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OMNOVA Solutions Inc. (NYSE:OMN)

F1Q08 Earnings Call

June 17, 2008 11:00 am ET

Executives

Kevin M. McMullen - Chairman of the Board, President, Chief Executive Officer

Michael E. Hicks - Chief Financial Officer, Senior Vice President

Analysts

David Begleiter - Deutsche Bank

Analyst for Laurence Alexander - Jefferies & Company

Daniel Rizzo - Sidoti & Company

Douglas Chuti - Keybanc

John Roberts - Buckingham Research

Tom Spiro - Spiro Capital

Robert Kosowski - OFI Institutional

Bob Bridges - Sterling Capital Management

Operator

Ladies and gentlemen, thank you for standing by and welcome to the OMNOVA solutions second quarter earnings discussion. (Operator Instructions) I would now like to turn the conference over to our host, Mr. Kevin McMullen, Chief Executive Officer and Chairman. Please go ahead, sir.

Kevin M. McMullen

Good morning and thank you for joining us for our conference call to discuss second quarter 2008 results. Joining me today is Mike Hicks, Senior Vice President and Chief Financial Officer. I would like to turn it over to Mike to make comments about forward-looking statements.

Michael E. Hicks

Thanks, Kevin and good morning. During this conference call, OMNOVA representatives may make forward-looking statements as encouraged by the Private Securities Litigation Reform Act of 1995. All statements in this conference call and in subsequent discussions with the company’s management other than historical information are forward-looking statements. These statements represent management’s current judgment on expectations for future operations. A variety of risk factors highlighted in the company’s 2007 Form 10-K and in our earnings release today could cause business conditions and the company’s actual results to differ materially from those expected by the company or expressed in the company’s forward-looking statements. Kevin.

Kevin M. McMullen

Thanks, Mike. OMNOVA Solutions continued to show strong sales growth year over year as revenues in our 2008 second quarter increased nearly 17%. The increase was due to a number of factors, including consolidation of sales from our former Asian joint ventures, product pricing and favorable foreign exchange. Overall volumes were down slightly, primarily in product lines that serve the residential housing new construction market, such as chemicals for carpet backing and laminates used in kitchen and bath cabinets.

The big news during the quarter was the extraordinary pace of raw material cost inflation precipitated by the extremely volatile oil situation. The cost for a barrel of oil has climbed to nearly $140 a barrel. This has rapidly and significantly increased raw material cost for OMNOVA. In response, late in the second quarter we successfully increased prices across performance chemicals and decorative products with minimal volume loss. As pricing actions took hold during the quarter, margins expanded from month to month and in May, the last month of the quarter, operating profit represented 70% of the quarter total.

Additionally, as costs for raw materials such as butadiene spiked upward in June, we announced further price increases of up to 30% across many of our product lines in performance chemicals. While the latest increases were not in time to positively effect our second quarter profit picture, they are providing needed pricing momentum for the third quarter and beyond. At current volume levels, third quarter price increases are anticipated to be more than double the second quarter levels.

Volumes in several key product lines were up in the quarter versus last year, and above industry trends. Paper chemicals as an example; despite weakness in the North American paper industry, OMNOVA has been able to grow market share because of our innovative product offerings and reputation for technical service that adds real value to our customers. Volumes across several specialty chemical product lines increased as well in the second quarter with non-wovens and tape applications leading the way.

Still, weakness in carpet chemicals remain a concern as the prolonged housing downturn looks to continue into 2009, according to industry experts.

These sources report that the carpet market was down approximately 13% in the first half of the year while new residential housing construction was down about 15%. In decorative products, sales in the second quarter grew year over year in domestic contract interiors, coated fabrics, and European wall coverings. While we continue to encouraged by the sales growth, we are seeing slowing in some of our end use markets related to general weakness in the U.S. economy.

The tremendous inflation and weak market conditions have masked some of the many improvements we have made to our cost structure which, excluding raw materials, is lower than at any time since our formation in 1999. The current operating environment is unfortunately also reducing the impact we would otherwise experience from our strong lineup of exciting new products and services.

In a moment, I’ll provide greater details on individual business segment performance and opportunities, but first I would like to summarize our second quarter financial results as reported in our earnings release.

OMNOVA Solutions had a net loss of $3.1 million, or $0.07 per share, compared to a net loss of $9.8 million, or $0.23 per share in the second quarter of 2007, which included $12.4 million of debt redemption costs.

