Lubrizol Q3 2007 Earnings Call Transcript

Oct.26.07 | About: Berkshire Hathaway (BRK.A)

Lubrizol Corp. (LZ) Q3 2007 Earnings Call October 26, 2007 11:00 AM ET

Executives

Mark Sutherland - Investor Relations

James Hambrick - Chairman, President and Chief ExecutiveOfficer

Charlie Cooley - Senior Vice President, Treasurer and ChiefFinancial Officer

Greg Taylor - Vice President for Corporate Planning,Development & Communication

Scott Emerick - Controller

Analysts

David Begleiter - Deutsche Bank

P.J. Juvekar - Citigroup

Saul Ludwig - KeyBanc Capital

Laurence Alexander - Jefferies & Company

Robert Felice - Gabelli & Company

Ivan Marcuse - KeyBanc Capital

Operator

Welcome to the Third Quarter Earnings Release ConferenceCall. At this time, all participants are in a listen-only mode. Later, we willconduct a question-and-answer session. Instructions will be given at that time(Operator Instructions)

I would now like to turn the conference over to our host,Mr. Mark Sutherland. Please go ahead.

Mark Sutherland

Thank you, Pam. And thank you for joining us today, October26, 2007, for a discussion of our third quarter 2007 results, which werereleased this morning. This call is being webcast by ccbn.com and will beavailable for replay beginning about 6 pm Eastern time today and for the next30 days.

Our Internet site, www.Lubrizol.com, has several supportingdocuments for this call at the investor relations/earnings release page. Youcan access the presentation titled "Third-Quarter TeleconferenceSlideshow" and you can follow along with today's teleconference.

From this site, you can also access the replay and a writtentranscript of this call. Also on our site, you will find reconciliations toGAAP financials. Our prepared remarks today include references to non-GAAPfinancials in our discussion of earnings, EBIT and outlook.

We want to remind everyone that this webcast containstime-sensitive information that is accurate only as of today. Anyredistribution, retransmission or reproduction of this call without writtenCompany consent is prohibited.

Participating in the call with me today are James L.Hambrick, Chairman, President and Chief Executive Officer; Charlie Cooley,Senior Vice President, Treasurer and Chief Financial Officer; Greg Taylor, VicePresident for Corporate Planning, Development and Communication and ScottEmerick, our Controller.

James will open today's call with some brief comments on thequarter and how we see performance going forward. Charlie Cooley will discussthe quarter's results and our updated outlook for 2007. We will then open thelines for questions and discussion. I need to remind you that some of theinformation to be furnished in today's session will constitute forward-lookingstatements within the meaning of the Private Securities Litigation Reform Actof 1995.

Forward-looking statements are those focused on futureplans, objectives of our performance as opposed to historical items. We remindyou that actual results could differ materially from results projected orreferenced in these forward-looking statements.

Additional information concerning factors that could causeactual results to differ materially from those in the forward-lookingstatements in this teleconference are contained in the risk factor section andthe forward-looking statement section of Lubrizol's most recent filings withthe Securities and Exchange Commission.

With that, I'll turn this over to James.

James Hambrick

Thank you Mark, good morning everyone. Welcome. I'd like tomake a few introductory comments, focusing on some points I'd like for you toconsider as you hear the quarter's details from Charlie.

First, in the context of our overall performance, I'm quitepleased to report that our consecutive string of favorable earnings comparisonscontinue. We're now at 13 quarters and counting. I really like that trend.

Our organization is gratified by their successes; itcontinues to perform very productively with vigor and with optimism about ourgrowth plans and our opportunities. In an overall context, the trend is goodand the tone inside the organization is good.

We set a volume record for the third quarter in the LubrizolAdditives segment. That's thanks to both geographic gains, as well assupporting customers who grew business in their markets at least in part as aresult of the valuable technologies and services that we provide to them.

Third-quarter Additives volume record follows a recordsecond-quarter volume performance and a near record first-quarter performance.Translated, this means we are operating at historic, high, manufacturingutilization rates. In order to remain very reliable, a top-rated supplieralways our intention and purpose.

At this higher level of demand, we will be taking a numberof specific steps, including the bottlenecking efforts at our hub plants inTexas and France. We will be using our regional and joint venture facilities tohandle peak demands and building inventory of critical materials asappropriate.

Being a preferred supplier means more than just deliveringtoday's products when, where and how our customers need them. It also means theneed to invest in the design of tomorrow's products to meet the newsignificantly higher performance requirements for fuel economy, as well asemissions controls.

You can clearly see that there are significant change forcesunderway in the global transportation industry. We're increasing our R&Defforts now. We will be investing further in our operations as we move thosenew technologies and we have been doing so and we will continue to do so intoour global manufacturing infrastructure.

Faced with these increasing costs, as well as what seems tobe the ever present higher material, energy, labor and services costs, weadvise Lubrizol Additive customers by letter earlier this week of our decisionto increase product pricing across all product lines and from all locations.

Turning to Advanced Materials, overall, we saw strong growthinternationally. That was offset by weaker demand experienced in North America.That is really the headline. A little bit deeper, we had a strong quarter inEngineered Polymers and Consumer Specialty product lines.

In an overall context, I mean it wasn't brillianteverywhere, but it was a good, solid performance overall. Our PerformanceCoatings business continued to feel the adverse effects of an extremelychallenging environment, especially in the textiles markets.

However, I remain confident that, as we continue ourbusiness improvement efforts, the margins there will move closer to margins forthe overall segment. And here's an opportunity for me to really to pause andreinforce for you the opportunities that Coatings presents for us.

The technology solutions for performance, industrialcoatings, the market that we seek to serve, sit right at the intersection ofour acrylic polymer technology coming out of our personal care business, oururethane polymer technology coming out of our Estane thermoplastic polyurethanebusiness.

Those resin technologies combined with our strong coatingadditives productlines, their surfactant technology base, as well as thepolymer functionalization technology base, all of those combined give us anatural, a unique and a buildable position for growth.

