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Cytec Industries Inc (NYSE:CYT)

Q3 2007 Earnings Call

October 19, 2007, 11:00 AM ET

Executives

Jodie Allen - Director, IR

David Lilley - Chairman, President and CEO

David M. Drillock - VP and CFO

Analysts

Steve Schuman - New Vernon Associates

Michael Judd - Greenwich Consultants

Robert Koort - Goldman Sachs

David Begleiter - Deutsche Bank

Chris Shaw - UBS

Laurence Alexander - Jefferies and Company

Robert Koort - Goldman Sachs

Michael Sison - Keybanc Capital Markets

John Mcnulty - Credit Suisse

Presentation

Operator

Good day and welcome to the Cytec Industries Incorporated third quarter earnings announcement. Today’s call is being recorded. For opening remarks and introductions, I’d like to turn the conference over to Ms. Jodie Allan. Please go ahead Ma’am.

Jodie Allen - Director, Investor Relations

Thank you, Connie and good morning everyone. We appreciate your participation in our conference call. For our call today David Lilly, Chairman, President and Chief Executive Officer will provide an overview of operation and Dave Drillock, Vice President and Financial Officer will review the financial results and the special items noted in our press release. David will then finish with some commentary on our outlook for the remainder of 2007.

This call is also being webcast in listen-only mode and it will be archived in audio format on our website for 3 weeks. During the course of this presentation and in response of your questions, you will hear certain forward-looking statements. Our actual results may differ materially. Please read our commentary on forward-looking statements at the end of our news release or the statements in our quarterly and annual SEC filings.

In addition, our discussion includes certain Non-GAAP financial measurements as defined under SEC rules. We have provided a reconciliation of those Non-GAAP financial measures to the most directly comparable GAAP measure at the end of our pres release. A copy of our press release is available on our investor relations website.

Before I turn the call over to David, I also want to take a moment to introduce myself. I am the new Investor Relations Director for Cytec. I have been with Cytec for 17 years in various businesses and functions with my most recent division as the Global Marketing Director for Polymer Additive. I look forward to working with you all in this new capacity and I hope to personally meet many of you over the next several months. With that, let me turn over the call to David.

David Lilley - Chairman of the Board, President, Chief Executive Officer

Thank you very much Jodie. This is a good quarter for Cytec, as all business units contribute to our sound financial performance and continue to take the initiative to improve all aspects of the business this positive activities within good stead not only for the balance of the year, but well into the future.

Diluted earnings per share and net of special items were $1.04 compared to $0.87 in the same period a year ago. In Cytec’s Performance Chemicals, sales were $181 million which compared to the same quarter in 2006 represent a 24% reduction due to the divesture of the water treatment product line, basically flat volumes in our base business and a 2% benefit from exchange. Prices were expectedly neutral in the period.

Customer order pattern in the mining and phosphine chemicals areas were the primary reasons for the volume shortfall. But, especially additives and precious sensitive additives had a good growth. Within mining chemicals, we continue to experience new commercialization of our Mac HD technology in a number processing and this was our benefit in the quarter.

All the manufacturing units run well and with good expense control, earnings for the segment were $18.3 million which is about a 10% margin. We also took some actions to improve the quality of our portfolio. Our Polymer Additives product line is comprised of some tremendously differentiated products in our driving health technology of family.

But also we have some more commodity ordinary chemicals. Our first priorities are clearly on the new value added products and after our extensive review, we’ve decided discontinue production of the commodity products such as Baxter at Willow Island, West Virginia. We are advising our customers our plan and determine a phase out schedule. We have started the reorganization and restructuring of the site in the production and service area such as warehousing, and these impacts about 63 jobs with a total restructuring expense about $5.5 million as mentioned in our press release for employee costs and dismantlement expenses. Dave, will cover the accounting in more detail later.

The benefits will not be realized until next year, but it is the right decision to focus on growth products and only manufacture commodity products if they need our cash and return of assets requirement. In Cytec Surface Specialties, third quarter of $13 million which compared to the same quarter a year ago equates to a 3% volume decline and benefits from price increase and currency exchange about 6% and 5% respectively. The curtailments of low margin solvable alkyds and acrylic sale by the closure of the French plan last year and weak economic conditions in key markets were the contributing factors for the volume decline.

If you examine the three key product sectors, there are some specific issues. The coating resins impacted by the Dijon enclosure, but there was continued growth in the water-borne products, which improved the mix and the margins. Powder coating sales improving volume terms in Europe and North America, but we’re weak in Asia as we focused our efforts on better margin products.

Where actual sales were down in all areas caused by weak demand, but we saw new opportunities in Europe and especially in plastic and photographic ink applications for products in this category. Across Cytec, our global procurement network remains vigilant on potential raw material cost increases; so that we can decide what actions we have to take on our own product pricing. We saw increased movement on methanol pricing for methanoic issues in Chile, and realizing the impact of polyramahide cost in Surface Specialties. We have raised the prices on our amino resin products. We gave about one month price protection to our customers, but our actions are aimed at margin protection. And we will continue this close collaboration between our procurement and marketing people.

Operating cost in Surface Specialty remain flat year-over-year on a constant dollar basis as a result of our wide number of productivity initiatives. The net result of all of the above was operating as segment worth $31.2 million compared to $18.8 million in the third quarter of 2006.

Willybot Chemicals continues previous good performance with $719 million. The sale of acrylamide product line to Kemira reduced sales volumes by about 19% compared to Q3 of 2006. But, we benefited by 26%, to the nitrite contract we gained in the Kemira transaction.

On the base business, we saw a 10% volume improvement and the benefit of 7% on improved product pricing. The only slight negative was reduced demand for our coliform by-products and more customers meet at our plant at Forshay [ph]. On the margin, we’ve covered raw material cost increases to pass through on product pricing. Despite some concerns at times on whether trends of potential impact to New Orleans area with Forshay Production Units running good operating rate and high utilization.

