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KMG Chemicals, Inc. (KMGB)

F3Q08 Earnings Call

June 11, 2008 10:00 am ET

Executives

Neal Butler – President, Chief Executive Officer

John Sobchak – Chief Financial Officer

Analysts

Daniel Rizzo - Sidoti & Co.

David Yuschak – SMH Capital

Ryan Connors - Boenning & Scattergood

Chris Sansone – Ribotti & Co.

Russ Haberman – Haberman Fund

Operator

Good morning and welcome to the KMG Inc third quarter 2008 conference call. We would like to begin by reminding you that the information in this conference call includes certain forward-looking statements that are based upon assumptions that in the future may prove not to have been accurate and are subject to significant risk and uncertainties, including statements as to the future performance of the company.

Although the company believes that the expectations reflected in its forward-looking statements are reasonable, it can give no assurance that these such expectations or any of its forward-looking statements will prove to be correct.

Factors that could cause actual results to differ include, but are not limited to, a loss of primary customers, successful implementation of internal plans, product demand, the impact of competing product, increases in the prices of raw materials and active ingredients, successful acquisition and integration of additional product lines and businesses, environmental liability, the ability to obtain registration and re-registration of products, increased environmental compliance cost of products and general, political and economic risk and uncertainties.

A transcript of the call will be available on the website. With that, I would now like to turn the call over to Neal Butler, President and CEO. Neal, please go ahead.

Neal Butler

Good morning and welcome to KMG’s third quarter 2008 conference call. Our CFO John Sobchak and I will take you through information on third quarter results and our outlook for the remainder of the year and fiscal 2009. However, before we get into details of the business I would like to make a few comments about our two newest Board members.

One of the key factors in continuing to deliver on our five year strategy is to consistently upgrade our Board’s capabilities and overall business strength. We’re extremely pleased to welcome two very experienced and talented gentlemen, both of whom come from executive positions in the chemical industry, leading multi-billion-dollar businesses.

Gerry Ermentrout brings over 30 years of experience in the global electronic chemicals sector. He retired in 2007 from Air Products where he was Vice President of the $2 billion electronic chemicals division, which included the high purity process chemicals businesses we recently acquired.

Gerry held a number of senior management positions in marketing, sales and operations and has brought experience in the management of major acquisitions and divestitures for our products.

Chris Fraser, the current CEO of Chemical Lime Company, a leading North American producer of calcium based alkaline products servicing the steel, water treatment and flue gas desulphurization industries. He was formerly the president and CEO of OCI Chemical Corporation. He provides a wealth of experience in operations, business development, marketing and operations.

As we continue to grow in our target sectors, their leadership, proven business skills and knowledge of the specialty chemicals business will be extremely valuable in achieving our growth plans. Now let’s talk about the business.

In late May we provided an update on our 2008 fiscal year end sales and earnings per share expectations. We announced last quarter that we expected year ending revenue of about $135 million. But today, we’re on track to end fiscal 2008 closer to $150 million.

While we’re on track to grow sales to about $150 million, we are expecting a decline in earnings per share of 10-20% below fiscal 2007’s $0.80 per diluted share. This is due to lower than expected third quarter sales in our penta and animal health segments for reasons discussed in today’s news release. You’ll find a more detailed description in our 10-Q.

Just to briefly reiterate, third quarter penta sales were negatively impacted by the price increase for the distillate oil that our wood treating customers blend with penta to treat utility poles. This caused utility customers to pause their poles purchases as they reevaluated their needs, but we have seen orders start to pickup in the fourth quarter and expect sales to be in line with last year’s fourth quarter.

We also experienced an increase in price of the key penta raw material which is tied to the price of fuel oil. This was coupled with a decline in third quarter penta sales volume relative to the prior year period resulting in lesser throughput at our Matamoras facility which created higher unit cost.

The net effect was a reduction in penta gross margin. We recently implemented a price increase for our penta products to mitigate the increasing raw material cost impacts and as mentioned have seen a resurgence in volume demand in the fourth quarter.

Penta [core fenal] and creosote as many of you know have been undergoing a re-registration process at EPA and it now appears this will be completed by calendar year end with both products being re-registered. This is an obviously important element as the registrations are basically our license to do business. The long term health of both registrations appear to be very solid.