It is a dynamic market space, it offers good opportunitiesfor skillfully constructed chemical formulations and we do that very well. Weremain active on the M&A front. We announced our intention to purchaseCroda Internationals refrigeration lubricants business in September. Wereceived regulatory approvals yesterday and expect to close that transaction ina week or two.

It's a great example of a type of bolt-on complementaryacquisition that we said we would pursue. We will disclose more about it afterwe get it closed. I just wanted to take the opportunity to highlight for youthat it is very attractive and a complementary addition to our business.

Also, I note that we missed another acquisition opportunityin the quarter. We just couldn't get to a price that made sense to us and so wedisengaged. We are patient. There are many good candidates in our pipelineright now. We’ll find businesses that are good fits and priced right in comingquarters.

So overall, we continued to set a very good pace as weentered the fourth quarter. October looks like a good, strong month for us inboth segments. I'm pleased with our position and I'm confident, without beingoverconfident, I don't want to give you that impression, but with goodconfidence in our ability to continue executing according to plan.

Before I turn the discussion over to Charlie, I do need toneed to comment on an item that appeared in our earnings release this morning,namely the announced restatement of our financial results. I just wanted totake the opportunity to give you a high-level view or the background on theissue and the factors that led us to this decision. You can refer to the Form8-K we filed this morning for more detailed information.

During the third quarter of this year, we identified postemployment benefit plans mostly associated with our additives operations inFrance where liabilities were not calculated properly and not appropriatelyrecognized on the balance sheet in accordance with U.S. GAAP requirements.

These errors, clearly unintentional oversights, applied toplans that had existed for many years and the errors accumulated over time tobuild in to the current unrecorded liabilities. To put the issue intoperspective, these errors combined would impact net income by approximately $2million per year for each of the last several years.

Not particularly significant to overall results, but clearlyimportant enough to need correction. We worked closely with our auditors andconcluded that a retroactive restatement would be the most appropriate courseof action and so we will be filing our amended reports as soon as practical.

Despite the relatively small size of these mistakes andtheir inaccuracies, I am embarrassed that we didn't get it right the firsttime, but I'm also equally pleased that our diligence in assuring the highestintegrity and transparency of our enterprise and its associated financialstatements brought this issue to light. We've dealt with it in astraightforward and a prompt manner and we will move on from here. With that, Iwill turn it over to Charlie.

Charlie Cooley

Thanks, James. Good morning, everyone. Before I begin, letme just pick up on the restatement issue to say that the financials that we'vereleased this morning have been adjusted to reflect the proper accounting forthe various post employment benefit plans. As James said, we will file ouramended the 2006 10-K and first and second-quarter amended 2007 10-Qs aspromptly as possible.

I don't have any further prepared remarks on the restatementbeyond what James has already said, but we will be happy to take any questionsduring the Q&A. I'll start my comments as I usually do with a viewheadlines for the quarter followed by a more detailed discussion.

Earnings this quarter reflected strong, continuedperformance in the Lubrizol Additives segment, but disappointing performance inthe Advanced Materials segment, especially in North America. However, bothsegments saw strong top-line growth in our international markets.

Also, on the quarter, a significant, environmental chargewithin the Lubrizol Additives segment was offset by a lower effective tax rate.The net result was a third quarter with strong, overall, operating performance.

In discussing results for the quarter, remember thatreferences to 2006 will be on a continuing operations basis and will excludethe impact of our divestitures from the year-ago period. And as a reminder, allreferences to earnings per share will be on a diluted basis.

If you are following along with the PowerPoint presentationthat is posted on our Website and investor earnings release page, I'm now on page4 where you can see the consolidated earnings for the third quarter of 2007compared to the year-ago period.

Earlier this morning, we announced that consolidatedearnings for the third quarter 2007 were $71.4 million or $1.02 per share,including a restructuring and impairment charge of $0.02 per share primarilyrelated to an impairment of a production line supplying businesses that weredivested in 2006.

Consolidated earnings from continuing operations for thethird quarter of 2006 were $50.1 million or $0.72 per share and included arestructuring charge of $0.03 per share primarily related to the closure of ourBromborough, U.K. manufacturing facility.

When we exclude the restructuring and impairment charge in2007 and the restructuring charge in 2006, adjusted earnings from continuingoperations of $1.04 per share for the quarter were 39% higher than the thirdquarter of 2006.

The primary drivers of consolidated earnings growth were animprovement in the combination of price and product mix, increased volume, alower effective tax rate, higher other income and reduced net interest expense.These improvements to earnings more than offsets the impact of higher materialand manufacturing costs and higher selling, testing, administrative andresearch or what we call STAR expenses.

Slide 5 compares the adjusted earnings from continuingoperations for the third quarters of 2007 and 2006. We have noted some of themore significant special factors that influenced our results for the quarter.We took unusually large charges totaling $0.06 per share for environmentalremediation matters in our Lubrizol Additives segment.

These primarily relate to disposal sites used by our Texasfacilities in the past. We called them out this quarter because Lubrizol has arelatively small environmental exposure overall and charges of such magnitudeare unusual for us.

Largely offsetting the environmental charges was the lowereffective tax rate in the quarter that contributed approximately $0.04 pershare when compared to the effective tax rate in the third quarter of 2006.

I'll talk more about taxes a little bit later. Finally, weestimate that currency contributed $0.07 per share compared to the thirdquarter of last year according to our pro forma calculation that comparesactual results to pro forma results translated at the prior period's exchangerate. Consolidated revenues increased 9% from the third quarter of 2006 to$1.12 billion.

Volume increased 4% from the year-ago period andimprovements in the combination of price and product mix increased revenues by3%. Currency was 2% favorable to revenues in the quarter. Gross profitincreased 11% as the higher revenues more than offset higher raw material andmanufacturing costs compared to the third quarter of 2006.