This all converted into good earnings and cash flow performance with operating earnings at $9.4 million. A $162 million, sales in slightly added material improved versus same period a year ago with volumes up 5% and the benefit of 1% each from price increases and currency exchanges.

So, with continued sales growth for our volume-related business caused by the high bill rates and greater penetration of competent applications and high performance Auto and [inaudible] sales for launch vehicles was strong as well. As expected, sales to EBITDA were down year-over-year caused by the A380 delays and the industry issues at some customer facilities, adversely impacting sales in the roto craft sector. Operating expenses were higher than a year ago as we ramp-up the plants for higher outputs as we also increase our investments in research and development for the emerging programs of the future.

Operating earnings were $28.8 million compared to $26.7 million in the same period in 2006. Sorry, we spent sometime in the four segments. Let me turn you over now to Dave Drillock to go through the financial results in more detail.

David M. Drillock - Vice President and Chief Financial Officer

Thank you, David. I’ll begin with an analysis of our gross margin and follow this with a discussion of two important efforts to improve operating margins and the special charges associated with those efforts. I’ll follow-up by briefly reviewing our operating expenses and cash flow.

Our gross margin after adjusting for the special items in both years improved 1% over the prior year period. This improvement came primarily from the benefit of pre-selling prices of about $30 million, which more than covered higher raw material costs of approximately $20 million. We continue to keep close tabs on this metric as raw materials continue to climb, and Dave will elaborate further on shortly.

We’ve also seen the benefit of the many operational excellence initiatives in our Specialty Chemical segments to improve returns and our product mix is more favorable than a prior year. As we have mentioned previously, a key initiative for us is in-depth review of our product portfolio to bottom slice and exit products where we have negative or insufficient returns and no likely prospects for sustained improvement.

In 2006, we ceased production of an unprofitable polymer additives product line, at our former facility in the Netherlands. And in the second quarter of 2007, we shut down our Dijon France facility and stopped making some unprofitable solvent borne, liquid coating resins. We can see the benefits of these actions in our margins already. We have now identified and announced two more similar initiatives. First, was at our Willow Island West Virginia facility as David mentioned earlier.

We’re discontinuing production of premature product technologies in polymer additives, so that we can improve the returns of this product line. Full year, 2006 sales for the discontinued products was approximately 30 million. The team at the plant did a fine job over the years to reduce costs, but unfortunately severe price competition has made these products uncompetitive. In conjunction with this we are restructuring operations and this will result in a reduction of approximately 63 positions. The total expense risk initiative will be approximately 5.5 million. We recorded 1.3 million in the third quarter and the remainder will occur over the next three quarters, as we exit these products in a non-disruptive manner to our customers. We will see modest earnings benefits in 2008 and a cash payback as less than two years. Actions, such as this are always difficult, but we are confident we are on a right track in turning around our polymer adhesive product lines.

Before I move on let me add that we’re focused on polymer additive differentiated products, David mentioned is clearly working and in 2006 these products grew approximately 15%. The second initiative we announced was restructuring of our liquid coating resins manufacturing facility in Wallingford, Connecticut.

Here, we’re also exiting a mature product technology that despite many hard efforts, we could not and do not see a path way to improve returns. Annual sales for this product technology in 2006 were approximately $20 million. In addition we are further automating operations at this facility and the net result is a reduction of approximately 35 positions these efforts are expected to not only improve our cost position at the site, but also lets us accelerate the second phase of our water-borne resin expansion at the site to 2009.

We are in track to start up the first water-borne line in the first half of 2008. The total restructuring expense is expected to be $1.8 million with 800,000 recorded in the third quarter and a remainder spread over the next three quarters. We also recorded an additional 700,000 in the quarter related to the clean and secure costs for the Dijon French manufacturing plant shut down earlier this year.

These expected costs were not accruable in our accounting rules as part of the charge taken in the fourth quarter of 2006. We expect to incur and record additional 400,000 in the fourth quarter of this year. These plus the many operational excellence activities going on at our Specialty Chemical manufacturing locations are the result of much hard work by our people and give us confidence we can and are continuously improving our financial results.

Operating expenses as a percent of sales are essentially flat with the prior period. Within these administrative expenses was up in the prior year, this is primarily attributable to a number of factors. The first being exchange, which is about a third of the increase, followed by normal wage inflation and continuing trend over the past several years, higher audit fees,.

Research and development costs are down year-on-year, but included in 2007 is a credit of 1.3 million as a reimbursement for certain R&D expenditures in Europe. Also, remember that 2006 includes R&D from divested water treatment product line. Excluding these two factors and factoring in exchange rate changes research and development increased about 4% year-on-year.

Interest expenses were down due to the lower debt balances. And during the quarter we’ve paid down an additional $32 million of our debt bringing the outstanding balance to $854 million. During the first five months of 2007, we have reduced our debt by $93 million. You should expect minimal changes in our debt balance until the first quarter of 2008 when 100 million of our outstanding debt is due.

Our income tax provision for the quarter was 26% and included in this is a benefit of 3.5 million as a result of recently enacted tax legislation that lowered the German corporate tax rate, beginning in 2008.

The accounting rule of that any long term deferred taxes be adjusted, when a rate change is enacted. We have net deferred tax liabilities in our balance sheet for our German entities. Hence, we reduced the liability and recorded the gains. Also similar to last quarter, we did not record a tax benefit on the French restructuring charge. After excluding these two items, the underlying annual effective tax-rate was 30.25%.

The equivalent rate for 2006 is 27.5%. The increase in annual effective tax rate over 2006 rate is due primarily to the items discussed in previous quarters mainly the divestiture of the water treatment and equivalent product line for the bulk of their earnings were realized in very low tax rate jurisdictions and unfavorable changes in U.S. tax laws regarding manufacturing, export incentives.