Selling, general and administrative expenses were $27.5 million, up $2.3 million from a year ago. SG&A for the 2008 second quarter includes $1.7 million from the decorative products Asian businesses, whereas these former joint ventures were not included in 2007 SG&A results since sales were not consolidated last year.

As a percentage of sales, we reduced SG&A by nearly 100 basis points to 12.5% in this year’s second quarter versus 13.4% for the same period in 2007. We remain vigilant in controlling discretionary spending.

Second quarter consolidated sales were up $31.7 million from last year, or almost 17% to nearly $220 million. Performance chemical sales increased $8.8 million, or 7.6%. Sales of decorative products increased almost $23 million, or 32% with $24 million of the increase coming from sales of the decorative products Asian businesses.

With the impact of raw material inflation, gross profit was $33.8 million, down $3.3 million from a year ago. Gross profit margin was 15.4%, compared to 19.7% in the 2007 second quarter.

Raw material costs during the quarter were up $14.4 million for the company, excluding Asia, which was up about $1.5 million, driven by the high price of oil. Tight supply has also been an issue, especially for butadiene which was put on allocation by all major North American suppliers during the second quarter.

OMNOVA finished the quarter with total debt of $197.9 million, up $24.9 million from the second quarter of 2007. Debt increased due to $32.4 million of borrowing and assumed debt to fund the acquisition purchase price and transaction fees of the buy-out of decorative products Asian joint ventures in January of this year, partially offset by $7.5 million of debt reduction utilizing cash from operations.

Our debt is comprised of $145 million under our team loan B credit facility, $47.4 million drawn against our $80 million five-year revolving asset-back credit facility, and $4.2 million in Asia. Access credit availability at the end of the second quarter was $27.8 million.

The weighted average cost of borrowing during the second quarter of 2008 was 6.6%, a significant improvement from 10.8% for the second quarter of last year. You’ll recall that OMNOVA completed a refinancing in the middle of last year’s second quarter. As a result of the improved terms achieved through the refinancing and favorable LIBOR rate levels, the weighted average cost of borrowing has been going down over the past year and on May 31, 2008 declined to 5.5%.

Our term loan B covenant leverage ratio of net debt to EBITDA at quarter end was 4.4%, up from the first quarter ratio of 3.9, but still comfortably in compliance with the covenant limit of 5.5. The term loan B covenant excludes our Asian EBITDA until cash dividends are repatriated to the United States.

Definitions of EBITDA and net debt are in our second quarter earnings release.

Turning to business segment results, first in performance chemicals, sales were just over $125 million in the second quarter, an increase of 7.6% or $8.8 million from a year ago. The increase was primarily due to higher selling prices. Volume decreased $1.6 million versus a year ago, driven by the weak market for carpet chemicals. Operating profit was $1.9 million, a decrease of $5.8 million in the second quarter of 2007.

Clearly the dynamic raw material situation I spoke of earlier had a dramatic effect on operating profit in our performance chemicals business as raw material cost rose $12.6 million year over year. Even with the product price increases of $10.4 million, they did not keep pace with the rapid ascent in oil-based raw materials during the quarter.

In addition to the pricing achieved in the quarter, we moved aggressively to implement additional pricing actions in performance chemicals of as much as 30% in June and expect improved raw material cost/price comparisons in the third quarter. Our pricing structure has included changing index pricing where applicable, adding surcharges to provide more timely relief, and traditional increases.

We were pleased by another good volume quarter for paper chemicals. Volumes increased in the high-single-digits year over year and above industry trends thank to our innovative GenCryl PT high strength latex binder. During the quarter, OMNOVA negotiated new pricing for our paper latex products and retained all major paper customers.

Specialty chemical sales were up 10% overall in the second quarter, led by sales for applications in non-woven, such as filtration, construction material and personal hygiene products. Likewise, sales remain strong for our polymer systems sold into high-end masking tape and oilfield applications.

Our advanced tape release coating and saturates continue to win new business for OMNOVA in the United States and Asia. While some production of masking tape is moving offshore to Asia, our release coatings are world-class and we have been able to deliver value-added products to this market segment through export channels.

The weak housing market, which has been in decline for over two years, is continuing to take its toll on the carpet industry. The carpet market was down about 13% in the quarter. OMNOVA's volume decline was in excess of the overall market due to customer mix, mill closures, and the loss of one customer, which was announced last quarter.

