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Executives

John Sobchak - Chief Financial Officer and Vice President

J. Butler - Chief Executive Officer, President, Director and Member of Risk Oversight Committee

Analysts

Stephen DeNichilo - ACK Asset

Rosemarie Morbelli - Gabelli & Company, Inc.

Daniel Rizzo - Sidoti & Company, LLC

Unknown Analyst -

KMG Chemicals (KMGB) Q3 2011 Earnings Call June 9, 2011 10:00 AM ET

Operator

Good morning, and welcome to the KMG Chemicals Inc. Third Quarter 2011 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 lines and businesses, the condition of capital markets in light of interest rate and current 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 now like to turn the call over to Neal Butler, President and CEO. Neal, please go ahead.

J. Butler

Good morning, and welcome to KMG's Fiscal 2011 Third Quarter Conference Call. John Sobchak, our CFO, and I will take you through the financials and provide an overview of each of our businesses, including progress on integrating the March 2010 Electronic Chemicals acquisition. We'll also discuss the outlook for the remainder of fiscal 2011 and after our comments, we will address your questions.

Our earnings release was filed earlier today and I hope all have had an opportunity to review it. You can access it on our website. We also plan to file our 10-Q later today.

While our third quarter results were below our expectations, we experienced solid sales across all 3 of our segments and accomplished in the performance of these businesses over the next several quarters. Net sales rose by 26% to $65.1 million for the third quarter of 2011 and were up by over 30% for the 9 months ended April 30 as our markets continue to recover from the lower demand experienced last year.

Our Electronic Chemicals business experienced sales growth of 30% in the third 2011 fiscal quarter versus the prior year, due primarily to the March 2010 acquisition, as well as the recovery in the semiconductor market we had seen throughout this fiscal year. Creosote saw strong top line improvement over prior year's levels with higher volumes driving a 37% increase in sales for the third quarter, which were still below expectations. Penta and Animal Health were in line with last year's revenue numbers, which we'll discuss in greater detail shortly.

For the third quarter of fiscal 2011, operating income was $4.6 million and net income was $2.6 million or $0.23 per diluted share. This compared to operating income of $5.8 million and net income of $3.3 million or $0.29 per diluted share for the same period in fiscal 2010. For the first 9 months of fiscal 2011, net sales rose 31% to $192.1 million, operating income was $14.9 million, and net income was $8.5 million or $0.74 per diluted share. In the same period last year, net sales were $146.2 million; operating income was $20.7 million with net income of $11.9 million or $1.05 per diluted share.

Regarding our Electronic Chemicals segment. Sales increased by 30% to $38.5 million from $29.6 million in the prior year period due primarily to the acquired business, along with increased demand due to improvement in semiconductor manufacturing. In the fiscal 2011 third quarter, we benefited from a full 3 months of sales from the acquired business as compared to only one month of sales in the third quarter of fiscal 2010. We also generated improved sales due to a healthier end-market that drove product demand in the U.S., Europe and Asia. This segment contributed $1.6 million to operating income, down from $2.2 million in last year's third quarter. This decline was due primarily to higher raw material costs, as well as the higher manufacturing and distribution expenses associated with the integration of our most recent acquisition.

Raw material cost increased in much of fiscal 2011. In response, we have committed a global price increase that phased in during the third fiscal quarter. Fourth quarter 2011 results will reflect a full 3 months benefit from these increases. Earlier this week, we announced an additional price increase for certain products that are continuing to be impacted by escalating raw material costs. We will see the full impact of this second price increase in our first quarter of fiscal 2012.

Distribution expenses for this business increased by $2.5 million to 16.7% of revenues from 13.2% of revenues in last year's third quarter. This increase was due to higher sales volume associated with the acquisition, transportation lanes that are temporary to lift and optimize as we consolidated production from 2 contract manufacturing locations, the continued rise in diesel prices and the tightening of the market for common carrier services. We did see some notable improvement relative to the second quarter of fiscal 2011, as we were able to achieve our previously stated goal for distribution expense as a percentage of revenue in the mid-16% range. While we believe additional improvements can be achieved, we do not anticipate being able to regain the 13.2% level of last year's third quarter which benefited from a dramatically lowered diesel prices in a very competitive common carrier market.

