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Executives

Neal Butler – President and CEO

John Sobchak – CFO

Analysts

Rosemarie Morbelli – Ingalls & Snyder

Andrew Miller – Madison Williams

Jay Harris – Goldsmith and Harris

Ross Haberman – Haberman Fund

KMG Chemicals, Inc. (KMGB) F2Q10 (01/31/10) Earnings Call March 8, 2010 10:00 AM ET

Operator

Good morning, and welcome to the KMG Chemicals, Inc. second quarter 2010 conference call. We would like to begin by reminding you that the information in this conference call includes certain forward-looking statements that are based upon assumptions that in the future may prove not to have been accurate and are subject to significant risks and uncertainties including statements as to the future performance of the Company.

Although the Company believes that the expectations reflected in its forward-looking statements are reasonable, it can give no assurance that such expectations or any of its forward-looking statements will prove to be correct.

Factors that could cause results to differ include, but are not limited to the loss of primary customers, successful implementation of internal plans, product demand, the impact of competing products, increases in the price of raw materials and active ingredients, successful acquisition and integration of additional product lines and businesses, the condition of capital markets in light of interest rate and currency fluctuations and general economic conditions, environmental liability, the ability to obtain registration and re-registration of products, increased environmental compliance cost of products and general, political and economic risks and uncertainties.

With that I would like to turn the call over to Neal Butler, President and CEO. Neal, please go ahead.

Neal Butler

Thank you. Good morning, and welcome to KMG’s Second Quarter 2010 Conference Call. John Sobchak, our CFO, and I will take you through the financials, provide an overview of each of our businesses, pending Electronics Chemicals acquisition we announced on February 26th and address any questions you have.

As we reported in our release last month and again this morning, the second quarter fiscal 2010 produced net income and diluted earnings per share that were more than four times 2009 levels.

This is all the more gratifying in that it was achieved on a 2.1% increase in revenue demonstrating the culmination of the efficiency improvement initiatives across the corporation.

We reported record second quarter revenues of $45.1 million versus $44.2 million in the comparable period last year, while operating income rose to $6.9 million, a 176% improvement compared to $2.5 million in the second quarter of last year.

Net income increased 339% to approximately $4 million or $0.35 per diluted share compared to $903,000 or $0.08 per diluted share in the same period last year.

Our earnings per diluted share for the trailing four quarters ended January 31st are $1.44. The measures implemented in fiscal 2009 to increase efficiencies and supply chain and manufacturing along with targeted acquisitions we took to offset raw material price increases continued to have a residual positive effect on our bottom-line.

Today, we will spend time discussing our upcoming acquisition of General Chemical’s electronic chemicals unit, but first, we’ll review the performance and our current expectations for our each of our businesses.

Moving first, our Electronic Chemicals business, global sales in this segment remained strong at $22.9 million, only slightly below the prior quarter. The strength of EC sales in the second quarter was especially welcome since semiconductor fabrication facilities sometimes shutdown during a portion of the holiday season.

Operating income for the quarter was $3 million compared to $1.5 million in last year’s second quarter. We continue to see a gradual, but steady return to more normalized demand for our North American and European businesses.

Electronic Chemicals margins expanded in the second quarter versus the first quarter due to the continued impact of previously implemented efficiency improvement initiatives combined with the operating leverage that is now present in the business.

A recent report from the American Chemistry Council on economic trends noted that semiconductor sales were up 47% year-over-year and the outlook for the remainder of the calendar 2010 is very positive.

Wood Treating Chemicals continued to be good performance in the second quarter with a favorable product mix positively impacting operating profits. Wood Treating sales were $19.8 million compared to $24 million in the same period in fiscal 2009.

As expected, we experienced a softening in customer demand in both utility pole and rail tie treating segments. And volumes declined about 14% from the same period in 2009 as utilities continued to spend less on maintenance and pole replacement.

Creosote revenues increased slightly relative to fiscal 2009 second quarter, however, sales volumes declined by 18.3%. Rail tie replacement rates in the U.S. have been at the high end of the historical range during recent years and have now been returning to more normal levels. As a result, Creosote demand is expected to remain close to current levels for the rest of fiscal 2010.

Second quarter operating income for Wood Treating was $6 million versus $3.3 million in fiscal 2009, which is a period when margins were depressed due to high raw material costs.

