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Ecolab (NYSE:ECL)

Q2 2010 Earnings Call

July 27, 2010 1:00 pm ET

Executives

Douglas Baker - Chairman, Chief Executive Officer and President

Michael Monahan - VP of External Relations

Analysts

Mark Gulley - Soleil Securities Group, Inc.

Steven McNeil

Rosemarie Morbelli - Ingalls & Snyder LLC

David Ridley-Lane - BofA Merrill Lynch

Robert Koort - Goldman Sachs Group Inc.

John McNulty - Crédit Suisse AG

Michael Harrison - First Analysis

Richard O'Reilly - S&P Equity Research

Edward Yang - Oppenheimer & Co. Inc.

John Roberts - Buckingham Research Associations

Laurence Alexander - Jefferies & Company, Inc.

Nathan Brochmann - William Blair & Company L.L.C.

Gary Bisbee - Barclays Capital

Dmitry Silversteyn - Longbow Research LLC

P.J. Juvekar - Citigroup Inc

Operator

Welcome to the Ecolab Second Quarter 2010 Earnings Release Conference Call. [Operator Instructions] Now I would like to turn the call over to Mr. Michael Monahan, Vice President, External Relations. Sir, you may begin.

Michael Monahan

Thank you. Hello, everyone, and welcome to Ecolab's second quarter conference call. With me today is Doug Baker, Ecolab's Chairman, President and CEO. A copy of our earnings release and the slides referenced on this teleconference are available at Ecolab's website at ecolab.com/investor.

Please take a moment to read the cautionary statement in Slide 2, stating this teleconference and the slides include estimates of future performance. These are forward-looking statements and actual results could differ materially from those projected. Factors that could cause actual results to differ are described in the section of our most recent Form 10-K under item 1A, Risk Factors, in our second quarter earnings release and in Slide 2. We also refer you to the supplemental diluted earnings per share information that is also in the release.

Starting with Slides 3 and 4, we continue to deliver strong earnings results in the second quarter despite mixed conditions in our end markets. The sales gain was fueled by aggressive actions to gain new accounts using our innovative new products and industry-leading service force. Margins improved on the better volume and benefited from favorable delivered product costs and cost-reduction actions. Looking ahead, we expect to continue outperforming our gradually improving markets and deliver superior growth once again in 2010.

Starting with some highlights from the quarter. Reported second quarter earnings per share were up 32% to $0.54. On an adjusted basis, excluding special gains and charges and discrete tax items from both years, second quarter 2010 earnings per share increased 12% to $0.56. The adjusted earnings per share growth was driven by better volume, new products, new account gains, pricing, favorable delivered product costs and cost savings, which more than offset higher operating costs and continued investments in our business.

Our U.S. and European Foodservice markets remained soft but are stabilizing. Lodging room demand has increased and is showing good trends worldwide. The Food & Beverage and Healthcare markets remained steady, and we continue to see good growth across all market segments in our Asia-Pacific and Latin America businesses. We continue to be aggressive, focusing on top line growth as we emphasize our innovative products and service strengths to help drive market share growth in our core businesses and deliver new account acquisitions among our national, regional and independent prospects. We're also making significant investments in key growth businesses to build future growth. We also remained focused on cost savings, emphasizing productivity and efficiency improvement to help increase margins.

Looking ahead, we expect third quarter adjusted EPS to increase 5% to 8% to the $0.64 to $0.66 range, compared with adjusted EPS of $0.61 in the third quarter 2009, reflecting comparison against strong results last year, easing raw material cost benefits and unfavorable currency trends. Despite the uncertain economy and fluctuating currency exchange rates, we continue to look for double-digit EPS growth with adjusted EPS of $2.21 to $2.26 per share for the full year 2010, representing an 11% to 14% gain over last year. That would represent another year in our decade-long performance of fixed currency sales growth, our ninth consecutive year of adjusted EPS growth and eight double-digit EPS gain in the last 10 years.

In summary, we expect 2010 to reflect yet another strong performance by Ecolab, as we use aggressively sales efforts to gain new accounts and achieve better sales penetration, along with improved efficiency and cost savings to once again deliver attractive growth and shareholder returns.

Turning to the details as shown on Slide 5, Ecolab's reported consolidated sales for the second quarter increased 5%. Looking at the components, volume and mix increased 2%, pricing was up 1% and currency benefited sales by 2%.

Slide 6 includes sales growth by segment and division. Sales for the U.S. Cleaning & Sanitizing operations rose 3%. Institutional sales rose 2%. New account gains, new products and the comparison to weaker distributor shipments last year benefited second quarter sales. We continue to outperform mixed market trends with continued soft food service foot traffic and strengthening lodging room demand in the second quarter. We remain focused on driving sales growth using innovative products in ware washing, laundry and housekeeping that provides superior performance while delivering water, energy and labor savings for our customers. We're also targeting new accounts with additional and redeployed sales people in program. These actions have resulted in good new account gains, and we're continuing our efforts to drive more sales at margin growth. We expect these gains, investments in our sales team and new accounts to help Institutional continue to outperform its markets in the third quarter and the year.

Case second quarter sales grew 6%, led by strong growth from new account wins and Food Retail. We also enjoyed good demand from existing and new Fast Food chain accounts. New products and programs like the introduction of Scrub-N-Go, the floor cleaner for QSR restaurants, benefited case results. We expect these initiative, along with continued good new account growth, to help drive strong gains in case third quarter.

Textile Care sales were up 3%, as customer gains, new program launches and the additional sales within existing customers offset continued challenging industry conditions. Ecolab is focused on innovative products and services, operational savings and service excellence to bolster results. With textile industry conditions remaining difficult, we look for sales to be flattish in the third quarter.

Healthcare sales increased 5% in the quarter. Gains in infection barriers and central sterile continue to more than offset the inventory work down of soaps and sanitizers from the prior year's spike in demand due to H1N1 fears. Excluding the H1N1 impact, sales would have increased by approximately 7%.

During the second quarter, we began installing the new OptiPro line of central sterile solid products. Looking ahead, third quarter sales are expected to continue to improve as H1N1-related product inventories appear to have stabilized. Food & Beverage sales grew 3%. Sales increased in the beverage and food markets, as corporate account wins and new products offset soft results in dairy, agri and meat and poultry. Food & Beverage will continue to focus on new account acquisition and new product sales to offset slow end markets and softer pricing. We look for Food & Beverage sales to show similar growth in the third quarter.