In our animal health segment, sales were affected by unusual weather patterns, particularly in the south, resulting in much cooler temperatures that caused a delay in the parasitic fly season. We expect to book much of the sales in the fourth quarter that would have normally been recorded in the third quarter.

High feed costs have also impacted the economics of cattle growers and their decisions on how to best invest limited capital. In canvassing our customer base, we still believe we will see modest sales growth this year, though less than we originally anticipated. One very positive result has been the recent receipt of several Latin American registrations for animal health products.

Last year we shared with you that one of our strategic initiatives for animal health was to expand into Latin America. This would increase the volume of sales and associated revenue and profits, plus provide the added value of mitigating some of the seasonality by working on both sides of the equator.

Ours is a spring and summer business and it is important to always have a market season in front of you. We will continue to expand Latin American registrations in 2009. Fiscal 2008’s animal health sales should modestly exceed fiscal 2007’s, but with the market downside will fall short of our 2008 expectations.

We saw a shift in our sales mix in the third quarter towards electronic chemicals and creosote relative to the previous year. These two businesses have lower margin product lines than penta or animal health products which affects our overall gross profit margin. However, the demand for both of these products is strong and we’ve seen an uptick in sales revenue of both.

John will provide financial details in a moment. Creosote sales in the third quarter were up 27% driven by continued strength in the railroad industry. We incurred several increases in creosote cost of goods and have implemented price increases in an effort to maintain gross margin. Due to market dynamics we have not been able to pass along price increases sufficiently to completely offset the rising costs, but as with penta, we have recently increased price to address this run up in cost.

While margins have declined somewhat, we will end the year with overall creosote revenue and profits higher than our record fiscal 2007. Our recently acquired electronic chemicals business which services the semiconductor industry contributed $26.1 million in third quarter sales, stronger than anticipated, and was marginally accretive to earnings and cash flow despite the associated integration cost.

Additionally, as reported in last week’s press release, our US and European sales teams have been successful in securing a new and profitable piece of global businesses for several HPPC products. We also successfully implemented necessary price increases to offset continued raw material increases and are recording improved margins in both the US and in Europe.

Transitional services agreements, though very necessary, has reduced that business’ contribution to earnings but we’re slated to complete the integration business, move off of transitional services and reduce our operating expenses as a consequence in August 2009.

This actually is one month longer than originally planned to accommodate the extensive systems testings we want completed before the transition. We’re very enthusiastic about our new electronic chemicals business and are highly encouraged by the prospects we see for this operation in the market it serves.

Although the margins for this new business are not yet as strong as our legacy businesses, it is important to keep in mind that those businesses did not start out with the margins they currently command. It was through the disciplined application of KMG’s acquire, optimize, grow business model that we’ve been able to improve margins in all of those businesses.

We are taking that same disciplined approach to electronic chemicals. I will now turn the call over to John to provide more detail on the financials and then I’ll discuss our outlook and summary before we open up for questions.

John Sobchak

Thank you Neal. Starting with a review of the income statement, revenue in the third quarter of fiscal 2008 increased 88% to $50.3 million. For the first nine months of the fiscal year, revenues increased 65% to $103 million. The largest contributor to that increase was the addition of the electronic chemicals acquisition.

Not including the electronic chemicals segment, revenues in our legacy business decreased 10% for the quarter and increased 9% for the year to date period. Revenues in our animal health business declined $3.6 million to $4 million for the quarter compared to last year due to the weather and economic conditions cited by Neal.

We anticipate fourth quarter sales in this segment to make up for the third quarter shortfall and that the year sales in animal health will be higher than last year, but not as strong as we originally anticipated.

Third quarter revenues for our wood treating chemical penta were down $2 million to $5.9 million versus last year, primarily as wood treaters slowed production of penta treated poles in response to the price spice for distillate oil that they use to blend with our penta when they treat utility poles.

Creosote revenues in the third quarter increased $3 million to $14.3 million on higher prices and somewhat higher volumes. We increased prices in response to higher creosote cost that we incurred. Gross profits increased by 48% for the quarter to $15.1 million and by 39% to $32 million for the nine month period.

The increase in gross profit dollars was primarily due to the new electronic chemicals business. The gross profit margin was 30% for the quarter, down from 38% for the same quarter last year. For the year to date period, the gross profit margin declined to 31.1% from 36.7% in fiscal 2007.

The decline was primarily due to sales mix with sales of creosote and electronic chemicals increasing while penta and animal health sales have decreased. Our penta and animal health segments have higher margins than our creosote and the average electronic chemicals product.