Despite OMNOVA's continued strength in many key performance chemicals markets, margins remain compressed by sky-rocketing energy, raw material and transportation costs.

This is the environment we are facing. Natural gas is up 100% in the past nine months. Incredibly, natural gas has risen 460% since the year 2000 according to the American Chemistry Council. OMNOVA has put a full court press on reducing our use of natural gas and other energy inputs through LEAN SixSigma improvements and capital investments in our facilities.

On the raw material front, our performance chemicals business uses oil-based styrene and butadiene and various acrylics. After jumping nearly 70% in 2007, the price of oil was up another 45% in 2008. This has put styrene costs at all-time highs, up 12% year over year. OMNOVA buys about 220 million pounds of styrene a year and a penny a pound change in styrene impacts our operating profit by approximately $2.2 million annually. Industry forecasters CMAI says it believes that styrene prices could go even higher in coming months. A further dynamic in styrene is the cost of benzyne, a key input to styrene. Benzyne climbed to well over $4 in June.

butadiene was up 25% in the second quarter to a new all-time high and supply is extremely tight. We purchase about 150 million pounds of butadiene a year and a penny a pound change impacts our operating profit by approximately $1.5 million annually.

Due to shortages of a key raw material feedstock known as Crude C4, butadiene was on allocation by all major North American suppliers in the first and second quarters of 2008. Performance chemicals has been able to meet all customer needs. However, industry forecasters say butadiene prices will increase significantly in the third quarter and remain high throughout the year with both supply and allocations tightening.

As I mentioned earlier, in addition to the second quarter increases, OMNOVA responded with further price increases early in the third quarter of up to 30% effective in June. Other raw materials, especially Acrylonitrile, have also increased dramatically year over year and have contributed to margin compression.

Performance chemicals continues to focus on cost reductions and to drive operational improvements and productivity gains through LEAN SixSigma efforts and by leveraging investments in our SAP enterprise business system. In addition, performance chemicals continues to drive record improvements in productivity as measured in pounds produced per employee and also in inventory turnover.

Productivity increased over 5% in the first half of 2008 versus a year ago. These improvements have been critical to reducing the impact of raw material inflation and the weak residential housing market.

Turning to the decorative products business, sales in the second quarter were $94.5 million, up 32% from the prior year. The increase included $24 million in sales from the Asian businesses that were acquired in January of this year. Sales from these former joint ventures were not consolidated in 2007.

Segment operating profit was $1.1 million in this year’s second quarter, down from $4.2 million a year ago. Key factors affecting the decline were higher raw material costs of $1.8 million, $1.2 million in lower profit from the Asian businesses, $600,000 in lower volumes, and $500,000 in higher manufacturing and overhead costs. These were partially offset by sales price increases of $1 million.

As with our performance chemicals business, clearly a priority for decorative products is to improve profit margins. This business has also been impacted by increased raw material costs. Market prices for PBC resin are up 33% year over year and plasticizers are up 44%. Price increases have been implemented across most product lines and should have a full affect in the third quarter.

Domestic contract interiors, coated fabrics, and our wall-covering business in the United Kingdom all grew year over year, while the weak residential housing market affected sales of laminates in the kitchen and bath cabinet applications.

The housing market slowdown, lower consumer spending, and the high price of gas is also having an impact on the floor and ceiling tile, marine and recreational vehicle markets. However, we have still been able to gain share in these markets.

Sales in our domestic contract interiors product line, which includes commercial wall-covering and upholstery, were up compared to last year as a result of steady refurbishment activity in our markets and innovative new products.

OMNOVA completed sampling and field placement of our new ECORE wall-covering in advance of a major promotional effort by our distributors at the NeoCon World Trade Fair in Chicago earlier this month. This truly innovative offering is designed to appeal to those designers and specifiers who have been looking for a recyclable product that delivers comparable performance to traditional vinyl wall-covering. With its strong environmental profile, ECORE wall-covering fit perfectly with the NeoCon’s shows emphasis on green products. They have low VOC emissions, utilize a water-based ink system, and are 100% recyclable. OMNOVA has exclusive rights to this material for the commercial wall-covering markets.

Vinyl wall-covering remains the product of choice for most designers and specifiers, especially in healthcare and hospitality. With ECORE, we are offering an industry-first alternative to vinyl wall-covering without any compromise in performance and design.

