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Ashland (NYSE:ASH)

Q3 2012 Earnings Call

July 26, 2012 9:00 am ET

Executives

David Neuberger

John E. Panichella - Senior Vice President, President of Specialty Ingredients and Member of Operating Committee

Lamar M. Chambers - Chief Financial Officer, Senior Vice President, Member of Executive Committee and Member of Operating Committee

James J. O'Brien - Executive Chairman, Chief Executive Officer and Member of Executive Committee

Analysts

Alina Khaykin

Michael J. Sison - KeyBanc Capital Markets Inc., Research Division

Olga Guteneva - JP Morgan Chase & Co, Research Division

Michael J. Harrison - First Analysis Securities Corporation, Research Division

Robert Walker - Jefferies & Company, Inc., Research Division

James Sheehan - Deutsche Bank AG, Research Division

Operator

Good day, ladies and gentlemen, and welcome to the Ashland Inc. Third Quarter Earnings Call. [Operator Instructions] As a reminder, this conference call is being recorded. I would now like to introduce your host for today's conference, Mr. David Neuberger. Sir, you may begin.

David Neuberger

Thank you, Kate. Good morning, and welcome to Ashland's Third Quarter Fiscal 2012 Conference Call and Webcast. We released results for the quarter ended June 30, 2012, at approximately 6:00 a.m. Eastern time today. And this presentation should be viewed in conjunction with the earnings release. These results are preliminary until we file our 10-Q.

On the call today are Ashland's Chairman and Chief Executive Officer, Jim O'Brien; Lamar Chambers, Senior Vice President and Chief Financial Officer; and John Panichella, President of Ashland Specialty Ingredients.

Before we get started, let me note that as shown on Slide 2, our remarks today will include forward-looking statements as that term is defined in securities laws. We believe any such statements are based on reasonable assumptions but cannot assure that such expectations will be achieved.

Please also note that during this presentation, we will be discussing adjusted and pro forma results. We believe these adjusted and pro forma results enhance understanding of our performance by more accurately reflecting our ongoing business.

In addition, we are providing ISP's historical financial contribution, representing Ashland's best estimate of the appropriate cost allocation and shared resource costs. Reporting results in this manner has inherent limitations, and we do not represent that these financial results were calculated using the same methodology used by ISP.

Please turn to Slide 3 for our third quarter highlights. Reporting earnings per share from continuing operations were $2 in the June 2012 quarter. When adjusted for key items, which I'll cover shortly, EPS was $2.04, as compared with $1 in the year ago quarter. Let me note that the $1 in the prior year does not include the results of ISP or the related financing costs. This is the only time this morning that we will present data in this manner. For the rest of the presentation and to aid in your analysis, we will present results on a pro forma basis, which includes the results of ISP in prior periods.

While on a pro forma basis, sales declined slightly to $2.1 billion, Ashland achieved large increases in operating margin and EBITDA. Operating income as a percent of sales was 12.8% during the quarter, a roughly 400-basis-point increase over the prior year.

EBITDA margins were up a similar amount to nearly 18% during the quarter. These improved margins were primarily driven by strong pricing discipline, with Specialty Ingredients, Ashland Performance Materials and Ashland Consumer Markets all generating significant year-over-year increases in profitability.

We are making substantial progress toward our long-term financial goals, and this quarter's margin performance was slightly above the implied 2014 margin expectations that we set out last November.

Our adjusted EBITDA was $381 million, a 24% increase over the $307 million of pro forma adjusted EBITDA in the prior year quarter.

Slide 4 details our key items. In total, 3 key items had a net unfavorable EPS impact on continuing operations of $0.04 in the June 2012 quarter. The first key item is a $2 million after-tax charge, or a negative $0.02 per share, related to the ISP integration and cost restructuring efforts we previously described. We have continued to make progress toward our overall cost reduction goal, and you'll hear more about this from Lamar.

The second key item is a $4 million after-tax charge, or a negative $0.06 per share, related to adjustments to environmental reserves during the quarter. This increase was associated with legacy sites unrelated to ongoing operations.

The last key item is on the net gain or loss on acquisitions and divestitures line and amounts to a $3 million after-tax benefit, or a positive $0.04 per share. This benefit stems from the transfer of a portion of Ashland Water Technologies' middle-market commercial business to Rochester Midland. This business transfer was completed early in the quarter and allows Water Technologies to focus on higher-margin, higher-growth opportunities.

In the year ago quarter, 2 key items combined for a net unfavorable impact on earnings of $0.06 per share. To aid in your analysis versus the peer group, Ashland's results included $29 million of intangible amortization expense during the June 2012 quarter. We carry higher-than-average amortization due to our corporate transformation and prior acquisitions. Without this amortization, earnings would be roughly $0.25 higher or $2.29 per share. Please turn to Slide 5 for Ashland's adjusted pro forma result. As a reminder, results are presented on a pro forma basis, including a full quarter of ISP in the June 2011 quarter. The year ago quarter also includes stepped-up depreciation and amortization related to purchase accounting.

As such, Ashland's June quarter sales decreased 2% over the prior year to $2.1 billion. This decrease was more than accounted for by currency translation, which had a $70 million negative effect on sales.

Normalizing for currency and adjusting for small-business divestitures, sales would have grown 4% over the prior year. Sales increased 3% sequentially, primarily due to normal seasonal trends. Gross profit as a percent of sales was 29.3%, a 360-basis-point improvement over the prior year.

I'll note that while a number of commodities have begun to decline in price, Ashland's overall raw material costs were still up significantly versus the prior year and also up versus the March 2012 quarter. Significant pricing in all of our commercial units has offset these increases, leading to improved profitability in the quarter.