The 30.25% in the underlying annual rate for 2007 is 50 basis points higher than we reported last quarter, although within a range of our full year guidance. The increase is due to a change in a mix of earnings for higher tax entities than our previous estimates. That’s it, for the income statement so let me move on to a discussion of our cash flows.

We again had good cash flow and in the third quarter cash flow from operations was a 104 million. For the third quarter our trade accounts receivable dollars declined and they rose slightly to 59. Inventory dollars declined slightly and days on hand were about flat at 73. The increase in accrued expenses is due to our restructuring accruals and timing of compensation related accruals versus the payments.

Other liabilities are use of cash primarily reflecting plant funding of our pension plans. Before moving on, let me add that year-to-date our cash flow from operations is a 195 million a 20% increase over the prior year. Capital spending for the quarter was 26 million and year-to-date, we are at 66 million. We have reduced our full year forecast for capital spending to a range of 100 to 110 million down from our previous forecast range of a 130 to 140 million.

Our growth expansion projects and Specialty Chemicals are on track, but we did extend the assessment phase of the carbon fiber plan expansion. We have prioritized our engineering efforts in the engineered materials business. As we balance activities between leading the increased production volumes, new business qualification projects and capital projects. These are exciting growth times in engineering materials and we have begun work on at it to ease those expansions at our manufacturing plans in Maryland. We are and must remain disciplined and how we allocate our resources towards all the opportunities to get the most out of each dollar spent.

Lastly, during the quarter we repurchased 372,000 shares of our common stock for about 24 million and year-to-date we have repurchased 805,000 shares for approximately 50 million. This leaves approximately 90 million left in our current authorization and our current expectation is to continue our stock buyback program to the end of this year.

With that let me turn over the discussion to David.

David Lilley - Chairman, President and Chief Executive Officer

Thank you, Dave. I would now like to spend sometime outlining some other trends in each business segment. Before, I comment on our full year expectation for Cytec.

For Performance Chemicals, we expect to maintain the progress and momentum achieves in our first three quarters of this year. We have good visibility on sales demand in the fourth quarter, particularly from our mining and coating chemical customers. Short term economic issues typically do not impact this sector with the exception of polymer additives and pressure sensitive adhesives. In polymer additives, we’re essentially taking share to the value of our PHD technology. And in pressure sensitive adhesives, despite some reports of reduced labor production we are making progress across a number of industries.

We are not exposing this segment to major sudden shifts in raw material costs, but we are exposing some tightness in supply for key raw material for polymer additives and some parts of our mining chemicals product line. This may impact deliveries in the balance of the year. We have packed this into our estimate and we’re working hard to establish qualified alternative sources to broaden our supply base.

Let’s turn to Surface Specialties. On the economic activity effects in the coding industries. Our customers report continue to weak condition in the United States of America. We have little prospect of the near term turnaround. There were some signs of weakening of demand in Europe in September and we’ll see how this works out for the balance of the year. Asia continued its strong growth. We’re also pleased with gaining market share in these weak market conditions, through the promotion of value we offer to our customers from our water-based technology.

The manufacturing operations have made excellent progress this year including supply we have the capacity and reducing cost. And we expect to continue this positive momentum. There’s always some risk on the raw material input side, particular with all time highs in oil and propylene and there is still tight supply of many of our raw materials such as epoxy resins and oxo alcohol.

However, we believe that we have packed in the increasing costs on the benefits of product price increases and we believe that we are on track for delivering our earnings expectation for the Surface Specialty segment this year. And continue the momentum towards achieving a sustainable temperature operating margin by 2010 with our comprehensive program of improvement initiatives.

We continued the development and promotion of new systems for our customers, examples being worked on now include water-borne phenolics giving high-temperature and chemical resistance for metal applications a water-borne… phenolic system to enhance performance of interior coating for two piece count a newly epoxy paint additive. So we continue our drive to improve the vitality index of our portfolio.

We’re seeing every quarter the success from our operation access programs, translating our financial result and we expect that to continue. We have mentioned previously our determination to rationalize our liquid coating resins portfolio, as we recognize to the solvent borne products are being reined optionally, particularly by water-borne equivalent. We also want to expedite this trend, but our propriety water-borne systems enjoy better margins and our new product development activities also see to capitalize on this trend.

In the European plan, yield to bottom slice that is eliminate the lowest margin product in reactive detrain with our with high margin or water-borne products and still keep the records full on operating cost effectively.

We’ve also see the opportunity in the United States to restructure our Wallingford, Connecticut Manufacturing Plant to centralize amino resin production in one shop using more ultimate equipment requiring modest capital investment and convert the other main unit to manufacture water-borne products for U.S. customers.

As part of this would you size activate poor margin product line which service blooming and laminate industries and shut down the associate equipment these actions are like other productivity initiatives on every urge to improve the efficiency and effectiveness of the side and we look forward to the benefits beginning next year. So we continue along the path back to a 10% margin or more importantly improve earnings in Surface Specialties.

In Building Block Chemicals, it’s all about execution. We have the demand to full the plant and the ability to pack our raw material cost increases into our product prices. All sites operating units are at Forshay [ph] continue to operate well into the yield, through put and utilization rates. We are challenged out again by raw material availability and you maybe aware that Shell has declared [inaudible] in the United States based on operating issues at its Norco facility in Louisiana. We have had full contract customers on allocation. We have been able to find alternative sources and expect to continue [inaudible] plant at full rates for the fourth quarter.

However, we do expect propylene prices to rise again and we were expecting to be able to pass this through into product pricing, although there is some demand destruction and at this prices at credit five to become more expensive compared to substitute such as cotton and polyester. A-B-A plastic producers do not have many other options so the nitride market, we expect to maintain margin.