Gross profit margin percentage improved 50 basis points fromthe year-ago quarter, but was down 100 basis points sequentially from thesecond quarter of 2007. This was the second consecutive quarter of declininggross profit margin percentage and it largely reflects renewed raw materialcost pressures and higher manufacturing costs.

STAR expenses increased 5% from the third quarter of 2006.Research and testing expense of $56 million in the quarter increased 11%largely as a result of increased engine testing at our U.K. technical facilitywhere we were further impacted by unfavorable currency affects. Selling andadministrative expenses of $104 million were up 2% primarily driven by anincrease in funding to support growth initiatives, annual salary increases andunfavorable currency.

These increases were offset partially by a lowerperformance-based incentive compensation expense. Adjusted EBIT, which excludesrestructuring and impairment charges, increased 26% in the quarter to $115.4million. Net interest expense was 15% lower than the year-ago quarterreflecting higher interest income associated with our higher cash balances andreduced interest expense associated with our reduced debt balances.

The effective tax rate for the third quarter was 27.5% comparedto 30% in the year-ago period. As I noted earlier, this reflected a $0.04 pershare contribution to earnings in the quarter as compared to the third quarterof 2006. As was the case in the second quarter, the low tax rate for the thirdquarter was the result of favorable resolution of tax matters from prior years.

The lower tax rate also is attributable to an improvement inour geographic earnings mix thanks to our strong international growth. Now I'llturn to the segment results. Revenues for the Lubrizol Additives segment in thequarter were up 12% year-over-year, including a 15% increase in Asia-Pacificand a 40% increase in Latin America.

Volume increased 5% thanks to solid growth in engine andindustrial additives. The combination of price and product mix also improvedrevenues 5% and currency contributed 2%. Commenting on the Lubrizol Additivessegment volume growth year-over-year by region, volume in North America wasdown 2%, but the decline mainly was the result of our having reformulated some moreconcentrated driveline and passenger car engine oil additive packages.

Volume in Europe was up 4% primarily driven by the successof our European customer base. Our Asia-Pacific region saw an increase of 7%largely attributable to order pattern principally in engine oil additives. Andvolume in Latin America increased 34% as we increased new business gains -- aswe experienced new business gains with fuel and engine additives.

We continue to face cost pressures in the Additives segment.In addition to upward pressure on raw materials, our operating expensesincreased 11% in the third quarter of 2007 compared to the year-ago quarter.This increase largely was driven by higher manufacturing costs, notably forcontract labor and maintenance in the U.S. Gulf Coast and in Europe.

These factors are part of the justification for our recentlyannounced price increase. Segment operating income in the quarter increased37%. The earnings performance reflects strong volume growth and improved pricemix despite increasing material and operating cost pressures. I'll also addthat the year-over-year comparison also is highly favorable since the operatingmargin percentage in the third quarter of 2006 was impacted by rapidly risingraw material costs.

Turning to the Lubrizol Advanced Materials segment.Third-quarter revenues were up 3% compared to the year-earlier period. Theincrease reflected a 2% increase in volume and a 2% favorable currency impactwhile the combination of price and product mix was 1% unfavorable.

Growth in Asia-Pacific continued to be strong with a volumeincrease of 17% while North American demand generally was weak as I mentionedearlier. I'll now go into the Advanced Materials product lines in a little moredetail. The Noveon Consumer Specialties product line had revenues of $103million, up 7% from the third quarter of 2006.

Volume grew 23% in Asia-Pacific, 12% in North America and 6%in Europe. Volume in Latin America was unchanged. The majority of the volumegrowth in North America was in lower margin surfactant.

Volume for Carbopol powdered thickeners for home andpersonal care product application increased 10% over the year-earlier quarterand our new liquid Carbopol product volume increased 25%.

Revenues in Performance Coatings productline were $136million in the quarter, a decrease of 2% from the third quarter of 2006.

This productline continues to be impacted by the weakness inthe North American textiles and coatings industries that we've discussed inprevious teleconferences. Results for this business were impacted by lowervolume and unfavorable product mix.

While we do not disclose operating income for theproductlines, I do want to point out that this business remains profitable, butnot at margins where we want to be.

We have plans underway to drive improvement and theseinclude stabilizing our textiles business, shifting production to our new Chinaplant, narrowing our focus on fewer key targets where we believe we havecompetitive advantage, improving our applications capabilities in these marketsand improving our operation.

The Engineered Polymers productline consisting of TempRiteand Estane Engineered Polymers reported revenues of $143 million in thequarter, up 6% from the third quarter of 2006.

By region, Estane products experienced strong growth inAsia-Pacific and Europe, while North America was flat with last year.

Shipments increased in a number of applications, includingpaint protection films, geophysical and wire and cable. We also successfullyincreased prices globally through several price initiatives in the quarter andwe will continue to take price actions as warranted.

Global volume for TempRite products increased 6% in thethird quarter compared to the year-ago period. This was characterized by stronginternational volume growth of 11%. Inparticular, volume in Asia-Pacific established a new quarterly record bygrowing 13% over the last year.

North American volume increased 2% as increases in ourindustrial and fire sprinkler applications partially offset the impact ofweaker plumbing volumes that were attributable to slower residentialconstruction and we believe some inventory destocking.

Performance in North America also was impacted by somecompetitive price pressures. We continue to be encouraged by the product demandin overseas markets, as well as for new applications, such as North Americancommercial building water distribution. In these applications, the current CPBCmarket penetration is low so, there is greater upside potential.

Despite the good top-line growth, Advanced Materials segmentoperating income in the quarter decreased 27% from the third quarter of 2006.

The segment material margins were impacted by rising rawmaterial costs across all of our businesses as well as unfavorable earningsmix. Importantly, we are moving forward with price increases in theproductlines that have been affected significantly by higher material cost,particularly the Estane business.

Excellent growth in Asia-Pacific was offset by weak demandacross most of our businesses in North America. This resulted in unfavorableearnings mix as margins are generally lower in Asia-Pacific compared to NorthAmerica.