Selling, general and administrative and research and development expenses, collectively referred to as SG&A, fell somewhat to $368 million. SG&A benefited from Ashland's overall corporate cost reduction program, as well as the effects of currency translation. EBITDA of $381 million grew an impressive 24% over the prior year and 16% sequentially. EBITDA as a percent of sales reached 17.8%.

Now turn to Slide 6 to review our volume trends. This chart shows underlying volume trends on a normalized and rolling 4 quarters basis. By totaling the trailing 4 quarters for each period, we are eliminating seasonality and showing yearly growth. The data have been normalized for acquisitions, divestitures and joint ventures.

As shown here, each of the commercial units has seen some evidence of a diminished macroeconomic environment. Specialty Ingredients, our largest and most profitable business, as well as our strongest growth vehicle, is proving to be our least economically sensitive commercial unit. Volumes in this business are holding up well, although we have seen a flattening out in recent quarters.

While John will elaborate on this shortly, this is largely due to volume declines in our more commoditized intermediates and solvents product lines. Excluding that effect, Specialty Ingredients would have been up.

Performance Materials had been growing at a good pace, coming out of the recession, but volumes have turned negative, primarily due to reduced demand in both Europe and the emerging regions.

Water Technologies continues to experience volume declines, particularly in the mature economies.

Ashland Consumer Markets has also declined, partially due to the loss of a low-margin tolling account, which was previously described, as well as market softness in North America.

While not shown on this chart, Ashland's sequential volumes were essentially flat, with all of our businesses holding up reasonably well.

Despite this overall softness in volume, Ashland's consolidated EBITDA increased considerably, as shown on the bridge on Slide 7. This chart shows what led to the June quarter's performance as compared with the year-ago period on a pro forma basis.

Improvements in margin drove the year-over-year increase in EBITDA. As I mentioned earlier, each of our commercial units has pushed through sufficient pricing to recover their increased raw material costs. Volumes had a $19 million negative effect on EBITDA, with each of the commercial units being somewhat affected by the macroeconomic climate. SG&A, which is normalized for currency and adjusted for recent divestitures, had a negligible effect.

Currency translation represented a $12 million headwind to EBITDA. Nearly half of our business comes from outside the U.S., and the dollar strengthened roughly 10% versus the euro and over 20% versus the Brazilian real. Altogether, EBITDA increased by $74 million compared to a year ago.

Now let's turn to Slide 8 for our liquidity and net debt. Total liquidity, which is cash plus revolver capacity, was $1.5 billion at the June quarter end, roughly in line with the March quarter. Our gross debt was down slightly to $3.7 billion, and our net debt declined to $3.1 billion.

Our balance sheet focus remains on the 9 1/8% notes callable June 2013. This is our highest interest rate debt, and it carries about $60 million of annual interest expense. As we mentioned at an investor conference last month, we are actively considering refinancing these notes before the call date. This refinancing would likely include a combination of cash and new debt.

Our decision on whether to pursue this option will be based on prevailing market conditions. But we could move quite quickly. In addition, we're also looking to put in place an AR securitization program to further lower our overall interest expense.

With that, John Panichella will now discuss Specialty Ingredients, beginning on Slide 9. John?

John E. Panichella

Thank you, David. Good morning, everyone. Specialty Ingredients had another strong quarter with nice growth in sales and earnings. I'm generally pleased with our performance across the division.

While on a pro forma basis, volumes were up 2% from the prior year quarter, sales rose 15% with improved pricing in all lines of business. Volume declines were driven by intermediates and solvents, which had unusually large volumes in the prior year quarter, and our MC product line, where the combination of an oversold position and the ability to sell out of inventory last year led to the year-over-year declines. Excluding these effects, our volumes would have been up.

Sales growth was broad-based. Our industrial businesses, which include energy and construction, led the way. We have seen tremendous growth in both of these markets since the beginning of the year, and that trend continued through the third quarter. Sales were also up in pharmaceutical, personal care and coatings. In each of these areas, we have held up fairly well despite the macroeconomic climate. Conversely, sales were down within our Specialty Performance business, which includes our intermediates and solvents product line.

While we have recently seen signs of reduced demand in these products, the larger contributor to year-over-year decline was a particularly hard comp in the prior year. During the third quarter of 2011, one of our competitors had a major supply disruption. And as a result, we had an exceptionally strong demand.

Broad-based pricing efforts led to gross profit as a percent of sales of 34.7% during the quarter. This was a 310-basis-point improvement over the prior year and a 120-basis-point sequentially. SG&A of $119 million was in line with our expectations.

Overall, EBITDA grew 29% over the prior year to $224 million. EBITDA as a percent of sales was 28.2%.

Slide 10 shows Specialty Ingredients' EBITDA bridge. Improved margin was the primary driver of the year-over-year increase in EBITDA, offsetting a number of other factors. The combination of volume and mix actually contributed $3 million of our EBITDA growth. While overall volumes were down, the declines were primarily in lower margin products, leading to an overall improvement in the business mix.

SG&A was up over the prior year to help support our strong sales growth, leading to the $9 million effect shown here. In addition, currency translation amounted to a $6 million negative. In total, EBITDA was up $50 million over the year ago June quarter.

Please turn to Slide 11. Our strongest performance during the quarter was definitely in the energy markets. Because of this, I thought you might appreciate some additional detail.

We sell specialty additives into all stage of upstream operations, including drilling, cementing, production and completion. Like many of our end markets, both ISP and Ashland historically sold into the space.

Our strongest product line has been guar-based chemistries, which now make up the majority of our energy position. For those of you not familiar with the term guar, guar is a bean primarily grown in India. This green renewable product is mainly used as a suspension aid for hydraulic fracturing. It is also used as a thickener in food and other consumer products.

Guar has been in extremely short supply, largely due to remarkable North American fracking demand. While this tightness in supply has put some upward limits on already strong volume growth, it has enabled us to proactively recover a tremendous increase in our raw material cost. This has helped to the near doubling of our sales for the broader industrial business unit.