We have raised monoamine prices again to reflect input costing increases and also get a better return for this chemical. So we’ve good demand, continuing solid operating performance and margin control. We are expected to stay in a strong financial contribution from this segment. And as in materials, we have to catch up on delivery in certain areas and we are improving our performance in this vital area.

We have good visibility in our sales expectations for next quarter and we do not expect any impact this year from the Boeing 787 delay. Neither do expect Airbus to pick up the pace in A380 this year. Retail, can we just focus on what we can control, I’m pretty I’ve meeting the growth in demand. We have just started our former reviews of the business plans for next year and it would pre-mature to comment on expectation in 2008.

However, it is appropriate to give you an update on two major programs, the Boeing 787 and our plans to increase the capacity of carbon and fiber. On the 787 in a recent communication, Boeing indicated the design and integrity of this new technology airplane remained solid. However, due to the complexity of the launch program on some well publicized shortages they now face six month delay of the first aircraft delivery.

They estimate this to translate about 30 to 35 planes being pushed back from 2008 to 2009 delivery. Boeing, had in general told the supply change, to continue building to the old schedule and we insight… we are maintaining regular dollar with our customer to assess any flow-down impact. We do expect full impact next year we probably will not be significant as our internal forecast is based on our continuing dollar with our customer and our experience with programs in the early development and certification phase.

We will continue to meet our commitment and work on qualification and production scale up to pull this exciting program. We’ll give you an update early next year, when we discuss full year 2008 estimates. On the carbon and fiber expansion project, we are one on a way to complete the final design. We have learnt we can optimize use of our technical resources without restraining our growth by dividing the project into phrases.

Initial phrase will utilize existing technology to manufacture existing carbon and fiber grade. And on later phase we’ll produce both existing grades on those presently underdevelopment. The third phase will include new independent precursors, oxidization and carbonization lines and a sub-infrastructure to support the second phase. It will increase our capacity by approximately 50%.

Based on our more detail engineering definition some change in scope and rapidly escalating costs of steel and other construction materials, we now just made the first phase, will cost about $200 trillion and should be completed at the end of 2010. Moving back to 2007 and the expectations for the full-year we have increased our earnings range, reflecting a strong performance year-to-date in performance chemical engine material and Building Block Chemical.

Some amount of flopping in the Surface Specialty industry and increasing high raw material cost. This translates to a full year range of $3.70 to $3.80 for adjusted diluted earnings per share excluding any special item. Now, a lot of noise and comments about potential economic conditions in the media, but we remain dedicated on what we can control to improve our business.

We believed that have made progress in all segments this year in what are already difficult economic conditions. As I said before, we will shortly begin our detail review of our business plans for 2008 guided by the ongoing commitment to always see to grow earnings and so enhance shareholder value.

So, can I now hang back to our moderator Connie? So let me go and respond to your questions.

Question and Answer

Operator

Thank you. [Operator Instructions].

And we’ll take our first question from Steve Schuman from New Vernon Associates.

Steve Schuman - New Vernon Associates

Hi. Good morning, guys.

David Lilley - Chairman, President and Chief Executive Officer

Good morning, Steve.

Steve Schuman - New Vernon Associates

Question on your performance chemical business… last quarter you had a nice 13% margin that’s back down, so has this business become more volatile or lumpy, if you will, as far as margins are concerned?

David Lilley - Chairman, President and Chief Executive Officer

I don’t think this business will be volatile in a sense of it being sensitive to big swings. I think your word lumpy is more appropriate. We deliver large volumes particularly of extracting chemical for mining applications. They tend to flow in different patterns quarter-to-quarter. In acrylonitrile chemical business, we have some very high margin products there and again there’s some schedule issues with our customers where they want a large volume in the early part of the year or the back-end of the year. So, I think you will see some shift changes in margins so to speak quarter-to-quarter over time.

Steve Schuman - New Vernon Associates

So looks like you got a big order in second quarter and may be little of that spilled over in third.

David Lilley - Chairman, President and Chief Executive Officer

That is correct.

Steve Schuman - New Vernon Associates

Do you expect those margins to sort of taper off towards that 7% to 8%, we have seen in previous years then?

David Lilley - Chairman, President and Chief Executive Officer

I think what we are showing to you is that we believe we’ve got this year margins in excess of 10% and we determined and dedicated to maintain that level of performance and improve upon it. We will see what our people can deliver in the business part of next year.

Steve Schuman - New Vernon Associates

Great. And your suppliers, as far as raw materials, took you for service specialties, you mentioned methanol, ethane glycol. We’ve got [inaudible] across almost all the sort of products you guys buy. Are they telling you that this is going to be a one quarter issue or do you think this is going to spill over into early 2008?

David Lilley - Chairman, President and Chief Executive Officer

Well, they are always showing hope for the future as all suppliers do but I think our realistic view is that there will be tight supply continuing and on that basis we are seeking alternative supplies of all key raw materials around the world, so again you heard me say this before but I think it’s appropriate we are…we are acting on the basis of the worst situation hoping for the best so we think tight supply will continue, and we’ll act accordingly.

Steve Schuman - New Vernon Associates

All right. Thank you.

David Lilley - Chairman, President and Chief Executive Officer

Thank you, Steve.

Operator

And we will take our next question from Mike Judd from Greenwich Consultants

Michael Judd - Greenwich Consultants

Good morning.

David Lilley - Chairman, President and Chief Executive Officer

Good morning, Michael.

Michael Judd - Greenwich Consultants

Just a question about methanol… how much methanol do you guys currently purchase on an annual basis and I thought that you also purchase formaldehyde also, is that true?

Basically the impact is in formaldehyde, Mike. Methanol drives our formaldehyde price. So in our formaldehyde contract we have pastures there. I have not got the formaldehyde number at my fingertips but I believe it is in our Investor Day presentation and I am gong to ask Judy Allen [ph] to get back to you after this call to reiterate those numbers for you.

