Executives
Mark Sutherland - Investor Relations
James Hambrick - Chairman, President and Chief Executive Officer
Charlie Cooley - Senior Vice President, Treasurer and Chief Financial 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
Lubrizol Corp. (LZ) Q3 2007 Earnings Call October 26, 2007 11:00 AM ET
Operator
Welcome to the Third Quarter Earnings Release Conference Call. At this time, all participants are in a listen-only mode. Later, we will conduct 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, October 26, 2007, for a discussion of our third quarter 2007 results, which were released this morning. This call is being webcast by ccbn.com and will be available for replay beginning about 6 pm Eastern time today and for the next 30 days.
Our Internet site, www.Lubrizol.com, has several supporting documents for this call at the investor relations/earnings release page. You can access the presentation titled "Third-Quarter Teleconference Slideshow" and you can follow along with today's teleconference.
From this site, you can also access the replay and a written transcript of this call. Also on our site, you will find reconciliations to GAAP financials. Our prepared remarks today include references to non-GAAP financials in our discussion of earnings, EBIT and outlook.
We want to remind everyone that this webcast contains time-sensitive information that is accurate only as of today. Any redistribution, retransmission or reproduction of this call without written Company 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, Vice President for Corporate Planning, Development and Communication and Scott Emerick, our Controller.
James will open today's call with some brief comments on the quarter and how we see performance going forward. Charlie Cooley will discuss the quarter's results and our updated outlook for 2007. We will then open the lines for questions and discussion. I need to remind you that some of the information to be furnished in today's session will constitute forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995.
Forward-looking statements are those focused on future plans, objectives of our performance as opposed to historical items. We remind you that actual results could differ materially from results projected or referenced in these forward-looking statements.
Additional information concerning factors that could cause actual results to differ materially from those in the forward-looking statements in this teleconference are contained in the risk factor section and the forward-looking statement section of Lubrizol's most recent filings with the 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 to make a few introductory comments, focusing on some points I'd like for you to consider as you hear the quarter's details from Charlie.
First, in the context of our overall performance, I'm quite pleased to report that our consecutive string of favorable earnings comparisons continue. We're now at 13 quarters and counting. I really like that trend.
Our organization is gratified by their successes; it continues to perform very productively with vigor and with optimism about our growth plans and our opportunities. In an overall context, the trend is good and the tone inside the organization is good.
We set a volume record for the third quarter in the Lubrizol Additives segment. That's thanks to both geographic gains, as well as supporting customers who grew business in their markets at least in part as a result of the valuable technologies and services that we provide to them.
Third-quarter Additives volume record follows a record second-quarter volume performance and a near record first-quarter performance. Translated, this means we are operating at historic, high, manufacturing utilization rates. In order to remain very reliable, a top-rated supplier always our intention and purpose.
At this higher level of demand, we will be taking a number of specific steps, including the bottlenecking efforts at our hub plants in Texas and France. We will be using our regional and joint venture facilities to handle peak demands and building inventory of critical materials as appropriate.
Being a preferred supplier means more than just delivering today's products when, where and how our customers need them. It also means the need to invest in the design of tomorrow's products to meet the new significantly higher performance requirements for fuel economy, as well as emissions controls.
You can clearly see that there are significant change forces underway in the global transportation industry. We're increasing our R&D efforts now. We will be investing further in our operations as we move those new technologies and we have been doing so and we will continue to do so into our global manufacturing infrastructure.
Faced with these increasing costs, as well as what seems to be the ever present higher material, energy, labor and services costs, we advise Lubrizol Additive customers by letter earlier this week of our decision to increase product pricing across all product lines and from all locations.
Turning to Advanced Materials, overall, we saw strong growth internationally. That was offset by weaker demand experienced in North America. That is really the headline. A little bit deeper, we had a strong quarter in Engineered Polymers and Consumer Specialty product lines.
In an overall context, I mean it wasn't brilliant everywhere, but it was a good, solid performance overall. Our Performance Coatings business continued to feel the adverse effects of an extremely challenging environment, especially in the textiles markets.
However, I remain confident that, as we continue our business improvement efforts, the margins there will move closer to margins for the overall segment. And here's an opportunity for me to really to pause and reinforce for you the opportunities that Coatings presents for us.
The technology solutions for performance, industrial coatings, the market that we seek to serve, sit right at the intersection of our acrylic polymer technology coming out of our personal care business, our urethane polymer technology coming out of our Estane thermoplastic polyurethane business.
Those resin technologies combined with our strong coating additives productlines, their surfactant technology base, as well as the polymer functionalization technology base, all of those combined give us a natural, a unique and a buildable position for growth.