In addition, we're able to time our guar raw material purchases very well, purchasing large amounts before the big spike in cost. This aided overall margins in the quarter and was a significant contributor to our sequential increase in profitability.

Let's go to the next slide. Looking over the next few years, we see a lot of opportunities within energy. Upstream drilling activity continues to expand, with an ongoing shift from vertical to horizontal drilling. Since horizontal drilling requires significantly higher amounts of frac fluids, demand for our types of specialty additives should continue to grow at accelerated rates.

In addition, energy companies are redirecting their focus from dry gas to more oil-rich and wet gas regions. This shift typically leads to a more difficult job for our customers, who in turn, look to us to help fulfill these more challenging technical requirements.

Given the recent price of guar, we are seeing a huge inflow of requests for substitute materials. Some of Specialty Ingredients' CMC-based products are well positioned to meet this need. We're also pursuing other technologies, which could compete well based on cost and performance.

Needless to say, we're also pursuing new products and new applications in the broader energy space. We have been building our portfolio of technologies to include new and improved cement additives, gas flow migration and fluid loss additives, and a host of other products to meet the needs of upstream operations.

Let's go to Slide 13. Beyond energy, we're pursuing a host of growth opportunities in nearly all of our end markets. Our overall volumes are holding up well, and a number of our product lines are at or near their full manufacturing capacity today. This includes our PVP and vinyl ether chemistries, where for example, our Gantrez products sold into oral care, are doing extremely well. Through our recent technical innovation, this product enables superior teeth whitening in both toothpaste and mouthwash and has seen huge volume gains as a result.

Similarly, number of our cellulosic-based products are in the nearly sold-out position. A great example of this is methylcellulose, where we have made significant inroads into the construction market over the course of the last year. Methylcellulose is frequently added to mortars and tile cements to improve workability, set times, water retention and adhesion.

Lastly, a number of our guar-based products are sold out, not only due to shortage in guar supply, but also due to our capacity constraints.

We're doing everything we can to meet overall demand, and we see great opportunities to expand capacity in support of continued growth. As we said last quarter, these are high-return projects with good underlying margins. We're building out our long-term capital plans now, and we're evaluating how to accelerate some of these projects to bring the capacity online sooner. Capacity expansion will be a consistent theme over the course of at least the next few years. To give you some idea of the size, at the Analyst Day last November, we referenced a 3-year capital plan of $600 million.

With that, please turn to Slide 14, and I'll turn the presentation over to Lamar Chambers.

Lamar M. Chambers

Thank you, John. Water Technologies sales were $427 million, down 13% from the year ago quarter. Approximately $25 million, or 40% of this decline, was attributable to the stronger dollar.

Divestitures also played a role. Normalizing for currency and adjusting for these divestitures, sales were off only about 4%. As compared to the prior year, our sales declines were roughly split between the paper and industrial markets.

Paper performed reasonably well in light of the overall market conditions, with currency adjusted sales off about 4%. While packaging and tissue and towel held up well, printing and writing markets have remained quite weak and sales were off around 10%. As described last quarter, printing and writing demand has suffered due to accelerated mill closures and extended outages in North America and Europe.

Sales declines over the industrial area are primarily attributable to market softness, as well as the loss of certain low-margin accounts and product applications, where we've been rationalizing our portfolio to focus on higher-margin opportunities.

Water Technologies sales were even on a sequential basis. Gross profit as a percent of sales was up 240 basis points from the prior year, to 32.1%, an equivalent performance to the March quarter. SG&A was down slightly versus the prior year to $119 million, but has increased significantly as a percent of sales.

While we have taken out costs in more developed regions and markets, we have also reinvested for growth in the emerging regions, as well as in the pulp, food and beverage and mining verticals.

While sales to date in these areas are below our expectations, we expect these investments to yield improved results over the next several quarters. Regardless, we expect SG&A as a percent of sales to incrementally return to more normalized levels, which would yield a greater than 300-basis-point improvement in EBITDA margin. This will occur through a combination of sales growth and internal cost production.

At $37 million, EBITDA declined 18% versus the prior year quarter, and EBITDA as a percent of sales was 8.7%.

Now let's turn to Water Technologies EBITDA bridge on Slide 15. As you can see, negative volumes were the primary driver of EBITDA decline versus the prior year. In total, volumes were off approximately 8% within -- with the issues that we described last quarter largely continuing. Both Europe and North America have remained weak and the softness within Asia has continued, at least compared to the prior year. Sequentially, our business was stable, with some signs volume recovery in Asia, essentially offset by very slight declines in North America and Europe.

Improved contributed $5 million to EBITDA. While raw material costs were up both year-over-year and sequentially, ongoing pricing discipline more than recovered these costs. Given that 1/3 of Water Technologies sales comes from Europe, currency was a headwind in the quarter, negatively affecting EBITDA by $4 million. In total, EBITDA decreased $8 million from the year ago quarter.

Obviously, the financial performance of Water Technologies remains below our expectations. While some of this is tied to broader market demand, it is clear we still have a lot of [indiscernible] in getting this business where it needs to be. More specifically, we must win new business and new accounts within the industrial space.

As stated in the past, the OnGuard monitoring and control platform is a meaningful piece of this strategy, and it appears to be gaining traction in the marketplace. Though still not a material contributor to sales, this platform continued to gain business in the quarter. We expect additional growth in this area and for the broader industrial market to become an increasingly important part of our portfolio over time.

Now please turn to Slide 16 for a review of our Performance Materials business. Performance Materials' reported volume and sales were down 21% and 15%, respectively, from the year ago quarter.

When we exclude the effects of the Casting Solutions and the recently divested PVAc business, year-over-year volumes were down 7% and sales were down 8%. While volumes and sales have remained weak due to the macroeconomic environment, Performance Materials had a great quarter with strong earnings growth in Composites, Adhesives and Elastomers.