Vehicle Care sales decreased 7%. The division remains focused on new more sustainable products and gaining new accounts. However, these efforts were more than offset by weak market demand. We look for Vehicle Care to continue to outperform its market and show sales similar to last year in the third quarter.

Sales for Other U.S. Services were flat in the second quarter. Test elimination sales were up 1% as gains in Fast Food and Food & Beverage plants were offset by slow conditions in other major end markets. We continue to develop new product and program solutions to better serve customer needs in the current environment.

Our new Bed Bug program that reduces room downtime for treatment cycles, and thereby helps to lower customers' total costs, is doing well, as is our new EPA-exempt pesticide, which poses a minimum risk to humans and the environment. It still provides an average kill time for common cockroaches of less than five minutes compared with eight hours for other liquid applications.

We continue to target specific growth markets, like Food Retail and Food & Beverage processing, to build contract growth. And we are working on other programs to provide improved service, efficacy and efficiency for our customers. We expect these efforts to help offset the soft markets and yields improved third quarter sales. GCS sales increased 1% in the quarter. Once again, profitability improved over last year in the first quarter. New account wins offset the impact of slow Foodservice business conditions.

GCS profitability continue to improve as productivity and efficiency improvements were gained throughout the business. We remain focused on developing chain account relationships and driving sales with our regional and franchisee organizations. We have used some of the improvement in profitability to invest in regional sales force additions to deliver current and future growth. Looking to the third quarter, we expect continued sales growth and further profitability improvement.

Measured in fixed currencies, international sales increased 5%. Europe, Middle East and Africa sales increased by 4% in the second quarter at fixed currency rates. Results benefited in part from a weak first quarter and year-ago period.

Europe's Institutional sales increased as Foodservice markets appear to have stabilized, and lodging trends improved in most European markets. Our sales teams targeted new business with regional and local customers. These efforts were leveraged by new products that offer customers superior results, cost savings and better efficiencies.

Food & Beverage sales improved. The business continues to focus on winning new customers by emphasizing the cost savings benefits of our leading products like DryExx and Water Care. Textile Care sales were off, reflecting reduced volumes from central laundries. Europe's healthcare sales were comparable to last year as strength in East Europe was offset by H1N1-related product inventory reductions by customers.

West Europe sales were also comparable to last year, as we continue to improve operations and drive profitability. We are starting to work with Europe's new business information systems platform to unlock costs and complexity in our operations, to drive faster sales growth and higher margins. We continue to expect significant improvements starting next year as the range of growth and profitability actions we will implement begin to take effect. We look for a modest gain in Europe's third quarter fixed currency sales, reflecting a less favorable comparison to last year.

Asia-Pacific sales grew 9% in fixed currencies as the region showed good recovery from last year's low level of the business travel and tourism. Institutional sales were strong as occupancy levels improved and economies recover. Food & Beverage sales showed strong growth. Both the beverage and brewing sectors continue to increase benefiting from improved product penetration and account gains. Looking ahead, Asia-Pacific expects continued good sales growth in the third quarter, reflecting recent account wins and stabilization of the markets.

Second quarter sales for Ecolab's Canadian operations were flat when compared to last year at fixed currency rates. Food & Beverage, Textile Care and Vehicle Care all reported strong sales growth. However, Institution and Healthcare were negatively affected by H1N1-related product inventory reductions. We look for our Canadian business to show better growth in the third quarter.

Latin America reported a strong sales gain, rising 9% in fixed currencies, as all divisions in that region increased. Institutional growth was driven by new accounts, increased product penetration and continued success with global and regional accounts. Food & Beverage sales reflected good demand in the beverage and brewing markets as well as the benefits of new accounts. Overall, we expect the track of growth trends to continue in Latin America with another solid gain in the third quarter.

Turning to margins on the income statement in Slide 7 of our presentation. The second quarter gross margins continued their recovery, increasing 100 basis points to 50.7%. The increase was driven by volume gains, pricing and improved delivered product costs. SG&A expenses represented 37.2% of sales, 70 basis points above last year. The increase in SG&A ratio was due to continued investments in our business, people and systems and other cost increases, which more than offset cost savings and leverage from the sales gain.

Operating income for Ecolab U.S. Cleaning & Sanitizing segment increased 10%. Margins expanded by 130 basis points. The increase was driven by volume gains and favorable delivered product costs. We also benefited from favorable cost comparisons against last year.

Operating income for U.S. Other Services grew 2%. Margins expanded by 30 basis points over last year, driven by pricing and cost savings actions, which more than offset higher service and other cost increases.

International fixed currency operating income declined 5%. Volume gains, pricing and favorable delivered product costs were more than offset by additional investments, including European systems expense and Asia-Pacific and Latin America investments and personnel.

Corporate segment and tax rate are discussed in the press release. We repurchased 1.2 million shares during the second quarter. The net of this performance is that Ecolab's reported second quarter diluted earnings per share was $0.54 compared with $0.41 reported a year ago. When adjusted for special gains and charges and discrete tax items in both years, adjusted earnings increased 12% to $0.56 when compared with $0.50 for the year ago.

Turning to Slide 8. Ecolab's balance sheet and cash flow remained strong. Total debt to total capital was at 34% at June 30, compared with 37% reported a year ago. Our net debt at June 30 was 30%. Looking ahead, we expect a continued mix performance in our end markets, but also look for gradually improving trends. Against that backdrop, we are taking appropriate actions to drive both our top and bottom line.

As outlined in Slide 9, we will continue to drive new account and market share growth using our product and service strengths that combine to help customers reduce their costs and improve their efficiency. We will continue to focus on investment in growth businesses like healthcare, China and Latin America, as well as new products and acquisitions to accelerate the top line. And we'll expand our sales and service force and invest in their field technology to make them more productive. We expect fixed currency sales to rise in the low to mid single-digit range in 2010, and look for gross margins to show continued good improvement.

SG&A will reflect the investments we are making in our sales force and systems. Corporate expense should moderate slightly. Interest expense is expected to be comparable to 2009, and the tax rate is forecast to be in the 30% to 31% range. As mentioned in our opening comments, we are cautious regarding the speed of the recovery and the impact of currency fluctuations on our second half results, but continue to look for double-digit EPS growth, with adjusted EPS in the range of $2.21 to $2.26 per share for the full year 2010, representing an 11% to 14% gain over last year.

