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The Valspar Corporation (NYSE:VAL)

F3Q 2011 Earnings Conference Call

August 15, 2011 11:00 ET

Executives

Lori Walker – Chief Financial Officer

Gary Hendrickson – President and Chief Executive Officer

Analysts

Jeff Zekauskas – JPMorgan

Mike Sison – KeyBanc

Saul Ludwig – Northcoast Research

Robert Koort – Goldman Sachs

David Begleiter – Deutsche Bank

John McNulty – Credit Suisse

Dmitri Silversteyn – Longbow Research

Don Carson – Susquehanna Financial

Rosemarie Morbelli – Gabelli & Company

Steve Schwartz – First Analysis

P J Juvekar – Citi

Operator

Gentlemen, thank you for standing by. Welcome to the Valspar’s Third Quarter Conference Call. At this time, all participants are in listen-only mode. Later, we will conduct a question-and-answer session. Instructions will be given at that time. (Operator Instructions) As a reminder, this conference is being recorded.

I would now like to turn the conference over to host Ms. Lori Walker, Chief Financial Officer. Please go ahead.

Lori Walker – Chief Financial Officer

Good morning and welcome to our earnings conference call. Today, we’ll be covering results for the third quarter. Gary Hendrickson, our President and CEO is with me on our call this morning.

Before we begin, I’ll direct your attention to the press release we issued this morning, which contains much of the information that we’ll be covering in the call. This call is subject to the forward-looking statements language contained in our press release and our comments may include forward-looking statements as that term is defined by securities law. This morning I’ll cover our results for the quarter, Gary will make a few comments, and then we’ll respond to your questions.

Third quarter sales totaled $1.07 billion, a 22.5% increase from last year driven by acquisitions and selling price increases. Adjusted for currency and acquisitions, sales were up 6.7%.

Third quarter adjusted net income per share increased to $0.80 in 2011, a 14.3% increase from $0.70 in 2010. Pricing actions, cost control, and productivity improvements helped to mitigate the effect of rising raw material costs. Third quarter adjusted net income per share in 2011 excludes a $0.10 per share charge related to the restructuring actions we announced in May.

Third quarter adjusted net income per share for 2010 excludes an $0.08 per share benefit from the sale of assets and a $0.04 per share restructuring charge. Net income for the third quarter of 2011 was $67.4 million and reported earnings per share were $0.70. Net income for the third quarter of 2010 was $75.1 million and reported earnings per share were $0.74. Excluding restructuring charges in both years, our third quarter gross margin this year was 31.4% down 260 basis points from 34% in 2010. Margins were impacted by rising raw material costs, which were partially offset by pricing actions.

Excluding restructuring charges in both years and the gain on the sale of assets in 2010, operating expenses as a rate to revenue were 19.8%, a 110 basis point improvement from 20.9% in the third quarter of 2010 due primarily to leverage on higher sales. Quarter-over-quarter operating expense dollars increased $28.7 million, due primarily to the addition of Wattyl operating expenses. The tax rate for the third quarter was 28.6% compared with a rate of 29.6% in the third quarter of last year. The lower rate for 2011 was due to one-time adjustments related to prior years. For the full year, we anticipate the rate to be approximately 31% to 32%.

Average shares outstanding for the third quarter were $95.9 million, down $5.2 million from last year. We did not repurchase shares in the quarter and have 9 million shares remaining under our current authorization. We estimate average shares outstanding for the fourth quarter to be approximately $96 million.

Recapping our sales performance for the quarter, adjusted for currency and acquisitions, our overall core growth was up 6.7% driven by high single-digit price increases, which offset a low single-digit decline in volume. Excluding the lost Wal-Mart business, volume was down about 1% in both our Coatings and Paint segments. Currency was positive 3.9% and acquisitions added another 11.9% for total growth of 22.5% in the quarter.

Looking at our segment results for the quarter, adjusted for currency and acquisitions, our Coatings segment sales increased 8.7%. Sales in this segment benefiting from pricing and new business. Paint segment sales increased 5.1% reflecting the impact of pricing. And adjusting for the loss of the Wal-Mart business, our Paint segment sales increased 9.1%. Sales in Other were flat.

I am now going to move into a discussion of our EBIT margins for the quarter. All of the numbers I’ll be discussing exclude restructuring charges in both years and the gain on the sale of assets in 2010. Our Coatings segment EBIT margin was 13.6%, down 180 basis points from 15.4% in the third quarter of 2010. Our Paint segment EBIT margin was 10.8%, down 110 basis points from 11.9% in 2010. The EBIT margin declined in both segments was due primarily to the lag between higher raw material costs and the impact of our pricing actions.

The EBIT margin for our Other category was 0.9% compared with 2.9% in the third quarter last year. As a reminder, Other includes our corporate expenses. The total company EBIT margin for the quarter was 11.6% compared with 13.2% in the third quarter of 2010 with the decline due to higher raw material costs and lower operating margins in Wattyl.

Moving to the balance sheet, our net debt at the end of the third quarter was $991 million, down $129 million from the end of the second quarter due to generation of strong operating cash flow of $164 million in Q3. We estimate that our free cash flow, which we define as operating cash flow less CapEx and dividends, will be in the range of $125 million to $150 million in fiscal year 2011.