Composites and Adhesives is benefiting from the strategic actions taken over the past few years. These actions, which included capacity reductions and cost outs, have allowed us to raise utilization rates above 90%. This enables Ashland to be far more selective in choosing which applications we will and will not pursue. This has led to a higher percentage of more differentiated products and a better overall mix. The best indication of this performance is a roughly 300-basis-point improvement in gross profit as a percent of sales within the Composite and Adhesives business.

Elastomers primarily benefited from falling raw material costs. Butadiene declined significantly during the quarter and Ashland's index-based pricing to the customer takes 4 to 6 weeks to adjust. We estimate this resulted in a benefit of roughly $5 million during the quarter. Butadiene appears to be flattening out, and we expect the overall effect to be neutral in the fourth quarter.

In total, Performance Materials achieved gross profit as a percent of sales of 18.1% during the quarter. We've done a good job of controlling our costs, and SG&A was essentially even over all periods.

EBITDA rose 75% to $49 million when compared to the prior year. And EBITDA as a percent of sales was 12.1%, a 620-basis-point increase over the year ago quarter and a 350-basis-point increase sequentially.

Now let's turn to Performance Materials EBITDA bridge on Slide 70. The effects of the ASK Chemicals joint venture and the divested PVAc business are captured in the Other category on this chart. Excluding those effects, increased margins in all business units were the primary drivers of EBITDA growth. The 7% decline in volume that I mentioned on the previous slide led to a $4 million reduction in EBITDA. Volume declines were focused in our Elastomers business, which is most heavily exposed to the North American tire market.

Excluding Elastomers, the rest of our business was off about 4% due to double-digit volume declines in Europe and Asia. Sequentially, both of these regions strengthened, providing some evidence that the macroeconomic environment has not materially worsened for our business. In addition, we have continued to improve in the Americas, with volumes up a little over 1% excluding Elastomers.

SG&A, excluding currency translation, was a $2 million headwind to EBITDA. And Other accounted for $1 million of the EBITDA increase. Within this item, a reasonably strong performance from ASK Chemicals more than offset the loss of EBITDA from the sale of the PVAc business. In total, EBITDA grew by $21 million to $49 million in the June 2012 quarter.

Now let's go to Consumer Markets on Slide 18. Lubricant volumes declined 8% as compared to the prior year and were roughly flat sequentially. Volume declines have been concentrated in the North American Do-It-Yourself market, which has been weak for several quarters.

While the most recent government data for miles driven shows a fairly flat amount of calendar year-to-date travel, the entire motor oil category has remained particularly weak. This weakness does not appear unique to motor oil as a number of auto parts retailers have pointed to softer overall demand, a further indication that consumers have been delaying routine automotive care and maintenance.

Sales of $517 million were off 1%, both versus the prior year and the March 2012 quarter. Gross profit as a percent of sales was up slightly to 26.8%, with a base hold increase we described in our April call being offset by an improved sales mix.

And SG&A was down $6 million, or 7%, from the prior year, primarily due to reduced advertising spend in the quarter. This decision was intended to better align the advertising spend with current sales and volume levels.

Overall, Consumer Markets generated EBITDA of $68 million, with an EBITDA margin of 13.2% for the June 2012 quarter.

Now please turn to Slide 19 for Consumer Markets EBITDA bridge. Higher margins and lower SG&A expenses were the primary drivers behind our EBITDA growth, more than offsetting the effects of lower volumes. The reduced volumes were a $9 million headwind to EBITDA.

Despite our volume declines, our DIY market share is up somewhat over this period based on quarter [ph] sales data. Higher margins contributed $10 million to EBITDA, with price increases more than recovering our higher raw material costs versus the prior year.

SG&A benefited EBITDA by $5 million, primarily due to the reduced advertising spend I mentioned. In addition, EBITDA increased by $6 million from the June 2011 quarter.

Let's go to the next slide. Given all of the recent movements in the base oil market, we thought it'd be helpful to provide a summary here. This slide shows announcements related to Group 2 base oils, which is the largest grade purchased by Ashland. As communicated back in April, we first received notice of a $0.24-per-gallon increase that became effective over the course of the June quarter. Since that time, we've received notice of 2 separate base oil decreases. Both of these will become effective during the September quarter. This includes the $0.35 per gallon decrease that was announced mid-June and the $0.30 per gallon decrease announced earlier in July. The net effect of these movements and other actions within the business should return Consumer Markets to profitability more in line with our longer-term expectations.

Please turn to Slide 21 for an update on Ashland's corporate cost reduction program. We continue to make progress against our $90 million cost reduction goal. You'll recall that this program is intended to eliminate stranded costs from the divestiture of Ashland Distribution and the formation of the ASK Chemicals joint venture, as well as to achieve anticipated cost synergies from the ISP acquisition.

As of the end of June, we have achieved roughly $75 million of annualized run rate savings. This includes the $40 million reduction of our stranded costs and roughly $35 million of ISP-related cost synergies.

For modeling purposes, approximately $10 million to $12 million of these total savings is in cost of goods sold and the remainder is in SG&A.

We continue to be pleased with the overall pace and progress of the integration, and the last major step will be the integration of ISP into a single Ashland-wide ERP platform during the summer of 2013.

Once this step is completed, we will be able to capture the remaining $15 million of cost synergies, stemming primarily from reductions in back-office support and supply chain. Expect to achieve these savings by the end of fiscal 2013.

Now let's look at some corporate items on Slide 22. Capital expenditures were $66 million for the June 2012 quarter, bringing our year-to-date spending to $164 million. We now anticipate capital spending for fiscal 2012 to come in a little below our $300 million previously indicated. Net interest expense was $53 million. As communicated last quarter, we expect this interest expense to be relatively stable until the 9 1/8% notes are out of our capital structure.

