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Arch Chemicals Inc. (NYSE:ARJ)

Q3 2010 Earnings Call

November 2, 2010 11:00 am ET

Executives

Michael Campbell - Chairman and CEO

Mark Faford - VP of IR

Luis Fernandez-Moreno - EVP

Joe Shaulson - EVP

Analysts

Sabina Chatterjee - BB&T Capital Markets

Douglas Chudy - KeyBanc Capital Markets

Ivan Marcuse - North Coast Research

Ian Zaffino - Oppenheimer & Company

Christopher Butler - Sidoti & Company

Operator

Good morning and welcome ladies and gentlemen to the Arch Chemicals third quarter 2010 earnings conference call. At this time I would like to inform you that this conference call is available to the public including the media is being recorded for re-broadcasting and that all participants are in a listen-only mode. This call is being broadcast live at www.archchemicals.com and is real media player and windows media player compatible.

If you wish to access the replay for this call, you may do so by dialing 888-203-1112 or if you are outside the US by dialing 719-457-0820. The access number for the conference is 6990420. I would now like to turn the conference over to Mr. Michael Campbell, Chairman, President and CEO. Please go ahead, sir.

Michael Campbell

Thank you very much, operator. Good morning everyone. Thanks for joining us. With me today are Steve Giuliano, Chief Financial Officer and Mark Faford, Vice President of Investor Relations. Also on today’s call are our two Executive Vice Presidents, Luis Fernandez-Moreno and Joe Shaulson who together oversee all of Arch's businesses.

Luis joined us in early September and has responsibility for our HTH Water Products and Wood Protection businesses, and Joe now overseas our Personal Care and Industrial Biocides business as well as Performance Products.

Before I comment on the quarter, I want to remind you that throughout this call we will make statements regarding estimates of future performance. Actual results could differ significantly from those projected and some factors that could cause such differences are described in our earnings release.

Earlier today we filed our earnings release as part of an 8-K that’s been posted on the Arch Chemicals website in the Investor Relations section. I am very pleased to report that we had another excellent quarter, our better than expected third quarter results were driven by record performance in our Personal Care and Industrial Biocides business.

Our sales in the quarter increased over the year ago period marking the fourth quarter consecutive quarter of year-over-year volume improvement. Third quarter earnings from continuing operations were $0.36 per share which included $0.10 for special items. Earnings were $0.46 per share compared to $0.41 per share for the prior year quarter excluding special items for both periods.

The earnings improvement was driven by strong profitability in the Personal Care and Industrial Biocides business and to a lesser extent Wood Protection. These solid performances more than offset lower expected sales in HTH Water Products and Performance Urethanes.

Taking a closer look at the quarter our biocides segment posted an operating income improvement of 24% over last year's quarter due to record profitability by the Personal Care and Industrial Biocides business. Within this segment HTH Water Product sales were below the year ago period principally due to unfavorable product mix and reduced volumes in the US.

The benefit from favorable weather patterns in our key US regions was more than offset by lower sales to several major mass retail customers. As we previously have discussed, these customers had shifted the timing of shipments from the third quarter to the seasonal second quarter.

Water Product's operating income declined from the year ago period chiefly due to the lower mass retail volumes and unfavorable product mix and increased operating expense for promotional activities and support of innovation and other growth initiatives in the US and Latin America. In our Personal Care and Industrial Biocides business sales and operating income increased significantly year-over-year.

Sales volumes were up 20% due to increased demand for our anti-dandruff biocides as well as biocides used in building products in other industrial applications. In fact sales of the anti-dandruff biocides achieved a quarterly record. This record demand was driven by growth in Asia, particularly in China and market share gains by our customers.

In addition, the quarter’s sales benefited from shipments that were accelerating into the third quarter to avoid potential delivery disruptions related to the Asia Games which are being hosted in China during November. We also experienced increased demand for our industrial biocides used in building products. This booth stemmed it from notable growth for our ZOE biocide which is used to preserve paints and coatings thus extending their shelf life and protecting painted surfaces from the growth of mold and mildew. ZOE is compatible with increasingly popular low or no VOC paint formulations.