Looking at SG&A, SG&A was $11.2 million in the third quarter, a $7.3 million increase over the prior year. Most of that increase was due to the new electronic chemicals business. For the nine month period, SG&A was $22.6 million, an $11.3 million increase.

$9.4 million of that year to date increase was due to the new electronic chemicals business. As a percentage of revenue, SG&A was 22.3% versus 14.5% in the third quarter of 2008. We include distribution expenses in SG&A. The electronic chemicals business is a supply chain intensive business with relative high distribution expenses.

Therefore its SG&A as a percentage of revenue is higher than KMG’s legacy business. Besides the normally recurring SG&A, we have also incurred an additional $225,000 of fees paid to outside accounting and IT consultants associated with the integration of the electronic chemicals business so far this year.

Also the transitional services that we purchased from Air Products is based on their overhead cost structure. We estimated that our overhead cost structure would reduce that expense by over $175,000 per month or $700,000 for the year to date period. Supply chain costs in our legacy business increased approximately $394,000. That was primarily tied to increased costs of railcar maintenance and higher fuel costs.

Sales and marketing expenses in our animal health segment increased $498,000 as we endeavored to increase the market for our products in north and south [inaudible]. Also, accounting and legal expenses increased by about $565,000.

Operating income declined by $2.4 million to $3.9 million in the third quarter over the previous year. For the nine month period, operating income decreased by $2.3 million to $9.5 million.

The increase in SG&A expenses exceeded the benefit of higher gross profits, driving down operating income. We anticipate this will improve in the fourth quarter as penta and animal health sales are expected to recover, but most of the improvement in the contribution to operating income from the electronic chemicals segment will occur in fiscal 2009 after the completion of the integration effort.

Our income tax rate was 36.7% in the third quarter as compared to 37.1% for the same quarter last year. Regarding discontinued operations, in the first quarter we reported discontinued operations associated with our MSMA business. Accordingly the financial results of that segment had been removed from our reporting of the results of continuing operations for the current and prior years.

MSMA is an agricultural product used mainly on cotton in the US which we manufacture at our Matamoras plant, it is our smallest segment with sales of $3.6 million in fiscal 2007.

Net income for the third quarter was $1.7 million or $0.15 per diluted share. Last year we earned $0.34 per diluted share in the same quarter. For the nine month period, the company earned $4.8 million or $0.43 per diluted share versus $0.62 per diluted share last year.

Moving onto our balance sheet, net working capital remained strong at $32 million and the current ratio of 1.8:1. Cash and cash equivalents were $2.3 million as of April 30, 08. Trade receivables were $41.6 million, up from $11.7 million at the beginning of the year. Inventories increased to $27.1 million from $13.1 million at the beginning of the year.

Accounts payables increased to $23.5 million from $8.1 million on August 1. The biggest contributor to the increase in net working capital was the electronic chemicals acquisition. Accordingly, this largely represents a new level of working capital funding for the company. However, this is also the time of year when our animal health business builds inventory receivables during the main selling season for the segment.

Looking at our debt, total debt including the current portion of long term debt was $63.2 million at quarter end versus $14.1 million at the end of last year. On December 31, we financed our acquisition of the electronic chemicals business and refinanced our then existing bank debt with an amended and restated credit facility led by Wachovia.

The new facility consists of a $35 million five year term loan and a revolving credit facility. Interest rates floats and was initially set at 2.25 over LIBOR, that’s currently the premium over LIBOR that we are paying. The revolving credit facility is the $35 million and we borrowed $9 million against that to finance the acquisition.

Additionally on December 31, we sold $20 million of non-amortizing fixed rate notes with an interest rate of 7.43% to Prudential Capital. The notes have a term of seven years bringing our total debt on December 31 to $70 million.

As of June 9, we had repaid $11.5 million of that debt, including $7.2 million of the amount borrowed on the revolving credit facility. That now leaves us with $33.2 million available under our revolver and it reduces our total debt to $58.5 million as of June 9 resulting in a debt to equity ratio for the company of 0.9:1.

I’ll now hand it back to Neal.

Neal Butler

Thank you John. Regarding our animal health segment, the overall animal health market was down significantly in March and April in the US and this is reflected in our third quarter sales. As mentioned, we’re actively pursuing greater sales in Latin America and the Western US. We recently obtained registrations in several Latin American markets and we’ll see marginal sales in those countries in fiscal 2008 with growth in fiscal 2009.