It is a dynamic market space, it offers good opportunities for skillfully constructed chemical formulations and we do that very well. We remain active on the M&A front. We announced our intention to purchase Croda Internationals refrigeration lubricants business in September. We received regulatory approvals yesterday and expect to close that transaction in a week or two.
It's a great example of a type of bolt-on complementary acquisition that we said we would pursue. We will disclose more about it after we get it closed. I just wanted to take the opportunity to highlight for you that it is very attractive and a complementary addition to our business.
Also, I note that we missed another acquisition opportunity in the quarter. We just couldn't get to a price that made sense to us and so we disengaged. We are patient. There are many good candidates in our pipeline right now. We’ll find businesses that are good fits and priced right in coming quarters.
So overall, we continued to set a very good pace as we entered the fourth quarter. October looks like a good, strong month for us in both segments. I'm pleased with our position and I'm confident, without being overconfident, I don't want to give you that impression, but with good confidence in our ability to continue executing according to plan.
Before I turn the discussion over to Charlie, I do need to need to comment on an item that appeared in our earnings release this morning, namely the announced restatement of our financial results. I just wanted to take the opportunity to give you a high-level view or the background on the issue and the factors that led us to this decision. You can refer to the Form 8-K we filed this morning for more detailed information.
During the third quarter of this year, we identified post employment benefit plans mostly associated with our additives operations in France where liabilities were not calculated properly and not appropriately recognized on the balance sheet in accordance with U.S. GAAP requirements.
These errors, clearly unintentional oversights, applied to plans that had existed for many years and the errors accumulated over time to build in to the current unrecorded liabilities. To put the issue into perspective, these errors combined would impact net income by approximately $2 million per year for each of the last several years.
Not particularly significant to overall results, but clearly important enough to need correction. We worked closely with our auditors and concluded that a retroactive restatement would be the most appropriate course of action and so we will be filing our amended reports as soon as practical.
Despite the relatively small size of these mistakes and their inaccuracies, I am embarrassed that we didn't get it right the first time, but I'm also equally pleased that our diligence in assuring the highest integrity and transparency of our enterprise and its associated financial statements brought this issue to light. We've dealt with it in a straightforward and a prompt manner and we will move on from here. With that, I will turn it over to Charlie.
Charlie Cooley
Thanks, James. Good morning, everyone. Before I begin, let me just pick up on the restatement issue to say that the financials that we've released this morning have been adjusted to reflect the proper accounting for the various post employment benefit plans. As James said, we will file our amended the 2006 10-K and first and second-quarter amended 2007 10-Qs as promptly as possible.
I don't have any further prepared remarks on the restatement beyond what James has already said, but we will be happy to take any questions during the Q&A. I'll start my comments as I usually do with a view headlines for the quarter followed by a more detailed discussion.
Earnings this quarter reflected strong, continued performance in the Lubrizol Additives segment, but disappointing performance in the Advanced Materials segment, especially in North America. However, both segments saw strong top-line growth in our international markets.
Also, on the quarter, a significant, environmental charge within 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 that references to 2006 will be on a continuing operations basis and will exclude the impact of our divestitures from the year-ago period. And as a reminder, all references to earnings per share will be on a diluted basis.
If you are following along with the PowerPoint presentation that is posted on our Website and investor earnings release page, I'm now on page 4 where you can see the consolidated earnings for the third quarter of 2007 compared to the year-ago period.
Earlier this morning, we announced that consolidated earnings 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 primarily related to an impairment of a production line supplying businesses that were divested in 2006.
Consolidated earnings from continuing operations for the third quarter of 2006 were $50.1 million or $0.72 per share and included a restructuring charge of $0.03 per share primarily related to the closure of our Bromborough, U.K. manufacturing facility.
When we exclude the restructuring and impairment charge in 2007 and the restructuring charge in 2006, adjusted earnings from continuing operations of $1.04 per share for the quarter were 39% higher than the third quarter of 2006.
The primary drivers of consolidated earnings growth were an improvement in the combination of price and product mix, increased volume, a lower effective tax rate, higher other income and reduced net interest expense. These improvements to earnings more than offsets the impact of higher material and manufacturing costs and higher selling, testing, administrative and research or what we call STAR expenses.
Slide 5 compares the adjusted earnings from continuing operations for the third quarters of 2007 and 2006. We have noted some of the more significant special factors that influenced our results for the quarter. We took unusually large charges totaling $0.06 per share for environmental remediation matters in our Lubrizol Additives segment.
These primarily relate to disposal sites used by our Texas facilities in the past. We called them out this quarter because Lubrizol has a relatively small environmental exposure overall and charges of such magnitude are unusual for us.
Largely offsetting the environmental charges was the lower effective tax rate in the quarter that contributed approximately $0.04 per share when compared to the effective tax rate in the third quarter of 2006.