Our net debt-to-capital was 38.1%. We ended our quarter with $476 million of reserve liquidity. That included $323 million of available committed credit facilities and $153 million of cash. Capital spending in the third quarter was $15 million compared with $12.9 million in the third quarter of 2010. Our capital spending forecast for the full year is approximately $75 million. Depreciation and amortization for the quarter totaled $25.4 million, up from $20.9 million in the third quarter of 2010. Our full year forecast for depreciation and amortization is approximately $90 million.

Just a brief comment about our restructuring actions. As we detailed on our second quarter earnings call, the total cost of the overall effort will be $0.30 to $0.35 with 60% of the spending in cash and 40% non-cash. We incurred $0.10 of the cost in Q3 and expect the majority of the remaining $0.20 to $0.25 in cost we incurred over the next two quarters. The savings will be $0.12 to $0.14 roughly a two-year payback. We anticipate realizing $0.06 to $0.07 of the savings in the back half of 2012 and the full benefit of the savings in fiscal 2013. As mentioned in our release, we expect to deliver double-digit earnings growth for the year in the range of $2.47 to $2.57 per share, which excludes restructuring and acquisition-related charges.

And with that, I will turn the call over to Gary for his comments.

Gary Hendrickson – President and Chief Executive Officer

Thanks Lori and good morning everyone. Thanks for joining our call today. Market conditions were somewhat difficult in the quarter with both the challenging demand environment and higher raw material costs, so we are pleased that we delivered solid results with double-digit increases in both sales and earnings per share.

We maintained our operational discipline and we prudently managed the things that we can control. We are making good progress in restoring our operating margins through pricing and improved productivity. Year-to-date, we have secured almost 10% in pricing globally and our operating margin was up 80 basis points sequentially from the second quarter.

Raw material costs continued their upward trend during the quarter and we now expect an increase of about 20% for the year, so we still have work to do, but we are in the process of working with our suppliers and our customers to address cost price and remain confident that we’ll restore our operating margins in 2012.

In terms of revenue, we achieved sales growth in all regions and in both of our segments. In our coating segment, our performance was driven by growth in our industrial and our packaging product lines with new business being particular strong in our industrial product lines. We have made significant inroads in markets for pipe coatings and coatings for shipping container, which are new segments for us and we continue to gain share.

In our paint segment, our U.S. consumer business grew despite a sluggish painting season and the loss of the Wal-Mart business. During the quarter, we launched Valspar Plus in the Home Center Channel, which is the first paint certified asthma and allergy friendly by the Asthma and Allergy Foundation of America and third-party data indicate that we continue to gain share in the U.S. do-it-yourself paint market.

We saw strong growth in China including over 100 new warrant stores that opened during the quarter. Overall new business is a company-wide focus that will position us well for the future and help offset lower demand in core markets. We are managing our cost well and maintaining cost structure that’s appropriate for the current external environment.

We are executing our restructuring actions as Lori mentioned to further lower our costs in our wood product line and taking the steps necessary to improve Wattyl’s profitability. The actions to both wood and Wattyl are on track.

Looking ahead to the remainder of the year, we continue to expect to deliver double-digit earnings growth in the range of $2.47 to $2.57 per share. Global economic conditions are presenting some challenges, but on a seasonally adjusted basis we are not expecting our volumes to change materially from what we experienced in the third quarter. We will continue to make progress in our pricing and we will in that remain focused on the things that we can control like winning new business and managing our cost structure.

With those comments, I will open the call for your questions.

Question-and-Answer Session

Operator

(Operator Instruction) We will go to line of Jeff Zekauskas with JPMorgan. Please go ahead.

Jeff Zekauskas – JPMorgan

Hi, good morning.

Gary Hendrickson

Good morning.

Jeff Zekauskas – JPMorgan

Is it fair to say that you are more encouraged with your pain price increases and less encouraged with your recovery of raw material costs in coatings?

Gary Hendrickson

Not really Jeff. I think in both segments where we have made roughly equivalent progress. In both segments we are about 80% maybe a little bit more than 80% in a way to recovering the cost price.

Jeff Zekauskas – JPMorgan

And is it the case that you expect to be closer to 100% in the fourth quarter or less than 80% in the fourth quarter.

Gary Hendrickson

We won’t be 100% in the fourth quarter, but we already more than 80% and I would expect to continue to make further progress in the fourth quarter toward 100%.

Jeff Zekauskas – JPMorgan

What if your bonus accruals been like year-over-year for the first three quarters and what do you expect for the year?

Lori Walker

Jeff, this is Lori. As we have commented in prior calls we had anticipated all along that our bonus accruals would be less in 2011 than 2010, we had such as fantastic year last year and that was built into the quarter and in to our full year guidance, with tracking as we had anticipated.

Jeff Zekauskas – JPMorgan

Okay. Thank you very much.

Gary Hendrickson

Thank you.

Operator

Next we go to line of Mike Sison with KeyBanc. Please go ahead.

Mike Sison – KeyBanc

Hey good morning everyone.

Gary Hendrickson

Good morning, Mike.

Mike Sison – KeyBanc

Nice quarter and tough times here, but Gary could you just give us a feel on volume trends as the quarter progressed. Did you see some incremental slowing as we headed in to July and I know August a little early, but the markets have been reacting that things are really, really weak out there any comments on some of the trends there?

