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Ashland Inc. (NYSE:ASH)

F1Q10 (Qtr End 12/31/09) Earnings Call Transcript

January 26, 2010 9:00 am ET

Executives

Eric Boni – Director, IR

Lamar Chambers – SVP and CFO

Jim O'Brien – Chairman and CEO

Analysts

Amanda Sigouin – Jefferies

James Sheehan – Deutsche Bank

Mike Sison – KeyBanc

Mike Harrison – First Analysis

Dmitry Silversteyn – Longbow Research

Lawrence Jollon [ph] – Barclays Capital

Steve Velgot – SIG

Operator

Good day, and welcome to the Ashland Incorporated first quarter earnings call. Today’s conference is being recorded. At this time, I would like to turn the conference over to Mr. Eric Boni. Please go ahead, sir.

Eric Boni

Good morning. Thanks, Brendon. Welcome to Ashland's first quarter fiscal 2010 conference call and webcast. We released our results for the quarter ended December 31, 2009 at 6:00 Eastern Time today, and this presentation should be viewed in conjunction with the earnings release. These results are preliminary until we file our 10-Q in February.

With me here today are Jim O'Brien, Ashland's Chairman and Chief Executive Officer; and Lamar Chambers, Senior Vice President and Chief Financial Officer. Before we start, let me note that as shown on slide two, forward-looking statements as defined in Securities Laws may be made during this presentation. We believe any such statements are based on the reasonable assumptions, but we cannot assure that such assumptions will be achieved.

Please turn to slide three. Please also note that during this presentation we will be discussing adjusted pro forma results. We believe these adjusted pro forma results enhance understanding of our current and future performance are reflecting certain key items and the impact of the Hercules acquisition completed November 13, 2008, about six weeks into our fiscal 2009 first quarter and the related accounting effects from that acquisition.

Our first quarter 2010 highlights are shown on slide four. We continue to be encouraged by Ashland’s profit improvement in spite of the generally challenging, but slowly improving demand environment. Overall, we earned $0.97 per share from continuing operations. When adjusted for key items, which I’ll discuss in a moment, EPS was $0.89.

As compared with the 2008 December quarter, our adjusted pro forma EBITDA increased more than 50% to $226 million. Ashland Consumer Markets, which is our Valvoline business, and Hercules Water Technologies posted record EBITDA for Q1. We generated free cash flow of $8 million during the December quarter.

Free cash flow was significantly affected in the quarter by a $101 million use of cash for trade working capital due to customary year-end payment practices by both Ashland and our customers. We typically see the favorable offset to this in the September quarter, as we did last year. Thus the December quarter is typically, by far, our weakest cash flow generating quarter.

Normal seasonality would indicate volume declines of 5% to 10% in the December quarter as compared with the September quarter. Most of our businesses did a little better, or in Ashland Performance Materials and Water Technologies cases, a lot better, continuing to suggest some modest improvement in the underlying end markets that we serve.

I would note, seasonally, March quarter volumes are typically flat with or slightly above the December quarter. Through our aggressive cost-cutting efforts initiated early in the recession, we have positioned Ashland to perform well in an improving demand environment.

We have achieved $405 million of run rate cost reductions exceeding our target of $400 million for our cost reduction program. During the December quarter, we recognized $92 million of savings in the income statement, which is $59 million greater than the savings achieved in the December quarter of last year. Of the incremental December quarter savings, $34 million was attributable to reductions in SG&A expenses versus the prior year quarter.

Please turn to slide five for key items affecting our income. For the December 2009 quarter, discrete tax items primarily related to certain foreign tax contingencies benefited earnings by approximately $6 million or $0.08 per share. In the year-ago quarter, we had a number of key items totaling $1.98 per share primarily related to the Hercules acquisition in November.

In addition, the results of the Hercules business prior to the closing of the transaction would have added $24 million of operating income or $0.11 per share to adjusted pro forma results in the prior year quarter. Both periods included non-cash intangible amortization expense, primarily the result of the Hercules acquisition. These charges amounted to $0.15 per share in the 2010 fiscal first quarter and $0.12 in the 2009 quarter. Also, during the 2010 fiscal first quarter, we recognized income from discontinued operations of $0.13 per share, primarily related to adjustments to Ashland asbestos insurance receivables.

Please turn to slide six for our adjusted pro forma EBITDA chart. For the December quarter, our adjusted pro forma sales declined 10% versus the year-ago quarter to $2 billion. As you may recall, it was in November of 2008 that we experienced the step-wise drop in global demand. Thus the latter half of the quarter marked the beginning of the easier year-over-year comparisons.

Gross profit as a percent of sales increased 530 basis points above prior year to 24.1%. Our SG&A expenses decreased 2%. Operating income nearly doubled to $146 million and EBITDA rose 54% to $226 million due to continued price and cost management. EBITDA was essentially flat on a sequential basis in a seasonally more difficult quarter. Our EBITDA margin increased by 460 basis points over the prior December quarter to 11.2%.

Please turn to slide seven for our EBITDA bridge. Our EBITDA bridge shows the factors affecting our comparisons for the first quarter of fiscal 2009 and 2010. By far, margin improvement was the primary driver of our increased EBITDA. Lower raw material costs and reduced manufacturing expenses were the main contributors.

The year-over-year volume and mix comparison was up slightly driven by both improving volume comparisons and better mix. This eliminates the key factor that has been negatively affecting comparisons over the past year. SG&A expenses, excluding the effect of currency translation and divestitures, declined by $12 million versus the prior year quarter.

I’ll turn the presentation over to Lamar Chambers to discuss Ashland’s business results, starting with Functional Ingredients on slide eight. Lamar?

