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Executives

Neal Butler – President and CEO

John Sobchak – CFO

Analysts

Alex Silverman – Special Situations

Arnie Ursaner – CJS Securities

Eric Glover – Canaccord Genuity

Jay Harris – Goldsmith & Harris

Jt Rieck – Crosscap

David Cohen – Midwood Capital

Steve Roberts – NorthPointe Capital

Steve Schwartz – First Analysis

Rosemarie Morbelli – Ingalls & Snyder

KMG Chemicals, Inc. (KMGB) F3Q10 (04/30/10) Earnings Call June 4, 2010 10:00 AM ET

Operator

Good morning, and welcome to the KMG Chemicals Incorporated Third 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 prices of raw materials and active ingredients, successful acquisition and integration of additional product line 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 again welcome to KMG’s Third Quarter 2010 conference call. John Sobchak, our CFO, and I will take you through the financials, provide an overview of each of our businesses, as well as bring you up to date on the Electronic Chemicals business recently acquired from General Chemical, which we closed on March 29th. After our comments, we will address your questions.

Net income for the first nine months of this fiscal year increased 125% to $11.9 million or $1.05 per diluted share versus $5.3 million of net income or 47 cents per diluted share during the same period last year. With regards to quarterly results, we are very pleased to report another record quarter for net sales, operating income, net income, and diluted earnings per share.

Comparing the current third quarter to last year’s, net income rose 20% to $3.3 million or 29 cents per diluted share from $2.8 million or 25 cents per diluted share last year. Net sales were $51.6 million, up 13% from $45.9 million. Operating income rose to $5.8 million, a 7% improvement compared to $5.4 million in the third quarter of last year.

Now I’ll discuss each of our businesses.

Sales of Electronic Chemicals rose 71% to $29.6 million from $17.2 million in the prior year period with gains achieved in both North American and European operations. The increase also reflects one month of sales by the newly acquired business which contributed $4.2 million to revenues for that one month we owned it during the quarter. Electronic Chemicals contribution to operating income for the quarter was $2.9 million compared to an operating loss of $649,000 in last year’s third fiscal quarter which was the trough of the recession for the semiconductor market.

The big news in the third quarter was closing on the acquisition of General Chemical’s Electronic Chemicals business on March 29th for a total cash purchase price of $26.7 million, which included $7.6 million of inventory. The acquisition includes chemical manufacturing equipment and a facility in Hollister, California, as well as equipment related to production to electronic chemicals in Bay Point, California. I’m pleased to report that once again we had no goodwill associated with this most recent acquisition.

There are several reasons for enthusiasm about this acquisition, some of which we described on our last conference call, but I would like to mention a few points here.

There is roughly an 80% overlap between our legacy product lines and those of the acquired business, and yet there is only about a 20% overlap in customers. This means broader exposure to an expanded customer base that services a wider global footprint. With this acquisition, we now have over a 50% market share of the $250 million US market for acids and solvents used to manufacture semiconductors.

We expect this increase in market share to translate into gains and operating margins, greatly driven by increased manufacturing throughput. This is in contrast to our first Electronic Chemicals acquisition where much of the improvement in profitability came from driving down operating expenses, specifically as a result of improved supply chain efficiencies and associated cost reductions.

The acquisition also expands our presence in Asian markets. Our 15% share in the European market did not change with this transaction. The integration is progressing on schedule, and so far, there have been no notable obstacles. We project there will be approximately $250,000 per month of transition-related costs through our fourth quarter, which will tail off over the first half of fiscal 2011.

During that time, we look forward to achieving significant operating synergies from combining certain functions of the two electronic chemicals businesses. For example, we have a large volume of solvent-based products being toll manufactured by a third-party under an agreement that expires at the end of calendar 2010. We plan to consolidate those volumes into the Hollister plant greatly improving the performance and utilization rate of that operation by almost doubling plant throughput.

We have initiated the expansion program that will incur one-time capital expenditures at Hollister of approximately $1.7 million. We will see similar synergies in CapEx at our Pueblo, Colorado plant. With this acquisition, KMG will be better able to service the needs of semiconductor and photovoltaic customers.

We believe we now own the largest high purity sulfuric acid bulk delivery fleet and the largest high purity nitric acid purification capability in the United States, along with the strategic position in high purity hydrofluoric acid.

Past acquisitions were typically acquired at a multiple of four-times EBITDA or less for the fixed assets and associated intangible assets. We spent $19.1 million for these long-lived assets, but expect that subsequent to the completion of the integration, this acquisition will contribute considerably more due to the synergies that will be gained through the consolidated of the two businesses.

Moving on to our Wood Treating Chemicals business, sales were $18.8 million in the third quarter compared to last year’s $25.1 million. During fiscal 2010, customer demand in both utility pole and rail ties segments declined. For the past several years, rail tie replacement rates in the United States have been at the high end of the historical range, but more recently have returned to more normal levels. We expect to see marginal improvement in the fourth quarter creosote sales versus the third quarter.

Third quarter operating income for Wood Treating was $4.8 million versus $7.5 million in fiscal 2009. In addition to lower sales volume, high raw material cost have caused our Penta and Creosote gross margins to recede somewhat from the very healthy levels we experienced in the second half of fiscal 2009. We expect our Wood Treating margins and operating income in this fourth quarter to be approximately in line with the third quarter results.