Gary Hendrickson

I think Mike, as Lori mentioned in both coatings and paint we were down slightly in the quarter about 1% and would say that was pretty consistent through the quarter. Remember we started we have the huge quarter in April of last year with the expiration of home buyer tax credits and things like that and then it sort of settled out to a more normalized rate after that. In this year, we have been trending slightly below what I would consider the normalized rate from last year. We didn’t see material change in the quarter and as I said, relative to the rest of the year we are anticipating that we are going to see material change from the run rates that we saw in this quarter.

Mike Sison – KeyBanc

Okay. And then I think your comments were that volume trends would be similar in the four versus the third?

Gary Hendrickson

Yes, on a seasonally adjusted basis that’s true Mike remember the third quarter is a pretty big quarter for U.S. The fourth quarter tends to there will be a less volume in the fourth quarter typically, but just relative to year-over-year comparisons we are saying that we got our guidance to assuming that there is not a material change.

Mike Sison – KeyBanc

Okay. As we head into 2012 what do you think it going to take to see your volumes start to grow again granted for that sort of 12 months outlay. In addition, when you look at the squeeze that you get back in 12 from for the raw material and pricing it looks to me that sort of 200 basis points plus as we head in to 12. Is that sort of how the maths works?

Gary Hendrickson

You’re going to have to help me with how you did that?

Mike Sison – KeyBanc

Well, its looks like the year-over-year squeezes in the first three quarters is about 150, 200 basis points in gross margin year-over-year so that sort of what should come back as we head in to ’12?

Gary Hendrickson

Gross margin in an environment where we have such significant inflation Mike, it’s almost hard to do the math on it. There are a lot of factors that go into it, but the main one is, that your top-line is inflated by the pricing that you put through and so your denominator is pretty large with numerator. So, we are focusing in the short to medium-term on our operating margin. As I said we are pleased that we are able to improve our operating margin 80 basis points sequential. Gross margin will take longer for us to recover because of the inflation that we have seen that and the top-line inflation that you see along with your pricing. So, for us we are managing our total cost structure. Our expense line as well as our gross margin line and the more relevant metric for us in the short to medium-term is our operating margin percentage.

Mike Sison – KeyBanc

Okay, great. Thank you.

Gary Hendrickson

You are welcome.

Operator

And next we will go to line of Saul Ludwig, Northcoast Research. Please go ahead.

Saul Ludwig – Northcoast Research

Good morning everybody.

Lori Walker

Hi, Saul.

Saul Ludwig – Northcoast Research

With oil prices having come down, propylene coming down, are you seeing your raw material bill, if you look at what your raw material bill was, or cost index was in the third quarter, do you see that flattening or even declining in the fourth quarter? And if not, what are the counterbalancing forces to the oil derivatives, propylene derivatives that are heading south?

Gary Hendrickson

It’s not declining, but the slope of the line is decreased, so, relative to the inflation that we saw in the first few quarters of the year.

Saul Ludwig – Northcoast Research

You think maybe flat fourth quarter versus third quarter?

Gary Hendrickson

No, I think it still going to be up. We are getting the benefits from the organic type raw materials, solvents, propylene etcetera. But the TiO2 and the inorganic materials that we buy are still increasing in price. That’s the kind of balance. So, what we are expecting to see is a decrease in the slope, but not totally flat in Q4.

Saul Ludwig – Northcoast Research

Next question is you read the same things that we all read about the potentially slowing in economic activity all over the world. As you think about that environment, are you initiating any new programs to lower operating costs or consolidate facilities over and above your actions that have already been announced back in when the environment was maybe a little better than it is today? I mean, how are you responding to the new normal, if you will?

Gary Hendrickson

The actions that we are taking in wood and Wattyl are pretty significant and we are managing our cost structure pretty aggressively. We are not expecting volumes to recovery in the short-term and so we are doing all of the things that we normally do in an environment like this at Valspar. We are managing our cost structure very aggressively, but in terms of additional restructuring we don’t have any plans for that at the moment.

Saul Ludwig – Northcoast Research

And final question, in your Coatings section, your earnings were not a whole lot different than they were a year ago. And within that, if you think about your industrial, your wood, and your packaging, was there a relatively different level of performance in the three broad areas that comprise your Coatings segment?

Gary Hendrickson

As I mentioned in remarks Saul, our industrial business is doing really well in terms of new business. And we were achieving operating leverage on that new business. And so I would say the relative performance in our packaging coatings continues to perform well for us as it almost always does. Our wood business is performing not so well as has been the case for the last couple of years, but we did get better performance out of our industrial business, because of the increased volume.

Saul Ludwig – Northcoast Research

And on the new business, anyway you could give us any quantification like if you just lump it all together without segmenting pipe or shipping containers, but how much you think the new business added over and above versus last year?

Gary Hendrickson

Net new business, that’s our metric. Net new business meaning new business netting out any loss business that we had was about 3% in the quarter.

Saul Ludwig – Northcoast Research

Great. Thank you very much.

Gary Hendrickson

You’re welcome.

Operator

And next we go to line of Robert Koort of Goldman Sachs. Please go ahead.

Robert Koort – Goldman Sachs

Thank you very much. Gary, I was wondering if you could help us out a little bit on the chunk of your business that goes into the architectural markets. I think it’s pretty easy to sort of track what’s going on in the domestic market, but can you talk a little bit about what you are seeing in the Australian markets and should we expect at least in the first several quarters here that Wattyl will be more of a margin enhancement story than a revenue growth? And then secondly in China in Huarun, there is an article today in the journal talking about how the Shanghai property market obviously needs to be cooled, but my sense is you guys are in the second tier markets, so maybe there is more emphasis on supporting that homeowner activity. So, could you talk maybe about the nuances in those markets?