We will continue to obtain registrations in Latin America and increase our portfolio offering in all key animal production countries in the Southern Hemisphere of the Americas. Additionally, we have expanded our animal health product line to include three new product offerings.

These products will not generate revenues as significant as Avenger, but will be important contributors to our animal health portfolio. A key component of our animal health strategy is to develop and introduce new chemistry in the various delivery vehicles we market such as ear tags and dusts.

This spring we placed a new ear tag in field trials and based upon field research data, hope to initiate registration efforts in late 2009 or early 2010. This will be an improvement on the current Avenger ear tag. We expect sales of approximately $150 million in fiscal 2008, up from $90 million last year driven by electronic chemicals sales and creosote.

We expect fourth quarter 2008 earnings per share to be significantly better than the comparable quarter of 2007, but it won’t offset the decline in third quarter earnings and as a result, we anticipate a 10-20% decline in year over year earnings per share for 2008.

We expect substantial growth in 2009, including net sales of approximately $200 million and significantly improved profitability. The factors contributing to this outlook include the following. Our electronic chemicals business will be consolidated for the entire fiscal year.

Also, again as mentioned earlier, we have successfully secured new and profitable business from several major global customers since completing the acquisition and we are currently bidding on new business in the Pacific Rim.

We don’t know at this point if we’ll be successful but we have been invited by several key semiconductor producers in Asia to participate in their request for quotes. We have implemented price increases for our wood treating and electronic chemicals products which should help mitigate continuing raw material price increases, especially those tied to rising petroleum prices.

We will continue to closely monitor raw material costs and strive to improve unit gross margin. Certain operating expenses will be eliminated in the fiscal 2009, including $1 million incurred in fiscal 2008 in connection with the integration of the electronic chemicals business and another $1.2 million of amortization of certain intangible assets, primarily associated with the June 2005 penta acquisition.

Projected amortization expense through 2012 is provided in note 8 of our 2007 10-K. In conclusion, I’d like to reiterate that we remain focused on three core competencies that are key to KMG’s success. First is maximizing free cash flow from operations which gives us the ability to pursue and fund acquisitions and maintain a strong balance sheet.

The second is identifying and closing acquisitions that meet our criteria and metrics. And the third is effective and efficient integration of new businesses thus minimizing the timeline to maximize cash flow. We are convinced that when implemented correctly, this becomes a perpetual effort that builds upon itself and provides an effective conduit to strengthen our position in selected markets and continues to build the scale of the company.

The 2008 five year strategy developed last year set as one of the key objectives of achieving revenue of $250 million by 2012. With the January acquisition of the electronic chemicals business, our 2009 sales as noted will be around $200 million. So we not only are well on our way to achieving this objective, but we’ll no doubt adjust it upwards when we finalize the 2009 strategy.

While we’re focused in the near term on completing the integration of our electronic chemicals acquisition, we continue to see attractive growth opportunities and are targeting companies in the animal health, electronic chemicals and agricultural chemicals segments that meet our criteria.

We are confident that we will achieve the level of success from previous acquisitions. Now I’d like to open the call for questions and operator I’d ask you to assist us with that. Thank you.

Question-and-Answer Session

Operator

(Operator instructions) Your first question comes from Daniel Rizzo – Sidoti & Co.

Daniel Rizzo - Sidoti & Co.

You indicated that creosote sales were relatively strong and higher prices and increased volume. Do you see that going forward because I know well for instance Coppers, saw creosote in their railroad tie sales falling off last quarter, so I was wondering why the divergence?

Neal Butler

One of the things that we had reported I think last quarter was that we believe the creosote sales, the demand for tie and the associated creosote sales would drop maybe 10-15%. Through this quarter we have not seen that in our sales. I know what you said about Coppers and their report on sales of railroad ties but thus far ours has remained pretty constant with last year.

John Sobchak

It’s interesting I think you have to keep in mind these treating facilities are actually associated with specific railroads along certain railroad lines and so depending upon the purchasing of the railroads that your treaters serve it can impact your results from a quarter to quarter, year to year basis.