Lamar Chambers

Thank you, Eric, and good morning. Functional Ingredients generated improved profitability during the December quarter despite the mixed global demand environment. Metric tons sold declined by 16% versus the year-ago quarter, although the decline was only 6%, excluding volume from the prior year period associated with the renegotiated supply contract in the oilfield sector, as we had mentioned in our March quarter of 2009 call.

The construction business continued to be weak with volume down 20% versus the prior December quarter. The energy and specialties business has experienced improved volume, as natural gas rig counts in the US were about 30% above the trough levels experienced in June, although they are still 35% below December 2008 counts. In comparison, the volume for our energy business was down 20% versus the prior year quarter, but up more than 25% from the trough.

As a result of the improving volume situation, we are anticipating restarting our Dalton, Georgia facility by the end of the March quarter to provide additional guar capacity primarily for the energy market. Regulated markets grew volume 8% as compared with the year-ago quarter, largely driven by the personal care sector and included growth in the CMC, HEC, (inaudible) and guar product lines.

Volumes in our coatings additives business climbed 13% last year as our new product introductions continued to generate substantial business. This increase was also supported by growth in HEC volume. With this continued growth, we look forward to the additional 10,000 metric tons capacity that our new Nanjing, China plant will produce when it begins operations, which we expect to occur by the end of the calendar year.

Regionally, Functional Ingredients had plus-30% volume growth in Asia-Pacific and Latin America, while the more mature markets in Europe and North America declined 13% and 20% respectively. In addition to capital investments in Functional Ingredients, we continue to fund new product developments. New products represented 23% of total sales during the quarter. Overall, sales for Functional Ingredients declined by 9% versus the prior year quarter.

Gross profit as a percentage of sales increased by 470 basis points over the prior year quarter as the business continued to better manage plant utilization and thus fixed cost absorption. SG&A expenses were 5% above the year-ago quarter, due to additional intangible amortization. Overall, Functional Ingredients’ EBITDA increased 10% to $54 million in the December quarter and represented 25.7% of sales, a 450 basis point improvement over the prior year quarter and a 210 basis point improvement sequentially.

Please turn to Functional Ingredients EBITDA bridge on slide nine. As the EBITDA bridge shows, favorable mix was able to offset volume declines for the quarter. Margin improvement led by favorable raw material costs drove the higher EBITDA versus the prior year quarter.

Now please turn to slide ten for Water Technologies results. We continue to be encouraged by Water Technologies, improving volume, gross margin, and EBITDA performance. Although sales declined 6% versus the year-ago quarter, volumes were flat. As a reminder, we sold our former Drew Marine business during the September quarter.

Our growth markets, which include such markets as tissue and towel packaging and mining, had sales growth of 6% year-over-year, while our base business was down 3%. And our remaining markets were flat, excluding the marine business. Regionally, sales in Latin America and Asia-Pacific, also excluding marine, increased greater than 10% versus the December 2008 quarter, while Europe grew 6% and North American sales declined 5%.

At 36.6% of sales, gross profit improved by 660 basis points versus the year-ago quarter, primarily due to decreases in both raw material and manufacturing costs. The growth in gross profit percentage was broad-based and included significant increases in nearly all markets and regions.

EBITDA increased by 85% to $63 million in the quarter, representing an increase of 700 basis points to 14.2% of sales. And sequentially, in spite of seasonally lower sales and the divestiture of the higher margin marine business, Water Technologies maintained this EBITDA margin. Excluding marine, EBITDA increased substantially in all regions versus the prior year quarter.

Let’s move to the EBITDA bridge for Water Technologies on slide 11. Please note that the other section of this bridge chart largely reflects the EBITDA impact of the Drew Marine divestiture along with several miscellaneous items. Thus improvements in items such as SG&A expenses exclude the changes that occurred as a result of this divestiture.

With that in mind, the increase in margin was a primary driver of the EBITDA increase during the quarter. Reductions in SG&A primarily due to integration savings and reduced travel expenses provided $6 million of additional EBITDA, excluding currency translation. Currency translation resulted in a $5 million positive impact to earnings.

Please move to slide 12 for Performance Materials results. We are seeing broad-based evidence for early optimism for our Performance Materials business. Pounds per shipping day declined 7% versus the prior year quarter, however volume did increase sequentially by 3%. Of particular note, volume for the month of December was 12% above prior December, as customer shutdowns were more typical with historical norms as compared with the extended shutdowns experienced in December 2008.

Our North American volume was down 12% versus the year-ago quarter. Our European volume was flat, and Asia-Pacific grew by greater than 30%. Our automotive business appears to have reset at levels more consistent with annual US life vehicle sales of 11 million units, though we have not as of yet experienced any significant additional increase over this higher level.

Recreational vehicle market has clearly improved, and increases are roughly 20% above trough levels. Even with these increases, the RV business is still 50% below peak production levels. Similarly, the marine market is forecasted by some to increase as much as 70% to 90% above 2009 production levels, but still remains substantially below peak. In particular, we are starting to see some evidence of these market improvements in our marine and transportation segments, with volume increasing in the 7% to 8% range sequentially.

Sales declined 16% versus the year-ago quarter, as average selling prices were about 14% below prior year. Gross profit as a percent of sales increased 250 basis points versus the December 2008 quarter, due primarily to reduced manufacturing costs resulting from previously announced plant shutdown. SG&A expenses improved by 9% versus the year-ago quarter as a direct result of the cost reduction action Ashland has taken over the past year. Performance Materials’ EBITDA increased by 17% versus the prior year quarter to $21 million and represented 7.7% of sales, an increase of 210 basis points.