Another innovative product you’ve heard me talk about is our unique digital wall murals. Digital murals are a prime example of where we are leveraging our expertise to expand into new related applications. Recent wins include a major hotel chain. In addition, trials of sampling are ongoing at several large hospitality and retail accounts.

Coated fabrics had a solid second quarter, led by shipments related to a new adjacent market for in-ground pool liners. Additionally, we grew in performance films and secured new business in marine seating and trim. While the marine industry is down overall, our sales are up year over year as we continue to win key accounts with the nation’s top boat builders.

Our versatile boat soft upholstery, along with our well-known Nautolex brand upholstery, is sold into the marine market as well as transportation. OMNOVA's brands are known for outstanding clean-ability and abrasion and stain resistance, as well as leading designs.

Sales in laminates were down from a year ago due to weak demand in the kitchen and bath manufactured housing and recreational vehicle markets. Among the many exciting products recently introduced for the laminates market is OMNOVA's Surf X 3D laminate. Surf X provides the capability for rounded edges that gives designers of furniture, horizontal work surfaces, and store fixtures increased flexibility. In addition, Surf X laminates offer excellent scratch and stain resistance. Surf X is frequently used as a replacement for the more expensive and less design flexible high pressure laminate.

OMNOVA posted its first fully consolidated quarter as the sole owner of its former decorative products joint ventures in China and Thailand. An operating loss of $900,000 was disappointing after recording operating profit of $1 million in last year’s second quarter.

This year’s loss was a result of a number of factors. Both businesses were affected by a one-time acquisition expense, the strength of the Thai baht and Chinese Yuan currency, and by high raw material costs. In Thailand alone, PVC is up 31% year over year and plasticizer is up 11%. Also in Thailand, bad debt and cost of quality issues contributed to the operating loss.

Earlier in the year, OMNOVA named an ex-pat executive to General Manager of the business in Thailand. Since that time, we have implemented a number of changes, including a management restructuring and new quality systems, which we are expecting to providing future cost reductions and manufacturing efficiencies.

In China, operations were shut down during a severe snowstorm following the Chinese New Year and the business incurred additional costs related to implementing environmental improvements.

We have a number of initiatives in progress to drive improvement in our Asian operations in the second half of 2008. These include pricing actions, product rationalization to provide a more profitable focus to the portfolio, capital improvements that create efficiencies, and a reduction in discretionary costs.

In addition, OMNOVA has secured several new accounts in marine and transportation upholstery and laminates, which we’ll be ramping up during the second half of the year.

As we work to accelerate key operational and cultural changes in our Asian operations, w are very excited by the opportunities these businesses will provide for OMNOVA to participate more fully in the tremendous growth occurring in the region. The Chinese economy is expected to continue to grow at about 10% plus per year for the foreseeable future. In addition, Asian manufacturing capability provides OMNOVA with an important advantage over smaller competitors who are not able to follow U.S. customers who have moved their manufacturing to Asia and require suppliers who could serve them with quality products on a global basis.

There are two other important actions that took place during our 2008 second quarter. At the beginning of the quarter, our SAP business planning system went live, a second decorative products manufacturing plant, a third decorative products facility is scheduled to be brought under SAP in the third quarter. All of the performance chemical plants have already successfully converted to the SAP platform.

Another significant event was the ratification of a new three-year labor contract at our decorative products plant in Jeannette, Pennsylvania. The successful negotiations reflect a desire by all parties to continue to provide excellent jobs at the plant while improving the competitiveness of the facility in a very challenging marketplace.

In summary, while OMNOVA Solutions continues to demonstrate top line strength, our priority to improve profitability remains challenged by the extreme inflation in our raw materials. The swift, unrelenting increases in raw material costs and high energy and transportation costs have not allowed our pricing initiatives to catch up. The price increases secured late in the second quarter across both business units, along with the additional increases of up to 30% of performance chemicals in June should provide a needed boost for the second half of the year. May, the last month of the second quarter, represented 70% of the total operating profit for the quarter, and price increases in the third quarter are currently anticipated to more than double those realized in the second quarter.

In addition, our employees are driving for further improvements in all areas that we can control, such as increasing productivity, streamlining processes, driving lower discretionary spending, and developing new products that deliver innovative solutions that enhance the value OMNOVA brings to our customers.

While the operating environment is very dynamic, we are building on strong positions we have worked hard to establish. Those positions include the fact that we are leaders in our markets, typically number one or number two in the North American markets that we serve. We have been able to grow at above market rates in key categories through innovative new products and leveraging industry consolidation. We have entered new related markets that leverage our competencies and open up a broader array of opportunities. We have greatly enhanced our global position and we have a cost structure that, excluding raw materials, is the lowest in our history and provides flexibility to grow.