The press release includes the line item forecast of our third quarter P&L. Net, we expect diluted earnings per share for the third quarter, excluding special gains and charges and discrete tax items, to increase 5% to 8% to $0.64 to $0.66 range compared with the adjusted earnings per share of $0.61 on the year ago.

In summary, as noted on Slide 10, we had a strong second quarter while still investing in our future. We look for a solid third quarter earnings gain and expect to deliver double-digit EPS growth for the full year 2010, representing our ninth consecutive year of adjusted EPS growth as we continue to outperform mix with our gradually improving end markets. And now, here's Doug Baker with some comments on the quarter.

Douglas Baker

Good afternoon. Before going to Q&A, I just wanted to offer a brief overview. My take on the quarter is that we had a solid quarter. We did exactly what we said we would do. And most importantly, we continue to build momentum in our business, and we're doing this against a backdrop of a really mediocre economic environment, and I'd also remind everybody is against a real history, meaning last year, our adjusted sales, OI and EPS grew. So where are we? Well, we're on the other side of a major SAP implementation which is good news. It means it's all upside from here. The disruptions that accompany a change in this [ph] (22:11) are mostly behind us and will soon be completely behind us. The service and productivity metrics in the region that impacted Europe are showing the right movement, and we're now able to get after savings that have been promised, have been part of this whole initiative.

Most importantly, and even more importantly, our collective growth and innovation investments are paying off. We continue to add share in Foodservice, Food Retail, F&B and our Healthcare businesses. We've had significant corporate account wins the last 12 months, the last six months being the most productive. Our innovation in warewashing, Apex, in laundry, more temperature and more water initiatives, in F&B, DryExx, in new antimicrobial, in QSR are solid, in FRS, our formula of foam, in Healthcare, our EnCompass, Protect, Optisolids, and now, new hand care system, all continue to show very good momentum. In this year's innovation pipeline, it's the second biggest in history, and by far, are most balanced. And also, new initiatives with SYSCO and others are just coming online as we speak.

So finally, the market has stabilized, but it is not yet our friend. We are improving the business without any market help, and we expect the market to continue to slowly improve. So our focus in the second half is really more of the same. Leverage all of the above good deeds to drive our top line acceleration and build sustainable OI momentum built on volume growth. So our forecast for the year is double-digit EPS, our growth of 15% EPS remains our goal, and we believe is the right goal. So while the market growth is slow, if that's we've got huge share upside and we are getting after it. So the business is progressing. We have no real drama to report. We need to continue to focus on execution and deliver the year the right way.

Michael Monahan

Thanks, Doug. That concludes our formal remarks. Operator, please begin the question-and-answer period.

Question-and-Answer Session

Operator

[Operator Instructions] Our first question comes from Gary Bisbee from Barclays Capital.

Gary Bisbee - Barclays Capital

You've talked recently about the pipeline being maybe more robust than it's been in a while, an awful lot of new products. And given that you've historically brought this out at premium price and in premium margin for you, are you seeing any sort of difference in the uptake of new products based on the weaker economy than what you've seen in the past? Or is that something that over the next 12 to 18 months, as you launch all these things, you think will be another good avenue for margin gain?

Douglas Baker

Gary, I would say our experience right now is very positive on the new initiatives. They are higher margin. But even more importantly, they were represent much better value for customers since they're really targeted at getting after water, energy, and in some cases, labor savings. So they've got a great economic benefit for customers and this year is exactly the right story to be taking to the market at this time. So you need to have the balance for those two, meaning, it has got to make sense for customers and the initiatives for launching new.

Gary Bisbee - Barclays Capital

It sounds like there's a lot more. And maybe it's just that you guys are talking about them than you would have in a typical 12-month period or whatever. Is there any issue with getting it all out there? Or is the sales force so targeted on their particular areas that you feel like you're well positioned of uptake on all these new products than one?

Douglas Baker

Yes, Gary, it is a big pipeline. But I guess the point is that it's a balanced pipeline. So this isn't all falling at the feet of one sales force. So we've got initiatives that are going to our Institutional team. We have initiatives that are F&B team. We have initiatives going out to our Healthcare team, our QSR team, our Food Retail team. These are discrete sales teams. And the number of initiatives per team is well managed. It's just that we have a number of initiatives across the teams, across the company. And so this has been planned for a while, and we have been, right, upping our R&D, upping our focus on what we call our anchor technologies, those that we think are the most important in terms of impacting customer satisfaction. So this is a result of several years of effort.

Gary Bisbee - Barclays Capital

I guess, one last question on the margins, particularly in international. It sounds like you've increased the level of investments. Should we read into that as sign that you're feeling better about just the macroeconomic progress in some of those markets are making? Or is it other reasons that you've stepped it up and had margins turned a little lower this quarter?

Douglas Baker

Yes, to answer your specific question, I would say, clearly, in Asia-Pacific and L.A. in particular, we certainly have found those and continue to believe that those are in better shape economically than, say, near-term U.S. and Europe. I don't think this is a unique view on our part. But certainly, we are upping the investments, particularly in Asia-Pacific, where we've added several hundred heads year-on-year, and then a number other things to continue to drive growth.

Operator

Our next question comes from Nate Brochmann from William Blair & Company.

Nathan Brochmann - William Blair & Company L.L.C.

Doug, just to follow up on that last question a little bit. Just wanted to think a little bit more on how you guys think about investment and kind of also balancing that with bottom line returns. And then also, secondarily, if you could talk a little bit about underlying productivity, if we are able to strip out some of the higher investments, if any?