And operating margins increased slightly despite the recent rebound in raw material costs specifically (inaudible) from the previous low levels in the prior three quarters. We expect these costs to continue at the levels realized in the second quarter as well as a potential further decrease in demand.

Creosote was a key contributor to the improvement in operating income in Wood Treating products in the second quarter of fiscal 2010 versus second quarter in 2009. This was mostly due to a previous shortage in domestically produced creosote, which favorably weighted our product mix.

This shortage has been alleviated and available domestic volumes have returned to a more normalized run rate as noted due to decreased maintenance levels and tie replacement among railroads we expect creosote demand to remain at this reduced rate for the remainder of 2010 relative to 2009.

For the second half of fiscal 2010, our outlook anticipates a partial retraction in Wood Treating operating profits relative to the first half due to confluence of increased average costs and an easing in demand for treated wood by utilities and railroads, which will likewise cause Wood Treating revenues in fiscal 2010 to show a decline relative to fiscal 2009.

In our Animal Health business, second quarter net sales are $2.4 million compared to $2.2 million in the same period last year. We saw a strong start to the main selling season in January and we are anticipating a modest recovery in the cattle and poultry markets relative to the downturn experienced in 2009.

At this time we are optimistic about this segment and a latter half of fiscal 2010 is sales are strongly weighted to the spring and summer months. We believe that our cost structure, our margins will continue to improve.

I would now like to touch on our pending acquisition. On February 25th we signed a definitive agreement to acquire General Chemical Electronic Chemicals business for $25.5 million in cash and approximately $850,000 of assumed liabilities. The purchase price included approximately $7 million for existing inventory.

This transaction is structured as an asset purchase and includes a complete purification processing facility for solvents used in the Electronic Chemicals business along with personnel located in Hollister, California. We do not currently have a facility with this capability.

General Chemical also owns a facility near Bay Point, California that produces and packages acids. That facility is similar to our facility in Pueblo but with the ability to produce certain acids that we currently do not have. The Bay Point Electronic Chemicals equipment is included in the transaction. However, the real estate and employees will remain with General Chemical.

General Chemical will toll manufacture certain acid products on our behalf at that facility under a long-term manufacturing agreement. General Chemical Electronic Chemicals business generated $43 million of revenues in calendar year 2009 with good margins under challenging global economic conditions. We believe this acquisition is an ideal fit for our existing Electronic Chemicals business.

We have a significant volume of solvent-based products being toll manufactured for us by a third-party under agreement that expires at the end of calendar 2010. We plan to consolidate those volumes into the Hollister plant, greatly improving the utilization rate at that facility.

While we typically look to purchase long-live assets such as fixed assets and associated intangible assets for a multiple of about four times EBITDA or less, we expect subsequent to integration that this acquisition will contribute considerably more due to the synergies that will be gained by consolidating the two operations.

We expect the transaction to close some time around end of this month, assuming the satisfaction of the closing conditions, which includes obtaining necessary operating permits and consents.

We anticipate the acquisition to be significantly and progressively accretive to KMG’s earnings in fiscal 2011 and 2012 as the business is integrated into our existing Electronic Chemicals business unit, although it will be mildly dilutive to earnings in the second half of fiscal 2010 mainly due to closing and integration expenses.

We will provide greater visibility with regard to our expectations for this business in our reporting after the close of the transaction.

At this point I’ll now turn the call over to John to provide additional information on the quarter as well as discuss certain balance sheet and cash flow highlights. John?

John Sobchak

Thanks, Neal and good morning everyone. As we reported, despite the modest 2.1% improvement in comparable quarter revenues, we realized a significant improvement in the bottom-line. Contributing to this improvement, gross profit margins increased to 37% of sales in the current period from 31.1% in the same period last year.

Gross profits were $16.7 million or 21.7% ahead of the $13.7 million of gross profits earned in the second quarter of last fiscal year. Through the second quarter of fiscal 2009, we had experienced rapid increases in the cost of our raw materials, while our pricing actions have lagged behind. This resulted in depressed margins in our second quarter of fiscal ‘09.

Fiscal 2010 second quarter is reflective of more normal unit gross margins, combined with a favorable shift in product mix in our Wood Treating Chemicals segment.