Uncertainty in the economy with weak demand in certain end use markets and the unprecedented escalation in cost for oil-based raw materials all combine to make our operating environment highly dynamic. But our focus is unwavering -- improving margins is clearly our highest priority and all of our associates are committed to making that happen.

I would now like to open it up to the operator for any questions that you might have. Operator, over to you.

Question-and-Answer Session

Operator

(Operator Instructions) We will go first to the line of David Begleiter with Deutsche Bank.

David Begleiter - Deutsche Bank

Kevin, first off, do you expect to be profitable in Q3, given the recent pricing actions?

Kevin M. McMullen

Yeah, we -- a very dynamic environment, Dave, as you can appreciate with the raw material environment. We are certainly not entering the quarter planning not to be profitable, a lot of focus on trying to get margins up but a very dynamic environment with the raw material situation.

David Begleiter - Deutsche Bank

Will prices exceed raws for you in Q3 do you think?

Kevin M. McMullen

That is certainly our plan, although the raw material environment is changing literally weekly, so that is our plan as we sit here now but it is a very dynamic situation.

David Begleiter - Deutsche Bank

And just in Asia, how long do you think it will take to restructure and improve that business to a consistent level of profitability?

Kevin M. McMullen

Well, I think there were some one-time costs that incurred, you know, as we took over for the business, part of the acquisition, some costs that we put in place, some environment improvements that we put in our facility. I think we will be able to, as we work through the second half of the year, get the business to a point where it can be profitable going forward as we go into 2009.

David Begleiter - Deutsche Bank

And just lastly on SG&A, ex the Asian JV increase, I think SG&A did increase by about $600,000. Was that normal cost inflation in your cost base or anything else drove up SG&A?

Michael E. Hicks

It was just normal cost inflation with wage increases versus last year.

David Begleiter - Deutsche Bank

Thank you very much.

Jennifer Driscoll

Thank you, Bob. Next question, please.

Operator

Thank you. Next we’ll move to the line of Laurence Alexander with Jefferies & Company.

Analyst for Laurence Alexander - Jefferies & Company

Hi, this is Lucy Watson speaking for Lawrence. Just a couple of questions; I wanted to ask, given the raw material pressures, what do you expect sort of your equilibrium margins to look like in two to three years?

Kevin M. McMullen

Well, our focus has consistently been to get back to double-digit EBITDA margins. We are certainly a long way away from that, but our goal remains to drive to that and between productivity initiatives we are taking, pricing actions that we are taking, and new products that we are introducing, that continues to be our goal. Obviously as oil goes to $140 a barrel, that is making that goal tougher but that remains to be the goal -- that remains the goal that we are shooting for.

Analyst for Laurence Alexander - Jefferies & Company

Has your timeline, or time horizon expanded to get there?

Kevin M. McMullen

Well, you know it really all depends on what happens with raw material in terms of the timing of getting there, I think. So we are still very focused on trying to achieve that. It will be very difficult if oil continues to go up at this rate. I think it’s much more achievable if the price of raw materials stabilize. There’s a much higher chance of us achieving it if the price of raw materials stabilize.

Analyst for Laurence Alexander - Jefferies & Company

Okay. And then separately, what is your outlook for any potential M&A in Europe in decorative products?

Kevin M. McMullen

Right now we are not looking at -- M&A in Europe, did you say?

Analyst for Laurence Alexander - Jefferies & Company

Yes.

Kevin M. McMullen

Yeah, we are not looking aggressively in Europe right now. I think there is opportunities but we see the opportunity in North America for the North American decorative products industry to continue its consolidation. That’s been going on for the last three or four years where we’ve seen probably on average two to three competitors exit the market each of the last really probably three or four years. We expect that to continue as we go forward and our focus is to try to take advantage of that from a winning business in the marketplace where there are some weakened competitors.

Analyst for Laurence Alexander - Jefferies & Company

Thank you.

Operator

Thank you. Next we’ll move to the line of Daniel Rizzo with Sidoti & Company.

Daniel Rizzo - Sidoti & Company

On that last question, you guys said that you are looking to win new business, so that means the weaker competitors, you’re not going to take over, you’re just going to try to take the business the old fashioned way?