Regarding our Animal Health business, third quarter net sales declined by 6% to $3.2 million from $3.5 million in the same period last year. However, operating profit improved by $96,000 as a direct result of a strategic move to reduce marketing expenses and expand direct sales coverage via our distribution agreement with AgriLabs. We are thus far pleased with the arrangement and believe it will have a materially positive effect on future sales and profits.

Growing our Animal Health business beyond ectoparasiticides is one of our strategic goals, and as most of you know in April, we signed an agreement with R&D LifeSciences, LLC to distribute their product line of probiotics and animal feed additives in North and South America. In addition, we are actively pursuing other opportunities to further expand our product line and more fully leverage our distribution networks in the US and Latin America.

For the nine-month period, operating margins improved from 8% in fiscal 2009 to 14% in fiscal 2010. It is worth noting that margins in the first half of fiscal 2009 were depressed by the rapid increase in commodity prices that comprise our input costs resulting in a more marked improvement in margins in fiscal 2010.

We were also very successful in driving efficiency improvements through our Electronic Chemicals supply chain. Distribution expenses as a percentage of revenue for our Electronic Chemicals business declined to 15.5% from 25.1% over the nine-month ended April 30, 2010 versus the year earlier period.

I’ll now turn the call over to John to provide additional information on the quarter and year-to-date, as well as discuss certain balance sheet and cash flow highlights. John?

John Sobchak

Thank you, Neal, and good morning, everyone. As we reported this morning, our earnings for the first nine months of fiscal 2010 exceeded the full 12 months of 2009, which has been a record year for the Company. For the first nine months, we achieved 125% improvement in our year-to-date bottom line on a 3% increase in net sales.

For that first nine-month period of the year, revenues increased by $3.9 million to $146.2 million versus the year earlier period. Electronic Chemicals revenues increased by $10.4 million, primarily due to the rebound in the semiconductor industry compared to the lows of 2009.

Wood Treatment sales declined by $6.1 million and Animal Health sales declined by $440,000 as compared to the first nine months of the last fiscal year.

Gross profit was $16.0 million or 31% of sales in the current third quarter compared to $15.4 million or 33% in the same period last year. For the year-to-date period, gross profit increased to $51 million or 34.9% of net sales from $44.6 million or 31.4% of net sales last year.

SG&A was $10.1 million in the third quarter or 19.6% of net sales. That’s an increase of only $214,000 compared to last year’s third quarter when SG&A was 21.6% of net sales. For the first nine months, SG&A decreased $2.8 million to $30.4 million or 20.8% of net sales from $33.1 million or 23.3% of net sales through the first nine months of last year. We include the distribution expenses in SG&A rather than cost of goods sold.

The 2010 results also include approximately $500,000 of transaction and integration costs associated with our most recent acquisition which closed two months into the third quarter. We expect to incur about $250,000 of cost per month associated with the integration of the business onto our platform through this fourth quarter. And those costs will be tailing off over the first half of fiscal 2011.

Interest expense in the third quarter declined to $542,000 from $732,000, and for the nine-month period interest expense decreased to $1.6 million from $2.4 million. The decrease is due to principal reduction on the indebtedness we incurred from the acquisition of the first Electronic Chemicals business in fiscal year 2008 and also the acquisition of certain penta assets in fiscal 2005.

Our income tax rate was 36% for the quarter versus 40.5% in the third quarter of fiscal ’09. For the first nine months, our effective tax rate was 36.9% and 39.5% for fiscal 2010 and 2009 respectively. We booked an NOL allowance in the fourth quarter of fiscal 2009 associated with accumulated tax losses we incurred at our operation in Italy, but with the return to profitability of that operation this fiscal year, the allowance was partially reversed, which had the effect of reducing our tax rate.

For the nine-month period, net income was $11.9 or $1.05 per diluted share versus $5.3 million or 47 cents per diluted share in the first nine months of fiscal 2009.

Moving on to our balance sheet, net working capital at the close of the third quarter was $40.3 million. That’s up 9% from the previous quarter. Included in that was $4.1 million of cash. The increase in working capital over the quarter was due to the additional inventory and receivables associated with the business acquired during the quarter.

Total debt on April 30th was $61.3 million, which included $20.0 million borrowed on our revolving credit facility to partially fund our $26.7 million acquisition. At the end of the quarter we had $21.3 million outstanding on our term loan.

During the third quarter, we paid an interest rate equal to 1.75% over LIBOR on our term loan borrowings which were $21.3 million at the close of Q3 as well as for the revolver. The LIBOR margin will remain the same during the fourth fiscal quarter despite the increased borrowing level associated with the acquisition.

In March, our revolving line of credit was increased to $50 million. The revolver and term loan mature in December of 2012. We also have $20 million of non-amortizing notes for which we pay a fixed interest rate of 7.43%. Those are maturing in December 2014.

Shareholders’ equity at April 30th was $81.7 million or $7.16 per diluted share. As of April 30th, we had 11.2 million basic shares and 11.4 million diluted shares outstanding.

As we reported, our Chairman and KMG’s largest shareholder, David Hatcher, sold 1 million shares of his KMG stock in April. He remains our largest shareholder with approximately 3.1 million shares. The placement of those shares he sold has enhanced the trading liquidity of our stock while bringing us some significant new institutional shareholders.

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

Neal Butler

Thank you, John.