Another contributor is the improvement in SG&A, which was $9.8 million in the second quarter, a 12.8% decrease from $11.2 million in the prior year period. As a percentage of sales, SG&A was 21.7% in the current second quarter, down from 25.4% of sales in the same period in fiscal 2009. The improvement was primarily due to lower distribution expense associated with the Electronic Chemicals business.

Supply chain costs were the primary focus of our operating efficiency initiatives undertaken during fiscal 2009. The 2010 quarterly comparison also benefited from other cost reduction initiatives undertaken during the second half of last year.

You should also note that SG&A during the second quarter of fiscal 2010 included $315,000 of due diligence and transaction costs associated with our pending acquisition.

Net interest expense declined in the current second quarter to $534,000 and down from $781,000 in the prior year due to both lower borrowings and interest rates on those borrowings.

Our income tax rate was 37.3% for the quarter versus 38.7% in last year’s second quarter.

That brings us to net income, which increased to $4 million or $0.35 per diluted share compared to $903,000 or $0.08 per diluted share in the second quarter of last year. Year-to-date net income was $8.6 million or $0.75 per share, which is the best result we have achieved in the first half in our history.

Moving to the balance sheet, net working capital at the close of the second quarter was $37.1 million compared to $29.7 million at year-end fiscal 2009. The increase in working capital was due to the increase in our cash position, along with lower accounts payable and accrued liabilities.

Cash on January 31st was $8.8 million. That’s up from $7.2 million on July 31st but down from $12 million at the end of the previous quarter and that was due to lower accrued liabilities and accounts payable.

At the end of the second quarter, we had total debt of $43.3 million, a reduction of $1.6 million compared to the end of the prior quarter and a $3 million reduction compared to the fiscal 2009 year-end.

At the close of the second quarter, our $35 million non-amortizing revolver was untapped. Our term loan balance was $23.3 million, for which we are currently paying 1.75% over LIBOR.

We plan to fund the purchase of the pending acquisition with available cash and borrowings on our revolver. We expect an expansion of our revolver to $50 million in association with the pending acquisition without any unfavorable change in terms.

While we don’t need the increased capacity on the revolver to fund this acquisition, we feel it’s prudent to take advantage of the opportunity to expand the facility.

We also have $20 million of non-amortizing notes maturing in December 2014 for which we pay a fixed interest rate of 7.43%. Shareholders equity at January 31st was $79.2 million or $6.94 per diluted share. For the quarter ended January 31st there was a weighted average of 11.2 million basic shares and 11.4 million diluted shares outstanding.

And now I hand it back to Neal for closing remarks.

Neal Butler

Thank you, John. We are very pleased with our year-to-date results and are particularly excited about the future of our Electronic Chemicals business with the pending acquisition. General Chemical manages a profitable and efficient acids and solvents business which very effectively serves the semiconductor market. This business alliance exceptionally well with our acid business unit and provides KMG the opportunity to offer quality circus to a larger customer base.

This represents KMG’s eighth acquisition since formalizing our acquisition program in 2002. As we continue to advance our strategy of growth through accretive acquisitions, the Electronic Chemicals sector will play a key role. These first half results provide us with a good path to achieving yet again another year of record earnings in fiscal 2010.

And last and before answering your questions I would like to point out that we will be presenting at the ROTH Capital OC Growth Stock Conference in Dana Point, California on March 15th. We hope to see some of you there. We’ll be posting the slides from this presentation on our Web site. We appreciate your participation with us.

And with that I open the floor for questions.

Question-and-Answer Session

Operator

(Operator instructions). Your first question comes from the line of Rosemarie Morbelli with Ingalls & Snyder. Please go ahead with your question.

Rosemarie Morbelli – Ingalls & Snyder

Good morning, all.

Neal Butler

Good morning, Rosemarie.

Rosemarie Morbelli – Ingalls & Snyder

And congratulations on a very good quarter.

Neal Butler

Thank you very much.

Rosemarie Morbelli – Ingalls & Snyder

Regarding the rail tie, you said that, and I am not as familiar with the way your company operates as I should be so I am working my way there. You said the demand was now at normal levels versus a three-year record replacement. What triggered the high level of the three years you are referring to?