Kevin M. McMullen

Well, we always look at kind of both but I think the old fashioned way is much more appealing. Obviously there’s no acquisition premium, so I think that has clearly been our focus and we think there’s opportunities for that and in a very perverse way, this very difficult environment that we are facing probably accelerates that consolidation process and that helps on that front.

Daniel Rizzo - Sidoti & Company

Okay. And I think you mentioned that some of your -- you see slowing growth in some of your end markets I think in decorative products. Which end markets were those?

Kevin M. McMullen

I think we see certainly some slowing in our laminates market. That’s affected by the whole kitchen and bath laminates side of the business and in manufactured housing and RV. Those would be segments that are slowing. I think in our coated fabrics business, the marine industry is slowing, although we have been growing and had positive year-over-year growth, despite a slowing industry. But as you can imagine with the economy and gasoline prices, the boat build is off considerably from where it had been historically. But despite that, we’ve been able to grow, gaining market share pretty consistently.

So those would be probably the ones that are slowing the most significant.

Daniel Rizzo - Sidoti & Company

All right. Thanks, guys.

Operator

Thank you. Next we’ll move to the line of Douglas [Chuti] with Keybanc.

Douglas Chuti - Keybanc

Good morning. First question; given the weak demand environment and raw material inflation, we’ve seen a number of capacity reductions within the specialty chemical industry. Is there anything that you feel you can do on this front to be more proactive in restoring profitability?

Kevin M. McMullen

Well, we are always looking at that. One of the things that we did back right at the beginning of our year is we announced a 50 million pound capacity reduction in our Mogadore, Ohio [inaudible] latex plant. So that was a pretty significant chunk of capacity that we have eliminated. And we continue to look at that. In fact, we are very focused on getting margins up and if that means that there is less volume and we need to shutter capacity, then we will consider that. But that’s something that we are looking at very closely.

Douglas Chuti - Keybanc

All right. Thank you. And secondly, you mentioned I think in wall coverings and marine some wins during the quarter. Can you maybe quantify new wins during the quarter, or maybe mention whether you are seeing it slow down or speed up relative to last year?

Kevin M. McMullen

I think the wins would be kind of in the couple million dollar range. We are supplying the largest boat builder in North America today as a customer that we hadn’t been supplying in the past. In wall-coverings, some large hospitality chains that we have secured the business for, so those are the types of wins that we were referring to.

Douglas Chuti - Keybanc

All right. Thank you very much.

Operator

Thank you. (Operator Instructions) Next we’ll move to the line of John Roberts with Buckingham Research.

John Roberts - Buckingham Research

Could you maybe go over the butadiene shortage situation in a little bit more detail and when you think that might be resolved?

Kevin M. McMullen

Well, the shortage is in the raw material that goes into making butadiene. It’s crude C4s. There’s plenty of butadiene capacity but it’s this raw material that goes into making it. Many of the major suppliers have declared [forced measure] because of shortage of this raw material and the allocations are -- they range from probably 50% to 75% across suppliers.

As oil and natural gas come more into historical relationship, we would expect that the supply of crude C4s to become more plentiful and the allocations to be less difficult, but right now even though oil has gone up dramatically, it is historically at a higher differential than natural gas. And even though natural gas has gone up dramatically, but it is still historically at a greater differential.

So if it returns to more historical relationships, there should be more crude C4s. That should open up supply of butadiene and that will improve the situation going forward. If it doesn’t, then we are going to continue to be in an allocation environment.

We have been very active in the merchant market. We’ve been working very closely with our suppliers. We’ve been able to meet all the needs that we have to keep our customers operating but it is obviously a very dynamic environment that we are facing as we look at it today.

Michael E. Hicks

And John, we have two suppliers of BD and they’ve got different kinds of allocation formulas, but generally to the plants where there’s a sole source situation, we are getting a higher allocation, almost 100%. So we have been fine through the month of May. We expect to be fine in the month of June. You know, if oil goes toward 150, I think BD will get tighter. If oil drops, as Kevin said, it probably will loosen up a little bit. And we are seeing for the first time in a while Europe -- imports coming in from Europe, scheduled to come in July, albeit at a higher cost.

John Roberts - Buckingham Research

Let’s say prices stay high for oil and gasoline and demand for crude C4 in the fuel market remains high -- do we need the refiners to add more extraction capacity? If pricing didn’t change over in the petroleum market, what would be the alternative way that would get you out of this bind?

