin business, particularly in Europe where we've made decisions about where to focus customer wise. So I think that plus the commitment to continue to drive productivity in that business, we will see ongoing good strong margins for that business.

Operator

And our next question comes from Laurence Alexander with Jefferies & Co.

Laurence Alexander - Jefferies & Co.

Good morning, I guess two questions. One is a question about the margin issue again. The target of a 20% margin and a mid-single digit growth rate has been around for awhile and given the restructuring efforts that you've been able to deliver and particularly the launch — sort of the greater data intensity or IT intensity of your business now, do you see any chance to structurally improve the margin profile beyond the 20% level?

Bradley J. Bell

Well, our goal is to get to the 20% EBITDA margin level on an annualized basis. We hit that in the third quarter, but we want to be able to deliver that over the course of the year. And as we have talked about it before, we see investing aggressively in the business while achieving that and holding that margin as our target.

Laurence Alexander - Jefferies & Co.

And secondly, and I realize it's a bit early for discussions on 2010, but any initial thoughts on the tax rate for the next couple of years?

Bradley J. Bell

Yeah. We're doing a lot on that front in terms of addressing our global configuration of businesses and how we finance and where we finance, et cetera, and some of the issues that get in our way. As I indicated, we expect the fourth quarter to be several points below this year and I would think that as we think about our 2010 and forward planning, we're kind of mid-30s like the rest of the corporate world looking more like statutory rates, et cetera.

Operator

And our next question comes from Brian Drab with William Blair & Company.

Brian Drab - William Blair & Company

Good morning, Erik. Good morning, Brad. First question just to followup on that tax rate question to be clear, in the fourth quarter, Brad, you're expecting the tax rate to be several points below which level?

Bradley J. Bell

Below the third quarter rate of 45.3%.

Brian Drab - William Blair & Company

And is that higher than the mid-30s that you expect for the long term just because of some additional restructuring related issues or what is it?

Bradley J. Bell

It probably starts with a four, Brian, and next year it'll hopefully start with a three and that is kind of what we are trying to signal here without getting carried away. Literally, until we have the business plan broken down by country, et cetera, it is a little hard to forecast, because we want to get into a position again where we can get out from having these valuation allowances and put noise in our book tax rate. So call it a mid-30s number next year and low 40s this fourth quarter.

Brian Drab - William Blair & Company

Great. And then next question on growth margin, this is obviously a strong quarter for gross margin because you've had the low cost raw materials flowing through at this point —

Bradley J. Bell

Brian, its more than that, it's a good portion of our productivity efforts that are aimed at better gross margins. It's how we operate the plants, it's the product line simplification — so I wouldn’t want people leaving the call thinking that gross margin is only what it is because of lower raws. There are a lot of internal efforts that show up there rather than other lines of the P&L.

J. Erik Frywald

And there's more to do on that productivity side. We've got a lot of programs going on to continue to deliver strong productivity in the fourth quarter and into 2010 so we're not, by any means, done with productivity. We're building the muscle to be able to drive cost productivity continuously and make it an enabler of growth.

Operator

And moving on we have a question from Michael Harrison with First Analysis Corp.

Michael Harrison - First Analysis Corp.

Hi, good morning. If I could just maybe continue on the gross margin front, was pricing versus raw material, was that a positive on a sequential basis benefit to gross margin?

J. Erik Frywald

Similar. There hasn’t been a radical change on a sequential basis.

Michael Harrison - First Analysis Corp.

Okay. And then I was also hoping that you could provide some more details on the large energy services transactions that you referenced that's coming up in 2010.

J. Erik Frywald

It's a piece of business that we'll supply in the first quarter and we're producing today. It's not going to make a material impact to that business for the full year next year that would be necessary to discuss today, but it's just a slug of business that we were predicting next year that's going to come early in the year and we need to produce for it today. It was offered up in the context of inventory level in the fourth quarter, building for that early 2010 delivery, that's all.

Operator

And moving on we have a question from Mark Gulley with Soleil Securities.

Mark Gulley - Soleil Securities

Hey, good morning, guys. Erik certainly noted the fact that in terms of hitting the breaks pretty hard some time ago in terms of cash flow and in terms of a lot of the initiatives, the success has been really pretty terrific. But as you have to take your foot off the break and hit the accelerator a little bit next year, which of the areas of productivity stay with us and which are you going to have to kind of relax a little bit? For example, perhaps the inventory or staffing levels, I mean those kinds of things.