Our integration and consolidation initiatives are progressing very well. All production slated for the movement out of General Chemicals' Bay Point plant has really been relocated to our Pueblo facility somewhat ahead of schedule. All but one product previously manufactured for us at Air Products' Dallas plant will be transitioned to our Hollister plant on schedule by the end of this month. We will continue to have one product made for us in Dallas for one or 2 months longer to accommodate our customer schedule.

As a result of additional production volumes, our Hollister and Pueblo plants are expected to run at over 80% of capacity as compared to approximately 50% prior to the plant consolidation. We project the consolidation production will increase operating margins by 200 basis points in fiscal 2012. We maintain an average of 60 days of inventory for our customers so the reduction in manufacturing cost that we achieved in July will generally lower our cost of goods sold in September.

As we mentioned on last quarter's call, we have one significant additional business from a large customer expanding operations in the U.S., the impact of which we expect to realize in the first quarter of fiscal 2012. Additionally, we have reached the one significant new business from a large customer building a new fabrication plant in the U.S. that is slated to go on stream in the third fiscal quarter of 2012. The combined annual sales that these 2 new pieces of business will generate has not been definitively determined, but we expect it will initially represent in excess of $6 million per year of new business, with the potential to ramp in future years. We're encouraged by other expansion plans that our customers have in various stages of planning and development, and believe we are well positioned to supply their future growth needs.

Moving on to our Wood Treating Chemicals business. Wood Treating sales were $23.4 million in the third quarter, an increase of 25% compared to last year's $18.8 million, due primarily to higher sales volume in the Creosote segment. Overall, Wood Treating contributed $3.2 million to operating profits in the third quarter of fiscal 2011 compared to $4.2 million in the same period last year.

In our Creosote segment, sales in the fiscal 2011 third quarter rose 37% to $17.8 million from $13 million. Income from operations in the Creosote segment was $1.5 million for the current quarter compared to $2.5 million in the third quarter of fiscal 2010. Margins were negatively impacted relative to 2010 due primarily to lower average prices from a shift in product mix and renegotiated contract pricing, coupled with higher average cost for purchased material. We also experienced slower-than-expected production rates during the quarter by our Wood Treating customers, resulting in continued drawdown of treated rail tie inventories.

With industry groups forecasting stronger demand for rail tie purchases by the railroads, and inventory sale -- to-sales ratios falling below historical norms, we anticipate increasing demand from our customers as rail tie production rates increase to meet purchase rates. Industry reports issued by the Railway Tie Association forecast rail tie purchases to trend up through 2013.

Increasing demand and declining inventory ratios would indicate a long-term increase in rail tie production and a growing need for Creosote. While monthly or quarterly demand is difficult to predict, we believe the long-term trend will be favorable for our Creosote business. This anticipated upward trend has been seen in our May Creosote sales. Pricing for coal tar, the precursor for Creosote production, is expected to increase and we will likely see an associated increase in cost for Creosote. We intend to pass any and all cost increases in our pricing.

Penta sales were $5.6 million compared to last year's $5.7 million. Income from operations from Penta was $1.6 million, which was flat compared to last year's third quarter. We anticipate volumes to remain at these levels through the end of the fiscal year, and for margins to be pressured by high oil prices and raw material costs. However, we expect fourth quarter Penta operating income to be approximately equal to last year's fourth quarter performance.

Regarding our Animal Health business. Third quarter sales were $3.2 million, which was consistent with last year's third quarter, resulting in income from operations of $312,000 compared to income of $228,000 in the same period of last year. Sales volume was impacted by reduced fly pressure in drought-stricken areas of the Western and Southwestern U.S., partially offset by increased demand in South America as a result of recently granted product registrations. The wet spring in the Midwest and Southeast should have a positive impact on fly pressure. However, that will be at least partially offset by continued drought in major cattle regions of Texas and the Southwest.

For the fourth quarter of 2011, we expect to see an increase in sales volumes for Animal Health products in South America, having recently obtained product registrations in some key cattle-producing countries. We continue to pursue additional registrations and sales opportunities in that region.