Neal Butler

And there’s one other factor to keep in mind with treated railroad ties. The white wood is actually putting inventory at the treaters and it is held in inventory for nine months to allow it to air dry. Once it air dries they have to treat that within a fairly short window, a fairly short period of time that they have to treat those ties. So a lot of the treating is a consequence of when the ties are ready and how many ties happen to be sitting in a particular treater’s lot.

Daniel Rizzo - Sidoti & Co.

You indicated that you’re going to be selling animal health products in Latin America, do you have approval to sell anything yet or is it were you just still waiting for its approval?

Neal Butler

No, we actually have approval and will sell, we’ll have sales this fiscal year, this quarter, the fourth quarter we’ll actually have sales into Latin America of several of our animal health products, predominately the ear tags, but actually in Puerto Rico we’re going to be selling our entire, just about the entire animal health product line will move into that country.

Daniel Rizzo - Sidoti & Co.

You said you just recently raised penta prices. Are you planning on raising prices further in the near future?

Neal Butler

Well I guess the best answer I can give you on that is if our raw material costs continue to go up we absolutely are going to continue to raise prices. You know just to cover the raw material costs. Part of our ongoing strategy is to cover raw material costs and attempt to improve gross margins and that hasn’t changed.

Operator

Your next question comes from David Yuschak – SMH Capital.

David Yuschak – SMH Capital

On the animal health you’re obviously halfway through the quarter here, have to be feeling pretty good then from your press release about that weather issue was more the factor than maybe acceptance from existing customers as well as potentially new customers.

So I was wondering if you could give us an update on that as well as some sense as to as you’ve seen the sales rolling out here in the third quarter into the fourth, are you getting good recurring revenue off of those who have used the Avenger ear tag last year are back this year and its only a matter that weather may be more of been the factor than concerns about the product line itself.

Neal Butler

There are actually two key factors that are impacting that market. The first one obviously is the weather and the fact that it has delayed the fly season because they just don’t work the cows and treat them when it’s cold. So that is an issue.

The other one is just the general economics of the market right now. The animal health market in general has not been particularly strong this year and most of it has been driven by fuel and feed prices. So both of them are having an impact in the market now.

To the other portion of the question that you asked about, the acceptance of the ear tag. Absolutely not, the Avenger ear tag, the acceptance of it and the marketplace’s acceptance of the tag has been and continues to be extremely good. It’s recognized I think universally, maybe that’s a strong word, but I do believe it’s recognized across the majority of the market as being the most efficacious horn fly ear tag in the marketplace today.

So we feel very good about that and I made a comment earlier about putting an additional or putting a new tag in trials and that new tag is basically an Avenger plus tag, it’s actually taking the Avenger tag and improving upon the efficacy.

David Yuschak – SMH Capital

On that new tag then would it be just replacing the old Avenger or is it going to be something that helps you kind of switch back and forth between the two so that in its entirety that product can have more longevity as far as years so the immunity factor doesn’t become an issue.

Neal Butler

The attempt in that particular tag is improvement upon the current Avenger tag, it’s not new chemistry per se, it’s an improvement in the efficacy of that tag. It’s not part of the resistance strategy. Now we are looking at additional pieces of chemistry to put in the various vehicles that we manufacture, you know whether its ear tags, dust, pour ons, etc.

We are looking at some additional chemistry right now to put in the tag that would do what you’re talking about and that is be a tag that you would use in rotation for the Avenger tag. Now those are trials that we’d be putting in place probably next year and inevitably when you put those into trials into field trials, you’re looking at probably 18 months to two years before you could actually apply for registrations.

But you do that recognizing that the life of these tags in terms of no resistance maybe six or seven years then you may start to see resistance. So it’s important to have your replacement on the shelf then.

David Yuschak – SMH Capital

As far as your process of expanding into Latin America, could you just give us, how is that sales structure setting up right now so that as you indicated you’re going to get some results in the fourth quarter and maybe what the kind of timeline to get further into South America like in Brazil, could you give us some timelines as to where you are on the infrastructure as you go further south and what are the things you need to put in place to get those resources so that you can be doing something as far as south as Brazil by next year.

Neal Butler

The first thing in terms of looking at channel partners which is our distribution network, we actually have that established in all of the major Latin American countries now. We’ve got distribution agreements that are signed and in place with our customers throughout Latin America.

There are a number of registrations, some of the ear tag registrations such as the Patriot tag or the Terminator tag or some of those that have been around a bit, those registrations actually are a little bit easier to get and they come a bit more rapidly, simply because there’s a large database that’s already available in those countries.