Are there any issues getting formaldehyde at this point?

David Lilley - Chairman, President and Chief Executive Officer

There is no issues getting the material it’s the question of what price?

Michael Judd - Greenwich Consultants

Okay thanks for the help.

David Lilley - Chairman, President and Chief Executive Officer

Thank you, Mike.

Operator

And we will take our next question form Bob Koort from Goldman Sachs. Mr. Koort, your line is open.

Robert Koort - Goldman Sachs

Can you hear me?

David Lilley - Chairman, President and Chief Executive Officer

Yes we can hear, Bob. Hello.

Robert Koort - Goldman Sachs

Sorry about that. David, I know you have had some success in divesting some of the product lines that you did not feel is optimistic about now you are taking some shut downs around some others. What is the approximate scale of some of those businesses and was there any opportunity to maybe sell a customer list or somehow get some monetization of those assets?

David Lilley - Chairman, President and Chief Executive Officer

There are some opportunities on the up side there so we are looking at particularly one of those commodity product lines and whether or not somebody else should own them, yes. So but it is not anything of significance or materiality Bob.

Robert Koort - Goldman Sachs

And then on the engineering expenses, additional expenses on the next Jan’s stuff, is that something that we can expect steady straight cost base or is there going to be lumpiness there as well?

David Lilley - Chairman, President and Chief Executive Officer

I think there should be some lumpiness as we go through the qualification work, and we’re trying to highlight that in advance. So for example if we’re going to take some extended time running carbon fiber materials, we’ll let you know because that’s quite expensive but I think as we go forward, you’ll see steady increases in our R&D line both for new people, new programs and qualification costs.

Robert Koort - Goldman Sachs

And then one last question if I might, obviously you have seen this play before where methanol spikes and then rockets back down. What did you learn from a year ago that’s changed the way you’re reacting to it, this go around?

David Lilley - Chairman, President and Chief Executive Officer

I think we continue the program to find other sources of methanol to feed off of aldehyde suppliers. We need to really have a broader spread of methanol producers to help us so that we not subject to international crisis like the situation with Argentina and Chile so I think it’s a diversification of our supply base is what we continue to learn.

Robert Koort - Goldman Sachs

Very good, thank you.

David Lilley - Chairman, President and Chief Executive Officer

Thank you.

Operator

And we’ll take our next question from David Begleiter from Deutsche Bank.

David Lilley - Chairman, President and Chief Executive Officer

Thank you. Good morning.

David Begleiter - Deutsche Bank

Good morning, David. David, at this time, answering materials, could you give us anymore detail on R&D expenditure and confrontation costs either in FY07 versus FY06 or at least Q3 versus the prior year or even Q3 versus Q2 in ‘07?

David Lilley - Chairman, President and Chief Executive Officer

Well first of all just a general comment. Quarter after quarter, I hope we can increase R&D cost as we bring on more people to work on these exciting programs so there’s a trend line going up, Bob, where army of a percentage of sales in Engineered Materials should increase possibly over time by one percentage point. Then we’ve seen some lumpiness, I think I can use that word again, so we did do, for example a qualification run on carbon fiber now this last quarter. Plus we have some development expenses for future programs out into the next decade. So there’s going to be some swings there, Bob. As I said previously or trying to give you a heads up when the carbon fiber trials are coming through.

David Begleiter - Deutsche Bank

I wish I could stop court, David, but I’m not.

David Lilley - Chairman, President and Chief Executive Officer

I am sorry. I am talking about Bob Koort’s previous question. I apologize David.

David Begleiter - Deutsche Bank

That’s okay and I just want, 787 are you suggesting that go on low slope production rates in 2008?

David Lilley - Chairman, President and Chief Executive Officer

I am just repeating what Bob have said so I think the question really is when is Boeing going to seal production so when so they do start routinely making 787s? But I think what they’re saying is that is going to shift by the period they’ve indicated. However having said what I said in my prepared remarks, David, was the chain, lots of people in the supply base, don’t you slow down you can make it, yes, at the rate that we’ve agreed to. I think what we also indicate is that we enclosed dollar with the customer and we think we are acting consistently with their requirements. Clearly there will be as slight negative next year in terms of our sales to that customer.

David Begleiter - Deutsche Bank

Are you still trying to gain additional special platforms or specifications on 787s going forward from Forshay [ph] or others?

David Lilley - Chairman, President and Chief Executive Officer

Yes we are trying to gain more applications as we seek to show our customer the value we produce by displacing metal out of the plane so we are basically working on programs that are more competent applications. I would say that is more in the mid term because in the short term Boeing is about getting its plane launched and going so when we come to various insert points, block points, we will be able to bring forth that technology and hopefully our customer will see the value we are presenting to them.

David Begleiter - Deutsche Bank

Thank you.

David Lilley - Chairman, President and Chief Executive Officer

Thank you, Dave.

Operator

[Operators Instructions]. And we will take our next question from Laurence Alexander from Jefferies and Company.

Laurence Alexander - Jefferies and Company

Good morning.

Unidentified Company Representative

Good morning, Lawrence.

Laurence Alexander - Jefferies and Company

I guess the first question on Surface Specialty, how much did raw material. Sorry. How much did pricing outpace raw materials this quarter and also if you look forward, is there any reason not to think that you will get your recoup any margin pressure faster than you did last time given that you have a better supply base than you did a year ago?

Unidentified Company Representative

As you know, we came into the full year being this year with a deficit so to speak on the raw material situation. I think we basically caught back up so a significant capture was in Q3. The question going forward is all about timing. When do raw material costs come in and can we get them, our pricing increases fast enough? So for example if we had a cost increase in December, you won’t see our price increase benefit till January so I can’t give you a straight forward answer, Laurence, all I can say to you is we are trying to cover the margins and we believe that’s the responsible thing to do. It will have some impact though potentially upon volumes as well which we got to be aware of so we are doing the balancing down that to optimize profits by getting the right price to volume relationship.