I'll talk more about taxes a little bit later. Finally, we estimate that currency contributed $0.07 per share compared to the third quarter of last year according to our pro forma calculation that compares actual results to pro forma results translated at the prior period's exchange rate. Consolidated revenues increased 9% from the third quarter of 2006 to $1.12 billion.
Volume increased 4% from the year-ago period and improvements in the combination of price and product mix increased revenues by 3%. Currency was 2% favorable to revenues in the quarter. Gross profit increased 11% as the higher revenues more than offset higher raw material and manufacturing costs compared to the third quarter of 2006.
Gross profit margin percentage improved 50 basis points from the year-ago quarter, but was down 100 basis points sequentially from the second quarter of 2007. This was the second consecutive quarter of declining gross profit margin percentage and it largely reflects renewed raw material cost 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 facility where we were further impacted by unfavorable currency affects. Selling and administrative expenses of $104 million were up 2% primarily driven by an increase in funding to support growth initiatives, annual salary increases and unfavorable currency.
These increases were offset partially by a lower performance-based incentive compensation expense. Adjusted EBIT, which excludes restructuring and impairment charges, increased 26% in the quarter to $115.4 million. Net interest expense was 15% lower than the year-ago quarter reflecting higher interest income associated with our higher cash balances and reduced interest expense associated with our reduced debt balances.
The effective tax rate for the third quarter was 27.5% compared to 30% in the year-ago period. As I noted earlier, this reflected a $0.04 per share contribution to earnings in the quarter as compared to the third quarter of 2006. As was the case in the second quarter, the low tax rate for the third quarter was the result of favorable resolution of tax matters from prior years.
The lower tax rate also is attributable to an improvement in our geographic earnings mix thanks to our strong international growth. Now I'll turn to the segment results. Revenues for the Lubrizol Additives segment in the quarter were up 12% year-over-year, including a 15% increase in Asia-Pacific and a 40% increase in Latin America.
Volume increased 5% thanks to solid growth in engine and industrial additives. The combination of price and product mix also improved revenues 5% and currency contributed 2%. Commenting on the Lubrizol Additives segment volume growth year-over-year by region, volume in North America was down 2%, but the decline mainly was the result of our having reformulated some more concentrated driveline and passenger car engine oil additive packages.
Volume in Europe was up 4% primarily driven by the success of our European customer base. Our Asia-Pacific region saw an increase of 7% largely attributable to order pattern principally in engine oil additives. And volume in Latin America increased 34% as we increased new business gains -- as we 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 expenses increased 11% in the third quarter of 2007 compared to the year-ago quarter. This increase largely was driven by higher manufacturing costs, notably for contract labor and maintenance in the U.S. Gulf Coast and in Europe.
These factors are part of the justification for our recently announced price increase. Segment operating income in the quarter increased 37%. The earnings performance reflects strong volume growth and improved price mix despite increasing material and operating cost pressures. I'll also add that the year-over-year comparison also is highly favorable since the operating margin percentage in the third quarter of 2006 was impacted by rapidly rising raw material costs.
Turning to the Lubrizol Advanced Materials segment. Third-quarter revenues were up 3% compared to the year-earlier period. The increase reflected a 2% increase in volume and a 2% favorable currency impact while the combination of price and product mix was 1% unfavorable.
Growth in Asia-Pacific continued to be strong with a volume increase of 17% while North American demand generally was weak as I mentioned earlier. I'll now go into the Advanced Materials product lines in a little more detail. The Noveon Consumer Specialties product line had revenues of $103 million, 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 volume growth in North America was in lower margin surfactant.
Volume for Carbopol powdered thickeners for home and personal care product application increased 10% over the year-earlier quarter and our new liquid Carbopol product volume increased 25%.
Revenues in Performance Coatings productline were $136 million in the quarter, a decrease of 2% from the third quarter of 2006.
This productline continues to be impacted by the weakness in the North American textiles and coatings industries that we've discussed in previous teleconferences. Results for this business were impacted by lower volume and unfavorable product mix.
While we do not disclose operating income for the productlines, I do want to point out that this business remains profitable, but not at margins where we want to be.
We have plans underway to drive improvement and these include stabilizing our textiles business, shifting production to our new China plant, narrowing our focus on fewer key targets where we believe we have competitive advantage, improving our applications capabilities in these markets and improving our operation.
The Engineered Polymers productline consisting of TempRite and Estane Engineered Polymers reported revenues of $143 million in the quarter, up 6% from the third quarter of 2006.
By region, Estane products experienced strong growth in Asia-Pacific and Europe, while North America was flat with last year.
Shipments increased in a number of applications, including paint protection films, geophysical and wire and cable. We also successfully increased prices globally through several price initiatives in the quarter and we will continue to take price actions as warranted.