Kevin M. McMullen

I think what would happen is butadiene prices would continue to go up. Right now, butadiene prices here versus in Europe are higher here, and so that’s leading to an opportunity for us to import butadiene from Europe, whereas historically that relationship had been the opposite and so there was no ability to import butadiene from Europe. So I think one of the things that would help get out of the bind is higher butadiene prices that would draw butadiene to North America from Europe. And in Europe, they produce a lot of crude C4s because of the way they crack in Europe, and therefore butadiene could be coming this direction, albeit at a higher cost, but the supply could open up from imports from Europe.

But in fact, we are actively working with suppliers to bring butadiene in from Europe now and one of the discussions we are having with our customers is that will be at higher costs but we will keep you operating by securing the material.

John Roberts - Buckingham Research

So there’s enough global availability of crude C4, it’s just -- it’s a transition problem here as we try to rebalance the world’s?

Kevin M. McMullen

I think that’s pretty accurate, yeah. I mean, it’s tight but I think there’s enough capacity. Obviously butadiene goes into tire production. The tire industry in China has been very robust, as you know, supporting the auto industry. And so a lot of butadiene has been going to China. But I think as prices normalize globally, I think it will open up opportunities for us to bring product in from offshore.

John Roberts - Buckingham Research

And then secondly in the carpet latex market, I thought most of that is now commercial demand rather than residential. I thought residential was the minority part and had been down for a while now, so it probably was small relative to commercial demand. Is this weakness that we are seeing now actually more commercial than residential, or is it residential decline still offsetting a stable market in the commercial side?

Kevin M. McMullen

I think still the majority of the market is residential still today. And so it’s largely continued weakness in the whole residential housing, new construction industry. That is clearly the biggest drive by far of the issue that the carpet industry is facing.

John Roberts - Buckingham Research

Okay. Thank you.

Operator

Thank you. Next we’ll move to the line of Tom Spiro with Spiro Capital.

Tom Spiro - Spiro Capital

A couple of questions; first, I see there’s about $13 million in cash on the balance sheet. Is that cash in the United States or elsewhere?

Michael E. Hicks

Most of it’s in the U.K., but it’s not restricted. We could bring it over if we wanted to.

Tom Spiro - Spiro Capital

Would there be taxes associated with bringing it over?

Michael E. Hicks

Modest, yes.

Tom Spiro - Spiro Capital

Secondly, debt to pay-down, do we anticipate paying down any debt in the second half of the year?

Michael E. Hicks

Absolutely. That’s our forecast and historically our trends are always negative cash flow first quarter, kind of flattens out in the second quarter and the last half of the year. Depending on profitability, we tend to be able to reduce debt anywhere from $10 million to $20 million in Q3 and 4.

Tom Spiro - Spiro Capital

Thanks. The paper industry as one of our end markets, Kevin, what are you hearing from our customers with respect to that industry?

Kevin M. McMullen

Well, the first half of the year was probably flat to slightly down as an industry. I suspect that it is pretty typical this time of year they’ll have mid-year shut-downs to correct inventory. I suspect that will be the case here this year as well. The good things that are working for the industry right now is a weak dollar. Imports have gone down pretty -- imports into the U.S. are down pretty significantly. This is an election year and an Olympic year -- both of those tend to help coated paper demand. On the other hand, the general malaise of the economy is working in the other direction, so I think overall the industry is probably going to be off versus last year in the second half but that remains to be seen as we get through it. But that would be my guess right now.

Tom Spiro - Spiro Capital

And lastly, our U.K. operations in the decorative products area, were those operations profitable in the last quarter?

Michael E. Hicks

Yes.

Tom Spiro - Spiro Capital

Okay. Thanks much.

Operator

Thank you. Next we’ll move to the line of Robert [Kosowski] with OFI Institutional.

Robert Kosowski - OFI Institutional

I was wondering if you could give us some more details on what changed in the pricing structure and what percent of your sales right now have a quick immediate pass through characteristic?

Kevin M. McMullen

In our chemicals business, the paper industry is largely on index pricing. That index pricing historically has had a lag, and it’s also been focused on a couple of the key raw materials. One of the structural changes we’ve made is to broaden those indexes to include other raw materials and transportation.

Secondly, we have implemented surcharges because of some of the lag to get relief more quickly across various parts of our performance chemicals business, particularly in paper and in specialties.