Complimenting the strong performance in the anti-dandruff and building products, our biocides used in various surface disinfectant applications in the health and hygiene market continue to grow.

Operating income for Personal Care and Industrial Biocides increased by 60% over the year ago period. This record performance was because of the higher volumes and favorable product mix as well as reduced production to our cost. Our Wood Protection business posted improved sales and operating results over the last year’s third quarter. The higher sales were mostly driven by increased demand in Europe particularly eastern Europe for wood preservatives used in industrial applications. We also benefited from the addition of new customers. These higher volumes were partially offset by unfavorable foreign exchange rates in Europe due to the stronger US dollar compared to the year ago period.

Wood Protection’s operating income improved by nearly $3 million versus last year. This increase was a result of the higher demand in Europe and reduced material costs especially for copper.

Now our Performance Product segment. Here the quarter sales were well above the year ago period while operating results were lower. Urethanes sales increased by 20% year-over-year mostly due to higher selling prices. Price increases were implemented earlier this year to recover higher raw material costs. In addition, the business saw increased demand for its glycol and polyol products, including new accounts.

Operating income for Performance Urethanes was lower than last year. The margin improvement from increased shipments and higher pricing was more than offset by the loss of income due to the expiration of the major contract in manufacturing arrangement at the end of 2009. And finally in our hydrazine business, we posted sales and operating income that we are both slightly below the prior year period due to lower hydrazine propellant shipments.

As a result of our strong earnings and continued focus on working capital, we’ve generated free cash flow from continuing operations of approximately $75 million which is significantly higher than last year. We assure we will continue to closely monitor the quality of our accounts receivable and manage inventory levels all without impacting our ability to supply our customers.

Finally, we are very pleased to have signed an agreement for the private placement of $250 million of unsecured senior notes at very attractive interest rates. This new financing arrangement provides us with a long term source of funding and it enhances our capacity to support the many growth opportunities in our biocides businesses.

Now let’s turn to our outlook for the full year. We are very encouraged by the strong global demand we have experienced for our biocides products. As a result, we’ve increased our earnings guidance for the full year. We are now forecasting full year earnings from continuing operations, excluding special items to be in the $2.40 to 2.50 per share range. That compares to our previous guidance in the 2.25 to 2.40 range. If you recall, we had a $0.30 per share earnings headwind this year as a result of the conclusion of the long-term performance urethane contract manufacturing arrangement. Therefore when you factor this in, our updated guidance represents an approximate 50% increase from 2009.

Our capital spending forecast for 2010 is now about $30 million and our depreciation and amortization forecast remains in the 40 to $45 million. Also we're still forecasting that our effective tax rate from continuing operations before special items will be in the 32 to 33% range.

Now let’s turn to our outlook for the fourth quarter specifically. We expect fourth quarter EPS from continuing operations to be in the range of a $0.06 per share loss to earnings of $0.04 per share. Last year's fourth quarter earnings from continuing operations was $0.12 per share. We are forecasting that favorable year-over-year operating income from the biocides product segment will be offset by lower results from the performance product segment. We are also expecting slightly higher income tax expense, corporate expenses and interest costs.

Let’s look at the individual businesses and we'll start with HTH Water Products. This business is expected to deliver higher sales in the fourth quarter of 2009. Growth should be driven by increased demand in Brazil and North America. The higher volumes in Brazil should result from a robust economy in a good pool season. North American volumes are expected to increase as we develop a strong early buy in the professional pool dealer and distribution segments.

Water Product's operating results are expected to improve from last year's final quarter. The margin from the higher sales should be partially offset by higher operating expenses due to investments in our global growth initiatives. The forecast also includes a net $1 million pretax anti-dumping duty benefit similar to last year's fourth quarter results.

This net benefit should be the result of an expected favorable ruling of $3 million for the first period of review mostly offset by a charge from an anticipated higher anti-dumping duty rate for the fourth period under review.

All told, the Water Products business remains on track to deliver double-digit top line growth for the full year and we expect operating margins to be comparable to 2009 on higher sales, therefore we'll see much improved bottom line results.