J. Erik Frywald

Well first of all, I think we're, as I said, strengthening our productivity muscle. So we're not going to relax on achieving productivity targets. And the numbers that we shared with you today, the $31 million in the third quarter as an example, are going to be held going forward. So these are not numbers that are one time, these are ongoing. So I don't see us hitting the breaks in productivity, I see us continuing to push hard on productivity.

But the other side of your question is will we increase our investments in growth. First of all, we have made significant investments in growth this year and we'll continue to do that, but as we see great opportunities will we further increase our growth investment? The answer is probably yes in 2010. How much and exactly where we're figuring out now based on being very confident that those efforts deliver, but we're doing a lot last year, this year, to setup for higher growth in 2010 and beyond and we're focused heavily on making sure that those programs deliver in the marketplace with customers.

I think also to our efforts to drive productivity and cash flow, we're doing those in a way that I also think is strengthening our execution muscle and you get better at execution you've got better processes, you've got better connection of commercial and supply chain and different parts of the organization and R&D. You get better at delivering growth projects as well.

So I'm looking for us to continue to drive productivity at the kinds of levels you're seeing now, continuing to work working capital by driving days of inventory and accounts receivable down and at the same time using that execution capability to deliver on the growth projects that take longer to deliver, but should start to really play out in 2010.

Mark Gulley - Soleil Securities

Okay. And as my followup, it sure sounds like 3D TRASAR has been even more successful and a bigger opportunity than you imagined 20 months ago when you arrived. When do we begin to see some of the same kind of benefits on the boiler side?

J. Erik Frywald

Well, we launched boilers earlier this year in the water side in WPS. We will launch them at the end of the year for early first quarter in the energy side downstream. What I would say is that we're on track. We've got a few hundred units out there demonstrating the value, performing very well, the bugs are all worked out, and now we're ramping out and I think in 2010 we'll start to see significant numbers of 3D TRASAR units and boiler applications so very pleased with the progress.

But as I look at and visit customers and as I talk to our people and as I look at the 3D TRASAR benefits, obviously very pleased with the progress that we've made so far, but there's still a lot of cooling towers, a lot of boilers out there, a lot of reverse osmosis units that aren't using 3D TRASAR yet that should be and that's our goal, get them converted. Our customers (inaudible) which is getting fewer, but new customers as well, great technology.

Operator

And moving on we have a question from Richard Hoss with Roth Capital Partners.

Richard Hoss - Roth Capital Markets

Hi, Brad. Just quickly on gross margin again, sorry but looking for timeframe to approach the upper 40s as a percentage, what sort of top line revenue do we need to see to start — high end, 48, 49, that sort of thing?

Bradley J. Bell

Rich, I don't know if it's a top line revenue number because the drag from under absorbed production, et cetera, is not as big as it was when we began this year. We've done some things on the cost front that is showing up through productivity efforts in gross margin. Again remember, our business isn't the same kind of a large fixed cost infrastructure of a typical manufacturing entity.

More of our plants are blending and we're a more variable cost operation. So I think our gross margin is going to be more a function of what happens to oil prices over the next 18 months and when net starts to show up in raw materials we might be buying and what that means for demand for our energy products and our own pricing, for that matter. So this is less about fixed-cost utilization and more about oil costs showing up in raws.

J. Erik Frywald

What I can add to that, Rich, is as we expand our business around the world and as we look to grow aggressively in China and India and the BRIC+ countries, we are not relaxing our margin targets, EBITDA margins, or gross margin targets. So we have demonstrated and we believe that we should continue to target and drive for not reducing our global margins as we grow in these far flung parts of the world.

Richard Hoss - Roth Capital Markets

Okay. So that was going to be my followup with the assumption of increased contribution from China and India we don't see gross margin erosion, we see stability and just assume that the internal improvements that you make will continue to expand them?

Bradley J. Bell

Yes. Our margins are not dissimilar around the world and we want to keep it that way.

Operator

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

Chip Moore - Canaccord Adams

Hi, thanks. It's actually Chip Moore for John. I was wondering if you could talk about air pollution and some of the recent developments there, particularly internationally in China?

J. Erik Frywald

Sure. We’re making progress in China. The three projects that we've talked about before are all delivering good results that are starting to open up additional projects. It takes some time to demonstrate over a period of time the results that we’re targeting and to communicate that for a new project, but its happening. We've had some additional projects.

In Europe our focus is largely in Poland, but we're starting to see opportunities in other geographies and those projects are moving along well also to demonstrate our capability and open up additional projects. In North America the biggest challenge here has been not delivering on the projects and demonstrating value which we've been doing nicely, it's been the vacated regulations and the low knocks and socks credit market to buy the credit, the uncertainty in where the regulations are headed that has really dried up pretty much completely the new project work for the time being.