Gary Hendrickson

Sure. The Australian housing market is not very robust. I mean that is a fact that is somewhat obscured by how well the overall economy is doing and the strength of the dollar because of the mining sector, but the housing market is not very robust. So, Wattyl sales were slightly below the trend line that we would have expected. However, the restructuring that we are doing in Wattyl is slightly above the trend line that we expect. In other words, we are doing a little bit better on our restructuring than we thought we might. So, net-net, I think you asked Bob is you didn’t ask if Wattyl was a growth story, but you asked it was a margin story. We never described Wattyl in the short-term as a growth story. It’s always been about improved – structurally improving the business and generating increased earnings. And that program is as I said on slightly ahead of our plans.

In terms of Huarun, I mentioned that we opened 100 stores more than 100 stores in the quarter and that’s good. We have seen some modest slowing of our sales in China. We still delivered mid single-digits growth in Huarun, which was a little bit below what we did in the third quarter of last year. I think there is a little bit of uncertainty among our distributors about what happens in the property market, but the fact that our distributors were willing to invest their money in opening a 100 new stores tells me that their long-term, medium to long-term view of the market is it remained strong. Lori just pointed out to me that I said mid single-digits for Huarun growth was actually mid teens.

Robert Koort – Goldman Sachs

Great. Thanks for the help.

Gary Hendrickson

You’re welcome.

Operator

And next we go to line of David Begleiter, Deutsche Bank. Please go ahead.

David Begleiter – Deutsche Bank

Good morning, Gary. Just on TiO2, the latest round of price increases that should hit in the fall, what’s your ability to push back in those price increases given some perhaps less robust volume growth we’re looking at?

Gary Hendrickson

We push back on all of them David and we had – today, we haven’t been successful, quite frankly. So, I think this is a story that will play out over the next couple of quarters maybe the next year or so, but I believe that there is a supply and demand imbalance in the world and they have some pricing power at the moment and we are dealing with that in other ways in terms of qualifying alternative materials and we have talked in previous calls about a number of things that we have to do to offset that, but just in terms of price, I think we are probably going to end up taking some pricing.

David Begleiter – Deutsche Bank

Gary, I know you’re trying to qualify Chinese and using more extenders. How much TiO2 have you reduced on a volume basis or how much more Chinese TiO2 are you using today than a year ago?

Gary Hendrickson

I don’t have that data, David. I don’t have that level of detail sorry.

David Begleiter – Deutsche Bank

And just the last thing, on China, on your non-Huarun business, can you talk about the demand trends and any perhaps slowing growth there on the wood side?

Gary Hendrickson

Well, what has been slow for number of quarters, I think we have talked about that in the past. That’s the Valspar Wood business, which is the export business for furniture that’s coming back to the U.S. The Huarun business remained strong. That’s a different wood business remained strong, that’s a different wood business for us. Those are distributors selling into the local market. That remains a good business. And our industrial businesses in China are doing well. That’s where our container business is and we have some new business and new segments in China and that business is growing nicely.

David Begleiter – Deutsche Bank

Thank you.

Gary Hendrickson

You’re welcome.

Operator

And next we go to line of John McNulty, Credit Suisse. Please go ahead.

John McNulty – Credit Suisse

Just a couple of questions, with the – it sounds like the 100-store increase at Huarun, it sounds like actually a bigger number than what you’ve been opening up than in the past. Can you put that into some kind of context as to how many stores you actually have right now and what the growth rates been there historically?

Gary Hendrickson

I know I can, but don’t hold me to these numbers – these exact numbers over the growth rate John, because it changes pretty quickly. Total number of stores is probably around 2500. And you remember these stores are owned by our distributors and that’s why there is a little bit of swap in the numbers. There are a bunch of stores that are being opened right now and it takes a little bit of while to process this through our system, but it’s the rough number is about 2500. The target this year will be exceeded. We had a target of about 150 would it be well over that. Part of this is because in fact the main driver of that is because in fact the main driver of that is because our distributors have started opening smaller format stores in the smaller cities. And they are opening some stores now as a new initiative and developments actually in a department development they put a Huarun store on the first floor, small format store would be a showroom where people who are buying the apartments in the complex could come in and have a look at the pain options. And so those that because we have been opening small format stores and that type of store, the growth rate on our store count is accelerating faster than we would have said a year ago.

John McNulty – Credit Suisse

Okay, great. And then with regard to the TiO2 raw material hikes, is there anything that you have been able to do or expect to be able to do to improve or change your contract structure with some of your larger customers, so that it may facilitate maybe an easier way of getting through price increases to offset some of these raw materials?

Gary Hendrickson

If there is any positive about the TiO2 story, it’s this is that there is an awareness throughout the supply chain that there is significant TiO2 inflation. So, we don’t need to educate our customers any longer about our need for pricing to deal with TiO2 inflation. They are all very aware of that. But just in terms of contract pricing, I don’t think we have changed. We haven’t changed our contract structure to accommodate a specific raw material.

John McNulty – Credit Suisse

Okay. And then just last question, you would, I guess you had indicated that there were, you didn’t have any share repurchases in the quarter and we should be thinking about $96 million for the fourth quarter. Does that assume that there is no further share repurchases or is that just kind of the where we start the quarter at and you may opportunistically buy shares back throughout the quarter?