Our effective tax rate for the quarter was 26%, excluding the effects of key items. This puts our year-to-date effective tax rate at just over 27%. We now anticipate our effective tax rate for the full fiscal year to come in at the bottom end of our previous guidance of 28% to 30%.

Trade working capital as a percent of sales has continued to marginally improve and now stands at 17.4%. Efforts to bring working capital more in line with our longer-term goal of approximately 16% have been hampered by the large run-up in costs and less favorable terms associated with guar purchases.

While we have timed our purchases well, the increased inventory value for guar alone is still accounting for more than a $100 million use of cash this year, or alternatively, a 120-basis-point increase in our trade working capital metric. Roughly $80 million of this increase occurred in just the June quarter. Given current guar pricing and expectations around inventory needs, we do expect this trend to reverse in the September quarter.

While working capital increases have helped support strong sales growth in energy, they have had an obvious effect on cash generation, and we reported only $34 million of free cash flow during the quarter.

In addition to the guar effect, we had an unusually high amount of pension funding in the quarter. This amounted to an additional $40 million in catch-up funding related to ERISA requirements for 2011.

Now I'll turn the presentation over to Jim O'Brien for his closing comments, starting on Slide 23.

James J. O'Brien

Thanks, Lamar, and good morning, everyone. As you heard today, our overall business did quite well during the quarter. We achieved significant increases in earnings and EBITDA despite reduced sales in a number of our commercial units. I am particularly pleased with our overall profitability.

We reported EBITDA margins of nearly 18% during the quarter, very much in line with our long-term expectations. Improved margins during the quarter were driven by a number of factors. This included pricing discipline in our commercial units, with each business more than recovering its increased raw material costs versus the prior year.

We're also doing a good job of controlling our operating expenses. Thanks in part to our overall corporate cost reduction program, total SG&A is down $11 million from the prior year quarter.

In addition, we have a much stronger business mix today. Our high-margin Specialty Ingredients business contributed nearly 60% of Ashland's consolidated EBITDA in the quarter, up 250 basis points from the year ago. Taken together, this performance serves as another great step toward our long-term financial objectives.

While earnings and profitability were strong for the quarter, Ashland's volumes declined 6% versus the prior year, after normalizing for the effects of divestitures and joint ventures. Pro forma sales declined slightly to $2.1 billion. However, when we normalize for currency and divestitures, sales would have been up 12%. This reflects the pricing actions taken by our commercial units.

We achieved EBITDA of $381 million, a 24% increase over the prior year and a 16% increase sequentially. Free cash flow for the quarter was $34 million.

Let's turn to our outlook Slide 24. We are occurring a lot of momentum as we enter our fiscal fourth quarter. Through July, demand trends are generally holding up well and in line with our expectations. In addition, raw material costs are beginning to move in our favor, and this could serve as a tailwind as we close out our year.

The clearest example of this is within our Consumer Markets business, where the 2 recent base oil decreases will help restore more normal profitability.

We are also making steady progress on the integration of ISP. Commercial teams have been finalized, and we are going to market as a unified Ashland. Progress continues on back-home integration. This last major step in the process is the rollout of Ashland's global ERP platform to support the broader business. When this is completed during the summer 2013, we will be able to capture the remaining synergy targets for ISP.

Since the closing of the ISP acquisition, we have posted 3 solid quarters of performance. You are now beginning to see the consistency and earnings power that we envisioned when we combined Ashland and ISP. Proof points include our significantly improved EBITDA margins, strong earnings growth and our demonstrated ability to reduce costs while integrating these 2 great companies. We're continuing to execute on our strategic plan. We're making steady progress toward our long-term goals and expectations.

With that, we'll take your questions.

Question-and-Answer Session

Operator

[Operator Instructions] Our first question comes from the line of John McNulty with Crédit Suisse.

Alina Khaykin

This is actually Alina Khaykin that's sitting in for John. Quick question. How should we think on raw materials sequentially in Performance Materials, Valvoline and Water Tech, because I know there's a lot of moving parts in all 3 of those?

James J. O'Brien

When you think of Performance Materials, they've achieved a quite significant benefit already from the raw materials. So we would expect next quarter that they would be flat to -- styrene is starting to move up a little bit. So that may be something we'll have to react to during the quarter. But at this stage, it hasn't had a material effect. On Water Tech, they have done a great job increasing their pricing to catch up on all of their costs. And I would say that they're totally caught up at this stage. So any benefit we get from propylene or any type of derivatives through the quarter should be a benefit to us through the quarters. We'll see how that plays out. And in Valvoline, we gave you, I think, a pretty detailed chart. So there it's pretty clear what the benefit is, and we fully expect to achieve those benefits as the quarter progresses. We won't achieve 100% because it takes about 3 months to fully roll through the system. But directionally, you will see that we'll achieve all that benefit through our raw materials and through our EBITDA as the quarter progresses.

Alina Khaykin

Okay. And just one other question. In thinking about the 2014 targets, it appears that most of the segments are actually on track except for water treatment. So how should we think about the margin progression in that business and maybe what management, you guys are doing internally to meet the target?