Segment STAR expense has increased in part due to theaddition of growth resources of approximately $1 million in the commercial andtechnical functions, especially in Asia, to position us for the future. Thesegment also incurred $2 million in expense for the quarter on theimplementation of an enterprise systems project.

I'll conclude my remarks on segment results with a quickcomment on corporate expenses, which were $17.7 million in the third quarter.This 20% decrease in corporate expenses mainly was attributable to the timingand amount of compensation and benefits expenses versus last year.

Turning now to cash flow, we generated $407 million in cashflow from operations for the first nine months of 2007 compared to $245 millionin the first nine months of 2006. This improvement was attributable to higherearnings, inventory reductions and a year-over-year improvement in accountspayable.

As a whole, we managed our working capital very well duringthe first nine months of 2007. Our day sales in receivables for the thirdquarter improved one day from the 2006 average and day’s sales in inventory forthe third quarter improved seven days over the 2006 average.

Regarding other uses of cash, capital expenditures for thequarter were $45.9 million, in line with our projected capital spending for2007. We repaid $37 million of debt in the third quarter, which includedrepaying in full our Euro credit facility.

In our April 27 conference call, we announced the expansionof our share repurchase program to buy back up to $300 million of common sharesthrough 2009. And during the quarter, we’ve repurchased 527,000 common sharesfor $32 million. And in the first nine months, we’ve repurchased approximately1.4 million common shares for $82 million.

As a result of these sources and uses of cash, our cashbalance at the end of the quarter was $646 million compared to $576 million atDecember 31, 2006. We currently expect to use some of this cash to retire the200 million in notes outstanding, which mature in December of next year.

This year, we introduced return on invested capital, orROIC, metrics to our corporate and operating segment incentive compensationscorecard. The corporate return on invested capital metric is defined asunlevered after-tax net income divided by average net debt plus equity.

For the four quarters ending September 30, 2007, ROIC was11.3% compared to 8.2% in the fourth quarters ending September 30, 2006 andthis certainly shows good progress towards our longer-term ROIC goal of 12% to13%.

Now I'd like to discuss our updated outlook. Our updatedguidance for 2007, including a restructuring and impairment charge of $0.01 pershare, is in the range of $3.84 to $3.89 per share.

And excluding the restructuring and impairment charge, 2007earnings guidance is in the range of $3.85 to $3.90 per share.

Implicit in this full-year guidance is our projection of a$0.64 to $0.69 fourth quarter is approximately $0.10 per share lower than ourprevious projection for the quarter.

Our model reflects an unchanged fourth-quarter outlook forthe Lubrizol Additives segment and a lower earnings expected from the AdvancedMaterials segment, notably in the Coatings business.

Our outlook also compares to the as-adjusted $0.71 per sharewe’ve reported in the fourth quarter of 2006, but when we remove from lastyear's fourth quarter the favorable legal settlements and discrete tax matterstotaling approximately $0.13 per share, we are expecting a favorableyear-over-year comparison on an operating basis.

And now, I will talk a little more detail about our outlook.For Lubrizol Additives, we are modeling approximately 1.5% volume growthyear-over-year, excluding acquisitions, with fourth quarter volume also up acomparable amount. And as James noted, October is looking strong.

We project unit material costs to be 3% higher in the fourthquarter than previously forecast. And our model includes only a minor impactfrom the recently announced price increase since the effective date is December1st.

For the Lubrizol Advanced Materials segment as a whole, ourearnings outlook is for less robust earnings than previously forecast drivenmainly by continued weakness in North America, especially in our Coatingsbusiness.

We also expect higher spending in the fourth quartertotaling approximately $5 million on the enterprise system project that isunderway.

For the full year, we project segment-operating income to bedown approximately 9%. And I’ll add also that October is looking stronger inthis segment than expected, so hopefully we will see some upside to our fourthquarter expectation.

We are now modeling corporate expenses and other income andexpenses net to be down year-over-year by approximately $7 million, largely theresult of higher currency translation gains included in other income. On aconsolidated basis, we are assuming revenue growth of approximately 9.5% comparedto 2006.

We're assuming that second half raw material costs will behigher than those we saw in the first half of the year. We now project netinterest expense to be approximately $66 million for the year.

Our tax rate assumption for the full year is 31%, which isdown from 32.5% mainly driven by the resolution of prior years tax matters andfor the fourth quarter, we're modeling a 33.7% rate.

We expect the euro to average a $1.42 for the fourth quarterof the year. We're modeling capital expenditures in the range of $175 millionto $180 million for the year and finally, our outlook for cash flow for thefull year now reflects a modest source of cash from working capital changes.

I'd like to conclude by saying that we are pleased with ourprogress in 2007 as we see ourselves well on track to deliver another year ofexcellent earnings growth.

And with that, Sam (ph), we can open up the lines forquestions.

James Hambrick

Sam?

Question-and-Answer Session

Operator

(Operator Instructions) Our first question comes from DavidBegleiter from Deutsche Bank. Your line is open.

David Begleiter - Deutsche Bank

Thank you, good morning.

James Hambrick

Hi David.

David Begleiter - Deutsche Bank

James, can you detail when you would expect margins inAdvanced Materials to recover to prior levels and a little more detailgranularity on the actual improvement programs in that segment going forward?

James Hambrick

What I'm going to, yes, thank you, David. I will do my best.Of course, it's a broad segment and a number of product lines. Let me see if Ican weave my way through here. First, let me take it at an aggregate level.

North America as a geographic region, the demand is down.That’s not unique to us. Others are experiencing the same thing, particularlythose who are associated with coatings and housing related products.

I'd also look from revenue, I would look at the expense areaand say that I do continue to manage this overall segment for long-term growth.I think you know me, many of you know me that despite a couple of disappointingquarters, we have been and continue to invest heavily in the segment to drivefuture growth. That is a drag on current results. There is no question aboutit.