Douglas Baker

Yes, I don't know, I mean, how philosophical you want to get. I mean, if you look at AP and L.A. OI growth was spectacular in the fourth quarter and just excellent in the second quarter. So it was in the 25% year-on-year range. And so we typically will continue to feed the business. And in AP, and L.A. in particular, we see very significant growth upside and very significant opportunity to capture increased share in a market we believe is going to grow faster than the balance of the world. So we want to seize this opportunity now. So we are investing somewhat on the comp as we go through this, right? We will add people and our people don't become productive immediately. We're making sure that we've got very smart infrastructure bets, not huge ones and they're very limited. The ones that we need to make is by and large. We've got the infrastructure built. We are rolling out fuel technology in these regions because we know it does two things. It enables us to supply even better value to our customers by collecting data. And it also allows us to drive productivity in the region as we build scale in that region. So I don't know if that gives you any color. Europe, we've also, obviously, had major investments, which is the other part of the international story for us. And those investments are largely around EBS. So we have the last wave, if you will, of EBS, eight countries, which by far, our largest wave. So you've got increased amortization showing up in the second quarter. That will stick with us. But even larger than that, you've got the natural but unfortunate disruption costs that come with flipping from one ERP system to another. Things like back orders, when you're moving from one inventory to the other, which means double shipments to a customer per order. Now all these costs are starting to move in the right direction, but they are incurred when you go through one of these things. And we're going to move out of this. So that's another big piece of the international OI piece. If I was going to give you a picture going forward, our expectation is that international acceleration on the top line is going to continue in Q3 and Q4. And we will start seeing significant OI momentum in our overall international segment beginning in Q4.

Nathan Brochmann - William Blair & Company L.L.C.

And then, just to think about the Asia-Pacific business a little bit. I believe, up until at least recently, that a lot of that growth has been coming from moving along with U.S.-based customers. Is that starting to expand a little bit beyond that base?

Douglas Baker

Oh yes, I would say it is. I mean, if you look at our top 20 customers in China, the majority of them would be Chinese at this point in time. And so that's been kind of an evolution that's been occurring because that market has been rolling. And obviously, local Chinese players are becoming quite a large player in the Food & Beverage space in particular.

Operator

Our next question comes from Mark Gulley from Soleil Securities.

Mark Gulley - Soleil Securities Group, Inc.

Doug, it had to be kind of interesting to see Institutional growth behind, let's say, Textile and Europe. And I know that a lot of it is market driven. But perhaps you can give us some observations on the pace of which you think U.S. Institutional can recover here.

Douglas Baker

Yes, Mark, I will -- we may record that and send it to the Institutional. They noticed that too. Institutional has clearly had the most significant market impact. We know that we are adding share when we look at customer accounts in that marketplace. But even when we go back, they've had three years of declining foodservice in terms of traffic count. So while it's stabilizing, and certainly, if you will, the decline has stabilized, they're still looking for the rebuild, which is coming in the future. I expect that business to continue to accelerate growth. They will rebuild at a fairly steady pace, which is what we've seen following other significant dips in Institutional growth rates. We're seeing that pattern, and all the things that we ought to be doing in that business, we're doing. We're after new accounts. We're driving in new innovations. We're working on penetration. I mean, all the stuff that we know is key to rebuilding the top line. And the team is doing a number of excellent things there. So I'm very confident that, that business will rebuild to the type of sales we expect.

Mark Gulley - Soleil Securities Group, Inc.

To make that happen, Doug, do you have to continue to add people? Or kind of following on some previous questions, are you really differentially adding people to high-growth areas, what you talked about in the slide deck, and maybe not so much in some of these low-growth areas?

Douglas Baker

Well, I mean, it's not even, meaning we are adding more significantly and investing more significantly in high-growth areas than we are in areas that aren't high growth. I would also say the high-growth areas are also self scale versus some of our other businesses. So those two things [ph] (34:14) in the high-growth arena. But with that said, in Institutional, we will make and continue to make very select investment. Because there are significant opportunities to grow that business in North America and in Europe as we move forward. So this isn't a case of that business doesn't get the investment. That business will get the right investment. There are a number of high potential share areas that we've identified that we're going after. We've increased the number of corporate account team in those areas. There's a pretty rich area in terms of regional accounts that we know we're going to get after. There's some very critical initiatives with large distributors that are really just starting to unveil. So there's a lot going on there. So they will get investment.

Mark Gulley - Soleil Securities Group, Inc.

And then finally, Michael, if you will, a sort of a housekeeping question. Built into your guidance, what kind of FX impact might we expect in the second half of the year?

Michael Monahan

We're looking for a negative $0.03.

Mark Gulley - Soleil Securities Group, Inc.

That's for the whole second half?

Michael Monahan

Yes, and we had a positive $0.03 in the first and we expect a negative $0.03 in the second.

Operator

Our next question comes from David Ridley-Lane from Merrill Lynch.

David Ridley-Lane - BofA Merrill Lynch

Healthcare sales, the H1N1 are up 7%. What are the internal revenue growth goals for healthcare and how quickly can you get back up to double-digit growth in that vertical?

Douglas Baker

Well, somebody answered what the internal growth goals are for healthcare, double-digit organically, right? And then on top of that, we will continue to look for smart acquisition target as we build that business. We would expect to be there, on a reported basis, early next year. I think if you look underneath, recall in the second half, we're going to still be going against a pretty inflated H1N1 purchase base last year. But the underlying metrics, the new initiatives that I highlighted in my opening comments are all making very good traction. That business continues to strengthen.

David Ridley-Lane - BofA Merrill Lynch

And maybe following on from your comment about certain geographies being subscale, what are the geographies where you would say you're the most subscale and would have the highest potential incremental operating margin from adding revenue?

Douglas Baker

Well, I'd say if you want a real broad comment, it would be -- AP and L.A. would be the regions that have the most subscale. But I would say, China, India, there's still significant upside in our Latin America business. And I would also say kind of other Asia, x Australia, New Zealand and Japan.

David Ridley-Lane - BofA Merrill Lynch

What was the raw material pricing change compared to last year?

Michael Monahan

A couple of cents.

Douglas Baker

$11 million year-on-year in Q2.

Operator

Our next question comes from Edward Yang from Oppenheimer.

Edward Yang - Oppenheimer & Co. Inc.

Doug, just following up on that last question. Don't you have the most margin leverage in Europe?

Douglas Baker

Yes, but the question was about subscale. We aren't subscale in Europe. What we are is poor margins. And so Europe, it is really leveraging the scale that we've already built. So yes, Europe has got the most upside margin. But the question I was answering is, where does volume growth have the most benefit? And I would say in the regions that I identified. In Europe, the margin journey is really as we've laid out in the past. Leveraging the EBS system, getting after the pan-European supply chain system, which means there's huge money in transportation and warehousing. We know there's money in purchasing, and we know operating, if you will, our plants more efficiently. There's big SP&A upside as we stop running 33 independent companies and start leveraging the scale of the business and move forward, which is all the play on to start moving from the nearly 4% to 5% OI margins that we're at today on an annualized basis, up to the teens that we've talked about.