James J. O'Brien

Yes, as far as our progress toward 2014, when you look at the Specialty Ingredients business, they're basically there on many of the metrics. So we're quite proud of that team's integration and what they have accomplished. And John and his team have worked very hard, and the organization, I think, has rallied around becoming a unified Ashland. And we're well on our way there. When you look at Performance Materials, they made a lot of improvements into capturing their raw material costs, as well as position themselves to win. I mean, they're running at 90% utilization rates as staffed. And I think that's why when you compare us against others in the market, why we've done much better, because we took actions early and we continue to take actions to position this business to make it win profitably through very difficult markets. Valvoline, of course, continues to work hard on getting this pricing through a very volatile energy market. And they've been successful. Water Tech is the one that we are trying to make the biggest change to near term. And although we're not pleased, as Lamar said, with its earnings to date, what we are pleased with is we're taking very serious action on repositioning its business and trying to get better positions in key markets, where we have historically not had great positions. So I think there, it's more of a repositioning story, and we're taking the right actions, having some patience with it. Although, we could be criticized as taking way too long, and I can't defend that; it has. But I think that what we see today, we've downsized the business. We've repositioned business. I think we're in the right markets, have the right strategies. Now it's all around execution. And we're starting to see some traction take place. Hopefully, next quarter, we'll show some of that improvement. But we're -- it's a great space. It's one that we have to win in. I think long term, if we can get ourselves a better position in some of these better key markets, it'll be a winner for us. So I'm really pleased what they're doing, although I'm not pleased with the performance to date.

Operator

Our next question comes from the line of Mike Sison with KeyBanc.

Michael J. Sison - KeyBanc Capital Markets Inc., Research Division

In terms of Specialty Ingredients, you noted that you're pretty much where you want to be for '14. Can you maybe help us understand what type of growth beyond this year you could see in the next couple years in that business?

James J. O'Brien

I'll let John answer that specifically. But where we're really focused is we are -- as John pointed out, we are sold out in many of our key chemistries. So we're going to have to expand organically and invest in this business in the near term. So the tension between the ASI group and Lamar and myself is how much money can we get them, and also how fast can they invest it and build it out. So that's where the tension lies. So as we look at the future, I'm quite pleased that there are very nice opportunities that John and his team identified, and we're working very hard to try to give them the support to get them to build it out. So with that, I'll give it to John. He can give you some more specifics.

John E. Panichella

Yes, I think, when you -- what you should be thinking about in the business is, obviously, we have, I would say, similar growth profile that we shared with you in November. We obviously have got a significant amount of growth this year. But some of the headwinds we shared with you around the intermediates and solvents, et cetera, are still out there. So I think the profile of growth is relatively similar. We just had an exceptional year. And we think that things will flatten out some next year, and we'll be on our way to continuing to see that growth. And obviously, as Jim said, it really depends on how we line up the investment strategy and things we're going to do to grow the business.

Michael J. Sison - KeyBanc Capital Markets Inc., Research Division

Okay. And then when you look at Valvoline, do you feel pretty good about the industry keeping pricing where it's at? Have you heard from customers looking to get price declines? And so I'm just trying to make sure I understand the benefit you can get with base oil falling.

James J. O'Brien

Yes, when you take a look at the history now of going through several cycles of crude coming down, crude going up, and what the industry tries to do during all these various cycles, is price does come down some. But the retailers are still trying to meet their own costs, and they're not looking for dramatic swings in the price of oil because that really hurts them when they compare against previous year comps, and they really are having difficulties trying to reach their sales goals. And motor oil is a very important segment for them. I mean, it's a sector which is a big part of the store's floor space and a lot of the turnover, what brings people into the store. So there is some motivation on all the parts of the supply chain to try to keep motor oil somewhat stable but be somewhat reactive to the price of energy. But what we've seen over the last cycles is that's not dramatic.

Michael J. Sison - KeyBanc Capital Markets Inc., Research Division

Got it. And last question, real quick, John. The new or guar substitutes that you can come up with, will those be as profitable as the guar products themselves?

John E. Panichella

Well, we're in the early phase of rolling these out. Customers have trialed materials and run jobs using them. So we're at an early phase. I think you should – they're at equal kind of margins that we're getting in that segment. So they're relatively comparable to what we're achieving today.

James J. O'Brien

I think to just add on the guar story. Obviously, it was a very important part of our earnings quarter and really, for the year. And as we look at next year, it's all dependent upon what happens with the yields coming out of the production that's going in the ground in India today. And of course, the monsoons are unclear as far as what they're going to do with yields. And there's a huge question mark there. If you take a look at if guar stays where it is today, if it's off, what, 10%, 20%, 30%, if it stays there, obviously, the earnings in that particular segment will go down. But as we look at where we think that the year will play out, we will have higher volumes because we will actually have more guar than we can synthesize and sell, plus the substitutes will come into play. So we think that guar will probably be lower next year for us. But we think that the other parts of our business are growing at a rate sufficient to overcome that. So if you look at the earnings next year, we think that we'll probably have lower guar earnings but we'll have higher earnings in the other key segments. And in some respects, that doesn't concern me, because I'd rather have the better mix than rely on guar, which is more of an opportunity than it is a strategy long term. So I'm really pleased that our other businesses are going to be able to make up what we see as being perhaps a shortfall if guar stays where it is today.

Operator

Our next question comes from the line of Olga Guteneva with JPMorgan.

Olga Guteneva - JP Morgan Chase & Co, Research Division

If we could just go back to that guar question. So you said that your inventories were up $100 million in the quarter due to guar purchases. It entail [ph] how much inventories you have now in terms of months for guar?

Lamar M. Chambers

Just one correction on that, Olga. It was up $80 million in inventory value in the quarter, about $100 million or a little over that year-to-date. So it hasn't been a significant use of cash. Our inventories are up substantially in dollar value, as you're talking about here. That's primarily driven by price. Price had tripled from the start of the year through the June quarter. And volumes are up a bit. But that's primarily due to pricing.

Olga Guteneva - JP Morgan Chase & Co, Research Division

Right. But if you look at the guar inventories, how much inventories in months, in terms of months do you have? Do you have an...

Lamar M. Chambers

Yes, we wouldn't disclose that. That's getting to a finer level of our business operations than we want to disclose for competitive and other reasons.

James J. O'Brien

Right. But what we had expected to see for this quarter that we're in is we're selling off a lot of that inventory. So we are expecting that it's going to be a source of cash this quarter versus a use of cash. We're expecting to have much of that inventory be sold through and recovered as working capital decrease, recover that in cash. So I think that's the good news in that. Even though the price has come off, we're rotating down on the inventory. So it's going to be a source of cash for the quarter.