We expect our fourth quarter results to be on par with the third quarter producing another record year for the company. We are looking forward to the increased market share that the expansion of our Electronic Chemicals line brings as well as realizing the synergies associated with combining the two businesses. As we said before, we expect our latest acquisition to be significantly aggressively accretive to earnings starting in fiscal 2011.

We track EPS performance relative to peer companies, and to maintain a position within the top quartile, our minimum target is an annual compound growth rate of 15%. A regression line run through quarterly EPS performance over the last five years shows a compound annual growth rate of over 30% through this quarter. We believe KMG will continue on a long-term EPS growth path of 20% or greater.

In line with our corporate strategy, we are continuously on the hunt for carefully defined market segments with acquisition opportunities of product lines and businesses and add significant market share, and a clear path toward market leadership through further acquisitions and organic growth. With this latest acquisition, we now have six production facilities with capacity sufficient to bring in new products that are either developed internally or purchased as bolt-ons to our current lines. Our key focus is improved asset utilization and the subsequent impact on increased profits through associated operational synergies.

And lastly, before addressing your questions, I’d like to point out that we will be presenting at the Sidoti & Company Micro-Cap Conference on June 25th in New York. We have also been invited to present in the Canaccord Adams Annual Global Growth Conference in Boston, which runs from August 10th through the 12th and at the Oppenheimer Annual Industrials Conference in New York on September 29th and 30th. We hope to see some of you there.

We do appreciate your participation today, and now open the floor for questions.

Question-and-Answer Session

Operator

(Operator Instructions) And your first question comes from the line of Alex Silverman with Special Situations.

Alex Silverman – Special Situations

Good morning.

Neal Butler

Good morning, Alex. How are you doing?

Alex Silverman – Special Situations

I’m doing well. Thank you. Great quarter. If I were to back out the $4 million or so from the one month of acquisition, that would suggest electronic, your base Electronic Chemicals business or your original Electronic Chemicals business is running at a little over $100 million run rate. Given that this quarter is seasonally weaker than others that would suggest that this business has really recovered back and probably through the prior cycle high. Is that fair?

Neal Butler

Yes. Basically, these were very close to what we think would be a normalized run rate, and for us, the legacy business, the normalized run rate would be about $105 million to $110 million and we are approaching that now.

Alex Silverman – Special Situations

OK. Secondly, is the math correct that you paid $26.7 million for the acquisition but you got $10.7 in inventory and receivables?

John Sobchak

We didn’t purchase receivables with this acquisition, Alex. We did pay $26.7 for the acquisition and we got $7.6 of inventory, and so the net payment for the long-lived assets was …

Alex Silverman – Special Situations

I got you. OK. Very good. Thank you.

Operator

Your next question comes from the line of Arnie Ursaner with CJS Securities.

Arnie Ursaner – CJS Securities

Hi, good morning. I know you provided it in your Q. Can you give us your Penta and Creosote revenues, please?

John Sobchak

For the quarter, Arnie?

Arnie Ursaner – CJS Securities

Yes, please.

John Sobchak

I’m sorry. We had not disclosed Penta and Creosote revenues separately. They will be provided in segment reporting in the Q.

Arnie Ursaner – CJS Securities

When will the Q be up?

John Sobchak

We are filing next week.

Arnie Ursaner – CJS Securities

OK. Can you quantify what I’m going to call atypical expenses that you incurred in Q3? It looks like you had roughly $185,000 of deal expenses or so based on your nine-month number versus the six months. You also – I'd like to get a better feel for how – what the integration expense was in the quarter? Could you just quantify the atypical items in Q3?

John Sobchak

In Q3, we had close to $200,000 of integration-related costs. We had $341,000 year-to-date in transaction closing fees in acquisition-related costs. Those fees were primarily in the second and third quarters.

Going forward, we had disclosed that we anticipate approximately $250,000 per month of integration-related cost through the fourth quarter and then those will tail off basically to zero through the first half of 2011. What that would not include is internal costs. So, you know, there’s going to be a bit of an overlap, if you will, in manpower as we higher up at our Hollister facility to handle additional throughput while we are still in fact paying for production at that third-party facility in Dallas. There is a little bit of an overlap that occurs over the next couple of quarters.

Arnie Ursaner – CJS Securities

And can you quantify what goes into the $250,000 or so per month? It seems like a pretty high number.

John Sobchak

There are third-party fees for project management for IT integration. There are third-party integrators that we use for our Microsoft Great Plains system and the conversion of the data from the acquired business onto our system. There is also a manufacturing agreement that we have in place with the seller for the Bay Point where they will be contract manufacturing certain assets for us. And there is a scaling down of that fee that’s going to occur through the calendar year initially that has a surcharge of $75,000. So it is $75,000 of additional COGS that we will be incurring in the initial months.

Arnie Ursaner – CJS Securities

A couple of financial questions for John, if I can. Can you give us your expected CapEx for the year and D&A for the year?

John Sobchak

The D&A information will be available in the Q. So we can’t disclose that. You know, we’ve been pretty public that our normal maintenance CapEx for the year is $3.5 million for the combined business now.

In addition, as Neal disclosed today, we will have approximately another $1.7 million of CapEx associated with the expansion of our Hollister production capabilities. And there will be some other minor CapEx associated with our Bay Point facility and the purchase of some incremental rolling stock trailers for the business.

Arnie Ursaner – CJS Securities

Are they included in the $3.5 million or is that in addition to?

John Sobchak

That’s in addition to.