Laurence Alexander - Jefferies and Company

And how much do the favorable effects contribute to earnings on the quarter?

Unidentified Company Representative

Perhaps, an end. Well in, first of all overall for the corporation, it was relatively minor because you get a plus on chemicals, plus on associated chemicals, nothing on building blocks and a minus, a negative impact on Engineering Materials so I think the net was whatever pretty small but I think its roughly on the positive side for Performance Chemical, I am sorry, Specialty Chemical, overall a couple of million dollars.

Laurence Alexander - Jefferies and Company

Okay. And finally on Building Blocks, it sounds as if you are with both volumes and margins should be sustainable for the next couple of quarters do you have any concern about the stability next year or at this point, do you see factors that could lead that to unwind?

Unidentified Company Representative

Well, I think what you are trying to say in prepared remarks is we aren’t concerned but we are reaching a point on [inaudible] pricing for acrylic fiber production. The alternatives materials will display acrylic and we saw that probably 18 months ago and so one of the bit worries, especially on our export business, that’s beating on our Expert Business Asia will see some softening there. It probably keeps pushing up and nitride prices go up. So volume pricing on nitride for the export market is a concern for us going forward.

Laurence Alexander - Jefferies and Company

Thank you.

Unidentified Company Representative

Thank you.

Operator

And we’ll take our next question from Chris Shaw from UBS.

Chris Shaw - UBS

Hi. Good morning. How you doing?

Unidentified Company Representative

Good morning, Chris.

Chris Shaw - UBS

I guess to quickly follow up on what Lawrence suggests. Just from what you said that, do you not think that the profit you got building blocks this quarter is sustainable going forward? I didn’t know what you were saying.

Unidentified Company Representative

I think we’re saying, given the full year estimate for our Building Blocks and we feel pretty good about that and we got to look at slight changes in that as we go forward due to the reason I gave before on the pricing side of acrylamide and also to take account of when we have our turn…big turn around in the plant as well.

Chris Shaw - UBS

Okay, thanks. In terms of engineering material, I’m just trying to understand the volume I guess as it comes down from first quarter. 13, I think it was may be 7%, second quarter, now 5%. Is that all Airbus delays?

Unidentified Company Representative

Well, it’s everything as all of you know, this person takes all over the place so roads were cracked that were strong in the first half was a bit weak in the third quarter because they had too much inventory. So you see effects like this. We saw a new gain in Formula One. We saw new benefits from more applicative use now in launch programs. I know we had some timing issues and delays to major customers where sales have crept into the fourth quarter which probably would have gone to the third quarter.

Chris Shaw - UBS

I also noticed that pricing growth in the business has been coming down. Is there anything specific we should watch for there or is that just normal?

Unidentified Company Representative

I think it’s normal and modest.

Chris Shaw - UBS

Okay. One last thing, where you guys consider your maintenance CapEx to be?

Unidentified Company Representative

The reason, I had to say is there’s two elements, I think to that question that I say so, there’s maintenance in terms of plant integrity. There is maintenance of business which is like to safety program. So basically this year, the combination of those two is probably of the order of $40 million. It’s quite significant because we have put a lot of money into our saving initiative this year.

Chris Shaw - UBS

Okay, great. Thanks a lot guys.

Unidentified Company Representative

Thank you.

Operator

And we’ll take our next question from Mike Sisson from Keybanc.

Michael Sisson - Keybanc Capital Markets

Hi, guys. Nice quarter. Welcome on board, Joney. In terms of, you look at the Aerospace or Engineered Materials, the operating leverage was somewhat muted. You guys discussed the higher R&D and sort of, a little bit higher raw materials. Is the R&D increase, is that sort of a one quarter event? Does that reoccur in the next couple of quarters, how big was that?

Unidentified Company Representative

I think there’s going to be some continuing increased in R&D expenditures for new people, for new programs, and for new qualifications. So there will be some one time impacts quarter-to-quarter as we look at significant trials, possibly in carbon and fiber materials but the gains I would give is you’re probably going to see continuing investment in this business, given the opportunities of a new programs way out into 2015. So, I think, what you should look out for in Engineered Materials is earnings growth above all which we can do to deliver, we believe.

Michael Sisson - Keybanc Capital Markets

Okay. And in terms of the raw materials, the increase in that division, is there is an automatic pricing there, right? To offset that?

Unidentified Company Representative

No, there is no automatic pricing, Mike we have the opportunity on a contrast to go back now and again basically requesting improvements in our price due to inflation impacts, would it be labor or raw materials. And I would describe the cost increases there as modest, yeah?

Michael Sisson - Keybanc Capital Markets

Okay. So the impact on both what maybe a percent or two on margins?

Unidentified Company Representative

I’d say it was extensively neutral.

Michael Sisson - Keybanc Capital Markets

Or for both in a quarter?

Unidentified Company Representative

Yes. I’d say, you know, many of them moved slightly in the negative direction but marginally, very marginally.

Michael Sisson - Keybanc Capital Markets

So the, when your sales are up 6% earnings growth 8, I mean so the May was more mixed that was sort of the issue?

Unidentified Company Representative

I’d say it was coming back to the operating expenses in terms of SG&A being up because of the investments in R&D and also they mentioned in my prepared remarks, we aren’t gearing out the plans for even more volume next year, that means we are bringing on people now who will be productive next year in producing the extra volume.

Michael Sisson - Keybanc Capital Markets

Okay. So the raw materials not an issue but as we head into ‘08 the operating leverage should be for what it’s worth, somewhat back to normal to what you see in the last couple of years.