We are driving geographic expansion. We're investing in newplants. We're adding people. And while we've made some efforts to moderatethat, I want to be careful that we're not trying to manage you here just forthe short term, that we continue to progress for the longer term.

Now down at the product line levels. So that’s really at theaggregate level. Down at the product line level, Consumers Specialties, reallyI'm not concerned and none of you should be either. Strong business, I'm verycomfortable that it’s order pattern related and in fact, we already seeevidence of that as a result of a very, very strong October there.

Coatings, I've already spoke about coatings in my comments,my opening comments. I note that Charlie also spent some time in his prepared remarks.We have talked a lot about things that need to be done there.

I wish I could snap my fingers and make it happeninstantaneously, but getting positioned in Asia, so much of the market hasmoved to Asia, we have a very significant capital project underway outside ofShanghai to get our manufacturing base into a competitive position.

We continue to invest on application knowledge specificallytargeted at differentiated products. And as I pointed out in the past, it's nota trouble free supply chain. It is work that continues to need to be done bothfrom an efficiency point of view, as well as a product line point of view.

Engineered Polymers, we've been making progress in theEstane business. Charlie mentioned top line growth in his comments. We arebeginning to introduce unique products, have already seen evidence ofimprovements in our competitive position.

We did recently announced a price increase. In the past, wehave tried to lead with some increases and have not been successful. That isnot the case this time that gives us some optimism that we will begin toaddress raw material issues here. Overall, my sentiment is this business is onthe right track for growth with improved profitability.

TempRite, business being impacted clearly by North Americanmarket demand. It remains a great platform for long term growth. It haswonderful potential for geographic growth. We continue to add resources andcapability there.

We also are focused for the first time here over the lastyear or so in areas for additional development of the product line. We alreadytalked about the extensions into other commercial applications in water pipingand sprinkler systems, but also in non pipe applications and it does take timeto launch those new lines.

Overall, I continue to have very strong confidence that weare implementing the right programs for the long term growth and I just cannotsee any reason to change our strategies here. I am confident, and as I said inmy opening comments and I really meant this, I don't want that to come acrossas overconfidence. It is prudent and appropriate confidence in our ability toreally take this thing to the next level.

David Begleiter - Deutsche Bank

That’s very helpful. Thank you. Just one more thing on yourlubricant additive price increase, have your competitors announced similaractions?

James Hambrick

David, I'm not aware of that and we will just wait and seewhat happens in the market.

David Begleiter - Deutsche Bank

Did you say what percentage increase the price increases arefor?

James Hambrick

I know it. I'm waiting for my hand signals to know whetherwe are talking about it or not. Yes, we are? Okay. It's 4% to 6% depending onproduct line and location.

David Begleiter - Deutsche Bank

Thank you very much.

Operator

Our next question comes from P.J. Juvekar from Citi. Yourline is open.

P.J. Juvekar - Citigroup

Yes, hi. Good morning.

James Hambrick

Hi. P.J.

P.J. Juvekar - Citigroup

NPRA was reporting that lubricant volumes declined 7% insecond quarter. How does that relate to your business? Is that something thatyou've seen or that is something you would see in the future?

James Hambrick

Well, I can tell you I think in Charlie's. I can't remember.Charlie, in your statistics, did you talk about North American volume inadditives?

Charlie Cooley

Yes, it was down 2%, but was largely due to the moreconcentrated packages.

James Hambrick

Yes. Here is the way I would like to handle it, P.J. We arenot experiencing that and again, we're doing great guns geographically. We dohave some new technologies out in the marketplace. We are faring very well.

P.J. Juvekar - Citigroup

And how much of your lube business is in the U.S. versusoutside the U.S.?

James Hambrick

I don't think that we've ever really broken that outgeographically. Have we, guys? Go ahead, Mark.

Mark Sutherland

Yes, I think that P.J. Mark Sutherland here. Most of ourlube additive business is outside of North America. I think in it is NorthAmerica is 40% and the balance is outside in Europe, Asia-Pacific, LatinAmerica.

P.J. Juvekar - Citigroup

Okay. Now on the Croda deal, can you talk to us aboutaccretion-dilution that you expect from the deal?

Charlie Cooley

P.J., it's Charlie. We'd like to hold off. And we will talkabout that, but I would like to hold off until we actually close thetransaction. As James noted, we got the European regulatory approval a coupledays ago and we're looking to close that deal in the next week or two and thanonce that is behind us, we can talk a lot more about it.

I think you've heard us talk about our excitement about theacquisition and I can assure you it will be accretive from the first quarteronwards. But we will have to wait and probably the next opportunity to talkabout it will be at the chemical conference in December.

P.J. Juvekar - Citigroup

Okay, great. Now with energy prices spiking here recentlyand generally you mentioned that October was strong in terms of volumes. Whatdo you need to do on the specialty chemical side to deal with this recent risein raw materials?

James Hambrick

P.J., this is James. We have been making some progress thereof recent. Now, I sense, in fact, listening to NPR this morning, some of theactivity that is going on in the oil market, I've been sensing and I see notonly current evidence of raw material pressure, but I sense more coming.

And in fact, as we've been going through our planningprocess, we've been talking a lot about properly positioning to manage that.You are never as successful as good as your want to be. I've talked a lot aboutpricing in the past and it is artful nature and it is balanced. We have ourfocus clearly on it.

P.J. Juvekar - Citigroup

Okay, thank you.

Operator

Our next question comes from Saul Ludwig from KeyBanc. Yourline is open.

Saul Ludwig - KeyBanc Capital

Good morning.

James Hambrick

Hi Saul.

Charlie Cooley

Hi Saul.

Saul Ludwig - KeyBanc Capital

Charlie, in the manufacturing, you're running the plantsfull out. Sometimes in prior quarters, you had let's say unabsorbed overheadbeing a hit. Was that issue a factor either absolutely or compared to lastyear?