Arnie Ursaner – CJS Securities

OK. And what sort of run rate SG&A with the integration completed should we be thinking about?

John Sobchak

We will be providing some additional disclosure in the Q, Arnie. And I would encourage you to look at that. We haven’t disclosed that in our financial release. So we can’t –

Arnie Ursaner – CJS Securities

You’re not disclosing very much on this call. So let me try one more. Can you quantify the expected synergies both on a revenue and cost basis now that the integration is complete? You mentioned in your prepared remarks you have an 80% overlap in business with over a 20% overlap in customers. Are most of the synergies you expect to be revenues, costs, or both? And again, can you quantify them rather than just generally speaking about them?

John Sobchak

Again, Arnie, I will refer you to the Q which will be coming up next week. And I also like to point out that we have some pro forma financial information that you could look at the nine-month 2010 period and I think it gives you a good indication of the accretiveness of the transaction.

Arnie Ursaner – CJS Securities

Thank you.

Operator

Your next question comes from the line of Eric Glover with Canaccord Genuity.

Eric Glover – Canaccord Genuity

Hi, good morning.

Neal Butler

Hi, Eric.

Eric Glover – Canaccord Genuity

Question sort of following up on the last one. You mentioned there is a 20% overlap in the customers in the Electronic Chemicals segment. I was wondering if you could actually specify who some of these new customers are and whether they would constitute to a significant customer for you, perhaps 10% or above chemical revenues.

Neal Butler

We don’t believe that the General Chemical’s previous largest customer in this space would constitute a significant customer, you know, under SEC definition. For instance, you know, our largest customer is – has been Intel and is still Intel. Intel was a relatively minor customer for General Chemical. Their largest customer was Micron. We actually had a relatively minor position with Micron prior to this acquisition. So it was a good pick in that regard.

Looking at the global footprint, 20% of our sales basically were occurring in Europe. General Chemical had a very small presence in Europe. But 20% of their sales did occur in Asia where we had a small position.

Eric Glover – Canaccord Genuity

OK. Are you willing to specify any, you know, new customers from General Chemical?

Neal Butler

You know, Eric, when we look at – I don’t believe that there are any, what I would deem, new customers. Most of them are customers that we indeed worked with, but we had a very small position with them. You know, the comparison was – the basic comparison was the largest customers we had are relatively small for them and the largest customers they had are relatively small for us. And again, in Asia, the significance in Asia was we had our most, I will say, very small presence there basically with – through distribution, one customer. And they have much broader footprint through several of the countries in Asia that we didn’t participate in.

Eric Glover – Canaccord Genuity

OK. And I understand what you mean now overall. OK.

Also on the Electronic Chemicals segment side; I was wondering exactly how much visibility you actually have in your production forecast from these customers.

Neal Butler

The customers give us actually pretty good view going forward. They typically have about a 90-day view of demand from them. You know, we did maintain safety stock for some of the largest customers so we have a recently good view at least three months out.

Eric Glover – Canaccord Genuity

OK. Thank you very much.

Operator

Your next question comes from the line of Jay Harris with Goldsmith & Harris.

Jay Harris – Goldsmith & Harris

To plough some of the same fields again in a little different manner. The $4.2 million of acquired sales in the third quarter suggests to me that you are looking at $12 million to $15 million of quarterly revenues out of the General Chemical acquisition in the July quarter. Are the gross margins in that business high enough to more than cover the short-term additional cost of good sales that are going to be incurred in the transition and the $250,000 or $750,000 quarterly integration costs? Can you put that in an appropriate perspective for us, please?

Neal Butler

Good morning, Jay. When you take into consideration those additional costs and also the additional interest expense that we’ve incurred to fund the acquisition, it gets close. And, you know, what we have said is that at this point we believe the acquisition in the fourth quarter will be mildly dilutive; mildly meaning, you know, pennies per share.

Jay Harris – Goldsmith & Harris

And when on the timescale do you expect those lines to cross in the first fiscal quarter of the following year?

Neal Butler

Yes.

Jay Harris – Goldsmith & Harris

All right. And will you be providing us in subsequent calls with how the $250,000 per month integration costs evaporate?

Neal Butler

Yes. Yes. We will, Jay.

Jay Harris – Goldsmith & Harris

All right. Switching over to Wood Treating Chemicals, can you give us a profile of what you expect to happen beyond the July quarter?

Neal Butler

We look at the rail tie and utility pole business over the course of the remainder of this calendar year, for instance, talk about that first. The forecast going forward from rail tie association is that the demand for rail ties will probably range somewhere around the 18 million to 18.5 million tie rate. Right now, the last several months, we’ve been running probably slightly less than that, between 17.5 million and 18 million ties is our estimate.

So we will see that business going forward will flat line, we believe, somehow – somewhere around that 18 million to 18.5 million tie level.

Utility pole market has – the market has been depressed just because of maintenance has slowed down, but the utility pole market cycles like the rail tie market does, because ultimately you have to do the maintenance, and we are beginning to see even this quarter that volume starting to ramp back up some.

Jay Harris – Goldsmith & Harris

And what do you think will happen to the margin issue on your chemicals there?

Neal Butler

If you look at the margins that we have in the third quarter, we believe fourth quarter margins and the margins going forward will range somewhere right in that general range.

Jay Harris – Goldsmith & Harris

And what’s –

Neal Butler

Maybe it’s a minor fluctuation, but I don’t think it’s going to be a significant fluctuation.