Unidentified Company Representative

Don’t mislead anybody here, Michael. I don’t want to mislead anybody. If you say back to normal, let’s say for three of four years ago? No.

Michael Sisson - Keybanc Capital Markets

Okay.

Unidentified Company Representative

We are in an abnormal situation, which is great.

Michael Sisson - Keybanc Capital Markets

Right.

Unidentified Company Representative

We’re in a fast growing market here and we are taking advantage of those programs. So we are putting resources in to continue the growth.

Michael Sisson - Keybanc Capital Markets

Right.

Unidentified Company Representative

So, here we could sit back and get 20% to 22% margins and give up the growth for the future and that would be the wrong thing to do. So you are going to see continued reinvestment in this business at all lines, so that’s what we talked about unused capacity raised the button in pre-paid capacity, these fiber capacity and with those goes start to expenses, introducing new labor, introducing new programs. On top of that we’ve got the R&D coming through as well. So if we are talking about normal, yeah normal in the context of a fast growing market and what we’ve been doing over last 12 months to 18 months.

Michael Sisson - Keybanc Capital Markets

Right. So maybe if you think about a 3 years to 5 year sort of view of the market, view of the business it’s still sort of a good mid-teens times earnings growth or maybe even higher type earnings growth type business?

Unidentified Company Representative

Yeah, what we have said, over a five year period we believe on average, remember on average we are going to get about a 10% growth here. We’ve got to get a bit backend loaded.

Michael Sisson - Keybanc Capital Markets

That’s top line?

Unidentified Company Representative

That 10% we to believe should come on average to a 15%, 15% growth in earnings year-over-the-year.

Michael Sisson - Keybanc Capital Markets

Right.

Unidentified Company Representative

That’s the type of leverage that we believe we’re going to be getting through given anyhow I just said about the investment.

Michael Sisson - Keybanc Capital Markets

Okay. So no change there …

Unidentified Company Representative

No change in our general guidance to what we expect till the next five years.

Michael Sisson - Keybanc Capital Markets

Then shifting gears real quick, in [inaudible] cure was a little volumes are being down there, could you help us just remind us the end market sort of maybe little bit more color, why that business is sluggish?

Unidentified Company Representative

Yeah, I think the end markets I’ve not got the right split again. It’s in our Investor Day presentation and Judy will back that up with the information in more detail, but basically repertoire is down in all the major markets.

Michael Sisson - Keybanc Capital Markets

Okay.

Unidentified Company Representative

It’s used both only, it is used in inks, packaging materials and things like other like and also some electronic applications. So we are seeing a general trend down at the moment due to economic conditions.

Michael Sisson - Keybanc Capital Markets

Okay.

Unidentified Company Representative

I’m sorry I should have mentioned what Dave’s reminded me of course in wood finishing, which will go into everything from parquet floors to furnishing.

Michael Sisson - Keybanc Capital Markets

Okay got you. Then lastly on water-borne, you know, volumes been up that’s great, is that just more market share gains that you are seeing there, because I don’t, I can’t imagine the markets in total are growing?

Unidentified Company Representative

We are gaining share at the expense of solvent-borne.

Michael Sisson - Keybanc Capital Markets

Okay.

Unidentified Company Representative

And that’s the reason why we are very confident of investing in the second phase of our U.S. plant. And over time we will be challenging them to what more capacity they need and at some stage we will have to think about capacity for water-borne in Asia as well.

Michael Sisson - Keybanc Capital Markets

Okay, great, thanks guys.

Unidentified Company Representative

Thank you Mike, good night.

Operator

And we’ll go next to Robert [inaudible] from Bear Stearns

Unidentified Analyst

Just like to flash out a little bit of what you guys were saying in Western Europe. One can you just refresh us how much of your sales going to Western Europe? What were you seeing it at the end of the quarter, have you seen the trends continue into October, I just wanted to hear about that a little more?

Unidentified Company Representative

Thanks Robert for the question. I think about what we are talking about here is about other about half of our business in service especially is in Western Europe and we were acknowledging was a slight softening in the industrial markets of Germany and Italy in particular. It’s too soon to say what’s happening in October and the balance of this quarter, but I think we are just acknowledging some nervousness there we have and we have factored that into our full year estimate.

Unidentified Analyst

I am just I guess my what we are hearing today in a lot of companies I am just trying to see if what you going on with the U.S. is going to spread and that’s my concern I just I guess you will flush that out later through the quarter?

Unidentified Company Representative

Yeah I mean obviously in a situation we are seeing at the moment Europe for the full year has been in more of a growth mode admittedly, relatively modest growth due to infrastructure build in those countries. So we will see how it flushes out what you are saying next year.

Unidentified Analyst

Okay thanks for your help.

Unidentified Company Representative

Thank you, Bob.

Operator

And we’ll take our next question from John Mcnulty from Credit Suisse.

John Mcnulty - Credit Suisse

Yes, good morning.

Unidentified Company Representative

Good morning, John.

John Mcnulty - Credit Suisse

Just a few questions. Not to maybe beat a dead horse but on the engineered materials business, can you give us your quantified growth that you saw in each of kind of the major segments the commercial aerospace military and say other for the quarter?

Unidentified Company Representative

Yeah, well can I say I believe the engineered materials business is a stallion job not a dead horse, okay? So, a wild stallion here what we saw john I would say is a large commercial aircraft, one customer obviously up and the other customer down, I would say that in a Rota craft I would say it was down, the reason I gave before, which was basically high inventories of materials of their customers clearly with a decline year-over-year and I would describe as commute aircraft the bombard embryo type models but there is growth or be it small given it is a small user in the business jet sector yeah, and military is basically flat as it applies to fixed wing aircrafts and the like.

John Mcnulty - Credit Suisse

Okay.