And is there some kind of a normal cycle and today, what we are seeing the normal cycle or when should we expect to see the next higher than normal level of volume demand the way you had in the past three years? Trying to get my arms around the demand and the cycle that seems to be there in the rail tie business.

Neal Butler

Although this cycle is not a secret cycle, it tends to run at about a ten-year time frame and the average run rate over that ten years has been somewhere around 17.5 million rail ties. We had a peak two years ago of almost 22 million ties, I believe, is what the RTA reported and now we’re seeing a movement back towards that 17.5 million ties to 18 million ties.

Rosemarie Morbelli – Ingalls & Snyder

What triggered the big jump to 22 million ties? Is that there was absolutely no maintenance going on and yet the economy was strong?

Neal Butler

I think there were two things. Number one, it was a catch-up in maintenance, where they had delayed maintenance programs for several years, so there was some catch-up to be accomplished. And the second thing was that there was a period when rail freight had picked up rather notably and these ties are replaced and they were out as a consequence of mechanical wear. And with time, with more and more freight running across them it just causes them to wear out more rapidly. So, they increase it for those two reasons.

Rosemarie Morbelli – Ingalls & Snyder

So as the economy recovers, shouldn’t we expect the number of replacements to increase in '11?

Neal Butler

We would anticipate it to, but I would be reticent to try to quantify what that means.

Rosemarie Morbelli – Ingalls & Snyder

Okay. And looking at the Wood Treating business, you are talking about the demand easing and your input costs increasing. And you did talk about the fact that profit will probably be down this year versus last year, if I understood you properly. As you can hear, I have an accent problem. Do you think that it could drag the cost and the lower demand could drag the Wood Treating business into the red?

John Sobchak

No, no, not at all. And Rosemarie, those comments are kind of a reflective of the fact that the fourth quarter, in particular, of last year was a very strong quarter in terms of Wood Treating demand and also raw material prices had declined substantially. Now, raw material prices have kind of moved back to more normal levels and we have seen an (inaudible) demand, but when you look at our results for the second quarter, when we put out our Q for the Wood Treating segment, you will see that the results are still very favorable compared to what we’ve been able to do in those segments historically.

Neal Butler

The (inaudible) market will remain a very strong market for us this year. It’s a very profitable business and remains so. It’s just when you compare that to a really record fourth quarter last year when all the stars were aligned with raw material prices going down, demand going up, so we saw a multiplier effect on margins and so we’re comparing third quarter and fourth quarter to third quarter and fourth quarter of last year. So it will be down a little bit relative to that. But it’s still very, very strong business.

Rosemarie Morbelli – Ingalls & Snyder

Okay. And if I may ask one last question and then I’ll get back on queue. Do you have any plans to move the production of the acid from Bay Point into Pueblo, would that make sense?

Neal Butler

Certainly, part of the synergies will be moving some of the acid production that’s currently in Bay Point to our Pueblo facility, absolutely.

Rosemarie Morbelli – Ingalls & Snyder

Okay. The reason I ask you that I was confused by the comment saying that you have a long-term tolling arrangement at Bay Point.

Neal Butler

Bay Point, there are a couple of specific acids, just a couple, that they make at Bay Point that we do not make at Pueblo. So the tolling agreement will be specifically for one or two products.

Rosemarie Morbelli – Ingalls & Snyder

Okay, thanks.

Operator

Your next question comes from the line of Andrew Miller with Madison Williams. Please go ahead.

Andrew Miller – Madison Williams

Good morning, gentlemen. Congrats on a great quarter.

Neal Butler

Thank you.

Andrew Miller – Madison Williams

Wanted to speak a little bit on your electro chemicals business. It’s been a strong driver in the last sort of six months. If you could speak to any sort of visibility that you might have on the end markets there. We certainly heard a little bit of rumblings and some softness in semiconductor, perhaps, you could speak to the photovoltaic side as well.

Neal Butler

Well, talk about the photovoltaic just a moment. We’ve seen some increases in our penetration in the photovoltaic market in Europe. And of course, photovoltaic market in Europe is a bit more advanced or further along than it is in the U.S. But we have seen an increase there; we have been participating to a greater degree in that business.