But we still continue to work with customers, there's demand for mercury technology for example that we're focused on, but we really need the regulations to come back into play before the North America market can really open up again. So that makes the global situation very difficult for now, but the technology is working, the projects that we've closed or are finishing are working, and we've got lots of confidence and optimism for the future.

Chip Moore - Canaccord Adams

Okay. And then real quick lastly on the carbon capture announcement with Argon National Labs, a fairly sizable award from the DOE, how aggressive are you going to be in pursuing technologies in that area?

J. Erik Frywald

I think we've got a great technology portfolio in development. We have some other proposals that have been submitted for potential research funding. Nalco is all about energy efficiency so there are lots of different ways to direct carbon capture technology and certainly other energy efficiency types of technologies are clearly on our radar screen. There’s a very good research team here that's focused in that area.

Just for those of you who haven't followed that closely, there were 37 projects awarded out of over 3,500 applications so we're very pleased with the fact that our technology project and our capability with our partner Argon was awarded that money.

Operator

And we have a question from Bob Court (ph) of Goldman Sachs.

Bob Court - Goldman Sachs

Hi, good morning. Erik, historically Nalco is a fairly nonvolatile company and had a lot of stability. You've obviously gone through a lot of volatility recently and brought a lot more measured focus on some cost containment. When do you think we get to a period where that stability returns and I think you mentioned maybe targeting a 20% EBITDA level, how far out in the future do we have to look to get to that sort of level?

J. Erik Frywald

Well, in the third quarter we delivered 19.9% EBITDA —

Bradley J. Bell

So we're getting close.

J. Erik Frywald

We're close, but we want to do it for a full year period and not just for quarter periods so we're making good progress there. The lack of volatility or the non-volatility historically has been due to the recessions being much milder, much less severe, and therefore customers cutting back production versus shutting down production.

The big change in this recession has been that it has been so severe, the worst one since the Depression as many describe it, that many customers, many industries, had a lot of facilities completely shut down and then were out of business. We don't sell anything when our customers shut down.

So I think the slow recovery, we'll see units start to come back and as long as the global economy continues to grow at a reasonable rate and we don’t have a huge recession like this of this magnitude, I would expect us to return to less volatility and more measured growth.

Bob Court - Goldman Sachs

Erik, would you argue then of those customers that didn't shut down you did have a reasonable amount of volatility and not the excessive that was caused by the full scale shut down?

J. Erik Frywald

I think our volatility mirrored our customers' shutting down volatility. Some of our business is process related, our refinery operations — little less than half is water and the other half is process. So a refinery reduces from 100% of capacity to 70% of our capacity, half of our business drops 30% and half of it is relatively unaffected with the water side.

So we do see some impact when economies slow down, when our customers slow down on the process side, but on the water side that doesn't happen unless the company, the customer, the plant site, shuts down completely. And we saw a lot more of that this time than we've ever seen before and hopefully that doesn't reoccur.

Operator

And moving on we have a question from Richard Eastman of Robert W. Baird & Co.

Richard Eastman - Robert W. Baird & Co.

Hi. My question pertains to the energy sector segment and I'm curious, getting my arms around the commentary that you had it sounds like there' sa little slowdown now on the oil field side. Adomite we know has been soft. As we roll into the fourth quarter, is the tone of business such that it overwhelms the seasonality that we typically see or should energy be higher seasonally into the fourth quarter?

And then I don't want to put a period there — just also I have a question on energy's exposure to Latin America and in particular Petrobras. Is that customer big enough to drive growth for that overall sector?

J. Erik Frywald

Let me take the Petrobras and the first question second. Petrobras was a minor customer for us for many years. We have strengthened our position with them both through stronger capability, rep capability, calling on them, and connecting our new and leading technologies. They're drilling for oil in new and leading edge areas and I believe appreciate the capabilities we bring to them, so important a customer that is becoming a material to our business and I think will be very important to us going forward.

In terms of what's happening in the energy business, the Adomite business will continue to be low with the low rig count in North America Gas although sequentially we did see some improvement in the third quarter because we are going beyond our North America focus in winning new customers in other parts of the world. That will help, but not fundamentally change the picture in Adomite until there's some improvement in the natural gas drilling in North America

Normally historically that's required natural gas being at about $5 over a reasonable period of time before that drilling starts again. There are some indications of some of that today, but we really need stronger natural gas prices for a period of time before we would see a significant turnaround in Adomite, but we're working to improve the picture.