Global volume for TempRite products increased 6% in the third quarter compared to the year-ago period. This was characterized by strong international volume growth of 11%. In particular, volume in Asia-Pacific established a new quarterly record by growing 13% over the last year.
North American volume increased 2% as increases in our industrial and fire sprinkler applications partially offset the impact of weaker plumbing volumes that were attributable to slower residential construction and we believe some inventory destocking.
Performance in North America also was impacted by some competitive price pressures. We continue to be encouraged by the product demand in overseas markets, as well as for new applications, such as North American commercial building water distribution. In these applications, the current CPBC market penetration is low so, there is greater upside potential.
Despite the good top-line growth, Advanced Materials segment operating income in the quarter decreased 27% from the third quarter of 2006.
The segment material margins were impacted by rising raw material costs across all of our businesses as well as unfavorable earnings mix. Importantly, we are moving forward with price increases in the productlines that have been affected significantly by higher material cost, particularly the Estane business.
Excellent growth in Asia-Pacific was offset by weak demand across most of our businesses in North America. This resulted in unfavorable earnings mix as margins are generally lower in Asia-Pacific compared to North America.
Segment STAR expense has increased in part due to the addition of growth resources of approximately $1 million in the commercial and technical functions, especially in Asia, to position us for the future. The segment also incurred $2 million in expense for the quarter on the implementation of an enterprise systems project.
I'll conclude my remarks on segment results with a quick comment on corporate expenses, which were $17.7 million in the third quarter. This 20% decrease in corporate expenses mainly was attributable to the timing and amount of compensation and benefits expenses versus last year.
Turning now to cash flow, we generated $407 million in cash flow from operations for the first nine months of 2007 compared to $245 million in the first nine months of 2006. This improvement was attributable to higher earnings, inventory reductions and a year-over-year improvement in accounts payable.
As a whole, we managed our working capital very well during the first nine months of 2007. Our day sales in receivables for the third quarter improved one day from the 2006 average and day’s sales in inventory for the third quarter improved seven days over the 2006 average.
Regarding other uses of cash, capital expenditures for the quarter were $45.9 million, in line with our projected capital spending for 2007. We repaid $37 million of debt in the third quarter, which included repaying in full our Euro credit facility.
In our April 27 conference call, we announced the expansion of our share repurchase program to buy back up to $300 million of common shares through 2009. And during the quarter, we’ve repurchased 527,000 common shares for $32 million. And in the first nine months, we’ve repurchased approximately 1.4 million common shares for $82 million.
As a result of these sources and uses of cash, our cash balance at the end of the quarter was $646 million compared to $576 million at December 31, 2006. We currently expect to use some of this cash to retire the 200 million in notes outstanding, which mature in December of next year.
This year, we introduced return on invested capital, or ROIC, metrics to our corporate and operating segment incentive compensation scorecard. The corporate return on invested capital metric is defined as unlevered after-tax net income divided by average net debt plus equity.
For the four quarters ending September 30, 2007, ROIC was 11.3% compared to 8.2% in the fourth quarters ending September 30, 2006 and this certainly shows good progress towards our longer-term ROIC goal of 12% to 13%.
Now I'd like to discuss our updated outlook. Our updated guidance for 2007, including a restructuring and impairment charge of $0.01 per share, is in the range of $3.84 to $3.89 per share.
And excluding the restructuring and impairment charge, 2007 earnings 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 our previous projection for the quarter.
Our model reflects an unchanged fourth-quarter outlook for the Lubrizol Additives segment and a lower earnings expected from the Advanced Materials segment, notably in the Coatings business.
Our outlook also compares to the as-adjusted $0.71 per share we’ve reported in the fourth quarter of 2006, but when we remove from last year's fourth quarter the favorable legal settlements and discrete tax matters totaling approximately $0.13 per share, we are expecting a favorable year-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 growth year-over-year, excluding acquisitions, with fourth quarter volume also up a comparable amount. And as James noted, October is looking strong.
We project unit material costs to be 3% higher in the fourth quarter than previously forecast. And our model includes only a minor impact from the recently announced price increase since the effective date is December 1st.
For the Lubrizol Advanced Materials segment as a whole, our earnings outlook is for less robust earnings than previously forecast driven mainly by continued weakness in North America, especially in our Coatings business.
We also expect higher spending in the fourth quarter totaling approximately $5 million on the enterprise system project that is underway.
For the full year, we project segment-operating income to be down approximately 9%. And I’ll add also that October is looking stronger in this segment than expected, so hopefully we will see some upside to our fourth quarter expectation.
We are now modeling corporate expenses and other income and expenses net to be down year-over-year by approximately $7 million, largely the result of higher currency translation gains included in other income. On a consolidated basis, we are assuming revenue growth of approximately 9.5% compared to 2006.