And then lastly, we have implemented traditional price increases where we’ve announced effective a certain date price increases are going up by a certain number or a certain percent, and we have done that in performance chemicals, all three of those in chemicals.

I think the new news in terms of structure is the surcharge and the broadening of the indexes to incorporate more of our actual costs that we are realizing.

Robert Kosowski - OFI Institutional

Thanks, that’s helpful, and could you give us an update on what’s going on in the benzyne market?

Michael E. Hicks

Benzyne closed in the most recent close period at $4.31, up about $0.40, so that has moved up as well. There is additional global benzyne capacity that’s going to come online in the next 12 months, so I think there will be plenty of supply and we would hope that we could see some price declines, because it’s not going to be as tight at the end of the year as it has been for the last year-and-a-half.

Robert Kosowski - OFI Institutional

Okay, and so that’s going to be kind of more of a fiscal 2009 phenomenon?

Michael E. Hicks

Probably.

Robert Kosowski - OFI Institutional

Okay. Thank you very much.

Operator

Thank you. (Operator Instructions) Next we’ll move to the line of Bob Bridges with Sterling Capital Management.

Bob Bridges - Sterling Capital Management

Getting back to the butadiene and the allocation, it sounds like so far you’ve got your two suppliers. You’ve benefited from that. How far out can you see what that supply trend is going to be to you? How many months in advance are you able to peg the trend?

Kevin M. McMullen

Well, it’s difficult to get clarity far out in advance. We can see out a couple of months now but the way these crackers work is they can modify whether they are cracking light feeds or heavy feeds, depending on the relative price of oil or natural gas. And right now, given the margins that they are making on some of their other by-products, they are not making acceptable margins when they are cracking the heavy feedstock which produces the butadiene by-product.

So the best leading indicator for us in terms of the butadiene supply situation is the relative price of oil versus natural gas. And right now, that is historically not in phase with where it’s been in the past. One would think that it would come back into a more consistent relationship but right now, that’s what we are fighting our way through.

Now they don’t -- I don’t think they turn these crackers on and off on a week’s notice but they clearly are earning the kind of return that they need to on the heavy feed crackers that produce the butadiene as the by-product.

Bob Bridges - Sterling Capital Management

What would be your expectations then going forward if this scenario, the relationship between the price of oil and gas stayed the same, would you expect to be able to get 90% to 100% of what you need to serve your customers, or would you expect that to weaken?

Kevin M. McMullen

I think it would get tighter. We would work very hard to secure all the product we need to meet our customers’ needs. We’ve been very -- we’ve shown time and time again that we can be very effective in the merchant market at finding shipments of material that are in scarcity, but I think it would become increasingly difficult. I think we would be paying more for butadiene in that environment, but I think we would be able to meet the needs of our customers.

Bob Bridges - Sterling Capital Management

You mentioned in the press release that you’ve been able to maintain, and I think in some of your earlier comments, you’ve been able to maintain your volumes with all your major customers. Would that apply to those who you are providing butadiene related product to thus far?

Kevin M. McMullen

Yeah, I think -- you know, in that kind of environment, we would be very focused on prioritizing who we would be able to serve and perhaps who we would not. So that would be a challenge that we would have if that environment came to pass.

Michael E. Hicks

And Bob, all of our paper and carpet customers where we’ve already negotiated the price increases here in June buy products that contain butadiene, and then about half of our specialty customers buy products with butadiene, so it makes up a good part of what we do and a lot of the price increases have been negotiated and are in place here for June.

Bob Bridges - Sterling Capital Management

Great. Thanks a lot.

Operator

Thank you. (Operator Instructions) Presenters, I have no further questions in queue at this time. I will return the call to you, sir.

Kevin M. McMullen

Okay. I’d like to thank you all for joining us for the second quarter release. We’ll look forward to talking to you at the end of the third quarter. Operator, maybe you want to provide the replay information for our listeners.

Operator

Thank you. Ladies and gentlemen, a digitized telephone replay is scheduled from June 17th at 1:00 p.m. Eastern until June 24th at 11:59 p.m. Eastern. Also, an audio replay will be made available on the OMNOVA Solutions website. That is www.omnova.com. OMNOVA is O-M-N-O-V-A. And that s available until noon Eastern Time zone on June 24th.

That does then conclude our conference for today and we thank you for your participation and for using AT&T’s executive teleconference service. You may now disconnect.

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Source: OMNOVA F2Q08 (Qtr End 5/31/08) Earnings Call Transcript

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