Jay Harris – Goldsmith & Harris

And what are the conditions that would cause a significant variance?

Neal Butler

Well, in Penta, a significant variance – the first significant variance would be just volume and the impact that has on plant throughput and the subsequent impact on cost of goods. As the volume ramps down, the demand ramps down, obviously our production goes down.

We see some increase in our cost of goods, which is what we’ve been seeing of the last several months. The other major factor, for instance, for Penta is the price of chlorine because chlorine is a key raw material for that product and the price of chlorine has come down a bit of late, I think, somewhere around $300 to $310 a ton now. So it has come down some from the highs.

If you look at the Creosote, Creosote basically, the major impact of Creosote in terms of unit gross margin is simply a function of what we have to pay for the Creosote that we import and the material that we buy domestically. We are buying a finished product there.

Jay Harris – Goldsmith & Harris

And the price of the Creosote is tied to what?

Neal Butler

There’s not a really good correlation to any trackable material. And, you know, the supply and demand characteristics are pretty complex because Creosote is basically a byproduct of the steel and aluminum production industries. But for the Creosote that we purchased in Europe, there is a loose tie to the price of heavy fuel oil.

Jay Harris – Goldsmith & Harris

But no such linkage in this country?

Neal Butler

No.

Jay Harris – Goldsmith & Harris

Interesting.

All right. Thank you, gentlemen.

Operator

Your next question comes from the line of JT Rieck with Crosscap.

Jt Rieck – Crosscap

Just one question, and we’ve kind of gotten pretty close to it. So you all said that about $341,000 of the transaction costs were year-to-date. Do you have that just in Q3? So I can get a clean Q3 number of integration and transaction?

John Sobchak

I don’t have that number available now. And we include it in the Q.

Jt Rieck – Crosscap

OK, that would be helpful.

Also another thing I just wanted to make sure I understood right is, kind of in the concluding paragraph on the release, you sort of indicated that your fourth quarter net income would be in line with the third quarter. And I guess you kind of already talked about that, but does that basically mean that all of the increase in the $16 million or so, give or take, $15 million, $14 million, whatever, of, you know, full quarter of the acquisition are going to be completely offset by the integration costs and the higher interest costs?

John Sobchak

Yes. So, you know, again, we would expect that integration. When you include all of those costs you just talked, about would be mildly dilutive.

Jt Rieck – Crosscap

OK. But none of the other businesses – you don’t see any turn-off in those to contribute to that decline, do you?

John Sobchak

Correct.

Jt Rieck – Crosscap

OK. Good stuff. Thanks, guys.

John Sobchak

Thank you.

Operator

Your next question comes from the line of David Cohen with Midwood Capital.

David Cohen – Midwood Capital

Yes.

Neal Butler

Hi, David.

David Cohen – Midwood Capital

Just on the Electronic Chemicals business where you had pointed out that you had a $2.9 million operating profit this year’s quarter, did the General Chemical business contribute to the operating profit or was it neutral on an operating profit basis?

Neal Butler

No. If you actually take into account the, you know, integration and transaction costs, it was, you know, slightly dilutive.

David Cohen – Midwood Capital

OK.

And the 25% decline in Wood Treating revenue, was that all volume? Were there actually negative price move that you guys realized or is it all volume?

Neal Butler

Volume.

David Cohen – Midwood Capital

OK. And just looking sequentially in a year-over-year, that business went from basically down $1 million in sales, but down $1.2 million in operating profit. How much of that change in operating profit was volume-driven versus raw material driven?

John Sobchak

David, we hadn’t disclosed that. That’s a good point. And we will look to incorporate something into the Q to provide some insight.

David Cohen – Midwood Capital

OK. All right. Thanks, guys.

Neal Butler

Thank you.

Operator

Your next question comes from the line of Steve Roberts with NorthPointe Capital.

Steve Roberts – NorthPointe Capital

Hi. When we’re looking at fiscal 2012, how much integration cost should we be including?

Neal Butler

In fiscal 2012, there won’t be any.

Steve Roberts – NorthPointe Capital

No. So basically, Q4 will have $750,000 of integration cost and then Q1 should be essentially zero?

Neal Butler

I’m sorry, you are asking about our fiscal 2011.

Steve Roberts – NorthPointe Capital

Oh, I’m sorry, yes, I’m on 2011. I’m sorry. Excuse me.

Neal Butler

So, I’m sorry, essentially next fiscal year. We hadn’t – we had not fully defined that yet. And, you know, frankly, the integration is fairly complex because it also involves getting certain products re-qualified for production at different locations with our customers. So it’s not just a question of what we can accomplish in terms of operationally and systems integration, but also what our customers can accomplish in terms of their capacity to get the products re-qualified. So we are working closely with our customers to, you know, narrow down the answer.

Steve Roberts – NorthPointe Capital

Can you give us a range though for ’11?

Neal Butler

Well, you know, what we had said was that integration costs are going to start out at – move from $250,000 per month at the beginning of fiscal 2011 and decline to basically zero by the end of the second quarter. So if you take a ruler and straight line that, you’re going to be too far off.

Steve Roberts – NorthPointe Capital

OK. Thank you.

Operator

(Operator Instructions) Your next question comes from the line of Arnie Ursaner with CJS Securities.

Arnie Ursaner – CJS Securities

First question I have is with Creosote contracts. Are they in euros or dollars? And how is the currency change affecting those contracts?