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

John Sobchak

Thanks, Neal, and good morning everyone. First, let me remind everyone that during the first quarter of fiscal year 2011, we changed the method we use to allocate corporate overhead cost to our reported segments. All corporate overhead is now allocated to the segments, except for those amounts associated with the KMG's operation as a public entity such as ford costs, RFPs, et cetera. The allocation is based on segment net sales and we provide prior year amounts to reflect the current method.

Neal has already covered our top line results in detail, so moving down to the gross profit line. On a consolidated basis, gross profit margins were 27% of sales for the third quarter of fiscal 2011 compared to 31% of sales in the third quarter of fiscal 2010. As of the case in the first half of the year, we continue to be impacted in the third quarter by rising raw material costs in the Electronic Chemicals business, which we responded to with global price increases that transitioned into place during the third fiscal quarter. Gross profit margins continued to be adversely impacted during the quarter by the duplicative plant costs in our U.S. Electronic Chemicals segment as anticipated. And we incurred costs for both the expanded operations in our Pueblo and Hollister facilities, as well as the contract manufacturing locations operated by Air Products and General Chemical as production was transitioned out of those sites. These additional costs are coming to an end; however, due to the average of 60 days worth of inventory maintained for our customers, we will not realize the impact of these cost reductions on our operating results until the middle of the first quarter of 2012.

Earlier in the fiscal year, we re-petitioned KMG in the Creosote marketplace following a substantial consolidation of our customer base. We have been able to execute strategic customer contracts that solidify our position as the leading merchant market supplier to the industry. The result of the execution of this strategy has been higher volumes at somewhat lower prices, adversely impacting our gross profit margins relative to year-over-year comparisons, but ultimately benefiting the long-term strategic position of the company in this important U.S. infrastructure market.

As Neal had mentioned, in addition to lower average Creosote pricing in the third quarter, we experienced slower-than-expected production rates by our customers given the overall U.S. demand for treated rail ties, as well as margin pressure brought on by higher average cost of purchased material.

Gross profits increased by 11.3% to $17.8 million in the current third quarter compared to last year's $16 million due to higher revenues, offset by the lower margins discussed above. Third quarter distribution expenses were $7.6 million compared to last year's $4.8 million. As a percentage of sales, distribution expense was 11.7% of net sales compared to 9.2% in the third quarter of fiscal 2010. Most of the increase in distribution expense can be attributed to the 30% year-over-year increase in quarterly revenues, mainly from business associated with the March 2010 Electronic Chemicals acquisition.

We made good progress in reducing distribution expense in the Electronic Chemicals business to our targeted levels, from 17.4% of net sales in the second quarter to 16.7% of sales in the third quarter, and anticipate being able to make further progress at reducing these costs in the coming quarters.

SG&A was $5.6 million in the third quarter, compared to $5.4 million in the prior-year period. The increase was attributable to the latest acquisition which was owned for only one month in the prior year's third fiscal quarter. That increase was offset by small SG&A reductions in other areas and as a percent of sales, SG&A declined to 8.6% in the third quarter from 10.4% last year.

For the third quarter, operating margins were 7%, a decline from 11.3% in 2010, a result of the gross margin pressures and distribution expense increases experienced during the quarter, as previously explained. Interest expense was $571,000 in the current quarter compared to $542,000 last year, reflecting the higher debt levels associated with the March 2010 acquisition. Our income tax rate was approximately 34.9% versus 36% in the same period in fiscal 2010, and we project that our income tax rate will be 38.8% for the balance of the fiscal year.

For the third quarter, net income was $2.6 million or $0.23 per diluted share versus $3.3 million or $0.29 per diluted share in the third quarter of 2010. Net working capital at April 30 was $45.7 million, and that included $927,000 of cash. We continue to pay down borrowings, reducing our long-term debt by $8.1 million to $51.2 million during the first 9 months of fiscal 2011. Our current borrowings include $17.9 million drawn on our $50 million revolving credit facility and $13.3 million on the term loan. Currently, we pay an interest rate equal to 2% over LIBOR on our term loan and revolver borrowings.