Lori Walker

John, I think you should think about it, we will opportunistically buy it. As we have stated before, our philosophy is to reduce our share count by 2% and then I guarantee that we offset dilution. And so you should expect that, that will be our philosophy going forward.

John McNulty – Credit Suisse

Okay, great. Thanks for the help.

Operator

And next we go to line of Dmitry Silversteyn, Longbow Research. Please go ahead.

Dmitri Silversteyn – Longbow Research

Good morning and congratulations on a good quarter in difficult times. I was wondering, given the fact that we've got one quarter left in 2011, why you wouldn't tighten your guidance perhaps a little bit more than $0.10. It seems to be pretty wide with one quarter left. So, can you give us an idea of what needs to happen to hit the high end versus the low end? Is it a question of price realization or is it a question of economic activity perhaps slowing down greater than your baseline?

Gary Hendrickson

It's simpler than that, Dmitri. I think we're pretty confident about what's going to happen with cost price in the fourth quarter. Yes, we've got a clear line of sight on that. It's really all about volume. We don't know what the recent events will do to our volume in the fourth quarter. Therefore, we're hedging our bets. And what would we need to get to the top end? We'd need volume in excess of what we've seen for the third quarter. Bottom end would be volumes that were slightly less than what we've seen in the third quarter. So it's all about volume.

Dmitri Silversteyn – Longbow Research

Okay. All right. Secondly, when you talked about the new business, net new business being up about 3%, you said it was net of the lost business so does that include the Wal-Mart loss or was that just coating specific and therefore does not include Wal-Mart loss?

Gary Hendrickson

I believe that includes the Wal-Mart loss, but if we're wrong about that, we'll get back to you.

Dmitri Silversteyn – Longbow Research

So, actually it sounds like your new business pickup is going very, very well.

Gary Hendrickson

I believe that we've gained share in every one of our businesses in the quarter. If you evaluated it on a year-over-year basis, I think every one of our businesses have picked up market share, including wood.

Dmitri Silversteyn – Longbow Research

Okay. On the new initiatives that you've outlined for us over the last couple of quarters including moving into UK with Valspar brand and getting Valspar brand into the Chinese market. You mentioned that you're picking up business in the container coatings. Can you kind of give us a timetable and perhaps if it's already happening, what the early results are of the paint initiatives in the UK and China?

Gary Hendrickson

About 11 stores, somewhere between eight and 11 stores have been set. And are selling the Valspar Paint and the early results are really good, better than we expected and better than our retail partner expected.

Dmitri Silversteyn – Longbow Research

Okay.

Gary Hendrickson

In China, the Valspar launch has gone a little bit more slowly than we expected, but we are now selling Valspar Paint. We've got a couple of projects that have been awarded to us. But keep in mind that I think I was trying to be clear at least that that's a modest initiative for us in the first year. We were looking for $5 million or $6 million in sales, and a breakeven business. So although it's a couple of months behind the time line we had had established, we're now on a good trend line.

Dmitri Silversteyn – Longbow Research

Okay, very good and then just trying to understand your comments around pricing and further realization of pricing. If I look at your results in your industrial coatings or in the coatings division, it's up about 16%, and then your Paint business is up about 8% if you exclude the acquisitions of Wattyl. So, it kind of organic growth. Is the difference between the two greater price realization in one versus the other or is it a volume difference?

Gary Hendrickson

No. I can't do the specific math for you, but here is what I can tell you, Dmitri. Our volumes in both segments were down slightly, very slightly for the quarter, and our pricing in both segments was roughly the same, within 1 percentage point of price realization in both segments.

Dmitri Silversteyn – Longbow Research

So, you were actually getting as much pricing in the Paints business at Lowe's and elsewhere as you are in the industrial business. If that's the case, I mean, wouldn't you ordinarily expect to see with better pricing in industrial since you can change it faster and more frequently versus kind of the once a year change that you get to do at big boxes?

Gary Hendrickson

Well, you've said a couple of things in there that I didn't say. I won't respond to the specific comments you made about how pricing works or the customer, but I'll just tell you that. To model this is a little bit difficult because we have several different types of industrial businesses. And they don't all move exactly at the same pace. I think the way I would like you to think about it, the way I think about it is that we normally get our recovery irrespective of segment or business in six to nine months.

And if you think about it that way, it might make the conversation a little bit easier. That's the way we think about it. We don't have put specific targets in front of our businesses. We expect them to recover their raw material inflation over time and over that six to nine month time period is what we want from them. But we've got parties on the other side of the conversation too and sometimes it takes a little bit longer, sometimes it doesn't take quite as long.

Dmitri Silversteyn – Longbow Research

Okay and then final question on pricing, Gary. Given the fact that your customers pay attention to your input costs as much as you do with the exception of TiO2, we did have some flattening or at least headline flattening in the petrochemical price chain. Do you expect that to make your price realization more difficult as you end the year or would you say that your pricing power is the same as it has been?

Gary Hendrickson

Well, I'd rather not talk about pricing power because I don't know that we have that. But what we do have is an open relationship with our customers about what our needs are and what our cost structure is and the fact is that we're still behind. The inflation in our industry actually started last year for us, not this year. And we had two quarters last year, where we didn't get much price in Q3 and Q4. We're in the process of recovering that, but we're still behind. As I mentioned earlier, we're about 80% recovered and we still expect inflation in the fourth quarter. So, we've still got work to do and the conversations with our customers are ongoing and I expect that between the two parties we will work out something, where we can get full recovery of our margins in 2012. Of our operating margin, again that's the way we think about it.