Neal Butler

The contracts are in dollars, Arnie. The only place where foreign exchange has an impact is on our business in Europe in the Electronic Chemicals business. And in the Electronic Chemicals business in Europe, we manufacture in dollars – excuse me, we manufacture in euros and we sell in euros. The only impact it has is on the translation of the profits.

Arnie Ursaner – CJS Securities

And I want to try to follow up Steve’s question. Your margin in Electronic Chemicals last quarter was 13.3% before you completed this acquisition. And I believe your view is, by the middle part of next year, this should be materially accretive to results. So, how should we, you know, is the 13% margin you had in Q2 prior to making the acquisition, given that we’ve got a nice strong cyclical recovery underway and that you plan to take actions to lower your costs, why wouldn’t that be at least a base number for your Electronic Chemicals margin going forward starting mid-year ’11?

John Sobchak

You know, we – correct, Arnie. We see no increases that would cause that operating margin to decline. You know, a large part of that driver was the efficiency improvements we’ve seen in supply chain. We see no reason why those shouldn’t continue. And in fact, there’ll be some improvement there due to the higher volumes that the new acquisition brings.

Arnie Ursaner – CJS Securities

OK. And you are incurring – and I don’t know how much again, I just remind you that under Reg-FD, anything you say on the call is perfectly acceptable so you can disclose whatever you can. It does meet the requirements of Reg-FD. So let me try one more question here. How should we think about margins after your tolling agreements end and they are supposed to be completed by calendar ’10? How much are they holding back margin now and how should we think about the incremental margin once those are completed?

John Sobchak

Again, Arnie, notwithstanding what your comment, we can say our SEC filings are primary source of communication with our investors and we do provide greater disclosure than minimum required in those documents, and we plan to provide some greater insights in that.

Arnie Ursaner – CJS Securities

OK. Was there any revenue contribution this quarter from the R&D LifeSciences agreement and also the other agreement you had disclosed previously? AgriLabs, was there any revenue contribution from that? If you could comment on both of those?

John Sobchak

Yes. There was no contribution from R&D LifeSciences. Basically in this quarter we had our sales force trained in those products so we are starting to see sales of those products now. And let me also say that, you know, we anticipate the contribution to be relatively minor this fiscal year.

With regard to AgriLabs, the benefit there was not only on sales, but also in terms of cost savings. We were able to reduce our sales and marketing expenses, and at the same time, increase the number of feet on the street that are representing our products. The commission that we paid to R&D LifeSciences was a little over $200,000 to about $220,000 this fiscal year. That shows up actually as a reduction in revenue because it’s a commission paid.

Meanwhile, we were able to save over $1 million in operating expenses in that business. So, you know, we believe that R&D – excuse me, the AgriLabs agreement was a major driver for the improved profitability in that business.

Arnie Ursaner – CJS Securities

Two more questions from me. In response to David’s question – David Cohen’s question, I believe you indicated that the operating profit contribution was dilutive. Does that imply – just to be very clear, does that imply having a negative operating profit in the quarter after the one-time expenses? And to follow that up, should we expect a – we've been assuming a flat contribution from the acquired business. Did you actually have an operating loss in the quarter and should we assume that for the next several quarters?

John Sobchak

My comment to David also took into account the interest expense – the additional interest expense we would incur because of the $20 million we got on the revolver to fund the acquisition. So with that consideration, we are – again, we are anticipating the acquisition to be mildly dilutive in the fourth quarter.

Arnie Ursaner – CJS Securities

OK.

And going back finally to the Wood Treatment volumes, which again I’m gathering I’m not going to get a lot of disclosure on much of anything, you did mention the industry data though appears to be down roughly 10%. Your volumes increased so that at least in the last quarter where I gather you did disclose it were down 18%. Are you losing share in some form or is there – is it perhaps an inventory reduction at your customers? How should we think about your volumes relative to the industry decline of roughly 10%? Are you better or worse than that industry numbers and perhaps comment further as to where you stand and why?

John Sobchak

You can’t look at just the – a broad industry decline and assign that to each of the players in the market because different railroads have different maintenance cycles that aggregate up to the overall industry levels. And if a wood treater doesn’t have a wood treatment facility on that particular railroad volume, you know, they will not be able to participate in the business for that railroad.

So, you know, different mines are having – they have their own cycles in terms of replacing the rates. We do not believe that we have lost any significant market share in the Creosote business. And going forward, we are starting to – we already started to see some mild recovery in volumes.

And if you look at the contribution for that business, we are still at a very healthy level of operating profit contribution. Granted, compared to where we were in the second half of last year, contributions are down significantly, but we have said consistently for the past 12 months that the third quarter and fourth quarter of 2009 were unusually strong quarters because the railroads and utilities maintained high levels of purchasing through the recession, and at the same time, we saw raw material prices come down dramatically as a result of the recession which, you know, benefited the company.

Arnie Ursaner – CJS Securities

One more final one from me. On SG&A you indicated that that included your distribution expenses in that line. Of the $10.1 million of SG&A what was the breakout of distribution expense?

John Sobchak

We’ll put it in the Q.

Arnie Ursaner – CJS Securities

Thank you.

Operator

Your next question comes from the line of Steve Schwartz with First Analysis.

Steve Schwartz – First Analysis

Good morning, guys.

John Sobchak

Good morning, Steve.