In our Personal Care and Industrial Biocides business, we are forecasting slightly higher sales as the result of new products, market share expansion and improving market conditions.

Included in our projection is lower sequential demand for our biocide used in anti-dandruff shampoo as sales were particularly strong in the third quarter. In addition, there is the usual seasonal slowdown in our end use markets.

Demand for Industrial Biocides used in building products and health and hygiene applications is expected to continue to grow. Personal Care and Industrial Biocides operating income in the fourth quarter is projected to be modestly above last year's quarter but off the record pace we saw in the third quarter.

This improvement should be in outcome of the stronger demand for industrial applications partially offset by higher plant cost due to a scheduled maintenance outage in our Rochester, New York plant.

Now turning to Wood Protection; we expect sales to be comparable to the year ago period as housing and construction markets particularly here in North America continue to struggle. Wood Protection's operating results should also be comparable to last year's quarter.

Let’s now turn to the fourth quarter outlook for our non-strategic performance product segment. We are forecasting European sales to be comparable to last year while operating results are projected to be below the year ago period. Price increases were implemented during the second quarter to recover higher raw material costs incurred earlier in the year, while the improved pricing more than mitigates the impact of higher year-over-year raw material cost, it will not be enough to offset the loss of the contract manufacturing arrangement that expired at the end of last year.

In the Hydrazine business, should report sales in operating results for the comparable 2009. Before wrapping up, I want to assure you that we continue to actively pursue the sale of our Performance Products businesses. These are not biocides businesses and they are not strategic to Arch. At the same time we’ve continue to pursue biocides related acquisitions that’s in our strategy and are consistent with our track record while meeting our financial targets. You can be certain that as soon as we have something to announce on either front, you will hear about it.

In conclusion, I am very pleased with our outstanding performance this year. 2010 will be another very strong profitable year for us and once again we expect to generate significant free cash flow, and I am excited about the earnings growth potential from our core biocides businesses.

Our business fundamentals remains solid, an innovation which will play an even greater role in our future success will drive the development and commercialization of new products. We have a strong balance sheet and ample liquidity to invest in our core biocides portfolio.

In summary, we are working to enhance shareholder value by continuing our efforts to increase margins, maximize cash generation, improve operational excellence, optimize our portfolio and maintain an attractive dividend.

That concludes my prepared remarks. We’d be glad now to field any questions you might have. To facilitate this, let me turn the call back over to the operator.

Question-and-Answer Session

Operator

Thank you, Mr. Campbell. The question-and-answer session will began at this time. (Operator Instructions). We’ll take our first question from Frank Mitsch with BB&T Capital Markets.

Sabina Chatterjee - BB&T Capital Markets

This is Sabina Chatterjee in from Frank Mitsch this morning. First off, I wanted to congratulate Steve on landing an excellent rate on the private placement. I think I could use you on my side when I go refinance my mortgage, so kudos there. It sounds like you got some help from pull forward in the biocide shipments. Could you just briefly quantify what the impact was of that incremental Personal Care business in Q3? I’m just trying to figure out what a normalized level should be for Q3 and just now going out into forward quarters?

Joe Shaulson

We had a just a particularly strong Q3 across the board. One of the factors was the pull through in anticipation of the Asian Games. We don’t have an exact number for that, but it was probably somewhere in the 2 to $4 million range in terms of sales that were pulled forward, but I think you know we’ll also as we go forward see a little bit of regular seasonality as we move into Q4, not just the impact of the pull through from Q3.

Sabina Chatterjee - BB&T Capital Markets

And Mark, appreciate the price and volume breakdown you guys provided by segment. I did notice trend of this somewhat lower pricing year-over-year for the major businesses, so could you just briefly shed some light on pricing dynamics, and since I haven’t yet scrubbed the numbers, I am not sure what the total top line breakdown is on price volume and ForEx changes year-over-year.