Edward Yang - Oppenheimer & Co. Inc.

And what was Apex's growth in the quarter and the penetration rates in the U.S.? And would you look to introduce Apex into Europe anytime?

Douglas Baker

Yes. Ultimately, we'll expand Apex technology globally. And we are finalizing, frankly, great manufacturing technology, which will allow us to do this very efficiently from a capital standpoint. And first, we're going to go to a different market, but Europe will get that technology in the near term. The growth rate was double-digit in Q2. Apex now represents over 25% of our warewash sales, machine warewash sales in North America. It continues to progress very well.

Edward Yang - Oppenheimer & Co. Inc.

And maybe a final modeling question for Mike. Interest expense has been pretty stable around $15 million a quarter, but your net debt is down sequentially, was down year-over-year as well. Any opportunities to get some interest expense leverage?

Michael Monahan

What do you mean by interest expense leverage, Ed?

Edward Yang - Oppenheimer & Co. Inc.

Well, your net debt is down, but the interest expense is remaining pretty stable. So is there any opportunities to get the effective rate of interest expense lower?

Michael Monahan

We just had $150 million of debt go short term, and it's due in February. So we'll be paying that down, and we've also been doing share repurchase as well.

Operator

Next question comes from John McNulty from Credit Suisse.

John McNulty - Crédit Suisse AG

Mike, I think in your original comments on F&B, you would talk about maybe some pricing being a little bit weak there. Can you go through what's actually driving that?

Michael Monahan

Well, pricing was very strong, if you remember, through 2008 and 2009. And I was just saying that relative to those periods, pricing is flattish compared to very strong pricing that we had in those two years.

John McNulty - Crédit Suisse AG

So it's not down, it's just not the usual robust pricing?

Michael Monahan

Just off a little bit. But it's flattish, off slightly.

John McNulty - Crédit Suisse AG

And is there any competitive reason as to why that's the case? Or is it just tougher times or...

Douglas Baker

I would say it's principally because plastic went on a monster ride up and then down quite dramatically. So it's more to cost -- we're talking about down less than 1%, and we had substantial increases for three years prior to that. So over the period of time, we have held on to 90% of the pricing.

John McNulty - Crédit Suisse AG

And then with regard to cash use, I know you've been looking and you said late last year, you were looking to put capital to work in M&A, and we really haven't seen much. What should we be thinking about in terms of the second half of the year? Is it going to be kind of continued share repurchases? Or are the M&A opportunities going to open up do you think?

Douglas Baker

Well, the plan is that the M&A activity will be better in the second half than the first half, which is a pretty low mark. So I would say our expectation remains that we will have a successful year in M&A this year.

Operator

Our next question comes from Steve McNeil from Jennison.

Steven McNeil

I wanted to talk a little bit about Europe and the investments you've made there. And it kind of seems like we're rounding the bases, so to speak, on and running towards home plate here. And I'm just wondering, as you indicated, you expect the EBIT momentum to develop here. I'm just wondering, as a company, I mean, Ecolab has traditionally delivered earnings growth around the 15% level, call it. I mean, are we potentially entering a period here where we could see earnings growth tick up to the 20% range plus as this momentum develops in Europe?

Douglas Baker

Well, I would say that our goal of 15% remains our goal. It's not a governor from that standpoint. However, I would say that's the target that I think we are comfortable talking about as we go forward. I would agree with you that we have reached a very important milestone in Europe in terms of having the rollout wave behind us. So that all the right now moving forward in Europe isn't about preparing new countries, isn't about worrying about what's next in terms of how do you prepare for the next rollout. It's about how do you capitalize on all the work that's already been done. And so from a mental standpoint, it is a huge milestone there. So we're excited about what that's going to bring. Last call, we said that our expectation is we would start seeing margin lift in Europe beginning in the fourth quarter. That remains our view, and that is what we will start seeing year-on-year margin lift as a result of this work, and then obviously continued margin lift for many years to come.

Richard O'Reilly - S&P Equity Research

And can you just remind us, the size of that business, I think, it's what, it's $800 million?

Michael Monahan

Europe?

Steven McNeil

Yes.

Douglas Baker

It's $1.8 billion.

Steven McNeil

So you basically have a...

Douglas Baker

And if you put Europe specifically, it's in the $1.6 range.

Steven McNeil

I just want to frame it and make sure I have it framed out correctly. So we're talking about a $1.6 billion business that today has 4%, 5% EBIT margin that you think it's to the teens over a period of time?

Douglas Baker

Yes. Absolutely.

Michael Monahan

Yes, we've said our goal is 13%, 14%.

Operator

Our next question comes from Robert Koort, Goldman Sachs.

Robert Koort - Goldman Sachs Group Inc.

I'm just curious, what do you think it would take to get back to that environment had for several years that you were generating 5% or 6% volume growth?

Douglas Baker

Well, I'll tell you that's exactly what's going on right now, is that we have split positive volume growth, following a year where we didn't have positive volume growth. So I think what we're doing is exactly what it takes to rebuild that kind of volume growth. As we have said, our goal for organic remains 6% to 8%. We expect the pricing environment going forward to be more like our historical pricing environment, which is one point. So it's going to take 5% to 6%, right, to get into that range. So it's new customers penetration, leveraging the other tools that we leveraged as we go forward. But we are starting to see positive movement in terms of volume.

Robert Koort - Goldman Sachs Group Inc.

And, Doug, I think I know the answer you'll give me but I want to ask anyway. Do you believe in Institutional, you're continuing to sustain or gain market share?

Douglas Baker

Absolutely. We know we are.

Robert Koort - Goldman Sachs Group Inc.

And I hear from folks that look at the lodging industry, just seeing that the trends there, I recognize there all coming from the abyss. But you've seen some momentum. So why haven't we seen a greater follow through or is that similar to your comment to the first question that you're cranking up the flywheel and that's on the horizon?

Douglas Baker

Yes, I think lodging, one year where you didn't -- lodging is moving in the right direction. We like the room demand. It's up. It's been business-travel led. It looks like RevPAR, which is important to our customers, revenue per occupied room, is going to be moving in the right direction as well, which is good news for us. But I think, if you look at room demand, we're back at like 2005 levels right now. In spite of that, we've grown this business this year and are moving in the right direction. But I would expect typically we lag, and I would expect that we would see continued improvement in lodging as the recovery unfolds.