Now, those are the ones that we’re getting today and we’re looking now to expand registration on basically the entire product line there which would be the Avenger tag and a number of the other dusts and so forth. And those will take anywhere from six months to 18 months depending upon the country.

The largest country down there in terms of animal health products is Brazil. Brazil just also happens to be the most difficult to get registrations. When you initiate a registration process in that country it takes anywhere from 12-24 months. I mean it’s very bureaucratically driven but nonetheless it takes a while to get the registrations there.

We have sales in Brazil right now with one of our tags and we’re expanding, we’ll be working to expand in all of those countries, so what you’re going to see over the course of let’s say the next 18 months, you’re just going to gradually see the addition of more and more registrations in the various countries.

And it’s difficult for me to tell you a timeline for each country because again, a lot of it’s just driven by local bureaucracy. But inevitably it’s going to be somewhere within 12-24 months for basically the full product line.

David Yuschak – SMH Capital

On the animal health, health offset some of the costs of the feed stocks and all of that to go into the cattle population. Can you not make a potential argument as an offset that the productivity gained by using a tag can’t help at least mitigate some of the costs in materials so that the cattlemen will begin to maybe take a more serious look to offsetting the cost of food by getting maybe more cattle weight?

Neal Butler

Absolutely, that’s the basic argument and the basic reason they use the tags. I mean it’s all based on return on investment. The only issue that I guess you have to take into account, you know and I made the comment just a moment ago is that they’re all operating on limited capital and they have to determine where they’re going to place that capital.

And one of the things when they look at the high cost of fuel, the high cost of hay, the high cost of feed, there are some things that are absolutes and you have to have and there are some other areas that you may have to cut. And in some areas, what some of the growers have done is they’ve cut some of the animal health expenses out this year. Now we don’t think it’s dramatic but we do believe it’s happening in some markets.

John Sobchak

Tagging the cattle is part of an operation that the cow growers do in the spring time as they work the cattle to put them out to their summer pasture. And we’ve had some anecdotal evidence that because of the economic pressures that these guys are under with feed costs and fertilizer costs that some of them aren’t working the cattle, they’re not putting them into a squeeze shoot and given them their vaccines and giving them their [bonuses] and other things.

And so when they’re not doing all that work, that’s when they clip on the ear tag. So if they’re just going to send them out to the summer pasture without working them, we’ve kind of lost our opportunity to sell tags there and we’ve seen a little bit of that.

David Yuschak – SMH Capital

What was the EBIT margin on your electronic chemicals in the quarter?

John Sobchak

We’ll have information in our Q which we’ll file either Friday or Monday with that detail, you’ll be able to calculate that.

David Yuschak – SMH Capital

On the debt repayment you had indicated you expect about $9 million of repayment, primarily the revolver but you’re already at $11.5 for the year, what’s it look like for the full year right now because it certainly means that you are going to be exceeding those initial expectations.

John Sobchak

Just to be clear David, we had said we expected to pay down the $9 million revolver but there was also in addition to that the normally scheduled $10 million principal payment on our [Oxy] note that comes due every June.

And the normal amortization on our term loan, so we always anticipated paying back more than $9 million by the end of the year and we are a bit ahead of schedule. And how much m ore debt we pay down versus holding on to the cash, we haven’t fully determined yet.

Obviously the business is still not withstanding the decline in earnings we saw in the third quarter, the business is still very strongly cash flow.

Operator

Your next question comes from Ryan Connors – Boenning & Scattergood.

Ryan Connors - Boenning & Scattergood

I wanted to touch back on the wood treatment business for a minute. And in particular the impact of the elevated petroleum related commodity price environment that we’re in. you know obviously this quarter, this time around it was penta impacted by that but we’ve seen the creosote business similarly impacted in the past.

And I’m curious to get your thoughts on if we’re to assume that the energy prices do remain at these elevated levels indefinitely and even increase from there, does that create a strategic risk for that business in terms of if you do have to keep raising prices does it become more difficult to compete with the alternatives? And is there a chance that substitution starts to really take a bite out of market wide demand?

Neal Butler

Well if you separate the two businesses and talk about them one at a time. Talk about the rail tie business and the associated creosote sales. Today there is not really an alternative for creosote in that market. You know people talk about concrete ties or some composite ties but those really aren’t replacements for the wood ties because you can’t mix them in a railroad bed.