We're assuming that second half raw material costs will be higher than those we saw in the first half of the year. We now project net interest expense to be approximately $66 million for the year.
Our tax rate assumption for the full year is 31%, which is down from 32.5% mainly driven by the resolution of prior years tax matters and for the fourth quarter, we're modeling a 33.7% rate.
We expect the euro to average a $1.42 for the fourth quarter of the year. We're modeling capital expenditures in the range of $175 million to $180 million for the year and finally, our outlook for cash flow for the full year now reflects a modest source of cash from working capital changes.
I'd like to conclude by saying that we are pleased with our progress in 2007 as we see ourselves well on track to deliver another year of excellent earnings growth.
And with that, Sam (ph), we can open up the lines for questions.
James Hambrick
Sam?
Question-and-Answer Session
Operator
(Operator Instructions) Our first question comes from David Begleiter 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 in Advanced Materials to recover to prior levels and a little more detail granularity 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 I can 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, particularly those who are associated with coatings and housing related products.
I'd also look from revenue, I would look at the expense area and 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 disappointing quarters, we have been and continue to invest heavily in the segment to drive future growth. That is a drag on current results. There is no question about it.
We are driving geographic expansion. We're investing in new plants. We're adding people. And while we've made some efforts to moderate that, I want to be careful that we're not trying to manage you here just for the short term, that we continue to progress for the longer term.
Now down at the product line levels. So that’s really at the aggregate level. Down at the product line level, Consumers Specialties, really I'm not concerned and none of you should be either. Strong business, I'm very comfortable that it’s order pattern related and in fact, we already see evidence 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 happen instantaneously, but getting positioned in Asia, so much of the market has moved to Asia, we have a very significant capital project underway outside of Shanghai to get our manufacturing base into a competitive position.
We continue to invest on application knowledge specifically targeted at differentiated products. And as I pointed out in the past, it's not a trouble free supply chain. It is work that continues to need to be done both from an efficiency point of view, as well as a product line point of view.
Engineered Polymers, we've been making progress in the Estane business. Charlie mentioned top line growth in his comments. We are beginning to introduce unique products, have already seen evidence of improvements in our competitive position.
We did recently announced a price increase. In the past, we have tried to lead with some increases and have not been successful. That is not the case this time that gives us some optimism that we will begin to address raw material issues here. Overall, my sentiment is this business is on the right track for growth with improved profitability.
TempRite, business being impacted clearly by North American market demand. It remains a great platform for long term growth. It has wonderful potential for geographic growth. We continue to add resources and capability there.
We also are focused for the first time here over the last year or so in areas for additional development of the product line. We already talked about the extensions into other commercial applications in water piping and sprinkler systems, but also in non pipe applications and it does take time to launch those new lines.
Overall, I continue to have very strong confidence that we are implementing the right programs for the long term growth and I just cannot see any reason to change our strategies here. I am confident, and as I said in my opening comments and I really meant this, I don't want that to come across as overconfidence. It is prudent and appropriate confidence in our ability to really take this thing to the next level.
David Begleiter - Deutsche Bank
That’s very helpful. Thank you. Just one more thing on your lubricant additive price increase, have your competitors announced similar actions?
James Hambrick
David, I'm not aware of that and we will just wait and see what happens in the market.
David Begleiter - Deutsche Bank
Did you say what percentage increase the price increases are for?
James Hambrick
I know it. I'm waiting for my hand signals to know whether we are talking about it or not. Yes, we are? Okay. It's 4% to 6% depending on product line and location.
David Begleiter - Deutsche Bank
Thank you very much.
Operator
Our next question comes from P.J. Juvekar from Citi. Your line 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% in second quarter. How does that relate to your business? Is that something that you'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 in additives?
Charlie Cooley
Yes, it was down 2%, but was largely due to the more concentrated packages.
James Hambrick
Yes. Here is the way I would like to handle it, P.J. We are not experiencing that and again, we're doing great guns geographically. We do have 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. versus outside the U.S.?
James Hambrick
I don't think that we've ever really broken that out geographically. Have we, guys? Go ahead, Mark.
Mark Sutherland
Yes, I think that P.J. Mark Sutherland here. Most of our lube additive business is outside of North America. I think in it is North America is 40% and the balance is outside in Europe, Asia-Pacific, Latin America.
P.J. Juvekar - Citigroup
Okay. Now on the Croda deal, can you talk to us about accretion-dilution that you expect from the deal?
Charlie Cooley
P.J., it's Charlie. We'd like to hold off. And we will talk about that, but I would like to hold off until we actually close the transaction. As James noted, we got the European regulatory approval a couple days ago and we're looking to close that deal in the next week or two and than once that is behind us, we can talk a lot more about it.