For the 9 months ended April 30, shareholders' equity was $96.5 million or $8.20 per diluted share. Cash flow from operations was $10 million for the first 9 months of 2011.

And now, I'll hand it back to Neal.

J. Butler

Thanks, John. Before handing the call over for your questions, I would like to provide you with some final thoughts and summarize our favorable expectations for the last quarter of the fiscal year and the beginning of 2012.

The market trends we've seen in each of our business areas are encouraging. We continue to project a strong fourth quarter and fiscal 2012, which we expect will be driven primarily by improved profitability in our Electronic Chemicals business following the completion of the manufacturing consolidation project and the recently implemented price increases and new business coming on stream. We believe we will continue to see a recovery in Creosote as rail tie production rates are expected to increase, and as evidenced by our Creosote sales in May. Animal Health should perform well in the fourth quarter as May, June and July months are some of the strongest seasonally and as new product registrations take effect in South American markets, we anticipate continued steady performance from Penta.

We have confidence in our strategy and believe it will continue to provide opportunities for sustained growth in revenue, earnings and cash flow. We're optimistic about our prospect's continued growth and look forward to reporting on KMG's continued development.

And lastly, before I answer your questions, I would like to point out that we will be presenting at the Canaccord Genuity Global Growth Conference on August 9th through 11th in Boston. We hope to see some of you there. We'll be posting the slides from the presentation on our website.

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

Question-and-Answer Session

Operator

[Operator Instructions] Our first question comes from Daniel Rizzo with Sidoti & Company.

Daniel Rizzo - Sidoti & Company, LLC

With the new contract you guys won, is that with a different customer than the one you announced last time?

J. Butler

No, same one.

Daniel Rizzo - Sidoti & Company, LLC

And then, can you just refresh my memory how these work? Are these contracts like another set number of years? Or is it just as needed? How does it work?

John Sobchak

Well, Dan, I'm sorry, a clarification: In the last earnings call, we reported on a new contract win. And in this earnings call, we confirmed that, that contract was progressing on schedule. But we also won an additional contract, which is expected to come on stream in the first calendar quarter of 2012. So that's 2 additional contract wins.

Daniel Rizzo - Sidoti & Company, LLC

Right. Now, with those 2 contracts, could you just refresh my memory, are they for set number of years? How do they work?

John Sobchak

It really depends on the contract and the requirements. One actually required a bit of a capital investment, which you'll see in our fiscal 2011 results. We've had to invest in some additional high-purity bulk trailer capacity. So we're spending close to $3 million over the next several quarters to do that, and then that's a 5-year agreement. So it depends on the circumstances around each of the contracts. And they're not for set volumes. So the contract terms generally refer to payment terms, product quality, how do you handle excursions from product quality, that type of thing.

Daniel Rizzo - Sidoti & Company, LLC

Is the second new one for 5 years as well?

J. Butler

No. The second was not for a 5-year timeframe. It is going to be, as it stands right now, the finalization of that contract is still a little bit before. It's only because we continue to add some additional products to it.

Daniel Rizzo - Sidoti & Company, LLC

Okay. And then with Creosote, you said that industry reports indicate that, that there's going to be an increase in demand over the next 3 years, I think through 2013. That's above the $18 million to $20 million in reference to the past, as annual replacement?

J. Butler

If you look at the forecast from the Railway Tie Association going forward, you look at -- and it's always calendar year, but the calendar year 2011 the forecast for total rail tie purchases is a little over 20 million ties. I think it's like 20.4 million ties; 2012 is 20.8 million ties and in 2013, it actually ramps up to about a little over 21 million ties. So the demand for rail ties is forecast to continue to trend upwards. One of the things that we've seen in the last year or so is that the inventory-to-sales ratio has declined, which means they simply -- the production has not been keeping up with the total purchases. So there is going to be a little bit of a catch-up, so we believe an additive effect going forward from this -- from right now going forward as a result of the rail tie demand plus the need to build inventories.