Steve Schwartz – First Analysis

Have you – let me put it this way. I guess in the railroad business, first quarter, even into the second quarter, there was a weather impact, treaters couldn’t get logs out. Do you foresee any makeup business in your fourth quarter and even in the second half of the calendar year?

John Sobchak

We believe we will see some mild makeup in the fourth quarter. We do believe we will see makeup in the second half of the calendar year yet. You know, to your point, they were unable to get into the woods to bring a lot of the timber out so there was a bit of pent-up demand there. And basically what it did is it burned up inventories at the treaters. But we will see some – we will start to see some uptick, we believe, in our Q4 and then certainly starting in August into the end of the year, we believe, we will see it ramp up some.

Steve Schwartz – First Analysis

OK.

And then just to recap a response you gave earlier on your raw material costs in that business, it does sound like both Penta US-source and European-sourced product, those are all costing you more these days.

John Sobchak

Well, Creosote is what we source out of Europe. Penta, we actually manufacture the Penta. We synthesize that product at our Mexico plant. As a matter of fact, we are the only Penta manufacturer in the Americas. So, that one is one that we actually manufacture ourselves. What you are referring to that comes offshore is the Creosote.

And one of the things you see with the creosote is this last year we had an issue with product mix. You saw the margins tick-up rather notably with creosote. A great portion of that was the consequence of the United States source of Creosote went short for a period of time. We were able to backfield that with Creosote that we supplied out of Europe. That’s a higher grade, slightly more profitable product that moved into what had been the US-supplied market prior. So we saw a bit of an uptick in the margins as a consequence of product mix, but it was not an issue of pricing.

Steve Schwartz – First Analysis

OK –

John Sobchak

It was not an issue of cost.

Steve Schwartz – First Analysis

OK.

John Sobchak

If I should say, you know, domestically, with the Pentachlorophenol, the issue there in raw material cost is chlorine. And I know you are familiar with the chlorine market. The prices that we are paying for chlorine now are six or seven times what we paid at the low point. I don’t expect chlorine to get back down to $50 a ton.

Steve Schwartz – First Analysis

So it’s chlorine and the Creosote. OK.

And just on the Electronic Chemicals business, we’ve been hearing about potential supply issues for anhydrous HCl. I think that’s one of your major raw materials in that business. So I think Dow may potentially step out of the merchant market and so forth. Is that at all impacting you and to what extent?

John Sobchak

No, we don’t actually purchase any anhydrous HCl. We buy hydrochloric acid. We do have some purification capabilities for that. We also manufacture hydrochloric acid as a byproduct at our facility in Mexico. It’s a byproduct of the Pentachlorophenol process.

Steve Schwartz – First Analysis

OK. So we shouldn’t be concerned about what we are hearing then in that area?

Neal Butler

Not with HCl.

Steve Schwartz – First Analysis

OK. Very good. Thank you.

Operator

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

Rosemarie Morbelli – Ingalls & Snyder

I was wondering if you could touch a little more on the Animal Health segment. You are saying the demand is increasing. Is that because of a larger size of herd or are there other factors behind it? And is it – do you see that pickup continuing?

Neal Butler

No, it’s not a consequence necessarily of larger herd. Basically it’s a consequence of a more – of a healthier market for beef right now. The beef prices have gone up; the profitability for growers has improved. When you look at the products that we supply to this industry, they are discretionary spend. They do indeed improve the return on investment for the grower, but nonetheless, you know, it’s a discretionary spend that the grower can do without if he gets, you know, during tough economic times. Now that has improved, what we are seeing now is an uptick simply as a consequence of a healthier market for the cows.

Rosemarie Morbelli – Ingalls & Snyder

OK.

If this is the entire bag, let’s call it, for lack of better words on my part, this is what you are selling into that market, right?

Neal Butler

Say it again, I’m sorry, I misunderstood the first portion.

Rosemarie Morbelli – Ingalls & Snyder

Well, all right. Then let me – have you actually – do it another way. What is it that you are selling again into the herd market since I don’t seem to come with a right explanation?

Neal Butler

I understand now. The products that we sell in the Animal Health are ectoparasiticides so basically they’re insecticides that are used on production food animals to control parasitic pests. And we sell a number of delivery vehicles.

The largest one we sell is ear tags. Again, these are used to control the parasitic flies. And then we sell another series of products that are liquid pour-ons, we have some dusts, and some other products that are similar to those that are used, again, to control – these are surface control for production food animals.

Rosemarie Morbelli – Ingalls & Snyder

So are you saying that when the price of these is low, we are all buying meat from not as healthy animals and the farmer – I mean, the rancher has no problem having those beefs, you know, not truly healthy? No regulation from the government comes into play forcing them to do what they have to do?

Neal Butler

The products we sell really aren’t a function of improving the quality of the beef that are necessary to the health of the animal. What it does do, though, is it improves the food conversion ratio. The parasitic pest will cause animals to gain weight at a reduced rate. And you control those parasitic pests and the food conversion ratio improves. And again, it does – it’s not required, the beef is no less, the health of animal is no less. It just doesn’t gain weight as rapidly.

Rosemarie Morbelli – Ingalls & Snyder

OK, I understand. That is helpful. So, now you are getting into additional – distribution of additional products for both North America and South America. Could you give us a feel as to how large you see that particular product of the Animal Health business two years out? I’m assuming that you have some plans that you have already put down when you decided to sign an agreement with LifeSciences.