I think you've heard us talk about our excitement about the acquisition and I can assure you it will be accretive from the first quarter onwards. But we will have to wait and probably the next opportunity to talk about it will be at the chemical conference in December.
P.J. Juvekar - Citigroup
Okay, great. Now with energy prices spiking here recently and generally you mentioned that October was strong in terms of volumes. What do you need to do on the specialty chemical side to deal with this recent rise in raw materials?
James Hambrick
P.J., this is James. We have been making some progress there of recent. Now, I sense, in fact, listening to NPR this morning, some of the activity that is going on in the oil market, I've been sensing and I see not only current evidence of raw material pressure, but I sense more coming.
And in fact, as we've been going through our planning process, 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 about pricing in the past and it is artful nature and it is balanced. We have our focus clearly on it.
P.J. Juvekar - Citigroup
Okay, thank you.
Operator
Our next question comes from Saul Ludwig from KeyBanc. Your line 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 plants full out. Sometimes in prior quarters, you had let's say unabsorbed overhead being a hit. Was that issue a factor either absolutely or compared to last year?
Charlie Cooley
Yes, we actually had a, for the quarter, we had a favorable shift 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 in this quarter, we saw inventory reductions, which enabled us to put effect still around -- we put some inventory on to the balance sheet, which enabled us to put some capitalize some of the manufacturing spends, which will then come into the 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 the course of the fourth quarter. I don't know if you caught in my prepared comments, I talked about the day sales and inventory being down seven days from 2006 average.
We were given a tight supply and high utilizations that we're running right now. We're looking to build as much inventory as we can through the end of the year. Maybe a rough number might be another $2 million capitalized in the fourth quarter.
Saul Ludwig - KeyBanc Capital
When you said your, I think, operating expenses were up $11 million in the third quarter that was net of this $4 million to $5 million held?
Charlie Cooley
Correct.
Saul Ludwig - KeyBanc Capital
James, you probably and admirably talked about the 13 consecutive quarters of growth, which is a tremendous achievement. And now we see that your guidance calls for anywhere from a 7% to 2% decline in the fourth-quarter earnings comparison.
Is there anything that you see that could be done to maybe continue the streak of better results, whether it be this inventory thing, maybe additional tax settlements, I don't know. Is there anything that you see that 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 the accounting matter, specials, tax rates and so forth, I'm going to let Charlie take an overall crack at what he sees as kind of what I call year-end affects and so forth and then I'm going to come back and talk about the underlying business.
Charlie Cooley
Your question was focused on fourth quarter, right?
Saul Ludwig - KeyBanc Capital
Correct. Yes, because implying a 32% tax rate in the fourth quarter too.
Charlie Cooley
Right. I tried to hit that question head-on in my prepared remarks because I noted, if you look at the now $0.71 that we earned in the fourth quarter last year, that was aided by some favorable legal settlements, as well as some favorable discrete tax items in the fourth quarter of last year. And those added up to about $0.13. And we are not modeling anything like that.
In fact, we don't have any of those kind of favorable items in our model for the fourth quarter of 2007. On that basis, we are actually looking at a fairly nice operating increase year-over-year in the fourth quarter.
One more comment and then I will turn it back to James. I think you've heard us now in maybe three different times talk about how October is looking strong and that is true in both segments. So I do hope, we've got some upside in our model for the fourth quarter in both segments just based on how the fourth quarter has gotten off to such a good start. James?
James Hambrick
Okay. Thank you, Charlie. Saul, kind of coming at it right where Charlie left off, I will pick up. Yes, the model would suggest based on what we see is October and my calculus about the business momentum going forward, I have to then stop and look at a couple other data points as I try to read the tea leaves here.
One is spending a lot of time watching others. We're not an island here. We're all addressing similar markets in a competitive environment and so I am cognizant that others are what they are doing and the difficulties they're having or not as the case may be.
The second data point I'm looking at is, and I made reference to this in my earlier comments about raw material prices, I know where we are today and I see the pressures and I see the increases coming, but I also recognize what can yet come at us. And so there is a level of uncertainty that keeps us as normal on a conservative side.
Saul Ludwig - KeyBanc Capital
Thank you. Charlie, in your fourth quarter guidance, what is it that you were assuming for the Advanced Materials comparison with $32 million 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 the fourth quarter?
Charlie Cooley
That is our model right now.
Saul Ludwig - KeyBanc Capital
That is a pretty strong, that would even be up from the third quarter. Why are you so let's call it optimistic?