Unidentified Company Representative

I am sorry I missed one of that and I think also in non aerospace applications, it’s slightly up I believe in Formula One being the large contributor there.

John Mcnulty - Credit Suisse

Okay. That’s a bit more helpful. Like with regard to the surface specialties business, it sounds if I recall you said, you would indicate that the price increases will basically take a month to follow on the raw material side that vaguely sound like it’s a quicker turn around than it was back bank in ‘06 if I remember correctly it was, it took almost you have the some of your customers had 3 month price protection is my memory correct on that?

Unidentified Company Representative

Your memory is exactly correct, John we have learned from those experiences of the year ago, so, we believe 30 days price protection is appropriate. And clearly we are not popular by going in with price increases but we are making the valid point that basically, when our margins are being eroded by this, then we have to share the load. So these price increases are effective for this quarter.

John Mcnulty - Credit Suisse

So as far as it sounds like you are going to benefit from having maybe a better supply situation, it also sounds like the turn around is quickest for the margins, I would imagine in surface specialties there is not a whole lot of risk than it coming any way near where they were kind of this time last year, is that fair?

Unidentified Company Representative

I don’t think there is any risk in terms of raw material, the price equation but the risk applies to action the customer may take to source materials to other supplier. So the risk is our volume job.

John Mcnulty - Credit Suisse

Okay, okay, no it’s fair. And then the last question on the mining chemical lumpiness, I know in the second quarter you had I guess a benefit from better or increased pass bean and that may have borrowed from first quarter but in terms of the mining chemical lumpiness was that an issue where second quarter benefited and borrowed from third, or is that an issue of the third you may have seen some get pushed to the fourth?

Unidentified Company Representative

Its mainly do with our copper oxide extraction you may recall that when a new mine opens there is this large fill order then we replenished the order which is like 10% of that fill year-after-year and we had a significant fill on significant larger order in Q2.

John Mcnulty - Credit Suisse

Okay and that nine rekind [ph], cause, I thought on the second quarter call indicated you start with the next 12 to much as well as 18 months of that business which all remain stable in second quarter level.

Unidentified Analyst

I think we will have indicate it was we ramping up production because we saw all the field coming along then we have to build inventory as we depleted inventory from large order.

John Mcnulty - Credit Suisse

Okay now that’s [inaudible], thanks a lot

Unidentified Analyst

I think we have for one more call.

Operator

Very good, take our question at the follow up from Laurence Alexander, from Jefferies & Co.

Laurence Alexander - Jefferies & Co.

Hello just a couple of very quick point the lower CapEx spending is that because you have your estimates for the total CapEx for the quarter to moving down or is it partly a timing issue and you just push back into FY08?

Unidentified Company Representative

Well, the prime issue was really just being pushed out of it.

Laurence Alexander - Jefferies & Co.

And with Surface Specialties, just to help us understand the seasonality in the business, if you look the pricing haven’t cause up to raw material this quarter. And given the restructuring that you’ve announced, is it fair to say that all of the equal you would expect Q3 of the next year, for example the back half of next year to be running at an 8% towards that margin rate?

Unidentified Company Representative

I would hope that we could target for that and the only reason we hesitate is going about the previous question, there’s so much of volatility in our market place in terms of demand of raw materials, well I don’t think that we can give you an expectation of that.

Laurence Alexander - Jefferies & Co.

Right. But it’s different term to help for the business that or that would be reasonable?

Unidentified Company Representative

What we’re trying to see is that we have, we do have some seasonality because we have all this in Christmas shutdown for our customer. So I think the best trend line to watch is what our margin year after year after year on an annual basis and just started on that.

Laurence Alexander - Jefferies & Co.

Right. And also, just to help us understand the Engineered Materials, sort of, on an annual basis rather than on a quarterly basis. This could, sort of, damage your another foreign. Can you still essence of what burden medallion is doing, if you look over five years, the tutorial CapEx qualification talk, higher R&D spending, when you have a pretty good sense of where you want to get to, do you have a sense of how much you need to invest over the next five years, so that you can think about. What the underline help for the business will be once that burden is lifted.

Unidentified Company Representative

Well, I think it’s five year time, I would expect, we would expect, excuse me, the R&D for example would be 100 basis point higher as today when we look our percent of sale. I think, we’re going to make dollar level of investment in the business and sustain it to that level. And in our regard as an investment rather as a burden, I think the CapEx is going to fill the growth. And it will be a great return for our shareholders, so again I think it’s a cost where the cost was barring because of the return of the top line, the profit that generate.

Laurence Alexander - Jefferies & Co.

I just wanted to be clear that 1% increase in R&D, does that includes the qualification cost or you have some estimate, what the total qualification cost could be very lumpy over the next five years?

Unidentified Company Representative

We have some idea on the next couple of years, where our qualification cost are and they are reasonably good, I think then after a lot of question will apply to the timing of the cost and how success we are in the program. So we’ve not a good handle for obvious reasons on these costs, because I was still working with our customers on these programs.

Laurence Alexander - Jefferies & Co.

Okay. Well, if you flag a horse, can you give us sense on the next two years?

Unidentified Company Representative

But just going through our replay and review, Lawrence, I don’t think this is the right quarter that question because in three weeks, we will be gone through all these reviews, so it’s a little early to say that. But when you go back, Lawrence, what we would say consistently is look over the five year period, look how for an average 10% sales growth and 15% earnings growth, here but they don’t mention, but that’s what we believe this thoroughbred will deliver.

Laurence Alexander - Jefferies & Co.

Perfect. Thank you.

Unidentified Company Representative

Connie, could we, I think we can now end the call.

Operator

Thank you. And at this time we will conclude today’s conference. We thank you for your participation. You may now disconnect.

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Source: Cytec Industries Inc. Q3 2007 Earnings Call Transcript
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