Please turn to slide 13 for Performance Materials’ EBITDA bridge. Improved volumes in international markets were not enough to overcome weaker year-versus-year North American transportation and construction volume. However, SG&A improvement to nearly $7 million, excluding currency translation, more than offset this volume decline. These improvements largely reflect headcount reductions, lower travel expenses, and lower bad debt expenses.

Now let’s turn to Consumer Markets on slide 14. Consumer Markets achieved another solid quarter with profitability comparable to the seasonally stronger September quarter. Lubricant volume increased 22% over the prior year quarter. And you may recall that in this quarter a year ago, volumes were up 17% primarily due to declines in the Do-It-For-Me market’s installer channel. On a sequential basis, lubricant volume was down a seasonally typical 5%. Sales increased 3% above the prior year quarter, as the effect of higher lubricant volumes was partially offset by selling prices that were below prior year levels.

Gross margin improved from 21.8% a year ago to 33.9% in the December 2009 quarter. It was 160 basis points below the September quarter. The gross margin decline from the September quarter was a result of higher raw material costs, partially offset by higher selling prices beginning in November. While all of the price increase is being achieved, the effective date typically lagged, which is why our December quarter results don’t include the full benefit of the increase.

In addition, our Do-It-Yourself branded and packaging business were a smaller percentage of total sales than they were in the peak summer months. This change in mix adversely affects margins. As a reminder, reductions in margins in our very price competitive private label business are unfavorably affecting Consumer Markets’ overall gross profit percentage by approximately 1% of sales starting with the December 2009 quarter.

SG&A expenses increased by 10% versus the December 2008 quarter, primarily from higher advertising expenses and currency translation, but were down 8% versus the September quarter. Earnings improved in all of the Consumer Markets lines of business and in all geographies versus the prior year.

As a result, EBITDA nearly tripled to $76 million for the December quarter, with only slightly less than the $79 million reported in the September quarter even with seasonally lower volumes. Let me note that this is the fourth straight quarter that EBITDA margins have been above 18%.

Slide 15 shows Consumer Markets’ EBITDA bridge. As you can see, both volume and margin improvement drove earnings growth versus the prior year December quarter. And Valvoline Instant Oil Change continued to show growth with same-store sales up 4%.

Now let’s move on to Ashland Distribution on slide 16. Distribution’s volume per shipping day decreased 8% versus the prior year quarter, but only 3% when we include volume related to the termination of our aliphatic hydrocarbons distribution arrangement with Marathon in the March quarter.

Volumes in our chemicals business declined 8% on that same basis. Meanwhile, plastic volumes grew 6% due to the strong growth in Europe. Sequentially, overall volumes were down only 4%, adjusting underlying demand improvement and taking seasonality into account. Month of December volume was only 1% below prior year level.

Sales dropped by 15% versus the year-ago quarter and 5% sequentially to $729 million, as average selling prices were 11% below the same quarter last year, although up 1% sequentially. Gross profit as a percentage of sales was up slightly, both sequentially and versus the prior year quarter, aided by improved mix.

SG&A expenses declined by 5%. As previously announced, cost reduction initiatives were partially offset by a $2 million swing in bad debt expense and $1 million in currency translation. Overall, EBITDA was down 28% versus the prior year quarter, although up slightly sequentially.

Now please turn to slide 17 for Distribution’s EBITDA bridge. During the quarter, SG&A expense reductions were not enough to fully offset the impact of the 8% reduction in volumes.

Now please turn to slide 18, and I’d mention a few corporate items. In recognition of the improvements in our balance sheet and improved cash flow performance, our corporate credit ratings are now Ba2 with a stable outlook from Moody’s and BB-flat with a stable outlook from S&P.

Our debt-to-EBITDA ratio was calculated for bank covenant purposes just 1.6 times versus our covenant performance of 3.5 times. Our $1.6 billion of debt carried a book interest expense of approximately $175 million annual. We currently anticipate refinancing our debt in the March quarter and would hope to be able to lower our annual book interest expense by $30 million to $40 million.

Capital expenditures were $21 million for the quarter. Typically, our CapEx spending increases during the spring and summer months. As a reminder, our total CapEx forecast for fiscal 2010 is $200 million. During the December quarter, we sold another $44 million worth of our auction-rate securities at 89% at par. We have $126 million of book value of these assets left.

Our expectation for our full year 2010 tax rate is in the low-to-mid 30% range as opposed to the 28% implied tax rate on our earnings in the December quarter. As a reminder, events and developments related to contingent and other tax matters in any given quarter can cause us significant fluctuation in the effective rate for that quarter. For example, we are in the process of completing a business restructuring in our European operations and would expect to recognize discrete tax expenses set in either of the March or June quarter as a result.

As we announced in December, we have reached agreement to sell the Pinova wood rosin and terpenes business for $75 million, including $60 million in cash and a $15 million promissory note from the buyer. We expect the transaction to close during the March quarter. As a reminder, we also contributed $100 million of Ashland’s stock for our pension plan in early November. This contribution reduced both future funding requirements and pension expense.

Our fully diluted shares outstanding at the beginning of January totaled approximately 80 million shares. As Eric mentioned earlier, we have achieved our $400 million cost reduction target. Incremental benefit to earnings in the December 2009 quarter versus the year-ago quarter was $59 million, including $34 million of SG&A.

In the upcoming March quarter, we should have approximately $30 million more in savings than we achieved in the year-ago March quarter, which included one-time savings from our furlough program. Similarly, we estimate $10 million to $15 million of incremental savings in each of the June and September quarters as compared with savings achieved in the respective prior year quarters. We do not expect additional significant savings in fiscal 2011.

With that, please turn to slide 19, and Jim O'Brien will conclude.