On downstream you can read about the shutdown of refinery operations because of reduced demand in North America. Obviously that affects us when we have customers that shut down the refinery. Other units have slowed down. That does not hurt our water business. It obviously slows down our process side of our business with those refineries. So slow growth for us in the refining business as long as that's the case. We are doing well with new refineries that open up in other parts of the world and I expect us to continue to do that to offset some of this weakness.

On the OFC, the upstream side, we continued to do very well on CapEx. There is more CapEx coming on next year and in 2011 I think we will do very well there. So I think that over reasonable periods of time we will see continued solid organic growth in our upstream oil business.

Operator

And our next question comes from Bogden Koberfield (ph) with West Elby Melon.

Bogden Koberfield - West Elby Melon

Hello, I have one question. You said that you are working after repayment of debt for 2010-2011, is there a chance to see one of these replaced with a euro denominated bond?

Bradley J. Bell

Well, we do carry a certain amount of euro denominated debt in the capital structure today. We find an effective economic hedge against the operations we have in Europe which generate euro and the ordinary course of business and good profitability. If we were — I'm not sure we would want to keep a fair amount of our debt rather than make a change to that profile. So does that answer your question?

Bogden Koberfield - West Elby Melon

Yes.

Bradley J. Bell

We're at the hour so let's just take one last quick question.

Operator

And we have a final question from Michael Boam with BlueBay Asset Management.

Michael Boam - BlueBay Asset Management

Hi. It's a fairly simple one. I just wondered if you could give me a breakout of the debt balance at the end of the quarter. Obviously there's been some movement given the refinancing that was completed so I mean how much senior secured debt is there now, senior notes, et cetera?

J. Erik Frywald

At the end of the quarter there's $167 million remaining outstation on the Term Loan D from 2003. There's $750 million of a leveraged loan to Term Loan D from May of this year. There's $190 million of US dollar notes, 7.75 due 2011. There are roughly $292 million of zero dominated 7.75 notes due 2011. There's $489 million of new senior notes. There's $465 million of the old (inaudible) due 2013 and there's $292 million equivalent, again euro denominated 9% notes due 2013, and there were $462 million value of the 9% senior discount notes.

Michael Boam - BlueBay Asset Management

Okay, great.

Bradley J. Bell

If we can close the call now?

J. Erik Frywald

Why don't I just make a quick comment here on the ery difficult economic conditions that we've been working our way through. I am very proud of our leadership and Nalco employees around the world of how we've been able to step up and drive productivity and cash flow during ti difficult environment in a way that's putting in place the sustainable processes and capability to continue to drive cost productivity and cash flow. I am also pleased with the growth investments that we've been putting in place and am very anxious or very much looking forward to turning those growth investments back into year-on-year revenue growth for our company in 2010. Thank you.

Operator

That does conclude today's conference. Thank you for our participation.

Copyright policy: All transcripts on this site are the copyright of Seeking Alpha. However, we view them as an important resource for loggers and journalists, and are excited to contribute to the democratization of financial information on the Internet. (Until now investors have had to pay thousands of dollars in subscription fees for transcripts.) So our reproduction policy is as follows: You may quote up to 400 words of any transcript on the condition that you attribute the transcript to Seeking Alpha and either link to the original transcript or to www.SeekingAlpha.com. All other use is prohibited.

THE INFORMATION CONTAINED HERE IS A TEXTUAL REPRESENTATION OF THE APPLICABLE COMPANY'S CONFERENCE CALL, CONFERENCE PRESENTATION OR OTHER AUDIO PRESENTATION, AND WHILE EFFORTS ARE MADE TO PROVIDE AN ACCURATE TRANSCRIPTION, THERE MAY BE MATERIAL ERRORS, OMISSIONS, OR INACCURACIES IN THE REPORTING OF THE SUBSTANCE OF THE AUDIO PRESENTATIONS. IN NO WAY DOES SEEKING ALPHA ASSUME ANY RESPONSIBILITY FOR ANY INVESTMENT OR OTHER DECISIONS MADE BASED UPON THE INFORMATION PROVIDED ON THIS WEB SITE OR IN ANY TRANSCRIPT. USERS ARE ADVISED TO REVIEW THE APPLICABLE COMPANY'S AUDIO PRESENTATION ITSELF AND THE APPLICABLE COMPANY'S SEC FILINGS BEFORE MAKING ANY INVESTMENT OR OTHER DECISIONS.

If you have any additional questions about our online transcripts, please contact us at: [e-mail]. Thank you!