Daniel Rizzo - Sidoti & Company, LLC

Okay, all right. And then one final question. I think last conference call, somebody asked if $13 million is going to be the run rate or around $13 million was going to be the run rate for operating expenses, and you said it would probably come down. Is that still your outlook? Because it didn't really -- I mean it came down a little bit, but not much for the quarter. I was wondering if you're still expecting you'd go down to $12 million, $11 million going forward.

John Sobchak

Yes. The big item in operating expenses, big variable there, is distribution expense. And we made some pretty good progress this past quarter of reducing that, bringing a little more efficiency into the supply chain after integrating the General Chemical acquisition, and we believe there's more opportunity to make improvements there. We're hard at work there.

Operator

Our next question comes from Rosemarie Morbelli with Gabelli & Company.

Rosemarie Morbelli - Gabelli & Company, Inc.

Just following up on the distribution expense. You -- it used to be 13.2%, it is now around 17%. How low can you get? And I think, Neal, you've said that it would be difficult to get back to that 13.2% of revenues. What do you think is the reasonable number that you can achieve?

John Sobchak

We're currently at 16.7%, that's down from 17.4% in the previous quarter, second quarter fiscal 2011. And going forward for the fourth quarter and beyond, we believe we can get that down to 16%, potentially lower depending upon what happens to diesel prices.

J. Butler

But we feel pretty confident, Rose, that we can get it down to, certainly, the 16% level.

Rosemarie Morbelli - Gabelli & Company, Inc.

What was the number, I am sorry, Neal?

J. Butler

16%.

Rosemarie Morbelli - Gabelli & Company, Inc.

16%?

J. Butler

Yes.

Rosemarie Morbelli - Gabelli & Company, Inc.

But there is no way you are going back down to 13% or anywhere between 13% and 16%, it sounds?

J. Butler

We may get below 16%, but I don't think it will be dramatically below 16%. The 13.2%, in all honesty, was a bit of an anomaly. And part of that, a portion of that was driven by the much lower diesel prices.

Rosemarie Morbelli - Gabelli & Company, Inc.

Okay, all right. Looking at the Creosote and the demand for railroad ties, I recently took a train ride from between Boston and New York and on the side of the track, there is a huge amount of concrete ties. Could you talk about the inroad of concrete ties replacing the wooden one needing Creosote and what that impact could be?

J. Butler

Certainly. Concrete in various composite ties have been in the marketplace for a long time. Our estimation, it is only an estimation on our part, is that they tend to represent about 10% of the tie demand. It's somewhere in that range. And you've seen that a number of the concrete ties tend to go in subways, some of the passenger lines, on the much heavier gauge railroads and most the railroads in United States are for freight. The heavier gauge railroads still tend to prefer the wooden ties. So it's not surprising that you see it on passenger lines but if you go out to the major rail ties, the railways across U.S. which are freight, their preference is still for wooden ties there.

Rosemarie Morbelli - Gabelli & Company, Inc.

Okay. So when we look at your 20.4 million ties, if we take 2011, are you saying that of that 10% could be concrete or are those all wood ties?

J. Butler

That's wood ties.

Rosemarie Morbelli - Gabelli & Company, Inc.

Wood ties, okay. And how about the -- a similar question for Penta, in electrical poles. Do you see a replacement of wooden poles by concrete poles, as well?

John Sobchak

There's always been, just talking to rail tie market, there always have been markets where they've used concrete and they use steel, and there's a certain portion of the market where they use some of the composites in the concrete. But from our viewpoint going forward, certainly for the foreseeable future, we believe that the demand for wooden utility poles will remain about where it is today.

Rosemarie Morbelli - Gabelli & Company, Inc.

Okay, so you don't see it declining?

J. Butler

Not in the near future. The near future being in the next several years, no.

Rosemarie Morbelli - Gabelli & Company, Inc.

All right, okay. And then if you could touch on the Electronic Chemicals. The operating margin, and I understand that you are duplicating some costs. Are the distribution costs included in that $1.6 million of operating income you are reporting for this quarter?

John Sobchak

Yes, that's net of the distribution expense.

Rosemarie Morbelli - Gabelli & Company, Inc.