Jim O'Brien

Thank you, Lamar. I’m generally pleased with the work our team has been accomplishing to position Ashland to perform well through the cycle. Each of our businesses will face different opportunities in the coming quarters. To provide some better visibility into our longer-term view of expectations for our business, the slide you see here also presents our targeted mid-cycle EBITDA margins by segment.

I expect Functional Ingredients to maintain its EBITDA margins in the 25% to 27% range, consistent with our targeted mid-cycle performance. In the near-term, we have obtained some new business at lower gross margins and expect some higher raw material costs. We expect the addition in volume to help us maintain current operating margins, as we better utilize plant capacity. In addition, we see further growth from regulated industries and the coatings additives business while we continue to improve the profitability of the construction business by managing our fixed costs.

My expectations for mid-cycle EBITDA margins for Water are 16% to 18%, which is several points above where it is today. Most of the cost-cutting for this business has already occurred, although there is still a little left related to finishing the last steps of integration.

Most of the margin improvement should occur with improved volumes, product mix, and end-market focus, combined with continued pricing and cost management. In the shorter-term, we have been generally pleased with the renewal process for calendar year contracts and believe these contracts will be neutral to slightly positive to margins. Raw material increases will likely provide some headwinds in the coming quarters.

Our Performance Materials business has the most leverage to the upside on a percentage basis of any of our businesses. I expect the mid-cycle EBITDA margins for Performance Materials will be in the 12% to 14% range. This will require a fair amount of volume to return.

As Lamar mentioned, we are seeing early positive movements in markets such as automotive, marine, and recreational vehicles, but they are still 30% to 50% below peak. Assuming the volumes improve incrementally as has occurred in the past several quarters, we would expect similar incremental improvements in March. While this business has been experiencing rising raw material costs, we expect our price increases to recover these additional costs.

During the past year, we have seen a step-wise change in the profitability profile of Consumer Markets. With the plus-18% EBITDA margins we have achieved in the last four quarters, we believe we are starting to demonstrate the longer-term potential for the business as compared to the historical norms.

While it’s still difficult to settle on a long-term view for margins due to the number of variables, my expectation is that the business should be an upper teens EBITDA margin performer. In the short-term, as you may be aware, we have received a base oil increase of approximately $0.20 announced earlier this month. The $0.20 increase in base oil represents approximately 2% of sales for Consumer Markets. This is a real cost increase to the business. And I expect the business to recover these costs.

Ultimately of course, any price increase is determined by the marketplace. As a reminder, the lag between cost and price increases creates a temporary margin compression. All of that said, we expect Consumer Markets fiscal year 2010 results to be close to fiscal 2009 record results.

Our mid-cycle goal for EBITDA margins for Ashland Distribution is 4% of sales. Increased volumes, as the economy recovers, should lead to better absorption of fixed cost in this business. Distribution has seen improved volumes, which appear to have stabilized at lower levels in the automotive and marine markets. We have seen significant cost increases, many in the 8% to 14% range from our suppliers this month that have been passing those through.

With that, please turn to slide 20 for a summary of our investment opportunity. The underlying economic environment appears to be improving for the markets we serve, even if the improvements haven’t been dramatic. Our own volumes have been slowly recovering for the last several quarters when you adjust for seasonality.

If there is a negative on the horizon, it is likely to be raw material costs. I expect our organization to be aggressive and implementing price increases where appropriate. We have developed the systems to process and the skills to apply our collective market knowledge and manage price and profitability effectively.

Our continued emphasis on pricing and cost management should create operating leverage to support with the increased profitability and growth as the economy recovers. But improving Ashland’s profitability is only one of our financial objectives. We must also continue to produce free cash flow. Effectively deploying the cash that we generate, whether for internal growth, small to medium-sized acquisitions, or return of capital to shareholders, has to create an attractive return on investment and value for our shareholders.

Our businesses are all positioned to capitalize on stronger volumes. We have eliminated more than $400 million of costs from our business, with two-thirds of these reductions permanent. We will continue to aggressively manage our cost structure as the economy picks up. We believe we are starting to demonstrate our ability to generate the consistent earnings, gross margins, and cash flows indicative of specialty chemical companies. When you consider these strengths along with our demonstrated financial discipline, I believe Ashland makes and excellent investment opportunity.

Eric Boni

Brendon, can you please open the line up for questions?

Question-and-Answer Session

Operator

Yes. (Operator instructions) And we’ll go ahead and take Laurence Alexander from Jefferies as our first question.

Amanda Sigouin – Jefferies

Hi, good morning. This is Amanda Sigouin in for Laurence.

Jim O'Brien

Good morning.

Amanda Sigouin – Jefferies

On working capital, if we look out to 2010, how do you see your ability to manage on working capital turns this year?

Lamar Chambers

We believe that we – we know we’ve made a lot of progress in the areas of working capital efficiencies improvement, and our cash flows over the last couple of years certainly reflect those improvements. We are continuing to focus very heavily on that area in terms of minimizing the cash we put into our receivables and inventories, of course managing our payables as well. We think there is opportunity for a little bit of further improvement in our metrics, as we measure it, relative to the level of sales of the business, although the significant progress we’ve made in the past couple of years now has us turning our focus to maintaining that progress and ensuring that as our revenues come back and our top line grows if we don’t grow our working capital disproportionate to that.

Amanda Sigouin – Jefferies

Okay. And then just one other if I may. Could you please give us an update on where we are with the divestiture program?

Lamar Chambers

We have previously announced, as you may recall, that we had several small to medium-size businesses that were not strategic to our core portfolio of businesses and that we would consider opportunities to monetize those small to medium-size businesses as the market made those opportunities attractive. We have concluded on some of those. Most recently, the Drew Marine business that we sold in the fourth quarter of last year, the Pinova business that we expect to close this quarter and some other smaller businesses that have occurred over the past year. There are additional businesses that would fit that category, but the opportunity to close those that are attractive values has to be present. So we’d want to predict the likelihood of other specific transactions. We’ll say that we continue to explore opportunities to monetize those at attractive values.