Charlie Cooley
Well, there are a couple of things going on, some I didn't mention. For example, in our personal care area in the third quarter, we had some one-time manufacturing expense associated with a unit down that we will not 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 we would have thought and sure enough we're seeing that come back quite strongly in October. So that is one of the product lines that is showing particularly good strength beginning the fourth quarter. Those would be some main items there, Saul.
We put these -- we're going to see a little bit of price increase 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-down review 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 terms of our outlook.
Saul Ludwig - KeyBanc Capital
And finally, within that, you've mentioned that the SAP implementation 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 third quarter. As embedded in your flat operating income comp, STAR expenses have got to 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 million of SAP expense that I noted in the prepared remarks.
Saul Ludwig - KeyBanc Capital
Okay, great. The final question is these tax matters that were resolved favorably, I think if we go back to the beginning of the year and look at the 10-K, you have a lot of these matters. You are not totally solved yet. There are still pending issues that could help you on the tax rate by the end of the year?
Charlie Cooley
Yes, thanks for asking the question because I'm not so sure everyone appreciates when we talk about tax matters. What we're generally talking about here would be reserves that we will be making ongoing, year in and 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 from our reserves some international-related accruals and saw further largely domestic reversals in the third quarter. And the question is a good one. Is this the kind of thing we should be expecting year in and year out? And I would say that the answer to that question is probably not. Don't bake in similar numbers next year.
And the main reason I'd site is that these NOLs that we had been utilizing as a result of the acquisition of Noveon and which we fully consumed at the beginning of this year, those NOLs will mean that our federal return in the U.S. will be open for a longer period of time. So I wouldn't bake in those kinds of favorable discrete items every year going forward, certainly not 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 from Alexander Laurence from Jefferies & Company. Your line is open.
Laurence Alexander - Jefferies & Company
Good morning. I guess next question then, on the international business in the Advanced Materials where you have the negative mix effects, is the plant in Shanghai going to be enough to bring international margins within striking distance of the North American margins or is it going to take a couple more years to close that gap?
James Hambrick
That is a complicated question -- in coatings, it will for sure. It certainly will improve our position. But that, of course, will not do anything -- for example, it does not have a CPBC resin plant in there, it does not have a Carbopol plant in there. And so it really has a fairly dramatic effect on coatings and of course, as you know Laurence, that is the place where we can use the most help.
Charlie Cooley
But if you look at personal care margins, we see comparable profitability in our personal care product line, certainly in the Carbopol product line throughout all four regions.
Laurence Alexander - Jefferies & Company
And I guess, secondly, the environmental charge this quarter, is this a new run rate for environmental expenses or is this sort of a blip and then you expect it to fall back next year?
Charlie Cooley
Yes, thanks for the question because I want to make sure that 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 balance sheet of about $14 million and that is $7 million for each segment.
So, I think that is a good indicator that, as a corporation our size, our environmental exposures are really quite low. So, that is one of the reasons why we called out these remediation matters in the third quarter because they were unusually high and would not expect those kinds of levels in the future.
Laurence Alexander - Jefferies & Company
And finally, the non-pipeline new TempRite application or the non-pipe application, do those have the same kind of regulatory barriers or structure as the pipe applications or is this going to be a different end-market dynamic?
James Hambrick
It is going to be a different end-market dynamic. This is going 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 them have been answered though. Volumes in additives were really quite strong during the quarter and they were quite strong during the second quarter as well. I was hoping you could parse through where specifically you're seeing the strength? I think you mentioned driveline and engine oils, but just if you can provide some color on that.
Charlie Cooley
Sure, it is Charlie. The -- Starting regionally, Asia-Pacific and Latin America saw very substantial double-digit growth and I mentioned those in the prepared remarks. And depending on where you are around the world, we're talking about the different segments of the Lubrizol Additives business.
We've had good growth in marine diesel, for example, in some parts of the world. Heavy-duty diesel has had good volume growth. I think the real star of the Lubrizol Additives segment in 2007 has been our traditional engine oils business.
And while volume in North America has not been the growth hasn't been what we've seen elsewhere in the world, we've certainly seen good recovery in margin. And then lastly, a product line that we don't tend to talk about very much as fuel additive.
It is relatively small within the Lubrizol Additives segment, but that has had some really nice growth as we have been adding new products in that market.
Robert Felice - Gabelli & Company
Do you think you are taking any share on the fuel additive side?
Charlie Cooley
No. No. I think as a general statement that our growth and volumes in our additives segment have really been thanks to being able to ride the success of our customers as they themselves have been gaining share.
Robert Felice - Gabelli & Company
Okay, and then additionally if I remember correctly, one major 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 seen a commensurate run-up in base oil prices.
So I guess the 4% to 6% price increases, is that really preemptive knowing that base oil price increases are inevitable with crude oil at current prices? Or are you actually seeing severe raw material cost pressure?