If you look at the fabrication facilities, for instance, in Europe, majority of the fabrication facilities that we work with there, I don’t know if it’s a 100% rate but carries a close to that. We have seen a similar increase in our demand in the U.S. for the semiconductor facilities here and we use our run rate as just a good indicator because we tend to be on the front end of supply chain, so a little bit of a leading indicator I guess for semiconductor production. And we’ve seen our movement now back to a more normalized run rate. Normalized run rate for us is somewhere on an annualized basis of total of about $92 million to $100 million.

Andrew Miller – Madison Williams

Okay. And does the recent acquisition, do you expect that your electro chemicals business then will wind up constituting closer towards 60% of the sales of the Company going forward?

Neal Butler

Yes.

Andrew Miller – Madison Williams

Okay. And what do you expect in terms of the integration cycle to extract the benefit the acquisition and see the margins on that business come back up to your existing levels on the original business?

Neal Butler

The integration effort will probably take through the end of calendar 2010 and we will see the synergies in fiscal 2011. The majority of which will fall into the second half of 2011.

Andrew Miller – Madison Williams

Are you providing any guidance on the year 2011 numbers at this time?

Neal Butler

No.

Andrew Miller – Madison Williams

Okay. That’s it from me. Thank you, gentlemen.

Operator

Your next question comes from the line of Jay Harris with Goldsmith and Harris. Please go ahead.

Jay Harris – Goldsmith and Harris

Hi. Also on the acquisition, can you share with us what the burdens of consolidation will be? I presume between now and the end of this fiscal year.

John Sobchak

Good morning, Jay. I’m sorry, were you asking about –

Jay Harris – Goldsmith and Harris

The Electronic Chemicals. You’ve just acquired or about to acquire from General Chemical. What penalties will you incur? You have to sell the inventories which you’ll have to mark up to retail value and there are other penalties, which I’m assuming they’ll all be history by the end of this fiscal year. I’d like you to go over that in a little more detail if you could.

John Sobchak

The inventories are about $7 million. We’ll see what they actually turn out to be when we close. And we’re –

Jay Harris – Goldsmith and Harris

Is that the retail marked up value or is that the purchase price?

John Sobchak

That is the book value for those inventories. It’s what cost them to produce that inventory. We’re buying it at cost. So there won’t be any –

Jay Harris – Goldsmith and Harris

You’ll have to write those up, won’t you?

John Sobchak

We will not be writing them up on our books. No. We will be purchasing that inventory at cost and selling it at their retail, so we will capture the normal gross profit margins on those inventories, as if we manufactured it ourselves.

Jay Harris – Goldsmith and Harris

So what will be the penalties? Narrower margin on those inventories than you’ll realize on selling the same quantity next year?

John Sobchak

Well, we would anticipate that our gross profit margins will expand after we fully integrate and optimize the two operations. However, the costs that we would be primarily facing in for the remainder part of fiscal 2010, which is primarily we’re talking about the fourth quarter those costs are going to be related to the costs of integration of the facility. We’re only going to have somewhere around three months, maybe a little bit more of operating margins for the business and at the same times we’re going to be working very hard at that time to get the businesses integrated. So a lot of those integration costs are going to be more front end loaded.

Jay Harris – Goldsmith and Harris

Can you share the budget for us?

John Sobchak

Now that we have a definitive agreement, we are in the process of putting together a detailed plan associated with that and after closing we will share better insight into that process.

Jay Harris – Goldsmith and Harris

And then final question on this acquisition. If they did about $43 million in calendar year 2009, what was the peak quarterly revenue in 2009?

John Sobchak

We haven’t disclosed that, Jay.

Jay Harris – Goldsmith and Harris

Well, it seems to me it’s a larger business than $43 million, because I presume, just the way your January quarter of 2009 was very weak, they must have had weak quarters as well.

John Sobchak

Yes, I mean, they have participated in the economic recession approximately the same degree that we have. We call it around a 30% decline in our top-line. They experienced somewhere around the same level of decline.

Jay Harris – Goldsmith and Harris

Okay, thank you.

Operator

Your next question comes from the line of Ross Haberman with Haberman Fund. Please go ahead.

Ross Haberman – Haberman Fund

Good morning, gentlemen, how are you?

John Sobchak

Good.

Neal Butler

Good morning, Ross.