That’s the first issue. The second issue is even if the price of creosote continues to increase, a creosote treated tie is still notably less expensive than the other, the alternatives which are again things like concrete and the composites. So no, I think, I don’t think there is a strategic concern in the creosote market.

If you look at the penta market, penta has always been notably more expensive than the primary competition which is CCA. The penta poles have been purchased traditionally and you know historically and to date, because of the fiscal characteristics of the poles, there’s several things about a penta pole that make them exceedingly better in a number of ways than the poles that are treated with a water based product because obviously the penta is an oil based product.

And those advantages don’t go away. Now the question is where is the threshold at which time somebody says well those advantages no longer are sufficient to offset the cost differential? I don’t know exactly where that threshold is. We’ve pressured it pretty hard lately and what we’ve seen is in canvassing our customers, we still think the penta demand is going to remain where it has been because of preference for those poles is still very strong.

They don’t like the cost of the oil but they understand the fact that if they want the penta pole and want the characteristics they’re going to have the pay the up price for the oil.

John Sobchak

One clarification, so everybody is clear, the cost advantage that CCA has over penta is not in the price of the CCA or the penta but primarily it’s in the cost of the dilutant. CCA is dissolved in water by wood treaters and used to treat utility poles and penta is dissolved in distillate oil, number two oil and then it’s used to treat utility poles by the treaters. And that’s where the additional expense for a penta pole comes in.

Operator

Your next question comes from Chris Sansone – Ribotti & Co.

Chris Sansone – Ribotti & Co.

I think a couple callers ago, the question was asked already about the electronic chemicals business. So you’re not providing any further information at this point on EBIT or EBITDA out of that segment this quarter?

John Sobchak

We have a full segment reporting coming out in the Q though and in the Q we have revenues, operating income and distribution and we have it broken out by the North American electronic chemicals segment and the ROW or really the Milan operation segment.

Chris Sansone – Ribotti & Co.

Just so I’m clear, in the quarter, in that segment, what were the expenses that are not expected to recur next year?

John Sobchak

Within the transitional services agreement, because we are paying basically an allocation of their product’s cost and their product is using a SAP system to run their operation and they have a larger overhead structure, we estimate that our costs to provide those same services will be $175,000 per month less.

In addition to that, we’ve incurred $225,000 from the period from January 1 through April, so for those four months, and those expenses were paid to outside accountant and IT consultants to assist us with the integration. So that comes out to about another $55,000-$60,000 per month of other costs that would go away after integration. So you could add those two up and say it was about $225,000-$230,000 per month cost savings.

Chris Sansone – Ribotti & Co.

Okay and those costs are showing up in operating expenses? Not in cost of goods sold right?

John Sobchak

That’s right, they’re primarily SG&A and again just to remind everybody, we consider distribution expenses as a sales expense, so it shows up as an operating expense in SG&A.

Chris Sansone – Ribotti & Co.

Can you talk a little about what your expectations are for that segment next year? If I recall correctly, that segment generated $90 million in revenue at the time of the acquisition and had a 40% market share with two other large players. Can you talk about your expectations next year with respect to, is that industry growing, do you expect to grow through market share?

John Sobchak

If you look at the results for the quarter, $26 million for the electronic chemicals segment, you know you can see that we’re on a forward revenue rate of closer to $105 million versus the $90 million that was done last year. You know we’re very pleased that the business is growing.

As Neal has mentioned, we’ve had some significant success over these first five months of owning the business at bringing in additional business from some of the large semiconductor manufacturers. So we’re very optimistic about that. I think it’s a combination of us spending some time and paying attention to the business.

But also, what we’ve seen in this economic environment, our customers haven’t been adversely impacted by the economy. We’re still seeing strong chip production in our markets. Going forward we’ll have more of an outlook to provide in our end of year release and our forward-looking statements for 2009.

Operator

Your next question comes from Russ Haberman – Haberman Fund.

Russ Haberman – Haberman Fund

You touched upon I guess adding additional acquisitions, would they be to the existing businesses, to additional businesses or is the emphasis going to be basically to pay down your $50-$60 million of debt before you would do any sort of add ons?

John Sobchak

In the near term, you know we’re focused on the integration and during that time period we’ll continue to pay down debt very aggressively. As we’ve said in the past, this is moving into our cash generation part of our cash cycle where receivables have built up and now we’re collecting cash.