Dmitri Silversteyn – Longbow Research

Right. So, given the fact that you're gaining share at least in your opinion in most if not all of your businesses, it doesn't sound like your price initiatives are hurting you in the marketplace.

Gary Hendrickson

I don't believe that they are.

Dmitri Silversteyn – Longbow Research

Okay. Thank you.

Gary Hendrickson

You are welcome.

Operator

And next we go to the line of Don Carson, Susquehanna Financial. Please go ahead.

Don Carson – Susquehanna Financial

Just clarification on your margin improvement for next year, do you hope to get back to 2010 gross and operating margins for the full year or is that a run rate by the end of the year because while it does appear that certainly on TiO2 the raw material pressure in architecture will just annualizing this year’s price increases will be a bit of a headwind next year as well.

Gary Hendrickson

Don, as I mentioned, we're more focused on operating margin than gross margin even over a 12 month timeframe. And whether we get back to our 2010 margins in 2012 depends on raw material inflation. If raw material inflation is benign, if that curve flattens out, then we would expect that we will restore our margins in 2012. If it continues to increase, then we need to deal with that one through more pricing.

Don Carson – Susquehanna Financial

Okay. And then I noticed that inventories were relatively flat at the end of this quarter versus sequentially. Was that a conscious decision to build inventory ahead of further raw material increases or did that reflect a slowdown in volume? What was happening there?

Lori Walker

Don that reflects more in terms of conscious decision to ensure, that we had the raw materials to support our customers.

Don Carson – Susquehanna Financial

So were finished goods inventories up or was it just that the raw material inventories were up?

Lori Walker

It's both.

Don Carson – Susquehanna Financial

Okay. And then finally, you talked about market share. I notice Hi-Def Interior's been one of your big successes, but your competitor PPG is coming out or has come out with Olympic 1 at a $24 price point versus your interior Hi-Def at 30 to 32. Are you worried at all about your ability to maintain share there, given that significant price difference?

Gary Hendrickson

I think we’ve got data that say that we’ve taken share for the last 13 or 14 quarters from the market, Don. We've got the premium price points in that particular channel and consumers have not traded down in that channel. So, I wouldn’t expect that, that behavior would start now.

Don Carson – Susquehanna Financial

Okay, thank you.

Operator

And next we go to line of Rosemarie Morbelli, Gabelli & Company. Please go ahead.

Rosemarie Morbelli – Gabelli & Company

Good morning, all. Going back to the inventories, are you satisfied with your inventory level? And what about your customers’ inventories, do you feel that if the economy slows down they are going to be – to put the brakes on or are they in such a situation that they can still continue buying?

Gary Hendrickson

They might, don’t know, if the economy slowed, I would expect that they might try to take their inventories down, but so far I think the – at this point in time the inventories and our customers seem appropriate for the demand environment. And as Lori mentioned, ours are a little bit higher for some specific reasons that we think are important to us in our customers.

Rosemarie Morbelli – Gabelli & Company

But your volume is down about 1%, so I am assuming that this is the same for your customers. So, even if the economy does not come down, but stays flat shouldn’t we expect there, fourth quarter in terms of volume being worse than in the third because they are going to start living off inventories?

Gary Hendrickson

Everyone is with contacts, I think in our supply chain while suppliers and customers everyone is managing their inventories more tightly than they have in the past. And I wouldn’t expect to see big swings in inventory anywhere other than for specific reasons like the one that we mentioned for ourselves that we’ve got pricing increases coming on some raw materials. We want to be able to make sure that we supply our customers where we have got potential shortages in other raw materials. So we’ve built some inventory. I wouldn’t extrapolate the fact that we’ve built inventory to the rest of our supply chain.

Rosemarie Morbelli – Gabelli & Company

Okay, that is helpful. Thank you. And could you – I mean, you may have given us the number but I missed it, looking at Huarun, did you talk about the same store type of growth?

Gary Hendrickson

No, we didn’t Marie. And frankly, we don’t have that.

Rosemarie Morbelli – Gabelli & Company

All right. So, we are mostly looking at the extension of the new stores, all smaller, but you have no idea as to whether the store A in Shanghai sold more than they did last year?

Gary Hendrickson

Well, we do. We do know that they sold more, because these new stores tend to take a while to go up and producing. And the business was up as I said earlier in the mid-teens. And these new stores, 100 stores, represented very small portion of the overall store count something like 3% or 4%. So, if you just do the math on that mid-teens minus 4% probably 50% or 4% is a more realistic number then. That says the existing store base that we had is selling well.

Rosemarie Morbelli – Gabelli & Company

Okay. And regarding your introduction of the Valspar’s product line into China, aren’t you competing against Huarun’s and therefore your own products or are they in a totally different category and therefore it is more complementary?

Gary Hendrickson

It’s the latter.

Rosemarie Morbelli – Gabelli & Company

It is the latter. Okay. And on the industrial market, if you exclude the new businesses, could you share with us what kind of growth you saw for your existing ones?

Gary Hendrickson

You want to take that Lori?

Lori Walker

Yeah, just a second here, why don’t you go to your next question here while I look at that?