Mark Faford

Sabina, just a big picture for price, I don’t think we’ve got a significant distinct. For total Arch it is around 2% lower, bonds were up 6% for the quarter, so total were about up in the range of 4% on the sales. If you look at the major businesses, water pricing was in the 2% range lower and wood was essentially noised around 1%, and in the biocides it was around 6% lower. In the biocides, expense related to some of our key customers in dealing with volume discounts, based upon the volumes and the strong arms that we experienced in the third quarter.

Luis Fernandez-Moreno

But we were never happy to give up price, but balancing price and volume, we came out the winner on that one.

Michael Campbell

And that’s across the business to it. It’s minimal, less than 1% of the total company and not really material, any other segment.

Sabina Chatterjee - BB&T Capital Markets

Okay, so the pricing, that’s not a reflection of competition or anything. It’s just a matter of somewhat of a mix and from discounts is that it?

Luis Fernandez-Moreno

Yes.

Operator

We will take our next question from Douglas Chudy with KeyBanc Capital Markets. Please go ahead.

Douglas Chudy - KeyBanc Capital Markets

Just a question here, you seem to have incurred a little bit of margin pressure on the water business during the quarter. You did note some higher marketing spending. Can you quantify the impact of this during the quarter?

Michael Campbell

Let me let Luis answer that one.

Luis Fernandez-Moreno

Yes, I would say that we expected the change fundamentally as we saw the higher sales in the second quarter. We knew that we would have lower sales in Q3. However, we continue to invest in the business and we had some impact of promotional activities, as well as investment in innovation and that was very much expected as we saw the quarter and when you look at the year-on-year, the total year sales, the strategy is really working because we do see significant growth on a year-to-year basis from the current strategy while we expect the margins to the full year to be consistent with last year's margins. So I would say this is more of a quarterly to a broader impact rather than a trend.

Douglas Chudy - KeyBanc Capital Markets

Okay and maybe the follow-up to that. When you evaluate increased marketing spending decisions, do you have certain criteria of maybe incremental sales dollars you expect to generate from the higher spending?

Michael Campbell

We often do work with each one of our key target customers and we have a specific targets and objectives. So obviously I wouldn’t want to share all of them but definitely we worked with our key customers in that regard.

Douglas Chudy - KeyBanc Capital Markets

Okay. And then just one other question, on R&D you did announce a consolidation of some facilities during the quarter. Is the benefit here expected to be more cost driven realization or is it related to more strategic R&D initiatives?

Michael Campbell

Well it's going to be more strategic R&D initiatives, we’ve made a strategic decision that we need to emphasize and invest in innovation to a greater extent. The consolidation will help us in two ways. It will through synergies mitigate some extent the spending we would make in innovation while increasing the creativity by getting all of our scientists together. So we think we'll get more bang out of our innovation buck by doing this.

Operator

We will take our next question from Ivan Marcuse with Northcoast Research. Please go ahead.

Ivan Marcuse - North Coast Research

Talked a lot about in the first couple of quarters, a change in how a key retail partner distributed the product. What kind of an impact do you think that had on this pool season?

[Multiple Speakers]

Michael Campbell

Yes, overall our mark-to-market segment is definitely ahead of last year. Now it's obviously a combination of the change that you mentioned and the fact that today we have actually more stores that are full year stock with raw materials. As well as a better season from the economy and so forth but clearly we saw a benefit in terms of the number of stores that now have materials for the full year which is significant benefit.

Ivan Marcuse - North Coast Research

Is there any way to quantify the impact of different change or is just too hard to tell?

Michael Campbell

We are not going to get into the sales to specific customers and of necessity we'd have to get into that to answer your question. But as Luis says, if you take a look at the full year, it has definitely helped us and should continue to help us because of the number of retail outlooks will continue to stock the product full year.

Ivan Marcuse - North Coast Research

And then on the chlorine and caustic soda, will those costs be up for you next year and will you be able just do, is there a pricing period to offset those costs or was that in negotiation?

Michael Campbell

We are not going to get into where we see those costs but until we get into the year end call. But as we said to you in the past when we take account of these costs, we are able to factor them in when we make our pricing decisions for the coming season. I know that there is always interest about chlorine and caustic pricing and we will talk more about that on the year end call.