Operator

Our next question comes from Rosemarie Morbelli of Ingalls & Snyder.

Rosemarie Morbelli - Ingalls & Snyder LLC

Could you touch a little bit on Pest which has really been slowing down quite a bit this quarter is worse than any others. Could you give us a better feel as to why and has the competitive arena changed? And is that one of the reasons?

Douglas Baker

Yes, Rosemarie, Doug. Yes, clearly, Pest has been impacted by the market situation, probably more severely than some other businesses. I would say two things: One, we are a premium product, sometimes a victim of our own success, and that if you're successful with Pest Elimination, people start forgetting that there are cockroaches and rodents still there to pester them in the coming months. We have seen business that has fallen off come back. If we track our underlying metrics in that business, things like account retention, new contract growth, et cetera, all those things have started to swing to the positive. Our expectation is that we will start seeing sales growth in the second half this year, and that we will start rebuilding the sales line on this business as well.

Rosemarie Morbelli - Ingalls & Snyder LLC

Any change in the competitive arena? Do you have to lower your price and not be as much of a premium product in order to regain some of that share?

Douglas Baker

I would say, Rosemarie, I don't think the competitive arena has changed, meaning there aren't new people doing new things or old people doing new things. I think people have had their positions staked out from a price standpoint. We are certainly re-crafting some programs and service level commitments and using those to gain new business. But I wouldn't say that's really a repricing phenomenon. We still plan to maintain our premium promise and premium price. Because frankly, that's the best value in the market.

Rosemarie Morbelli - Ingalls & Snyder LLC

And then Doug, you mentioned that you were adding, you were still working on additional cost savings. Could you give us a better feel as to what you're doing now that you haven't been doing for the past two years? And where you stand in terms of reducing the number of SKUs?

Douglas Baker

Yes, SKUs, I'm going to have somebody dig up the exact number where we are. We have made huge progress in SKUs globally and by key region. In terms of initiatives, when we introduced Lean Six Sigma several years ago, so certainly they focused on unique initiatives simply as we move down the Pareto chart of opportunities, you end up focusing in different areas. If you want the big buckets for us, I mean clearly, the things that we staked out in Europe are huge opportunities. So we also, we know in U.S. have major share service opportunities, and we also have similar opportunities in AP and LA. The focus is going to be Europe first, North America second and these opportunities, and then we will start moving into AP and LA. The best way to drive margin in AP and LA right now is to through volume and through sales growth.

Rosemarie Morbelli - Ingalls & Snyder LLC

Could you give us the losses for GCS?

Douglas Baker

Yes, GCS lost $1.2 million in the quarter and continues to show annual and sequential improvement.

Rosemarie Morbelli - Ingalls & Snyder LLC

And are you still expecting to break even by the first quarter of next year?

Douglas Baker

The only thing between us and breakeven is more volume. So I'd say the most important metric to watch in GCS right now is how we're doing on the top line. We were down, I don't know, 3.5%, 4% in the first quarter and were up positive 1% in the second quarter. So we made directionally the right move in terms of generating sales growth. The business runs well, operates well, we've got the efficiency we are looking for. Now we've got to get the volume to go drive the OI performance.

Operator

Our next question comes from Laurence Alexander from Jefferies.

Laurence Alexander - Jefferies & Company, Inc.

I guess, first question I wanted to ask was about your sales force compensation. I mean, a lot of the benefits that you've outlined in the past was ASP [ph] (53:30) has more to do with the SKUs and the logistics in the back office. Is there a chance over the next two years that you start looking at the sales force training and compensation schemes and look for ways to better align those with new growth targets?

Douglas Baker

Yes, I would say, there's been a couple of things happening simultaneously. We've been investing and moving bodies, if you will, into what we call key sales position. We have built corporate account teams in F&B and Institutional, where we had virtually none. We are doing similar things in terms of identifying the right corporate account teams to have in our Healthcare business as well there. We are looking at ways that we can reshape compensation. We're probably doing or further along in the Healthcare business. But certainly, the system will give us the transparency you need to drive the types of sales schemes that we run in the balance of the world effectively, i.e., paying comp per product, understanding what outs [ph] (54:38) are through distributors for their trade sales all the way through the system. We do not have those capabilities. We didn't have those capabilities until rolling out the system. Now we do have them. So that opens the door to many of the initiatives that we've already undertaken, say, in North America and other parts of the world.

Laurence Alexander - Jefferies & Company, Inc.

And separately in Healthcare, as you've evaluated the past to market for the new business, I mean, are you looking at separating the consultative sales from the product sale?

Douglas Baker

I mean, I guess a simple answer is no, but it's probably somewhat nuanced. But I guess in Healthcare, importantly, what we're working on is making sure that we do the right job equipping our sales team with the information they need to effectively sell the programs that we put together. This is not unique to Healthcare. It's the work that we do in Institutional and F&B, in Food Retail, QSR, and we're also undertaking it in Healthcare. We have a number of great initiatives in Healthcare. They are moving the right direction. We are gaining traction. We're getting the yeses, we are installing these things. So all the trends and the movements in the right direction. If you get down to where we're separating the consultive part and the other part, I guess we are going to have a specific team that's going to handle some of the maintenance in hospitals that will be different from the team that is representing and doing the consultative service part of the growth. That's not completely unique to think that we do in other businesses. But that is going to happen in Healthcare.

Operator

Our next question comes from P.J. Juvekar from Citi.

P.J. Juvekar - Citigroup Inc

Doug, can you explain how much investment did you make in installing the new European systems? What was the impact on the quarter?

Douglas Baker

Well, in the quarter, I mean, overall, I mean this system over several years was in the range of $200 million. Now that includes, obviously, all of our internal people, all the travel associated with it. But it's a sizable investment from a company standpoint. For the quarter, Q2, we had a step up from Q1 and $5 million in amortization. But probably the bigger piece of the expense was what I would call on the resultant inefficiencies that happen as you roll eight countries. That stuff dissipates fairly quickly, obviously, the amortization there until it runs out.

P.J. Juvekar - Citigroup Inc

And how much of those inefficiencies? Just sort of ballpark number? I'm trying to understand the impact.

Douglas Baker

It's north of $5 million in the quarter.

Michael Monahan

It's the stuff that Doug referred to earlier, P.J., about backorders having to make two shipments to a customer rather than one, things like that.