Rosemarie Morbelli – Gabelli & Company

I was wondering also if you had anything special in the Other category, which grew at about 2.6%, which is more or less the same as last year, a little lower, a little slower, is that kind of a trend line going forward if you eliminate the quarters where you had a big downswing last year?

Lori Walker

Well, there is nothing unusual in Other in the third quarter. And then I would anticipate going into the fourth quarter the trend in terms of rate to revenue will be somewhat similar in the fourth quarter this year as it was last year.

Rosemarie Morbelli – Gabelli & Company

Okay. And if I may, while you are still looking, you did very well at Lowe’s with Valspar brand. Did you do as well throughout the quarter or did you see some slowdown towards the end of the quarter?

Gary Hendrickson

The quarter was the three months in the quarter or about the same.

Rosemarie Morbelli – Gabelli & Company

Okay. And no signs – and I think someone asked, but no sign of any change going into August?

Gary Hendrickson

Yeah. It’s too early to talk about August, Rosemarie.

Rosemarie Morbelli – Gabelli & Company

Okay. Do you have the industrial, Lori?

Gary Hendrickson

Or I just say this, rather than to ask Lori to – she doesn’t necessarily need to be this specific, as I mentioned. Generally speaking, our industrial business grew at a rate that was higher than both our packaging business and our wood business. And the reason for that, that I would say the underlying core markets didn’t behave much differently. They were down very slightly, but the industrial business generated significant new business.

Rosemarie Morbelli – Gabelli & Company

Okay. But core was down slightly?

Gary Hendrickson

Yeah.

Rosemarie Morbelli – Gabelli & Company

And was that the case for packaging as well, you said they did better than industrial, but was it up? That usually is pretty stable.

Gary Hendrickson

And I would say packaging was pretty stable as it usually is.

Rosemarie Morbelli – Gabelli & Company

Okay, thank you.

Gary Hendrickson

You’re welcome.

Operator

Next we go to line of Steve Schwartz, First Analysis. Please go ahead.

Steve Schwartz – First Analysis

Hi, everyone.

Lori Walker

Hi Steve.

Steve Schwartz – First Analysis

Hi, Gary, you mentioned I think with respect to the architectural business you used the word sluggish and I just wanted to confirm that that’s just more of the general economics versus some acute factors or one-time factors that might have occurred within the quarter?

Gary Hendrickson

Yeah, I think there is weather in the beginning of the quarter that wasn’t so great, first cold weather and rainy weather and then very hot weather. And so, just the volumes weren’t what we had hoped that they would be. Just by segment though Steve, it will be helpful, in our Home Center segment, we actually grew volume and revenue. The sluggishness that we saw as we described our market had more to do with our independent channel than it did with our Home Center channel.

Steve Schwartz – First Analysis

Okay. And since we are talking about weather and architectural if we could shift it over to Wattyl, this did come up on the last call but I just want to clarify with you all. Even though it’s southern hemisphere, I don’t think they have the extreme seasonal changes like we have in terms of temperature, but they do have the rainy season versus dry. Is there in fact a seasonal volume pattern to that business?

Gary Hendrickson

Yes, there is.

Steve Schwartz – First Analysis

There is? Okay.

Gary Hendrickson

Yeah, yeah.

Steve Schwartz – First Analysis

And so as we head into what is your fourth quarter and then first quarter, is that in fact the stronger painting season for them?

Gary Hendrickson

The first quarter of next year for us would be stronger for them. That’s correct.

Steve Schwartz – First Analysis

Okay. But then to put that into context with the comments you made earlier with the housing market in Australia being what it is, that’s trumping the seasonal growth or change?

Gary Hendrickson

Don’t know. We are still six months away. Their biggest pain season is around Christmas, so we sort of bracket Christmas by a couple of months and that’s when they sell most of their – more paint than at other times of the year in Australia. So, there is still some time before we can declare victory or not in terms of volume growth in that business.

Steve Schwartz – First Analysis

Okay. And then you’ve answered this in a number of different ways, it relates to your pricing, but I am just wondering if you could give us a 30,000-foot view of what your pricing arrangements are like in a spot concept versus contract. So, in other words, how much of your customer base is your pricing locked in to a mechanized price increase or timing versus where you can just pass along price increases as you generate invoices?

Gary Hendrickson

It will be up very little of our business is the latter. In other words, almost every one of our discussion – every one of our price increases is negotiated with our customers. We have very few places where we can just change our price list and our customer’s invoice price changes. So, almost everything is negotiated. We have some customers and I can’t don’t really don’t want to be specific about how many of our customers are on contracts and how those contracts work. That’s just something that we rather not get into. We have a very diverse business. And there is a whole range of different arrangements that we have with our customers.

Steve Schwartz – First Analysis

Okay. And then just one last one, Lori, as we see your short-term here continue to creep up. What we expect in terms of how you are going to handle that. What impact will that have on your interest expense over the next couple of quarters, do you expect maintain a high level and just keep rolling it forward a little color please.

Lori Walker

Well, probably one of the things that you are seeing in terms of the short-term debt is we have a bond maturing next year and so that moved from long-term to short-term. So, I think that might be what you are looking at because total that actually declined. And so we would expect that to decline between now and end of the year.

Steve Schwartz – First Analysis

Total that so you are going to use cash or you going to use roll it over in to new debt and what can you expect there in terms of interest expense?

Lori Walker

Well, the interest expense in the fourth quarter we used to expect the trend line to be similar to what we had in the third quarter.