Okay. So we have 2 costs then, in that, right? We have the fact that you are duplicating production, and then the fact that as you are moving to Hollister's and Pueblo, and I may be wrong on that assumption, so please correct me, is the distance between your customers and your new location longer than what it is with Air Products? And, I mean, with your new acquisitions?

John Sobchak

Yes. That's an excellent point, Rosemarie. Actually, the General Chemical had a fairly optimized -- they had a fairly optimized system of transportation lanes servicing their customers from their production sites. And when we move those production sites to our locations, right, the transportation lanes, in many instances, get longer and less efficient. If you look at these transportation lanes graphed out on a map, it's like a spider web going around the country. So the trick is to optimize those lanes, reducing the ton miles traveled while at the same time being able to service your customers and reducing the number of less-than-truckload quantities. So it's a pretty complicated exercise. We have enough data now to be able to conduct that exercise. So what you saw in the reduction in expenses that you saw between the second quarter and the third quarter was the result of some of that. And there'll be more of that in the next couple of quarters.

Rosemarie Morbelli - Gabelli & Company, Inc.

But as you are producing more at your own facilities, how do you reduce the time travelled since you have extended the distance? Are you saying that you will supply to your customers maybe not 4 times a week, but only twice a week with fuller truckloads? Is that something that can work, or am I missing something?

John Sobchak

Yes. Actually, if you look at it, the product really travels from plant to semiconductor fab site. It'll go to one or 2 different distribution centers where it's aggregated and shipped to their customer fab site as required. So it's a question of optimizing those transportation locations. And in some cases, we might choose to actually package the material in another location, at a third-party location, if it's closer to the customers' site rather than shipping it across the country. There are various options to do that. In general, the transportation expense, I think your original question was are some of the shipping lanes longer? And yes. So when we had -- when we came up with our 200-basis point improvement in operating margins for the Electronic Chemicals business, as a result of this acquisition, some of that was mitigated by the fact that we're going to be paying a little bit more for distribution cost because the ton miles traveled will be a little bit higher. But that's going to be, the overall benefit is going to be -- will justify that.

Rosemarie Morbelli - Gabelli & Company, Inc.

Okay, and then last question, if I may. When I look at the operating margin in the quarter and even last year, the Electronics Chemicals, which is supposed to be, I would have thought the most profitable business, has the lowest margin. Can you comment on that, and how high can those margins go over the next couple of years, let's say?

John Sobchak

That's interesting. The Electronic Chemicals business is where Penta and Creosote were when we first acquired them. In fact, Penta and Creosote weren't as attractive when we first acquired them. So I kind of look at the Wood Treating business as the poster child of what we're looking to accomplish in Electronic Chemicals through consolidation and efficiency improvement. We do anticipate margins to improve significantly in the Electronic Chemicals business from the price increases that have been put in place now to recover the raw material costs we've been absorbing for the last few quarters, and also the efficiency gains from the manufacturing consolidation.

Rosemarie Morbelli - Gabelli & Company, Inc.

And on the long-term, what are you looking at? Where would you be satisfied, at which kind of an operating margin for that business?

J. Butler

We really haven't quantified a target-operating margin. I think what we would probably be safer stating is that we're looking at an operating margin trend and we'll continue to trend the operating margins upward. But we haven't put a ceiling on where that might go.

Operator

[Operator Instructions] Our next question comes from Carl Maclogus [ph] with Graham Partners [ph].

Unknown Analyst -

Just curious, on the -- so the 200 bps op margin, I guess, so that's what we should expect to see improvement from current levels. So it's -- we're not going to be get to 12% op margins, as I had previously -- I sort of had previously thought we might get to 12% op margins. So it's 2% of what where we are today, correct?

John Sobchak

No. We had said that we expected operating margins -- and what we've been telling the market is that operating margins will be able to get back to 15%. The 200 bps was off of where we were prior to the acquisition.

Unknown Analyst -

Okay. So what I'm confused by is, so is this operating margin improvement from where we are today after this next quarter closer to like 400 bps by the end of the year or something? By the end of the calendar year?