James Hambrick
Hi, Robert. This is James. We are definitely seeing pressure. These price increases, as I said in my comments, it's about investment in plant equipment, people, technology, products the need to bring new component technology to the marketplace.
There really are significant changes going on in the global transportation industry, engine design and so forth there is raw material pressure. We are taking it now. It is building. It's going to continue to build. Energy costs continue to be high and volatile.
Labor costs, materials cost, contract services cost, it is an aggregate and we've done detailed analysis of all this and we're going to go out and we've got to get some prices to recover that.
Robert Felice - Gabelli & Company
So it sounds like you have some additional STAR expenses going in there and you know that raw material price increases are just around the corner to cover it.
James Hambrick
No, sir. We are already having raw material increases. It is here.
Charlie Cooley
In fact, I think I mentioned in this my remarks, this is Charlie, that our outlook for unit material costs in the fourth quarter are about 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 to maintain the current -- the margin expansion you've experienced year-over-year into the fourth quarter? I know you will have a seasonal downturn there, but do you 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's a lot of moving pieces there and I was kind of hoping you can provide a bridge to the year-over-year decline in operating income.
Charlie Cooley
Yes, hi. This is Charlie. I can give you a little bit of help there. It's really mainly two stories. One, we've been talking about quite a while and that is the Performance Coatings business, which has been effected, as we've noted, by generally weak North American demand, material cost pressures.
The other area is in TempRite. TempRite year-over-year also saw an earnings decline and it should be no surprise since we are exposed to North American housing, but what we've also pointed out to you folks for the last several years is that the very strong value proposition of TempRite being at such a lower installed cost versus the competing metal materials enables it to see much milder swings relative to housing starts.
I'll give you a for-instance. In the third quarter, our North American plumbing sales volumes dropped about 8% or 9% in the third quarter versus the third quarter of 2006. But in that period of time, housing starts were down 31%.
So that -- and that is not atypical to see the strong performance relative to housing starts in North America by the TempRite product line. So, that probably would be my way of giving you the bridge. It's really focusing on those two product lines.
Robert Felice - Gabelli & Company
Okay, that is helpful. And I guess as we look to 2008 for that business, should we expect to see a significant decline in operating income 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 in the fourth quarter, but I guess as we looked at '08, by how -- what magnitude do you think you can rebound off of that?
James Hambrick
Yes, I'm going to disappoint you with my answer. Consistent with every third-quarter teleconference, we really steer clear about talking about our expectations for the following year and this is no exception.
A lot of reasons for that, the least of which is we're right in the thick of our planning cycle and talking about the business internally and with our Board. So hold off until February and we will give you a lot of answers 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 KeyBanc Capital. Your line is open.
Ivan Marcuse - KeyBanc Capital
I just have a quick question. Could you -- how much of the price increase do you guys typically capture on a year? If it's 4% to 6%, how much of that would you typically capture?
James Hambrick
You’ll laugh, I'm sorry. I hate to just sing the second verse of the same song, but we don't -- I'm going to disappoint you with my answer. We don't divulge that information.
Ivan Marcuse - KeyBanc Capital
Okay. One last question. What raw materials specifically are you 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, of course, 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 got in front of us. So, almost all of our raw materials are facing some upward pressure.
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 opportunity since; I'm glad to hear that there were no questions regarding our restatement and frankly, I think, that was appropriate since our view is that these were really dealing with errors in prior years and with small annual impacts.
But I having seen some of the headlines that came out in the press this morning, I really do want to make sure that investors are put at ease that while these are clearly errors that should not have happened in the first place, A we're taking all the appropriate steps to make sure our international folks understand the U.S. GAAP accounting, scouring landscape to make sure that others of these types of things have been identified.
So, we feel pretty confident in our addressing of the situation. It will indeed be treated as a material weakness under the Sarbanes-Oxley terminology, but this is a matter that we are rapidly putting behind us.
Mark Sutherland
Okay. And Pam and audience, if there are no further questions, I'd like to thank you all for dialing in this morning. Before signing off, I'd like to provide two telephone numbers for follow-up.
One is my direct line for clarification and the second will be the dial-in number for telephone replay. My telephone number is 440-347-1206 and Pam, could you please provide the replay telephone number?
Operator
Yes. Ladies and gentlemen, this conference will be available for replay after October 26, 2007 at 2:30 PM Eastern time today through November 9, 2007 at 11:59 P.M. You may access the AT&T teleconference replay system at any time by dialing 1-800-475-6701 and entering the access code 888911.
International participants dial 320-365-3844. Those numbers again are 1-800-475-6701 and 320-365-3844, access code 888911. That does conclude our conference for today. Thank you for your participation and for using AT&T executive teleconference. You may now disconnect.
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