Amanda Sigouin – Jefferies

Thank you.

Operator

Thank you. Our next question comes from James Sheehan with Deutsche Bank.

James Sheehan – Deutsche Bank

Thank you. Good morning.

Eric Boni

Good morning, James.

James Sheehan – Deutsche Bank

On lubricant oil, manufacturers have announced some price increases along the lines of 6% to 10%, recovering these increases in day’s oil. And I was just wondering if you anticipate making similar price increases in Consumer Markets, and what gives you the confidence that you will be able to implement these price increases you recovered at high base oil cost?

Jim O'Brien

The announcements, as you have described, have indeed taken place. And it’s basically a reflection of the refinery – how to run the refinery and the tightness in the base oil marketplace. So as a consequence, these are real costs that are being passed on to us and we will push very hard to get these passed through in the marketplace that we participate in. Now, it’s never easy and sometimes it may take several months to get them through. But as we approach our Valvoline business, these are real costs and therefore there has to be real recovery in the marketplace. So my expectation is that they will work very hard to get these passed through.

James Sheehan – Deutsche Bank

Okay. Also you made some comments on a variety of segments that raw materials are probably heading up in 2010. Could you sort of specify what the largest raw materials are that you are referring to that you think are going up this year?

Eric Boni

James, as you look at our businesses, we have a – certainly have a variety of different raw materials that could impact. But some of the key raw materials that we have been seeing some pretty significant increases on as of late. Styrene is certainly one of them that we announced increases for January. We are in the double digits range on a percentage basis, and we are seeing a number of products in those types of categories, but a lot of (inaudible) products make up some of our key raw materials.

James Sheehan – Deutsche Bank

Okay. Also, just real quickly on Aqualon, could you comment on what your operating [ph] rates are in that segment?

Eric Boni

Yes. As we look at the different product categories, you are going to find some differences. Clearly construction end market has been down quite a bit. Volume is still down about 20% versus prior year. Of course, key products in that end market would be things like methylcellulose. So that production facility was running at or near capacity. Prior to the downturn in the economy, we’ve seen that volume up 20%. So you can see the utilization rates for that particular facility. Most of the other product lines, frankly, are close to capacity, and that’s why we’ve talked about reopening the Dalton facility for guar and why we are excited to have the Nanjing facility on for additional HEC volume.

James Sheehan – Deutsche Bank

Okay. Thank you.

Operator

And our next question comes from Mike Sison with KeyBanc.

Mike Sison – KeyBanc

Hey, guys, nice start of the year.

Jim O'Brien

Good morning, Mike.

Mike Sison – KeyBanc

In terms of your mid-term goals, you’re there already in Valvoline and seems like you are pretty close, striking distance from Aqualon and Water Technologies. Is the bridge to get to the goal is really just recovery of volume and sort of how long do you think it takes to recover that volume to get there?

Jim O'Brien

Well, a lot of it is volume-related on some of these businesses because fixed cost absorption is an issue that we have with almost every business that we manage. So if you look at the mid-cycle, we are talking about going back to the 2006, 2007 levels of production. And it’s a couple of things. One, we work very hard on getting our margins up. And this has been reflective of the SAP work that we did with GlobalOne to get price management and market management consistent throughout all of the businesses that we manage and be able to have some real transparency into – while we’re really getting the market price, are we the one that’s the problem on trying to discount things. So from that standpoint, we’ve done a much better job in getting our margins up.

That was step one. Two is getting our cost right. I think we’ve done a very good job through this period getting the cost out of our business and more importantly, maintaining the culture by keeping costs out, not reverting back to some old habits of spending that may not be conducive to reaching the objectives that we want [ph]. I think we are more focused on that to do a better job. So the next step in the most cases here is to get some volume back to reach some of these goals. And we think as the economy continues to recover and go into an expansion, this will be possible. And we are very focused on trying to get a mid-term cycle EBITDA of greater than about $1.3 billion. So that’s really what we are trying to shoot for and what we are pushing our management team to achieve. So that’s what we believe is possible and that’s where we’re positioned to achieve.

Mike Sison – KeyBanc

Great. In terms of Valvoline, you seem to be a little bit more optimistic this call expecting results of fairly close to ’09 levels and despite – and increase in base oil cost. So can you just sort of give us what’s changed a little bit since the last call, is demand getting a little bit better, is it your pricing abilities, just a better cost saving, sort of bridge the gap from the previous call?

Jim O'Brien

Sure. When we were trying to forecast the year coming off of last year, the crude oil was advancing fairly aggressively week after week, as the talk was that the economy was expanding worldwide and China was starting to take off and India was going to have demand, you could have foreseen crude advancing $100 easily with the momentum that was building. Now with the news that’s out there, China seems to be backing off a little bit, the United States is growing but not at an aggressive rate, and things have sort of settled out. You see crude kind of approach the mid-80s, now drop off to the mid-to-high 70s. So we are kind of anticipating and expecting with what we know today that there is going to be a slow recovery, but a recovery nonetheless, and crude will not advance, I think, beyond what the economy would demand.

So from that standpoint, we think that the marketplace is going to be easier to manage and that we are not going to be faced with our worst case scenario, which is lube stock increases every three weeks. I mean, that really kills our ability to maintain margin and get cost pass through. If we are faced with a situation where you get one once a quarter, once every four or five months, much easier to manage and the impact on our margin compression to recover that is a lot less. So as we sit there and anticipate what the year looks like, I think we have at least more confidence in what we’ve seen play out in the first quarter that we believe that our earnings for this year will be much closer to last year that maybe we’d have thought even three months ago.