And so we’ll be paying down debt aggressively. Going forward we would prefer to look at some bolt on acquisitions for the platforms that we’ve already established. We think there’s a lot of opportunities in electronic chemicals and that there are opportunities also in animal health.

You know we have plans to aggressively grow animal health organically but also through acquisitions. You know that being said we also see opportunities in agricultural chemicals and remain open to ideas there. Entering yet a new business segment is probably further down the list.

Operator

Your next question comes from David Yuschak – SMH Capital.

David Yuschak – SMH Capital

Judging from some of your comments you made earlier about getting some new business opportunities over in Europe as well as some of the things you’re seeing here, it does suggest your early experience with electronic chemicals is probably better than expected, is that fair to say?

Neal Butler

Maybe, I mean it may be marginally better. You know when we dissected this business during our due diligence process, we saw some areas that we thought we could increase the business and basically we saw areas where Air Products was probably just paying a bit less attention. I mean they weren’t doing a bad job they just weren’t paying the degree of attention that we anticipated we’d be paying to some of these businesses.

So there have been a couple of upsides that we’ve taken advantage of that we didn’t anticipate but there have been several that we have pursued that we anticipated prior to the acquisition that we could target, go after and be successful. So it’s been a bit of both.

David Yuschak – SMH Capital

So it does suggest though because of that latter success that you’ve had that the things that you were hoping to have been able to achieve on the get go looked pretty darn comfortable to you. There’s no problem so to speak surfacing in addressing issues that may have been a negative surprise for you?

Neal Butler

That’s an accurate statement, I don’t know of anything from a negative standpoint that has been a surprise to us. You know as we continue to drill down into this business and wrap our arms around it and gain a better working knowledge of it, inevitably you know you keep finding some of these hidden gems that exist in a business like this that we go out and take advantage of.

John Sobchak

The one thing that might have surprised us a little bit were some of the raw material prices that have been tied to fertilizers. Sulfur, phosphorous, those raw material prices have increased aggressively, probably more so than we had anticipated in October when we signed the original purchase agreement with Air Products.

As anticipated, we have been able to respond in the market. However, especially in Europe, we had not, you know in the beginning months, our main focus was on stabilizing the customer base.

You know it was not, we didn’t feel it was a good strategy to come out of the box and start raising prices aggressively. You know we feel like we have established ourselves with customers and now we’re addressing the pricing issues and we’re doing so very successfully I think.

Neal Butler

John makes a good point though, that is one of the things and I stand corrected on that, that is one of the things that did surprise us a little bit was that the raw material prices ramped up a bit more rapidly than we had anticipated. And particularly as John said, the sulfur based products and there’s three of our major products that are directly impacted by the price of sulfur.

And sulfur as you’re probably aware has been driving up as a consequence of the fertilizer demand around the world. And we have been aggressively increasing prices to compensate for that increase in cost. And we had to be a little more aggressive earlier on than we had anticipated.

David Yuschak – SMH Capital

But the fact that you’ve been able to stabilize that customer base when the customer has been used to dealing with Air Products, it’s a well known entity versus a KMG Chemicals that’s not so well known and be able to anchor that and be able to recover some of these things does suggest that execution wise right now you’re pacing very well on the acquisition.

Neal Butler

Yes I think that’s a true statement. One of the things that we recognized going into this though was just the point you made was that they were used to working with a large multinational company, KMG was not kind of known, it was unknown to most of these people, so that’s one of the things that we recognized at the very onset that we were going to have to pay particular attention to.

And we’ve made a concerted effort to address that and try to ensure that we worked with the customers where they had a comfort level in working with us and I think we’ve accomplished that, at least certainly to date we have.

John Sobchak

We really have to tip our hat to the new employees that joined us from Air Products, they did a masterful job I think at transitioning those relationships over.

Neal Butler

Yes there was some notable talent that has come into our organization with that acquisition.

Operator

There are no further questions.

Neal Butler

We want to thank everybody for taking the time to meet with us today. As John said the Q will be coming out shortly and there will obviously be a greater detail about everything that we have gone over today. A transcript of this conference will be on our website. And with that we want to thank everybody’s participation and we look forward to being with you next quarter. Thank you.

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Source: KMG Chemicals, Inc. F3Q08 (Qtr End 04/30/08) Earnings Call Transcript
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