P.J. Juvekar - Citigroup Inc

Doug, you mentioned that room demand is back to 2005 levels. Over that time, if you look at U.S. margins, the U.S. margins are higher than what they were back in '05, and European margins are almost half of what they were in '05. Europe has been lagging for a couple of years. So can you talk about that sort of margin progression in the two continents?

Douglas Baker

Yes, I would say there's two key things driving Europe margin. One is what I will call a planned initiative called EBS. And we knew that while you're building this and laying on a second system on top of the historic or legacy system, that you are going to have margin erosion as a result of this. Because you can't turn off the old system until the new system's running. So that has obviously been a significant impact. Coupled with that, we also did a number of things that we talked about which we said would have an impact on OI margin but a benefit in NI margin, which was increased costs associated with putting together a principal company model. That also, if you will, had margin impact. And then the other is we have a different competitive environment, and we had raw materials rising, and it's taking us longer to recoup, if you will, raw material price increases in Europe than it did in North America and some of our other regions given just the market dynamics to go on. Those are the same market dynamics which lead us to guide you to say, while there's significant upside in our margin in Europe, say to the 13%, 14% range, it is still going to have a significant delta versus North American markets. So those factors, but we're quite confident in our ability to start driving this margin up.

P.J. Juvekar - Citigroup Inc

I mean, that 13% to 14% margin goal, is that realistic? I mean, you've never been consistently that high for any period of time in Europe.

Douglas Baker

Well, yes, well look, I guess I wouldn't give you that number if I didn't think it is was realistic. So we believe it's realistic. We have very clear plans. We've run that business. We run AP and LA in double digits. They've got absolutely no scale in those regions at this point in time versus what we have in North America and Europe. So I think we've got a very clear path. A big hunk of this is frankly, money that we spend inefficiently by running a bunch of discrete product supply systems versus leveraging them efficiently.

Michael Monahan

P.J., part of the reason they weren't that high before is just the reasons we did this because you had a very complex system that did not allow you to see transparency and operate that business with a $1.6 billion, $1.8 billion worth of scale, and since we were operating basically 27 different entities. And so, again, part of the reason we never got it before is just the reason that we did it. So that's why we see the opportunity to get margins like that. And as we look across the rest of the world, we can see what the margin potential is so we can hypothecate to what we think we should be able to get out of Europe.

P.J. Juvekar - Citigroup Inc

So you're saying that during the system change you got hit with the recession which is what crushed the margins?

Douglas Baker

I would say I think the margins dropped for several reasons. Yes, certainly the economic crisis wasn't planned for, it didn't help. But I would say, you would've seen margin erosion during this period even if the economy had maintained its same pace simply because you had, one, we're layering on a duplicate system. You got to put in the system two before you can take out system one. That's extra cost. There's just no way around it. And second, as I said, we did see raw material inflation quite dramatic over the whole company, and it impacts us differently by region. In Europe, it takes longer for us to recover that margin loss than it does in other regions because of the competitive environment. We are recovering it.

Operator

Our next question comes from Dmitry Silversteyn from Longbow Research.

Dmitry Silversteyn - Longbow Research LLC

If you look at the sequential margins in the International business, they've improved quite a bit. Was that the result of the ERP going live and some of the duplicate cost beginning to come out? Or was it just a sequential volume improvement or pricing versus raw material?

Douglas Baker

Dmitry, are you looking at first quarter to second quarter?

Dmitry Silversteyn - Longbow Research LLC

Yes, I mean, there was better than a two point improvement in sequential margin.

Michael Monahan

Normal season that are looking right [ph] (1:03:04) but I thought there were enough headwinds to keep it a little bit more subdued this time around.

Douglas Baker

It's principally volume driven.

Dmitry Silversteyn - Longbow Research LLC

But you really didn't see any costs starting to come out of the ERP? That's all going to be in the second half.

Douglas Baker

Yes, because as I said, it's really starting fourth quarter into next year is when you're going to start seeing those benefits. So no, that's not in that. In fact, what I would say is there's extra cost in the second quarter as a result of the ERP not cost out yet.

Dmitry Silversteyn - Longbow Research LLC

You talked about the GCS profitability or loss improving to $1.2 million on the operating profit line. You're starting to see sporadic volume growth there. You talked about needing to see revenues to leverage the cost investments that you've made in that business. As you look out towards the second half of the year, and I know we've been through this, I think going back to 2008 when you were first supposed to turn profitable or at least break even in this business. Given the last couple of years as we were at this point, how confident are you that you're going to be in fact being able to get this business to at least a breakeven by the end of the year?

Douglas Baker

I don't know, Dmitry, that. We aren't saying that this business will be breakeven by the end of this year. I would make a couple of comments, though. One, this business is not losing cash. It's been generating positive cash for the last several years and continues to. And as we move forward, what we've got is a one-front war which is a, as you pointed out, a volume issue. As we grow this business, I mean, the thing that's standing in the way is we've got to get the appropriate level of sales on top of this infrastructure to make money. That's what it's going to take. And we don't believe we're going to have enough volume by year end to get us to breakeven. However, the path is very clear. It's not sucking up resources corporately. I mean, right now, I'd say we've got an upside chip to play that didn't cost us any money to play it.

Dmitry Silversteyn - Longbow Research LLC

Do you get a sense in the market that there's some momentum building out behind that business in terms of customers asking for it or how receptive they are to getting bids and actually following through and then signing contracts with you? And have you reached out to the manufacturers. I remember at one point that there was a possibility as well of becoming kind of a registered rep for the manufacturers as well?

Douglas Baker

Yes, I would say, I don't want to -- I guess, I would say it this way. We're happy that we have seen a quarter-to-quarter improvement in the sales growth trend. I guess, I don't want to overplay a 1% growth. It's better than a 3% or 4% decline, but it's not the level of growth that we expect or need from this business long term. We expect this to continue to move forward. But right now, I would call the environment better than last year, but not quite as good, right, in terms of the Foodservice environment it's playing in. But we expect the environment to also steadily improve, which has been a consistent forecast from us for a while now.

Michael Monahan

And Dmitry, we're selling a different way doing kitchen equipment repair to our customers. So it's obviously, you have to do some missionary selling on that and in this environment, as you commit, it's not the most ideal environment. So we think we're making good progress there as we've seen with the sales and the operating profitability for the business over the last few quarters. And we think that's going to continue as we go forward and continue to make more progress and as the environment gets better, it should continue to also get better.