Mike Sison – KeyBanc

Great. And last question, sounds like you feel a little bit more comfortable in terms of the economic demand, things maybe stabilizing a little bit. Do you – given easy comparisons in the second quarter, should we start to see sort of improvement in volumes year-over-year based on sort of normalized sequential patterns?

Jim O'Brien

Yes. When you take a look especially at this – the month of January, February and March, January and February are normally pretty tough months for us irregardless of the recovery. March, things start picking up more dramatically. So I think the quarter is going to play out how March goes. And if we come out of this into the spring with most of the markets expanding for the summer sales month, I think we will have a pretty good quarter. But (inaudible) upon March, everyone have that type of transparency of how March will look like. But if you look at January and February, I would not anticipate that the cost would be a lot different than what you saw last year because the growth is still relatively slow. And my anticipation is we are not going to see better cost until we get to that March/April/May timeframe.

Mike Sison – KeyBanc

Great. Thank you.

Operator

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

Mike Harrison – First Analysis

Hi, good morning.

Eric Boni

Good morning, Mike.

Mike Harrison – First Analysis

In the Water Technologies business, can you break out the 6% sales decline as far as the contribution from price and mix and divestiture? I know that you said volume was flat.

Eric Boni

Right. So as you – Mike, as you look at the split between the various components that you mentioned, volume is essentially flat, excluding the marine business. And then as you look at pricing as well, we haven’t seen material changes in the pricing environment. A lot of what we have been seeing is mix improvements over the last – really over the last year, but particularly in the quarter.

Jim O'Brien

Yes. One of the things this business has done, I think, a tremendous job in, as I've sat down and gone through the integration, they have really focused on some key markets that they are going to participate and really get some different share in some of these markets. And I believe we are starting to see some benefit of that. We are not just taking what comes to us. We are out aggressively trying to build a business based upon certain market segments that have better structure to them and therefore will have a better margin and return profile to us. So I think that’s a big difference in how we are approaching the marketplace and how we are incentivizing our sales force to go out and get business.

Mike Harrison – First Analysis

And so the impact of the Drew Marine divestiture, was that about negative 7% or 8% then?

Eric Boni

That’s right. It was $36 million.

Mike Harrison – First Analysis

And then another question on the Water Technologies business. Can you give us any more detail on what’s driving the growth on the European side of that business? Historically, the European paper business has been a very difficult area. Is it the paper business that’s improved or is it other parts of your Water business in Europe?

Jim O'Brien

Europe is an interesting market for us. The team we have over there is very settled and has been a fairly high-performing team for sometime. When we did the integration, the – I think the key leader we have over there is very knowledgeable of the market. I think he has done a very good job getting his team behind him. And I think they have just been stable and able to compete in the market. There has been a lot of uncertainty in that market, lot of change in the profile of the competitor base there. And we’ve been – we had the big acquisition last year, one of the more stable competitors. So I think our stability in our focuses has helped us extract from that marketplace good returns and good growth.

Eric Boni

And Mike, we’ve seen pretty broad-based improvement in Europe. One thing, of course, Europe over the last couple of years, there was some significant decline in the paper area and a lot of the mills – our customers’ mills have not shut down that we are going to shut down. So we are not seeing a lot of additional customer shutdowns at this point, which is helping to stabilize that environment as well.

Mike Harrison – First Analysis

Got it. On the Aqualon side of the business, given the pressure that you are seeing on the energy piece of that business, has that mix shift helped your margins? And now with you starting up this Georgia facility again, could we actually see a negative mix impact on margin?

Jim O'Brien

Yes, you will see some – guar is of course our lowest margin piece of business, but it has good cash flow and profitability. As we look at – starting up this guar facility will help our current margins because we are not getting producer economics out of it, as to where it stands today. So I think it will help us longer-term to restart the unit and as long as the market continues to grow at some level of rate. We are at the point that we can have better economics by producing than just buying on the outside. So that’s what the decision that we are making in that area.

Eric Boni

And Mike, on the flipside, of course, HEC is one of the higher margin products. So as that brand comes on, the additional volume comes on there, that would help – that mix improvement would help to offset some of that guar reduction.

Jim O'Brien

Yes. As you take look at Aqualon, the performance of that business, really their paint and coatings in personal care have really been strong in the last quarter. They have really recovered. And the work that that team has done to capture the business that they have gone after has been extraordinary. So as we contemplate starting up this plant and start working the plans on getting the HEC plant in Nanjing, opened in the last quarter of this calendar year, it’s a welcome addition of capacity. I think we could actually move that material fairly well to the marketplace throughout Asia, and I think it’s going to present a huge opportunity for us to expand our business. So we are excited about that startup and we are trying to accelerate its opening.

Mike Harrison – First Analysis

All right. And the last question I had, as you look at the businesses and how they have historically handled raw material cost increases, and I mean overall, not just Aqualon, where do you see you are most confident that you can prevent margin pressure and where are you maybe most concerned?

Jim O'Brien

Well, moving price through this marketplace was low growth. It is not going to be easy. So I think that what you should expect is if we move pricing through on an aggressive basis, there will be some near-term margin compression till we get full recovery of that cost. It’s not like it was three or four years ago with high demand and rising cost where you could put it through because there was a shortage of materials, this is about just good management and working through the marketplace. So this is going to be a dogfight. I mean this is not going to be easy. But our intent is to get it through, and I think that our experience has shown us over the last three months, we’ve had price increases that we had to put through the marketplace. We are getting it, but it takes sometime.