Charlie Cooley

Yes, we actually had a, for the quarter, we had a favorableshift of $4 million to $5 million.

Saul Ludwig - KeyBanc Capital

Versus a year ago?

Charlie Cooley

Versus the third quarter of '06.

Saul Ludwig - KeyBanc Capital

In manufacturing?

Charlie Cooley

Yes, that is right. This relates to, really crudely stated,the relationship between how much we make versus how much we sell and so inthis quarter, we saw inventory reductions, which enabled us to put effect stillaround -- we put some inventory on to the balance sheet, which enabled us toput some capitalize some of the manufacturing spends, which will then come intothe P&L on future quarters.

Saul Ludwig - KeyBanc Capital

Will this issue be a factor in your fourth-quarter outlook?

Charlie Cooley

We're looking to be building inventory further during thecourse of the fourth quarter. I don't know if you caught in my preparedcomments, I talked about the day sales and inventory being down seven days from2006 average.

We were given a tight supply and high utilizations thatwe're running right now. We're looking to build as much inventory as we canthrough the end of the year. Maybe a rough number might be another $2 millioncapitalized in the fourth quarter.

Saul Ludwig - KeyBanc Capital

When you said your, I think, operating expenses were up $11million in the third quarter that was net of this $4 million to $5 millionheld?

Charlie Cooley

Correct.

Saul Ludwig - KeyBanc Capital

James, you probably and admirably talked about the 13consecutive quarters of growth, which is a tremendous achievement. And now wesee that your guidance calls for anywhere from a 7% to 2% decline in thefourth-quarter earnings comparison.

Is there anything that you see that could be done to maybecontinue the streak of better results, whether it be this inventory thing,maybe additional tax settlements, I don't know. Is there anything that you seethat could happen to maybe make things better than they now appear?

James Hambrick

Saul, thank you. Thanks for the question. It's a good one.I'm going to split the answer. First of all, in terms of the details of theaccounting matter, specials, tax rates and so forth, I'm going to let Charlietake an overall crack at what he sees as kind of what I call year-end affectsand so forth and then I'm going to come back and talk about the underlyingbusiness.

Charlie Cooley

Your question was focused on fourth quarter, right?

Saul Ludwig - KeyBanc Capital

Correct. Yes, because implying a 32% tax rate in the fourthquarter too.

Charlie Cooley

Right. I tried to hit that question head-on in my preparedremarks because I noted, if you look at the now $0.71 that we earned in thefourth quarter last year, that was aided by some favorable legal settlements,as well as some favorable discrete tax items in the fourth quarter of lastyear. And those added up to about $0.13. And we are not modeling anything likethat.

In fact, we don't have any of those kind of favorable itemsin our model for the fourth quarter of 2007. On that basis, we are actuallylooking at a fairly nice operating increase year-over-year in the fourthquarter.

One more comment and then I will turn it back to James. Ithink you've heard us now in maybe three different times talk about how Octoberis looking strong and that is true in both segments. So I do hope, we've gotsome upside in our model for the fourth quarter in both segments just based onhow the fourth quarter has gotten off to such a good start. James?

James Hambrick

Okay. Thank you, Charlie. Saul, kind of coming at it rightwhere Charlie left off, I will pick up. Yes, the model would suggest based onwhat we see is October and my calculus about the business momentum goingforward, I have to then stop and look at a couple other data points as I try toread the tea leaves here.

One is spending a lot of time watching others. We're not anisland here. We're all addressing similar markets in a competitive environmentand so I am cognizant that others are what they are doing and the difficultiesthey're having or not as the case may be.

The second data point I'm looking at is, and I madereference to this in my earlier comments about raw material prices, I knowwhere we are today and I see the pressures and I see the increases coming, butI also recognize what can yet come at us. And so there is a level ofuncertainty that keeps us as normal on a conservative side.

Saul Ludwig - KeyBanc Capital

Thank you. Charlie, in your fourth quarter guidance, what isit that you were assuming for the Advanced Materials comparison with $32million or so that they made last year?

Charlie Cooley

For the fourth quarter?

Saul Ludwig - KeyBanc Capital

Yes, sir.

Charlie Cooley

I know the answer in my head -- flat.

Saul Ludwig - KeyBanc Capital

Flat with the fourth quarter a year ago?

Charlie Cooley

Yes.

Saul Ludwig - KeyBanc Capital

So after being sort of flat in the first quarter and down 5%in the second and down 25%-27% in the third, you're going to be flat in thefourth quarter?

Charlie Cooley

That is our model right now.

Saul Ludwig - KeyBanc Capital

That is a pretty strong, that would even be up from thethird quarter. Why are you so let's call it optimistic?

Charlie Cooley

Well, there are a couple of things going on, some I didn'tmention. For example, in our personal care area in the third quarter, we hadsome one-time manufacturing expense associated with a unit down that we willnot see coming back in the third quarter.

Also and maybe more importantly in personal care, we saw --at the end of the summer, what surprised us to be lower demand than what wewould have thought and sure enough we're seeing that come back quite stronglyin October. So that is one of the product lines that is showing particularlygood strength beginning the fourth quarter. Those would be some main itemsthere, Saul.

We put these -- we're going to see a little bit of priceincrease benefits in Estane in the fourth quarter. I would probably stop there.But I think you know us. We have a fairly detailed bottom-up and then top-downreview of our models that we do before we talk to folks. And I just want to --so there's quite a bit of substance behind our communications to you in termsof our outlook.

Saul Ludwig - KeyBanc Capital

And finally, within that, you've mentioned that the SAPimplementation is going to cost you $5 million in the fourth quarter, whereas,it only cost you $2 million in the Advanced Materials sector in the thirdquarter. As embedded in your flat operating income comp, STAR expenses have gotto be up, what, $6 million, $7 million?

Charlie Cooley

STAR.

Saul Ludwig - KeyBanc Capital

For specialty materials.