John Sobchak

We're not giving specific segment-by-segment operating profit forecast, Tom, I'm sorry. There is various moving pieces that are going to occur as we finish up the manufacturing consolidation that we're discussing. The math that you're -- the piece of the math I think you might be missing is the price increases that were implemented.

Unknown Analyst -

Okay. And those -- the full effect of those is not until the September quarter, right?

John Sobchak

Yes. So we're looking at a...

J. Butler

As we go forward, Tom, we think that the operating income -- the operating margin for Electronic Chemicals, we should in up in about end of this year somewhere in the 15% range.

Unknown Analyst -

Okay. I'm just confused by the 200 bps versus that number...

J. Butler

Yes. The 200 bps, as John said, you did not get. We should have just gone back and just continued to clarify that because when we first started talking about it, our baseline was the operating margin that we got in the Air Products acquisition to once we've finalized all the integration process, it's got to the point where we've fairly -- we'll maximize the operating income generation at that point prior to the acquisition of General Chemical. So our baseline was that, was that just was a number just prior to the acquisition.

Unknown Analyst -

So I guess what we should be expecting to see is a fairly dramatic improvement in the gross margin, not so much in the other 2 items in the cost?

John Sobchak

Yes. It'll be on the gross margin line. There'll still be some improvement in operating expense and yes, some on the SG&A also. But most of it is manufacturing costs because our -- because the contract manufacturing sites will be going away. And also now -- versus where we are now, we're going to be recapturing some of the cost increases through our -- the price increases we've implemented.

J. Butler

It's a combination of all the above, but we will see just through increased plant utilization, plant capacity utilization will have a notable impact on the cost of goods.

Unknown Analyst -

Okay, thanks for the clarification.

J. Butler

Certainly.

Unknown Analyst -

Okay, thanks for the clarification.

J. Butler

Certainly.

Operator

[Operator Instructions] Our next question comes from Bruce Winter.

Unknown Analyst -

I'd like to understand your Electronic Chemical business from a value-added perspective. I'd like to hear your thoughts, but I'm kind of wondering along the lines, do you do chemical reactions? Do you add value by blending or formulating? Do you add value by purifying the chemicals? And if you do add value by purifying, what steps do you do to purify the chemicals? And if you add value by purifying the chemicals, my intuition is that it's better to purify the chemicals closer and sooner to their final use. So why does it -- why don't your customers just do it themselves? I'd like to hear your thoughts on the whole value chain that you use in that process. Thanks.

J. Butler

When you look at the value-added that we bring to the high-purity acids and high-purity solids, there are several key components that you will be adding to the outline. And the first one is, the point you just made a while ago is that we go through a purification process for a lot of our chemicals. And some of this is done through distillation, some of this done through filtration, some of it done through a combination of all the above. So we bring it to the prescribed purity levels and we track over 35 different metals in this process in determining purity levels and purity level requirements to meet our customer demand. So, when somebody says you just purify, it's actually a bit more involved and we just made it purer. It's important to realize that there are a lot of components in there that we test for. So that's a key point of being -- the key point of the value-added prospect. A second key element, though, is the actual packaging of the material, because when you take these products to purity levels that are sub-EpB, you're looking into a parts per trillion kind of level, it doesn't take much to contaminate that purity level. So the packaging process, the packaging equipment, the choice of packaging containers, whether it's a resin or whether using Teflon-coated stainless steel with the other components is the other key value-added because once you purify it, the next critical factor is to make sure that you get it to your customers' loading dock and that purification level has remained the same. For a customer to do this, it just wouldn't be cost-effective. And we also do some blending of these products. There are number of blends. A lot of these blends are specific to particular customers. And those blends, again, have to meet these purity requirements, and it goes through the same process of ensuring that the purity levels are being delivered to their loading dock with no contamination and no reduction in the purity. So the value-added is sort of a component of purity and also the packaging and delivery.

Unknown Analyst -

Okay. I still don't understand why it's not cost-effective for your customers to buy impure raw materials and blend them and filter them and distill them right next to their process.