Mike Harrison – First Analysis

All right. Thanks very much.

Eric Boni

Thanks, Mike.

Operator

And our next question comes from Dmitry Silversteyn with Longbow Research.

Dmitry Silversteyn – Longbow Research

Good morning, gentlemen. Congratulations on getting the year off to a solid start. Couple of questions around margins that I’d like to follow up on. We saw pricing down in both Performance Materials and Distribution businesses, and yet your gross margin was up in both businesses year-over-year. I take it that raw materials have declined significantly more than pricing, or was this more of a mix or the improvement driver of margin?

Eric Boni

It’s really combination of factor. One piece of it is the reduction in manufacturing costs. We talked about the $400 million of reductions that we’ve been making in the business, and about – $93 million in the quarter, about $36 million of that is reduced manufacturing cost. So that’s a piece of it. Pricing has come down, as you mentioned, and raws have come down at similar levels for the most part.

Dmitry Silversteyn – Longbow Research

So you are passing on raw material price declines fairly in line with as they are occurring?

Eric Boni

I think at this point, generally speaking, yes, that’s been the case.

Dmitry Silversteyn – Longbow Research

Okay. You talked about your attempts to raise pricing as raw materials going up and expecting or telling us to expect some sort of a lag. I know it’s difficult to pinpoint, but I mean, typically are we talking about intra-quarter lag or two to three quarters lag?

Jim O'Brien

I think it’s all within the quarter. I think Valvoline has experienced about three months. When you look at some of their businesses, between one to two months. So Valvoline probably has the longest lag. But we try to get it all recovered within the quarter.

Dmitry Silversteyn – Longbow Research

Okay. And your customers and your markets are disciplined enough to expect that, but it’s not going to be a shock to them?

Jim O'Brien

Well, I would say that nothing is done easily. But experience would tell you that they know that the marketplace is not overly long. I don’t think in materials. So people are really paying attention to their production rates. So I think that’s the factor that will allow the pricing to move through is that there isn’t this expectation or reality of long materials that would delay increases because you had to move inventory.

Dmitry Silversteyn – Longbow Research

Right.

Jim O'Brien

I think that’s going to be the factor that allows it to happen.

Dmitry Silversteyn – Longbow Research

That kind of leads me into my next question. Are you guys going to be longer inventory going forward? Do you have a view that raw material prices are going to continue to increase in 2010?

Jim O'Brien

We run our production rates to the demand. So we have forecast what we think we are going to sell. We produce that. We don’t run our plants at full capacity and just try to manage the inventory that we produce. During the last 12 months, we have worked extensively to shut down capacity, shut down plants to get to an 80% run rate even in the lowest demand environment. So we want to run our plants to demand. And I think that the way our plants already in the capacity that we have on line will allow us not to get our inventories out of line where we have pressure to move – just to move product.

Dmitry Silversteyn – Longbow Research

I was more talking about your raw material inventories. I mean, given the raw material prices are expected to go up, does it make sense to go long inventory?

Jim O'Brien

No, we don’t do that.

Dmitry Silversteyn – Longbow Research

Okay.

Jim O'Brien

We don’t try to speculate in the raw material. We just buy what we need.

Dmitry Silversteyn – Longbow Research

Got you. In terms of getting pricing, particularly with respect to Valvoline, because I think that’s where a lot of people are focused as far as your sustainability of margins, is there one area that’s easier to get pricing versus the other, whether it’s Do-It-For-Me market or the Do-It-Yourself market? And is it likely that – I guess what I’m asking is, you raised prices several times in these markets over the last couple of years as base oil price was going up, and the pricing didn’t come down when base oil came down significantly. Is there room to go back to additional price increases as base oil begins to move up? And is there a sector of Valvoline business where it’s going to be easier to achieve them than another?

Jim O'Brien

Right. When you take a look at the cycle we have been through, prices peaked, but prices did come down. We did give material cost, material relief, coming back down that curve. So there has been relief coming down. And so that, to me, is kind of indicative of what the expectation of the market is. They’ve got the prices went up. They’ve got some relief as it came down.

Now, as pricing climbs again, they’re going to have to take it back up again. And over the last probably three years, that’s been the experience in the marketplace. So that’s not to say that everybody just roll over and say, sure, yes, pass it through. You still got to fight tooth and nail to work it through the system. And probably the easier place to get it is on the Do-It-For-Me side, because there it’s more of a channel distribution. And on the Do-It-Yourself side, you’re going to more to the retail segment. And there you’ve got different factors that go into play about when you actually get it, what’s your cycle as far as when you’re putting your materials on ad and all that. And all of that influences when you – when they actually take the price. But ultimately, the market is the determinant. The market is pushing it. We want to get it, and we want to push it through.

Dmitry Silversteyn – Longbow Research

Very good. And then final question on the use of cash that continues to build in your balance sheet, now that you’re not [ph] paying down debt, you’re looking to divest a couple of other businesses, are we talking about share repurchases here or increasing dividends, or are you kind of putting [ph] the cash for a meaningful strategic acquisition down the line?

Jim O'Brien

As we got our debt ratio, I think, in the right position, as Lamar pointed out, we are going to look at potentially going out and refinancing. And that will be a big help to lower our interest expense for the rest of the year. But as we continue to build cash, the importance there is having some liquidity I think in this marketplace, I’m still not 100% certain at this – if we are not going to have a double dip or whatever. So it dip so much as insurance as anything else. This becomes clear that there is a growth pattern and the economy is indeed expanding.