Charlie Cooley

For Advanced Materials, STAR sequentially will be up about$2 million, so --

Saul Ludwig - KeyBanc Capital

Sequentially?

Charlie Cooley

Yes, sequentially. So that takes into account the $5 millionof SAP expense that I noted in the prepared remarks.

Saul Ludwig - KeyBanc Capital

Okay, great. The final question is these tax matters thatwere resolved favorably, I think if we go back to the beginning of the year andlook at the 10-K, you have a lot of these matters. You are not totally solvedyet. There are still pending issues that could help you on the tax rate by theend of the year?

Charlie Cooley

Yes, thanks for asking the question because I'm not so sureeveryone appreciates when we talk about tax matters. What we're generallytalking about here would be reserves that we will be making ongoing, year inand year out to address uncertain tax positions that we will have in the U.S.and in Europe.

So in the second quarter, we had some -- we released fromour reserves some international-related accruals and saw further largelydomestic reversals in the third quarter. And the question is a good one. Isthis the kind of thing we should be expecting year in and year out? And I wouldsay that the answer to that question is probably not. Don't bake in similarnumbers next year.

And the main reason I'd site is that these NOLs that we hadbeen utilizing as a result of the acquisition of Noveon and which we fullyconsumed at the beginning of this year, those NOLs will mean that our federalreturn in the U.S. will be open for a longer period of time. So I wouldn't bakein those kinds of favorable discrete items every year going forward, certainlynot next year.

Saul Ludwig - KeyBanc Capital

Thank you very much.

Operator

Our next question comes from Jeff Zekauskas, JPMorgan. One moment. He dropped off. And next question comes fromAlexander Laurence from Jefferies & Company. Your line is open.

Laurence Alexander - Jefferies &Company

Good morning. I guess next question then, on theinternational business in the Advanced Materials where you have the negativemix effects, is the plant in Shanghai going to be enough to bring internationalmargins within striking distance of the North American margins or is it goingto take a couple more years to close that gap?

James Hambrick

That is a complicated question -- in coatings, it will forsure. It certainly will improve our position. But that, of course, will not doanything -- for example, it does not have a CPBC resin plant in there, it doesnot have a Carbopol plant in there. And so it really has a fairly dramaticeffect on coatings and of course, as you know Laurence, that is the place wherewe can use the most help.

Charlie Cooley

But if you look at personal care margins, we see comparableprofitability in our personal care product line, certainly in the Carbopolproduct line throughout all four regions.

Laurence Alexander - Jefferies &Company

And I guess, secondly, the environmental charge thisquarter, is this a new run rate for environmental expenses or is this sort of ablip and then you expect it to fall back next year?

Charlie Cooley

Yes, thanks for the question because I want to make surethat people don't start assuming that's a new run rate because it is not.Lubrizol has -- as of last year, we had environmental reserves on our balancesheet of about $14 million and that is $7 million for each segment.

So, I think that is a good indicator that, as a corporationour size, our environmental exposures are really quite low. So, that is one ofthe reasons why we called out these remediation matters in the third quarterbecause they were unusually high and would not expect those kinds of levels inthe future.

Laurence Alexander - Jefferies &Company

And finally, the non-pipeline new TempRite application orthe non-pipe application, do those have the same kind of regulatory barriers orstructure as the pipe applications or is this going to be a differentend-market dynamic?

James Hambrick

It is going to be a different end-market dynamic. This isgoing to be value proposition-based.

Laurence Alexander - Jefferies &Company

Okay, thank you.

Operator

Our next question comes from Robert Felice, from Gabelli& Company. Your line is open.

Robert Felice - Gabelli & Company

Hi, guys. Just a couple of quick questions, most of themhave been answered though. Volumes in additives were really quite strong duringthe quarter and they were quite strong during the second quarter as well. I washoping you could parse through where specifically you're seeing the strength? Ithink you mentioned driveline and engine oils, but just if you can provide somecolor on that.

Charlie Cooley

Sure, it is Charlie. The -- Starting regionally,Asia-Pacific and Latin America saw very substantial double-digit growth and Imentioned those in the prepared remarks. And depending on where you are aroundthe world, we're talking about the different segments of the Lubrizol Additivesbusiness.

We've had good growth in marine diesel, for example, in someparts of the world. Heavy-duty diesel has had good volume growth. I think thereal star of the Lubrizol Additives segment in 2007 has been our traditionalengine oils business.

And while volume in North America has not been the growthhasn't been what we've seen elsewhere in the world, we've certainly seen goodrecovery in margin. And then lastly, a product line that we don't tend to talkabout very much as fuel additive.

It is relatively small within the Lubrizol Additivessegment, but that has had some really nice growth as we have been adding newproducts in that market.

Robert Felice - Gabelli & Company

Do you think you are taking any share on the fuel additiveside?

Charlie Cooley

No. No. I think as a general statement that our growth andvolumes in our additives segment have really been thanks to being able to ridethe success of our customers as they themselves have been gaining share.

Robert Felice - Gabelli & Company

Okay, and then additionally if I remember correctly, onemajor base oil producer actually reduced group one prices at the end of August.And despite oil being at now above $90 a barrel but I don't know if you've seena commensurate run-up in base oil prices.

So I guess the 4% to 6% price increases, is that reallypreemptive knowing that base oil price increases are inevitable with crude oilat current prices? Or are you actually seeing severe raw material costpressure?

James Hambrick

Hi, Robert. This is James. We are definitely seeingpressure. These price increases, as I said in my comments, it's aboutinvestment in plant equipment, people, technology, products the need to bringnew component technology to the marketplace.

There really are significant changes going on in the globaltransportation industry, engine design and so forth there is raw materialpressure. We are taking it now. It is building. It's going to continue tobuild. Energy costs continue to be high and volatile.

Labor costs, materials cost, contract services cost, it isan aggregate and we've done detailed analysis of all this and we're going to goout and we've got to get some prices to recover that.