Steve Schwartz – First Analysis

Okay, great. Thank you.

Gary Hendrickson

You are welcome.

Operator

And next we will go to line of P J Juvekar of Citi Please go ahead.

P J Juvekar – Citi

A lot of questions have been answered, but I wanted to get sort of view on the contractor market. Do you believe that DIY still gaining share from that market or do you think that’s a sort of leveled out?

Gary Hendrickson

Probably leveled out I mean that’s like four year process I think P J when we went in to the recession I think people started doing more DIY projects rather than hiring contractors. I’m not sure that consumers feel any more comfortable about their balance sheet than they did a few years ago. So, it’s in first the data we have is in precise, but I would say is probably not changed significantly in the last 18 months or so.

P J Juvekar – Citi

Okay. Do you think it’s played out, but doesn’t go to the other way?

Gary Hendrickson

No. I would be speculating. I don’t think things changed materially from where they are today.

P J Juvekar – Citi

I think you also reduced your CapEx guidance from $90 million to $75 million is that correct and if it is then what was behind that?

Lori Walker

That’s correct. Just updating it in terms of realistically what we can spend in the fourth quarter.

P J Juvekar – Citi

Okay. So, it’s what you can spend rather than what you see going on in as a result you are not reacting to what you think is happening?

Lori Walker

We slowdown a little bit, but its more reacting to just giving you a realistic update.

P J Juvekar – Citi

Okay. Thank you.

Operator

And next we will go to line of Jeff Zekauskas, JPMorgan. Please go ahead.

Jeff Zekauskas – JPMorgan

Thanks. What was the cash flow from operations in the quarter?

Lori Walker

$164 million

Jeff Zekauskas – JPMorgan

Okay. Can you describe what you attempt to accomplish in your restructuring of wood and Wattyl? What are the things that you want to get done over the next six months?

Gary Hendrickson

Well, in wood we closed two plants Jeff. We are consolidating to one and we will get a lot of operating leverage out of that and obviously expense savings that’s the main objective there. And in Wattyl it’s similar, its plants and distribution the main focus of the restructuring in Wattyl’s plant distribution and products. So, we are reducing SKUs. We are reducing our manufacturing footprint and we are reducing our distribution footprint.

Jeff Zekauskas – JPMorgan

Are you hurt by the change in the Australian dollar year-over-year?

Gary Hendrickson

No.

Jeff Zekauskas – JPMorgan

What’s tax rate in Australia? What’s your book tax rate for Wattyl so far this year?

Lori Walker

Somewhere in the low 30s I think Jeff.

Jeff Zekauskas – JPMorgan

Low 30s. Okay, thank you very much.

Gary Hendrickson

You are welcome.

Operator

And next we go to line of Saul Ludwig, Northcoast Research. Please go ahead.

Saul Ludwig – Northcoast Research

You mentioned a number of times that it takes you about six to nine months to fully recover, when there is a raw material cost increase. So, I understand that when there is a raw material cost decreases does it take the same amount of time before your customers catch up with that and that you would have a period of substantial margin expansion for six to nine months, if we did see a retrenchment in raw material costs?

Gary Hendrickson

That might happen. I think our customers are aware that we're not recovering margin rates, Saul. Our initial conversations with customers are about recovering raw material dollars and that’s fair. But it also fair if it that has raw material costs go down that we have an opportunity to restore our margin rates?

Saul Ludwig – Northcoast Research

So then you put some of that in your pocket?

Gary Hendrickson

And at some point in time we end up in conversations with how to share that benefit.

Saul Ludwig – Northcoast Research

Second question is I think now you would anniversary the introduction of Hi-Def, when you first introduced Hi-Def there is huge positive switch from Valspar Ultra Premium to Hi-Def. Now we have got the apples and apples what was the experience this quarter in let say Hi-Def versus Hi-Def the year ago?

Gary Hendrickson

Yes, it's still continuing to penetrate. The word we used is penetration versus Signature or in other words changing the mix of Hi-Def to Signature and the trend continues to be positive for them.

Saul Ludwig – Northcoast Research

You mean Hi-Def to Ultra Premiums?

Gary Hendrickson

Hi-Def to Ultra Premiums sorry thanks for helping with that, so, Signature Hi-Def continues to become a larger part of our mix than Ultra Premium.

Saul Ludwig – Northcoast Research

Got it. Thank you very much.

Gary Hendrickson

You are welcome.

Operator

There are no other questions in queue at this time. Please continue.

Gary Hendrickson – President and Chief Executive Officer

Well, thank you everyone for your questions. To summarize, we pleased with our quarter. We continue to make good progress and restoring our operating margin through pricing and improve productivity. We are managing our cost structure and win new business and we expect to deliver double-digit earnings growth for the year in the range of $2.47 to $2.57 per share. So, thanks for joining our call today and we will look forward to speaking with you again in our fourth quarter conference call in November.

Operator

Ladies and gentlemen, this conference is being made available for replay after 12.30 PM today, running through Monday August 29, 2011 at midnight. You may access the AT&T Executive playback service at any time by dialing 1800-475-6701 and entering the access code of 212371. International participants may dial 1-320-365-3844. Again those numbers are 1800-475-6701 or 1320-365-3844 with access code of 212371. That does conclude our conference for today. Thank you for your participation and for using AT&T Executive Teleconference service. You may now disconnect.

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