What we would look at is we would use that cash predominantly to hopefully find good opportunities. I think that there is still a pretty good shakeout that’s going to happen in the marketplace and I would like to participate where we really have identified I think good opportunities that will increase shareholder value if we could actually transact and expand, but these would be more tuck-in type acquisitions, not a big acquisition. So I don’t want to take on anymore debt. So if I did it, I’d rather do it just with cash. And building these tuck-ins will really strengthen areas of our Aqualon business and in our Water business. Those would be the two targeted areas that we’d want to expand and grow.

Now, if we don’t find good opportunities, and these things don’t come to pass, the next area that we’d look would probably be increase our dividend. I think that you would expect over time that with the cash that we would generate and it becomes clear that we have consistent cash flow, we would raise the dividend. That’s one opportunity that we would consider. And then beyond that, we’ve demonstrated in our past history that we have bought back shares and then things when we had cash, we had not identified for other areas to increase shareholder value.

So we would evaluate that against buying back shares. So we’ve done all these in the past, and not to say that we wouldn’t do one or maybe all three of these things over time, but our intent right now is to accumulate some cash, one, to give us some insurance going into the future, and more importantly, as opportunities come to pass through this cycle, we don’t want to miss them. And I think we’d get some good values, and I think if you have cash, you can participate.

Dmitry Silversteyn – Longbow Research

Very good. Thank you very much.

Jim O'Brien

Thanks.

Operator

We’ll take our next question from Lawrence Jollon [ph] with Barclays Capital.

Lawrence Jollon – Barclays Capital

Hi, good morning. It’s Lawrence on the high yield side. Going back to the refinancing of the term loan, just to be clear, I’m assuming given your comments around reducing interest expense that it would be simply a refinancing of the term loan as opposed to potentially issuing bonds to term out [ph] bank debt?

Lamar Chambers

We are looking at a pretty broad range of options, and the market has certainly come much more attractive for a variety of approaches to our refinancing than it was just a few months ago. So we wouldn’t – certainly wouldn’t preclude issuing additional bonds. We will look at and are looking at kind of the bank side as well as the leverage that’s up.

Lawrence Jollon – Barclays Capital

Okay, thank you. And then my second question, I just wanted to get a sense for your near-term goals as it relates to potentially achieving investment grade status, and then particularly referencing your ratings on your bonds, which are currently BB-minus at both Moody’s and S&P. I guess is there any rush? Imagine you’d like to be there and your comments just made around not wanting to take on additional debt for acquisitions certainly would help your case. But I was just trying to get a sense for timing, whether it was kind of a clear goal or whether there was no rush.

Jim O'Brien

Our objective is really more around performing at a level that’s consistent with investment grade ratings. I mean, ultimately the ratings or what the rating agencies believe to be our financial profile and our outlook, our objective is to get strong earnings consistent with specialty chemicals type high performance, a bit stable predictable earnings, and we’re well along the path toward the transition of the company to do just that.

We believe that as we achieve kind of margins that we describe to – that we believe are reasonable expectations in a mid-cycle economy and get ourselves positioned in the industries in which we are continuing to advance through that we will attain investment grade type metrics. That’s only helpful from the standpoint of giving us more opportunity as to how we structure our capital and certainly helps from the standpoint of cost of capital. So our objective remains the same as we’ve discussed in the past, and that’s to achieve metrics that are consistent with investment-grade quality.

Lawrence Jollon – Barclays Capital

Okay. Thanks for the color.

Eric Boni

Thanks. We have time for probably one more question.

Operator

Thank you. Our last question comes from Steve Velgot with SIG.

Steve Velgot – SIG

Yes. My question is around the Distribution business. Now that private equity is back in business, is the management looking at potentially trying to sell the Distribution business or at least is that a 2010-type decision? And secondly, I wanted to know if in your view, Jim, the Valvoline business could be a standalone business one day.

Jim O'Brien

As you take a look at the transformation that’s taking place inside of Ashland, we’ve made it very clear to the market that our intent is to ultimately have businesses that perform – specialty chemical businesses perform, that’s double-digit EBITDA performance, strong position in the markets that they serve, very good predictable consistent earnings. These are the type of businesses that we are trying to build. And as you look at both Distribution and Valvoline, Valvoline’s performance financially meets those criteria. And it’s contributing tremendously to the operations of the company.

When you look at Distribution, it doesn’t meet that same criteria. And whether it stays inside the portfolio or not, they need to get to a 4% EBIT – EBITDA and really show a performance level where it contributes a nice return on investment for the company if we keep it, and if we decide to put it into someone else’s hands, we will command a good premium for it through the markets. So irregardless, these businesses have to perform and have to get to a certain level, and really it comes down to alternative values, what is the alternative investment.

If the business is performing at a level that contributes to the corporation, we have to find either a financial idea or some sort of divestiture idea, an acquisition idea that goes along with it, that would be superior. So it’s a combination of things to determine whether or not we do something with those assets or not. And ideally you have to have a good alternative investment that obviously is superior to just sell. I think just selling things for the sake of selling it and returning to cash may be good for the short-term investor, but may not be as good for the long-term investor.

Steve Velgot – SIG

And at a 4% type EBITDA margin kind of mid-cycle, you’d be earning your cost of capital for that business?

Jim O'Brien

Yes, it would be way above it, because when you look at Distribution, it’s really a turnover business, an asset [ph] turnover business. So we’ve done a much better job managing the working capital. When you look at the working capital consumed through this cycle we are going through now, it is much less, probably half of what it was through previous cycles of equal growth. And that is really going to help the ability of that business to demonstrate a high ROI return business.

Steve Velgot – SIG

Thank you.

Eric Boni

Well, we thank everyone for their participation in the call. And we look forward to speaking to you here in the future.

Operator

That does conclude today’s conference. Thank you for your participation.

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Source: Ashland Inc. F1Q10 (Qtr End 12/31/09) Earnings Call Transcript

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