Neal Butler

When you look at the products that we are purchasing from the R&D LifeSciences, these are probiotics. These are products that can be used to replace antibiotics in certain markets. These are relatively new product lines in the state. They have been around a bit, but they are gaining some – a great foothold and lot more traction in the marketplace. So when you look at it, the question is, what portion of the antibiotic markets can you obtain with probiotics?

And, you know, we’ve got projections going forward, but, you know, at this juncture, it’s not a projection that we’re taking to the marketplace, because, number one, we are not certain what that market is going to do; and number two, for comparative reasons, we just think it’s not a proper thing to start communicating this.

The second component is Latin America. Latin America wouldn’t be moving some of these products, and the Latin America R&D LifeSciences is obtaining the registration from these countries. So a portion of when we begin selling it to some of these countries is along the timing of when they receive the registrations.

Rosemarie Morbelli – Ingalls & Snyder

OK. And when you talk about adding – expanding your product portfolio, I am assuming you are talking about the bolt-on type of acquisitions.

Neal Butler

Yes, basically. Bolt-on acquisitions and – Rosemarie, are you talking about specifically the Animal Health area?

Rosemarie Morbelli – Ingalls & Snyder

Yes.

Neal Butler

Bolt-on acquisitions, but also acquisitions – excuse me, not acquisitions, but other contractual arrangements that we’ve constructed with R&D LifeSciences that helps us to better leverage off of our existing distribution chain.

Rosemarie Morbelli – Ingalls & Snyder

There will be – so, is there going to be a manufacturing component of, for example, your agreement with LifeSciences or is it just distributing products that they are making and therefore it will add to your top-line but not necessarily improve the margins of that particular overall business?

Neal Butler

That’s correct. That R&D LifeSciences agreement is a distribution agreement. And the margins for selling of those products aren’t as robust as they are for the products that we manufacture ourselves.

Rosemarie Morbelli – Ingalls & Snyder

Over time we will see revenue growth and margin decline for that business?

Neal Butler

Yes. And of course, the goal is overall increase in operating profit though.

Rosemarie Morbelli – Ingalls & Snyder

OK. Thank you.

Operator

Your final question comes from the line of Jay Harris with Goldsmith & Harris.

Jay Harris – Goldsmith & Harris

I’d like to return to Electronic Chemicals. The activities in your Colorado plant, as you integrate the acquired product lines, will you be forced to – are you still going to be in a single shift mode?

John Sobchak

Jay, we are actually working our staff with four 10-hour days.

Jay Harris – Goldsmith & Harris

All right. And you consider that single shift?

John Sobchak

Yes, we consider that single shift. And in order to – in order to accommodate the additional production that we anticipate – that we are going to have in Pueblo is beyond anticipation. We are going to have to increase the hours worked at that plant.

Jay Harris – Goldsmith & Harris

So –

Neal Butler

We’ll make some second shifts, yes.

Jay Harris – Goldsmith & Harris

All right. So that – for purposes of estimating the incremental gross profit potential on the Electronic Chemicals purchased from General Chemical, labor is not a fixed cost, it’s a variable cost.

Let me give you an example of what’s in my mind and then perhaps you can address the question. Let us assume you’ve just acquired a $50 million business and in the hands of the seller generated a 30% gross margin, 70% cost of goods sold. If all of the product lines were to be put into Pueblo, Colorado, and I’m making assumption that half of the cost of goods sold are raw materials and utilities and the other half are fixed charges, those related to capital investment and part of your recent answer, labor.

So, if you are going to add $50 million of incremental revenues and have a 35% gross margin against that because all the fixed costs in Pueblo are fully reflected in each of your quarterly numbers, that would be a very high incremental gross profit contributor once we are through with the integration phases that we discussed earlier on this call. Can you provide any massaging of the number system that I’ve just thrown out to make the calculations more accurate?

John Sobchak

Yes, Jay. When we talked fixed and variable components in the past, and we’ve said that approximately 30% of our costs associated with Electronic Chemicals business are fixed, we were including labor as a fixed cost.

So when we talk about variable cost, we talk about variable on a week-to-week basis. The labor that involves, let’s say, at Dallas, in manufacturing solvents, we don’t have to replace that man pool, person-for-person in Hollister when we move those products to our new facility in Hollister. The reason is because you don’t necessarily need two plant managers. You don’t need to double your laboratory requirements. You don’t need to double your supervisors. So while there are some additional manpower additions that are going to occur at Hollister, it is less than what we will be leaving in Dallas. And we will be able to provide some greater insight into our expectations in the Q.

Jay Harris – Goldsmith & Harris

Well, just on the basis of your response, it sounds to me that on the sound basis of the $50 million addition to your system, that at some point you are going to be getting an incremental 50% gross margin on that $50 million.

John Sobchak

And Jay, you know we never disclose the gross margins for each of our segments. We look at the operating margin for segment reporting.

Jay Harris – Goldsmith & Harris

I appreciate the comment. Thank you.

Operator

At this time, there are no further questions. Presenters, do you have any closing remarks?

Neal Butler

We do want to thank everybody for participating today. Again, we do want to communicate that we have been and continue to be very pleased with this newest acquisition and we are enthusiastic about the impact it’s going to have on our business going forward, most notably in the second half of fiscal 2011. We hope to see some of you to the conference we will be presenting at and we look forward to visiting with you next quarter.

Operator

This concludes today’s conference call. You may now disconnect.

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