Robert Felice - Gabelli & Company

So it sounds like you have some additional STAR expensesgoing in there and you know that raw material price increases are just aroundthe corner to cover it.

James Hambrick

No, sir. We are already having raw material increases. It ishere.

Charlie Cooley

In fact, I think I mentioned in this my remarks, this isCharlie, that our outlook for unit material costs in the fourth quarter areabout 3% higher than those that we saw in the third quarter. So as James said,it is right on us right now.

Robert Felice - Gabelli & Company

Okay that’s fair enough. Do you think you'll be able tomaintain the current -- the margin expansion you've experienced year-over-yearinto the fourth quarter? I know you will have a seasonal downturn there, but doyou think you'll be able to hold the year-over-year margin expansion?

James Hambrick

Yes, sir.

Charlie Cooley

Yes, that is our expectation.

Robert Felice - Gabelli & Company

Okay. And then flipping over to Advanced Materials, there'sa lot of moving pieces there and I was kind of hoping you can provide a bridgeto the year-over-year decline in operating income.

Charlie Cooley

Yes, hi. This is Charlie. I can give you a little bit ofhelp there. It's really mainly two stories. One, we've been talking about quitea while and that is the Performance Coatings business, which has been effected,as we've noted, by generally weak North American demand, material costpressures.

The other area is in TempRite. TempRite year-over-year alsosaw an earnings decline and it should be no surprise since we are exposed toNorth American housing, but what we've also pointed out to you folks for thelast several years is that the very strong value proposition of TempRite beingat such a lower installed cost versus the competing metal materials enables itto see much milder swings relative to housing starts.

I'll give you a for-instance. In the third quarter, ourNorth American plumbing sales volumes dropped about 8% or 9% in the thirdquarter versus the third quarter of 2006. But in that period of time, housingstarts were down 31%.

So that -- and that is not atypical to see the strongperformance relative to housing starts in North America by the TempRite productline. So, that probably would be my way of giving you the bridge. It's reallyfocusing on those two product lines.

Robert Felice - Gabelli & Company

Okay, that is helpful. And I guess as we look to 2008 forthat business, should we expect to see a significant decline in operatingincome margins? I mean unless you can rebound off of second half '07 levels,the first half of '08 will have really tough comps and on an average basis,that will drag down '08 margins.

I know you expect to flatten out performance sequentially inthe fourth quarter, but I guess as we looked at '08, by how -- what magnitudedo you think you can rebound off of that?

James Hambrick

Yes, I'm going to disappoint you with my answer. Consistentwith every third-quarter teleconference, we really steer clear about talkingabout our expectations for the following year and this is no exception.

A lot of reasons for that, the least of which is we're rightin the thick of our planning cycle and talking about the business internallyand with our Board. So hold off until February and we will give you a lot ofanswers to that question.

Robert Felice - Gabelli & Company

Fair enough. I had to try though.

James Hambrick

Okay, good try.

Robert Felice - Gabelli & Company

Thank you.

James Hambrick

Okay.

Operator

Our next question comes from Ivan Marcuse, from KeyBancCapital. Your line is open.

Ivan Marcuse - KeyBanc Capital

I just have a quick question. Could you -- how much of theprice increase do you guys typically capture on a year? If it's 4% to 6%, howmuch of that would you typically capture?

James Hambrick

You’ll laugh, I'm sorry. I hate to just sing the secondverse of the same song, but we don't -- I'm going to disappoint you with myanswer. We don't divulge that information.

Ivan Marcuse - KeyBanc Capital

Okay. One last question. What raw materials specifically areyou seeing – I am applying pressure?

James Hambrick

Well it's really across the board in preparation for this.Mark Sutherland could put together a list if you went to start hearing some --nomenclature. He'll lay it on you.

Mark Sutherland

Hi, Mark Sutherland here. In LVA, our additives business, ofcourse, it starts with crude and then it's ethylene, propylene, benzene,phenol, plus all the second and third tier materials as well.

In the Advanced Materials segment, it's our accruals (ph)the natural alcohols, the PTMEG, MDI, so it’s the usual suspects that we've gotin front of us. So, almost all of our raw materials are facing some upwardpressure.

Ivan Marcuse - KeyBanc Capital

Got you. All right. Thanks a lot.

Operator

I'm not showing any further questions in queue at this time.

Charlie Cooley

This is Charlie. I would like to take this opportunitysince; I'm glad to hear that there were no questions regarding our restatementand frankly, I think, that was appropriate since our view is that these werereally dealing with errors in prior years and with small annual impacts.

But I having seen some of the headlines that came out in thepress this morning, I really do want to make sure that investors are put atease that while these are clearly errors that should not have happened in thefirst place, A we're taking all the appropriate steps to make sure ourinternational folks understand the U.S. GAAP accounting, scouring landscape tomake sure that others of these types of things have been identified.

So, we feel pretty confident in our addressing of thesituation. It will indeed be treated as a material weakness under theSarbanes-Oxley terminology, but this is a matter that we are rapidly puttingbehind us.

Mark Sutherland

Okay. And Pam and audience, if there are no furtherquestions, I'd like to thank you all for dialing in this morning. Beforesigning off, I'd like to provide two telephone numbers for follow-up.

One is my direct line for clarification and the second willbe the dial-in number for telephone replay. My telephone number is 440-347-1206and Pam, could you please provide the replay telephone number?

Operator

Yes. Ladies and gentlemen, this conference will be availablefor replay after October 26, 2007 at 2:30 PM Eastern time today throughNovember 9, 2007 at 11:59 P.M. You may access the AT&T teleconferencereplay system at any time by dialing 1-800-475-6701 and entering the accesscode 888911.

International participants dial 320-365-3844. Those numbersagain are 1-800-475-6701 and 320-365-3844, access code 888911. That doesconclude our conference for today. Thank you for your participation and forusing AT&T executive teleconference. You may now disconnect.

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