Operator

Moving on, we'll take our next question from Ian Zaffino with Oppenheimer & Company.

Ian Zaffino - Oppenheimer & Company

Just a question will be on copper; as they grown up here. What are your thoughts on the impact, I know you hedged a bunch of it but I know you have some exposure there. So if you could walk through that, that would be helpful thanks.

Luis Fernandez-Moreno

Clearly we continue to use our hedge strategy that has been described in the past and that gives you exposure to what our price of copper is going to be moving forward. There is no question that there has been a trend of copper and other commodities are used in the Wood Protection business that has continued to increase over time. So we are clearly going to increase prices and plan to have been in effect. To compensate at least for the increases that we are seeing moving forward and we believe strongly about those increases that’s fundamentally where we are.

Michael Campbell

And if I may just add to that, those increases won't occur this year as they are non-forecast into our estimate. But again when we talk about the full year at the call in January, we'll talk much more about these price increases because we are dedicated to that.

Operator

And we will take our final question from Christopher Butler with Sidoti & Company.

Christopher Butler - Sidoti & Company

You had mentioned that surface disinfectants and health and hygiene are expected to be strong for the fourth quarter. I was wondering was there a significant boost in the fourth quarter last year due to concerns of flu season, is this growth then and on top of that?

Michael Campbell

I think this is more of just regular growth in this segment. We’ve got lots of initiatives out there to continue to introduce new products and formulations and we’re just seeing those efforts paying off as opposed to anything that’s related to particularly the flu season.

Christopher Butler - Sidoti & Company

And you are freeing up some cash, you had mentioned numerous growth opportunities, so I was wondering if you could go into a little bit more detail there.

Michael Campbell

Well, we see some investments that we can make internally. We've talked about marketing and promotion certainly innovation is going to become an area of bigger investment for us. We have some capital projects coming down the line that appear to be very attractive in terms of cost and sustainability. Again we’ll lay those out when we’ve made final decisions on them.

But in addition to that, we continue to look for acquisitions. We look for acquisitions that will get us into new product to geographic markets. We look for acquisitions that will give us new actives. Part of our innovation for example, and this is only an example, part of our innovation is open innovation where we hope to get ideas and products from outside of or rather than insisting that everything be invented here and there the investment might be in the form of acquiring new actives that will get us into new and different markets, who are licensing actives that sort of thing. So, its acquisitions, it’s paying for licensees, its internal investments in innovation, marketing and its also capital improvements.

Christopher Butler - Sidoti & Company

So with the $125 million on the balance sheet now and another $125 million by the end of the year, no thoughts of returning cash to shareholders with that?

Michael Campbell

At this point in time when we have been asked this question in the past as you know Chris, our position is that we have a very active process underway at looking at acquisition opportunities. Now opportunities are difficult to always turn in to actual transactions but I would say that the level of activity internally is higher than it’s been in quite some time. So I would want to keep our powder dry for acquisition opportunities and as you know, we also have some pension obligations that we'd like to get caught up on so that we're not under funded in the pension area. So we rather play those cards out first and then see where we are with our cash position.

Operator

And seeing that we have no further questions in our queue I will now turn the conference back over to Mr. Campbell.

Michael Campbell

Thank you operator. Before I close, let me just make a few comments. As I have emphasized, today and in my meetings with you over the year, we feel very positive about Arch’s future. Our global markets are improving and we can see that improvement. We are introducing the new products and we are increasing our market share as a result of our new products and our services and we are continuing our relentless focus on tightly managing our working capital. We are working to optimize our portfolio and improve our margins. I hope I see many of you at our Arch analyst day on Monday November 22 in Manhattan.

We are going to discuss our long term outlook and including details of our margin improvement plan and you can register online at our website or simply call Mark Faford or send him an email. But I do hope I will see you there because we are going to lay out details of where we're headed. But let me assure you in the mean time that all Arch leaders are committed to our goal of enhancing shareholder value by delivering strong top line and bottom line results. That’s all for now. Thanks again for your participation and the opportunity to provide you with this update. Have a great day bye, bye.

Operator

And all parties may now disconnect.

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