Ross Haberman – Haberman Fund

Did you specify the operating income relating to that $43 million of revenue for the new acquisition?

Neal Butler

No, I’m sorry, we have not. We are waiting for the close of the acquisition before we provide more detailed insight.

Ross Haberman – Haberman Fund

Generally or I should say, historically, has that operation done about the same as yours? Better, worse or what?

Neal Butler

Their operating results were in line with ours.

Ross Haberman – Haberman Fund

Okay. I guess given the increase and leverage from the new operations, is there expectations that you can significantly improve your margins once it’s all integrated in?

John Sobchak

Yes, absolutely.

Ross Haberman – Haberman Fund

And have you put any guesstimates on that yet?

John Sobchak

We haven’t made any disclosures on that, Ross, and again, once we close the transaction, we’ll provide more insight.

Ross Haberman – Haberman Fund

And just one final question. What’s going to be the pro forma debt with the new acquisition?

John Sobchak

We’re looking at something less than $20 million, $15 million to $20 million, depending upon the working capital requirements.

Ross Haberman – Haberman Fund

So you’re saying about $58 million to $63 million pro forma total?

John Sobchak

We currently have $43 million of debt –

Ross Haberman – Haberman Fund

Right.

John Sobchak

So let’s add $17 million onto that, so that come out to $60 million pro forma.

Ross Haberman – Haberman Fund

Got it. Okay. All right, guys. Best of luck. Thank you.

Neal Butler

Thank you.

Operator

Your next question is a follow-up from the line of Rosemarie Morbelli with Ingalls & Snyder. Please go ahead.

Rosemarie Morbelli – Ingalls & Snyder

Hi. If you look at the announced acquisition, prior to the recession, could you share with us what their growth rate has been for five years prior to obviously the end of '08 and '09?

John Sobchak

Rosemarie, I don’t have that information available right now. And we haven’t disclosed that. But if that is something investors would be interested in, we could provide some insight to their prior growth rate when we have further disclosure on the business.

Rosemarie Morbelli – Ingalls & Snyder

And is it your perception that they can grow as usually as you do with acquisitions that they can grow a lot faster under the KMG umbrella?

Neal Butler

Rosemarie, I don’t know that it will be necessarily an issue of growing faster. Obviously, will be increased market share that comes through the acquisition. The other thing and probably the more significant issue is with the synergies related to the increased throughput to the production facilities, the most notable growth will be in operating margins.

Rosemarie Morbelli – Ingalls & Snyder

Okay. Your SG&A declined from 25.4% to 21.7% of sales. Is that the new low, sustainable of a certain period of time or do you think you can take it down further as a percentage of sales? And then linked to that, is the acquisition going to change that number?

John Sobchak

Well, initially the acquisition will probably increase that as a percent of sales.

Rosemarie Morbelli – Ingalls & Snyder

Yes, I meant really after the synergies are taken into consideration.

John Sobchak

We expect that to either stay there or decrease.

Rosemarie Morbelli – Ingalls & Snyder

You don’t have a three-year goal of taking it down to 19%, for example, to pick a number out of a hat.

John Sobchak

We have not set that goal, Rosemarie.

Rosemarie Morbelli – Ingalls & Snyder

Okay. And then my last question. Even though the demand on the Wood Treating business has slowed down, could you eventually pass through those higher costs you are getting via selling price increases and with how much of a lag, if the answer is yes?

Neal Butler

With time, we typically in past most, if not all, the increases along. We, on the average, usually lag at least a quarter.

Rosemarie Morbelli – Ingalls & Snyder

No more than that, even with the lower demand?

Neal Butler

Sometimes it’s longer than that, but we never do it quicker than that.

Rosemarie Morbelli – Ingalls & Snyder

Okay, thanks a lot.

Operator

At this time, I would like to turn the call back over to Neal for any closing remarks.

Neal Butler

We sincerely appreciate everybody’s participation today. As I mentioned while ago we’ll be presenting on the West Coast here later this month and we would look forward to seeing any of you there. And with that John and I both would look to thank you and we look forward to visiting with you again next quarter.

Operator

Thank you, ladies and gentlemen. This will conclude today’s conference call. You may now disconnect.

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Source: KMG Chemicals, Inc. F2Q10 (01/31/10) Earnings Call Transcript
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