Olga Guteneva - JP Morgan Chase & Co, Research Division

Do you disclose the amount of sales of guar-based derivatives per year, per quarter?

David Neuberger

This is Dave Neuberger. We do disclose it in the appendix to the presentation. And for the trailing 12 months, it would be roughly $300 million of sales.

Olga Guteneva - JP Morgan Chase & Co, Research Division

And for the Specialty Ingredients segment in general, is there any seasonality in demand? And how should we think about demand sequentially from the third to the fourth quarter?

John E. Panichella

So we think demand sequentially, Q3,Q4 will hold up pretty similar overall across Specialty Ingredients. So we think that there'll be some relaxation, as others have already commented around guar, but the remainder of the business has picked up. And so we think, in general, you should be thinking about it something pretty similar.

Olga Guteneva - JP Morgan Chase & Co, Research Division

And on Valvoline, if I may. So just to remind me, what's your longer-term goal for the gross margin for the segment?

David Neuberger

This is Dave again. It would be high 20%, as we disclosed previously, at the gross profit line.

Olga Guteneva - JP Morgan Chase & Co, Research Division

And for -- in terms of pricing. Did you say that you more than offset the 24% increase in base oil you had back in April?

James J. O'Brien

When you look at the base oil increase, our intention was to have a price increase to fully recover that. Obviously, we put pricing out and we still have pricing that has yet to be recovered from those accounts. The team is working very hard to get that value through the system. Will 100% of that be recovered? I think it's unlikely, but I think we'll recover some. And at the same time, we're getting a benefit of the pricing decrease. So it will average out as far as additional price, additional cost savings to a number that we described in the presentation in the quarter that our margins will move up and then how much will be determined in the quarter when the price cost kind of settles down.

Operator

Our next question comes from the line of Mike Harrison with First Analysis.

Michael J. Harrison - First Analysis Securities Corporation, Research Division

John, maybe if we can spend a little bit of time talking about ISP and some of the top line synergies you might be seeing now that you've had the business in the fold a year? Initially, the thought was that there was going to be some customer cross-pollination and then, longer term, maybe some R&D cross-pollination between the ISP people and the legacy Aqualon people. Can you just give us a little bit of detail on what you're seeing in maybe both of those buckets a year out from doing the acquisition?

John E. Panichella

Yes. So I think, as we previously have commented, we have obviously a totally integrated team now. So all that's completed. And we have a single go-to-market strategy in each industry vertical that we compete. So in personal care, we have a team representing the full portfolio of products that we sell, and it's that way for every industry vertical. The same thing in technology now. The technology teams are integrated. So we have an integrated pharma technology team that works across both heritage portfolio. So that's gone extremely well. We see a lot of opportunities in the combined portfolio. And so when you visit with -- I think we've shared in the past personal care, pharma and energy are very attractive, meaning that the portfolio has come together for us to offer much broader solutions to customers. We're seeing that play out in the marketplace, where we're getting lots of opportunities based on that portfolio. And so kind of our thesis of how this would come together and what it would deliver for us is playing out, as I see it in the marketplace. So the integrated approach gives us one channel to customers. And the integrated technical approach gives us lots of opportunities to develop some pretty unique materials based on the portfolio that we have.

Michael J. Harrison - First Analysis Securities Corporation, Research Division

Great. And if I can maybe ask a question on Performance Materials. You gave a little bit of detail on the stronger performance in Composites and Adhesives. And it sounded like the main driver there was better mix. But you also said past utilization was up around 90%. So how much of that better performance from Adhesives and Composites is fixed cost leverage? How much is better mix? And kind of where do you stand in terms of capacity? If you needed, if we saw some kind of recovery, would you be able to just increase shifts? Or would we see capacity constraints if we saw a sustained recovery?

James J. O'Brien

On the fixed cost utilization piece, the reference I made to the 90% was as staffed. So as you just pointed out, the way you would get additional capacity, would be to increase staff and basically increase your capacity that way. If you looked at just the pumps and pipes that we have, those are being utilized about 65%. So if we had a big turnaround, we had to go out and had the opportunity to get more business, that would be how we would do it: add more shifts, utilize the pipes better and run them. The area that we have spent a lot of time in is really getting this business reoriented and trying to go after the higher end of the market, and not chase a lot of the commodity businesses and run a lot of plans at very low rates. Because I think that's a loser's bet right there. And we have spent the last 5 or 6 years repositioning this business so that as it continues to be challenged with lower demand and just a tough market, I think that we have done as well as anybody in the marketplace. And I think that I'd put our business up against anybody as far as profitability. And as a consequence, this business is performing very, very well, in spite of a very, very difficult market. And the primary reason is mix and price, and the 2 kind of go together. If you're in the higher end of the market and you have a good technology that in high demand by your customers, you'll get higher value for it. And as raw materials came down, they've been able to get the full benefit of that. So I'm quite proud of what the team's done there.

Michael J. Harrison - First Analysis Securities Corporation, Research Division

And then last question is on Valvoline and the delays that you cited in routine auto maintenance, not just oil changes, but kind of across the board from the auto parts guys. Do you have any sense that this is more than economically driven? We've talked in the past about increasing change intervals. Are we seeing some kind of a meaningful shift in consumer sentiment toward auto maintenance? Or it is it just economically driven?

James J. O'Brien

My experience has been through these various business cycles, especially in the DIY side, normally, you have customers that fairly well maintain their cars. So it would be more of a "fix before it breaks." And then when economics start enter into it at a higher degree, you get more into a break-fix. So they don't fix the car until it breaks. And that's kind of the difference. I think we're kind of more in a break-fix mode right now, and that cycles for a while. And in motor oil, it's no different. They will kind of look at what they're going to do and they'll delay it by months, 45 days, stretch it out, because they just don't have the dollar to spend. So ultimately, they have to spend the dollar though. And this cycles for a period until the economy improves, then they go back to their previous behavior, which is try to fix it before it breaks and be much more attuned to trying to stay on a certain schedule. And I think that's what we're facing right now.