John Sobchak

Well, it's strictly a cost-related factor. The volumes that a customer may be purifying would be sufficiently small enough not to justify the CapEx it would be required to put the equipment in to do it. Because you'd need to run huge volumes of that equipment to make it cost-effective. It's no different than the acids, for instance, that we produce. There's some acids that we purchase and we purify it and the question is, why don't you vertically integrate and produce those acids. We don't -- it's not cost-effective simply because we could not run the levels, the volume levels, through that production facility to justify the CapEx.

Unknown Analyst -

Okay. Very interesting. I appreciate it.

John Sobchak

I think the other part of the value chain to keep in mind, too, is that the cost of these chemicals is less than 1% of the final cost of the manufactured ship. So while it's an important product in the manufacturing process, it's not on the top of their concerns in terms of where their costs are.

Unknown Analyst -

Yes. It seems that, like a key thing to all these is your ability to distribute these things all around the place without losing quality.

J. Butler

That's the crux of it. I mean, that's the final -- the final value-added is indeed that.

Unknown Analyst -

Okay. You must be able to do it. I mean, parts per trillion is pretty tough. But I guess you can do it.

J. Butler

Yes, it amazes me, too, but we can indeed do it.

Unknown Analyst -

Okay, good.

Operator

Our last question comes from Steve DeNichilo with ACK Asset Management.

Stephen DeNichilo - ACK Asset

You mentioned -- Neal, you mentioned 15% operating margin target on Electronic Chemicals. Is that with the new reporting structure with all of corporate expense allocated?

John Sobchak

Good question. No, that's pre-allocation.

Stephen DeNichilo - ACK Asset

Okay. And what would be post-allocation?

John Sobchak

Well, on our segment reporting, Steve, we provide all of the allocations. So you can easily back that out and how most of the folks have been modeling the company and then how I do it, too, is building up the operating profits on a pre-allocation level and then calculating the corporate overhead as a separate entity, a separate number because it's just -- it's been -- it doesn't feel the same way.

Stephen DeNichilo - ACK Asset

Right. Is there just a ballpark number that we can use to adjust the differences between the 2?

John Sobchak

You could -- it's just math. I mean, you could back into it --

Stephen DeNichilo - ACK Asset

Okay, all right. I'll figure it out myself. Got it.

John Sobchak

-- from the report.

Stephen DeNichilo - ACK Asset

Got it. Got it. Okay, so then when we look at this 15% pre-corporate allocation number. This is when all of the production is moved over, all the price increases have gone through? With the new business, we think will be on that run rate?

John Sobchak

Correct.

Stephen DeNichilo - ACK Asset

And your target from a timing standpoint is, it sounds like the middle of the first quarter?

John Sobchak

That's right. It's -- the middle of first quarter is when all the cost have kind of run through the P&L.

Stephen DeNichilo - ACK Asset

Right, right. Okay, okay. And just my final question. You put a comment on your press release on acquisitions, is there anything more imminent? It just -- it surprised me for you to guys to call that out while that's always been your strategy longer term. Is there something that's come into your radar?

John Sobchak

There is always stuff in the radar, Steve.

J. Butler

There's nothing that we have today that -- where we're close to signing agreements. But to John's point, it's a bit of a daily exercise for us. So we do have a pretty full of plate of acquisition opportunities that we are looking at and assessing as we speak, yes.

John Sobchak

I tell you, we've been -- I've been at KMG for 10 years and work on this M&A program, and this is one of the most active periods of time I've seen.

Stephen DeNichilo - ACK Asset

Right. And just from a size standpoint, I mean, is there any type of gauge on what type of acquisitions you're looking at?

J. Butler

We don't have a specific target for acquisitions, but if you wanted -- if we range the sizes, the range of these probably is going to be anywhere from $25 million to $60 million of revenue.

Stephen DeNichilo - ACK Asset

Got it. Okay. All right, great. Congratulations.

J. Butler

Thank you.

Operator

Thank you, I'll now turn the conference back to management for closing remarks.

J. Butler

Well, John and I want to thank you, everybody for being on the conference call with us today. As we mentioned, we'll be in Boston in August and we look forward to seeing a number of you there. So with that, we thank all of you.

Operator

Thank you. This concludes today's conference, all parties can now disconnect. Have a great day.

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