Dmitry Silversteyn - Longbow Research LLC

Question on raw material and pricing, there was a little bit of a pricing down draft in this quarter. I think, Doug, you said there was -- you were giving up some pricing as plastic prices come down. Where are you in terms of kind of the trend curves with respect to pricing raw materials? Have you basically anniversaried the price increases that you've gotten in 2009 and now you're looking at giving up maybe a percentage or two of pricing? And what are raw materials doing to you in the second half of the year?

Douglas Baker

Yes, so first on price. We're specifically talking about F&B, and it was a global conversation for Food & Beverage. In total, our price for Ecolab was positive in Q2, it would round up to a point, about what we've been talking about. But obviously, if you go into some businesses, you're going to have different answers in different businesses. But in total, we were up about a percent. In terms of -- and we expect that that's going to be the answer for the foreseeable future. That's probably the best thing to model. Raw materials, they were favorable year-on-year. But basically, this an annualization impact. Raw materials have really been relatively flat for the year, if you will, about the price coming in this year, about what we're paying now and what we expect to pay for the balance of the year. So really the deltas that we're talking about are because last year was a very different story quarter-to-quarter. This year, it's a fairly benign story quarter-to-quarter.

Dmitry Silversteyn - Longbow Research LLC

And then final question in Vehicle Care, I mean, this business has been struggling going back to, and I think 2007 was the last time you guys had a positive revenue number there. Kind of what's the future -- I mean, what's the future of that business? I mean, we're seeing miles driven, higher year-over-year in the first half of this year, and anything that seems to be associated with or in some way related to miles driven and within other companies, businesses seems to be doing well. What is it about Vehicle Care that is causing this business to continue to lose revenue and see revenues decline going into the fourth year now?

Douglas Baker

I would say, fundamentally, car washes are down quite dramatically in total, right across the industry. And so, one of the places that people have chosen to economize is that they're either not washing their car or they're choosing to do it in their driveway with a garden hose. They're not driving through traditional car washes. Those counts are down double-digit and have been for a while. So this is one of the consumer areas that have been impacted quite dramatically. I mean, that's what's going on in that business right now.

Michael Monahan

But Dmitry, I mean, that business is still making money. It's got a good profit margin, so it's not like this is a big drag on the bottom line.

Dmitry Silversteyn - Longbow Research LLC

I understand that, Mike, but Ecolab has not become the company that it's become by investing in such businesses, or by investing in businesses that have long-term negative growth trends. So I'm just wondering, strategically or philosophically, how this business fits with what you guys doing.

Douglas Baker

Yes, well, I don't know what to say, Dmitry. It's a business under pressure right now on the top line, principally market-driven. We're not going to offset that. That's the plan. So the plan is to go fix the business as it is right now, and that's it.

Operator

Our next question comes from John Roberts from Buckingham Research.

John Roberts - Buckingham Research Associations

At the National Restaurant Association meeting you had a private showing for some what looked like significant new products. Did any of them make it out of the -- into commercialization in the last couple of months? I know it's kind of early, but some of them were near term compared to others.

Douglas Baker

Yes, several of them are in what I would call a quiet launch, and Some of it is because we're building capacity capability. But I would say that they have done quite well, and we're using them with some very strategic customers in terms of building what I would say is long-term capability.

John Roberts - Buckingham Research Associations

Then, secondly, and this may be a stretch. But here in Manhattan, we've had some bedbug outbreaks at retailers, clothing retailers. We've had it in some office buildings. These are not your traditional markets, Pest Elimination, you don't serve apparel retailers very often. But is this a tip of the iceberg kind of -- do your epidemiologists or your guys in your insect control areas think they live in clothes and things like that and that there's something more to this?

Douglas Baker

Well, you'll have to ask them specifically. But I would say, if bedbugs are absolutely resurgent, they are going to become much, much wider spread throughout society. And so, that's the nature of the little beast, right? That's the way it was in the '30s. And frankly, throughout human history, they went away for a period of time. Most people point to DDT as a thing that unintentionally, it was for a different purpose, knocked down the bedbug population. DDT's been banned to save the eagle and fish and the rest and we have bedbugs back, and this is a theory. So yes, they're going to be widespread. We aren't going to be chasing the Retail business, but people are going to find them in homes and other places, I would say we have a very good competency and a unique competency in bedbugs. Plenty other people promise that they can take care of them too.

Michael Monahan

It's one of the growing areas of pest, John. As we've mentioned we've got new technology which is highly effective and substantially cuts down the amount of time that our customers need to clean them out. So it's a good area of growth for us, unfortunately.

Douglas Baker

Think of them as mosquitoes without wings, it makes you feel better.

Operator

Our next question comes from Mike Harrison from First Analysis.

Michael Harrison - First Analysis

On the F&B business, can you give us a more details on the trends that you're seeing in dairy, agri and meat and poultry. You mentioned they were soft right now. When are you expecting to see improvement? And what kind of drivers or metrics do you look at?

Douglas Baker

Yes, a lot of these segments, and obviously, it's somewhat different by region of the world. But they're fairly flat right now. I would say long term, F&B, the macro trends, that business globally is performing exceedingly well, right. And this business shifts around. I think our F&B business, what that team is doing, how we're moving in terms of innovation, I'm very bullish on the F&B business. And so well, we're going to go through these trends. Long term, there's going to be more mouths to feed. They're shifting to protein, which means they're going to need even more calories than they do to date per mouth, as we go forward. We like the macro trends in this business, and we like our position. But we're going to go through dairy's hot, dairy's cold, people are going to shift protein sources. But I don't think that's going to be the big story long term.

John Roberts - Buckingham Research Associations

And just in terms of Canada, I know there was a tough prior year comp. But any further detail on what happened there this quarter? And what's going to get things do better in the second half?

Douglas Baker

Well, mainly it was the last year comp on H1N1, and this year, the Canadian government basically put a freeze on all hand sanitizer. They run the healthcare system because they had a large inventory stockpile. So it's really kind of a quarter start.

Operator

Now I will turn the call back to Mr. Monahan for closing remarks.

Michael Monahan

Well, that's the end of our call. So thanks everyone for participating today and have a good day and rest of the week. Thank you very much.

Operator

Thank you for participating in today's conference call. You may disconnect at this time.

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Source: Ecolab Q2 2010 Earnings Call Transcript
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