David Neuberger

And -- this is Dave Neuberger. I'd add one point to that just to reinforce what Jim said. If you look at the DIY, that's certainly where to volumes have been concentrated in terms of the declines. If you look at the broader installer channel and the Do-It-For-Me segment, that's up in volumes mid-single digits year-over-year. So arguably, the part of our business mix that's less affected by the macroeconomic environment, that part's doing quite well.

Operator

Our next question comes from the line of Laurence Alexander with Jefferies.

Robert Walker - Jefferies & Company, Inc., Research Division

This is Rob Walker on for Laurence. I guess after being elevated for all of 2011 versus it's kind of regressed value on oil, base oil has finally gone back in line, has the market shifted long yet? And do you expect prices will fall below kind of that regressed value with oil noticeably in 2013?

David Neuberger

Yes, this is Dave Neuberger. It's due to regression of base oil versus crude. Clearly, crude's your best indicator of long-term base oil value. And you'll confirm that regardless of what time period that you look over. Based on the models that we've run, I'd say base oil is still a little bit long versus crude. So that would imply that if crude stays where it is, base oil, all else being equal, would have a tendency to keep coming down. The other piece that I'd add to that, which is a fairly big change coming on within the base oil environment, and as we've noted in the past, there is a lot of capacity coming online within base oil the next 3 years. So the Group 2s are expected to go up around 20% the next 2 to 3 years, and the Group 3s are expected to nearly double. So it'll be interesting just to see how that affects those normal comparisons as well.

Robert Walker - Jefferies & Company, Inc., Research Division

And then just briefly, given the recent change in the pension law, can you just give us a preliminary outlook for what you're thinking about in terms of how that could be impacting your underfunded status at the end of the year and your required contributions next year?

Lamar M. Chambers

That's a good question. Just going to put the numbers in perspective and then get back to your question. This year, we would expect our pension funding to total about $160 million. This is for global pension funding, not just the U.S. plans. At the start of the year, we had anticipated that number would be about $120 million. So as we noted in our commentary, we did have about $40 million in the June quarter of catch-up funding related to ERISA requirements for our fiscal 2011 year end, and it just takes time to get all the actuarial information finalized to determine that amount. So we're at a level currently about $160 million per year. We're in an environment where the discount rate has moved down about 90 basis points, by our math, from where we were at fiscal year-end. And that by itself, absent the legislative change, would have increased our funding requirements for next year and going forward until the discount rate moves to more historical norms. What we have seen, we think is a good thing, is legislation's relaxed the available or the opportunity to relax the competition of your discount. It's set out as an option, not a requirement to do that. But we're looking at that legislation with our actuaries to try to determine exactly what that means. I wouldn't want to put a specific dollar amount on it. At this point, we don't have that. But it would be a meaningful reduction in our pension funding requirement. It could keep, even if discount rates stay where they are today, could keep our funding approximately in the range of where it has been this year as we look forward into the next year.

Operator

Our last question comes from the line of Jim Sheehan with Deutsche Bank.

James Sheehan - Deutsche Bank AG, Research Division

John, I was just wondering if you could help give us a sense of proportion for how much of the margin increase in Specialty Ingredients this quarter was attributable to guar-based products versus some of the other main product lines?

John E. Panichella

Yes, usually, we don't give out that level of detail. But guar, more broadly in the industrial business, it was a pretty significant contributor to the sequential improvement. But for Q4, it's starting to -- the price will come down and our volumes will likely be off a bit, and that'll be a headwind, but not a real significant one that we think that will offset with the other Specialty Ingredients businesses and products that are taking traction. So that's kind of how we're looking at it. In long term, what happens around the cost on guar will obviously depend on the crop and the drilling activity that occurs with our customers.

David Neuberger

And just to add a number to that to put in perspective, the gross profit increase as a percent of sales sequentially for John's business, it was about 100 basis points. So that should put that in context.

James Sheehan - Deutsche Bank AG, Research Division

And John, on some of the other Specialty Ingredients, more in the construction side, do you believe you're taking share in Europe? And what's driving the success of your business in construction overall?

John E. Panichella

Actually, it's probably not so much share in Europe, but other parts of the world. And so we do believe we're taking share. And we have had a strategy for the past 2 years to improve this business segment via new products and optimizing the cost in the facilities. And that strategy has taken hold. So we're launching new materials and we're getting costs out of the manufacturing operations. And that combined is really starting to come through, and we're seeing nice performance in this business.

James Sheehan - Deutsche Bank AG, Research Division

And a question for Jim, just on the Water Technology. You're talking about efforts to increase sales growth in industrial areas. How much of that is dependent on the macro situation versus how much that you can control?

James J. O'Brien

Yes. The macro situation, obviously, is going to be important. But in spite of that, there are -- in the areas that we're trying to compete, our share is so low that I think regardless of what the macro situation does, the expectation is they have to go out and win some new accounts. And the work they've done with new product development, as well as some of the equipment that they have designed to compete with, I think is world class and will be the reason why they gain new business. And obviously, that takes some time. But we've worked at it now for several months. So I would fully expect that this quarter should start showing some traction. And we'll be able to report on that, hopefully, at the end of this quarter on our progress.

David Neuberger

This is David Neuberger again. Thank you for your time this morning and for your interest in Ashland. If there are any additional questions, please contact me at (859) 815-3527. Thank you.

Operator

Ladies and gentlemen, thank you for participating in today's conference. This does conclude the program and you may all disconnect. Everyone, have a great day.

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