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Cytec Industries, Inc. (NYSE:CYT)

Q2 FY08 Earnings Call

July 18, 2008, 11:00 AM ET

Executives

Jodi Allen - IR

David Lilley - Chairman and CEO

David M. Drillock - VP and CFO

Analysts

David Begleiter - Deutsche Bank Securities

Laurence Alexander - Jefferies & Co

Chris Shaw - UBS Securities

Michael Sison - Keybanc-McDonald Investments

Dmitry Silverstein - Longbow Research

John McNulty - Credit Suisse

Operator

Good day, and welcome to the Cytec Industries Incorporated Second Quarter Earnings Announcement. Today's call is being recorded. For opening remarks and introductions, I would like to turn the conference over to Ms. Jodi Allen. Please go ahead ma'am.

Jodi Allen - Investor Relations

Thank you, Patrick and good morning everyone. We appreciate your participation in our conference call. For our call today, David Lilley, Chairman and Chief Executive Officer, will provide an overview of operations; and Dave Drillock, Vice President and Chief Financial Officer, will review the financial results and the special items noted in our press release.

David will then finish with some commentary on our outlook for the remainder of 2008. This call is also being webcast in listen-only mode, and it will be archived in audio format on our website for three weeks.

During the course of this presentation and in responses to your questions, you will hear certain forward-looking statements. Our actual results may differ materially. Please read our commentary on forward-looking statements at the end of our news release or the statements in our quarterly and annual SEC filings.

In addition, our discussion includes certain non-GAAP financial measurements as defined under SEC rules. We have provided a reconciliation of those non-GAAP financial measures to the most directly comparable GAAP measure at the end of our press release. A copy of our press release is available on our Investor Relations website.

With that, let me turn over the call to David.

David Lilley - Chairman and Chief Executive Officer

Thank you, Jodi and good morning everyone. As you should be aware in late June we announced the appointment of Shane Fleming, as President and Chief Operating Officer of Cytec Industries. Shane is starting and is all impatient for his new responsibilities and he is looking forward to further accelerating the growth of Cytec.

Today I will highlight the results in the second quarter, but in October, Shane will take responsibility for this section of the Investor Call and I will talk about market developments and the full year estimates.

The second quarter was extremely turbulent with dramatic increases in raw material, energy and freight costs, coupled with an economic slowdown and consequential demand reduction in the United States.

However, some of our product lines continue to grow given that particular market dynamics and the strength of their technology, and we're pleased with our overall performance and delivering diluted earnings per share of $1.20 excluding special items.

Performance chemical sales were $202 million which represents a 2% overall improvement in volume and 2% and 5% benefits from price and currency exchange respectively, when compared to the same quarter a year ago.

Mining chemical sales were strong, polymer additives continued to make good progress but phosphine chemicals and pressure sensitive adhesives suffer from weak demand. We also continue to move away from Kemira, as they take responsibility for their own supply of water treatment product and this reduced sales by 2% compared to prior year, but had a negligible impact on earnings.

However, raw material cost continued to increase and we are little behind in our pricing initiatives to offset them. However, we've now implemented price increases in many product areas and expect to close that gap in the balance of the year.

Operating earnings were $21 million compared to $24 million in Q2 of 2007, reflecting sales order pattern, as well as loosing some ground to the raw material increases. Surface specialties sales were $473 million, which represents a 1% increase in volume essentially flat prices and a benefit of 12% from currency exchange, compared to the same quarter a year ago.

Looking at the segments on our product line basis, liquid coating resin volumes were down slightly in volume with weak U.S. demand. This demand show was all in the decorative, construction, OEM and general industrial sectors in the U.S. where we have a good profitable position.

In powder coatings, we experienced strong volume sale with Asia and Latin America doing well. Europe was up modestly and the U.S. was basically at last year's level. Competitive actions on pricing, required us to react in various situations and price on average were down about 3% for powders. In the Radcure product line similar to powder coatings we had good volume growth in Asia and Latin America, modest volume growth in Europe and flat demand in the United States of America.

Our action in Radcure is a continuously new applications for an environmental friendly product. On a geographical basis, the concern remains North America, as sales decline by about 7% in this quarter, primarily due to the housing on automotive weakness. European sales growth was modest and we saw growth in Latin America and Asia from our more mature product line.

The rapid ramp up in raw material cost increase in surface specialties, run ahead of price increase in the quarter. But we expect to announce price increases to more than cover the escalation of raw material costs. We also maintain vigilance on inventories and receivables and reduced manufacturing outputs at some units to achieve our working capital goals.

The net result is that operating earnings were $22.2 million compared to a $32.8 million in the same quarter last year. As the significant cost increases far offset the benefit from the modest sales growth and our pricing initiatives.

Building block chemical sales were $138 million, which represents a 4% decline in volume and benefit of 46% in price compared to the same quarter a year ago. We sold increased volumes of melamine but acrylonitrile volumes were lower compared to Q2 2007 as the acrylic fiber market softened.

Raw material costs increase of propylene, natural gas and ammonia, while we accomplished our goal of patting these to as a minimum into a product pricing. The Fortier plant successfully completed a major four-week maintenance turnaround of acrylonitrile units which is now back on stream.

We maintained good control of all expenses and operating units were $6.5 million compared to $4.6 million a year ago, as we realized the benefits of pricing initiatives.

Engineered materials sales were $193 million compared to $167 million in the same period a year ago, as volumes increased by 13% and we realized pricing benefits of just under 3%. We increased sales to all sectors with strong growth in rotorcraft and large commercial aircraft areas.

We experienced increased raw material costs on acrylonitrile, as well as energy cost escalation, but the adverse impact was more than offset by price increases. The plant's again net increase volume demand in a cost effective manner and we continue to invest in the growth of the business through additional resources for our R&D organization.

The net of this was operating earnings were $41.8 million as we gain leverage of the increased volume through the P&L but still continue the reinvestment in the field to growth of the business.

With that let me turn you over to Dave, to go through the financial details.

David M. Drillock - Vice President and Chief Financial Officer

Thank you, David and good morning everyone. I will begin with a review of our gross margin followed by an overview of our operating expenses and some cash flow highlights.

Our gross margin, after adjusting for the special items in both years, decreased about 2.5% over the prior year period. This decline resulted primarily from rising raw material cost which our specialty chemical segments were not able to fully recover in the quarter in addition to a less favorable product mix.

As David mentioned earlier, we are accelerating our price increase initiatives to recover the higher raw material costs. We had two special item charges included in manufacturing cost of sales of about $1.5 million each for previously announced initiatives.

One is related to order improvement activities at our Willow Island, West Virginia and Wallingford, Connecticut facilities, both of which are on track and should be completed before the end of the year.

The second special item is accelerated depreciation in relation to our decision to exit Radcure manufacturing at our leased Pampa, Texas facility and rationalize our U.S. manufacturing of Radcure products.

Most of the assets cannot be economically transferred and as a result, we have accelerated depreciation to bring those assets to zero for the remaining production period, which we expect to be the end of this year. While we expect to see benefits from this manufacturing rationalization in future years, the impact of the additional depreciation expense for the full year is still forecast to be $5.6 million.

Operating expenses are up about 10% year-on-year. Unfavorable exchange rate changes account for about two-thirds of the year-on-year increase on operating expenses, but the remainder primarily due to higher spending in our growth businesses for selling and research and development efforts.

Other income/expense for the quarter was a net benefit of $3.4 million and was simply due to exchange gain, some favorable insurance settlements and tighter cost controls. We work on a number of projects that belong to this category although they are difficult to predict when final resolution will occur. But a typical quarter could be anywhere from zero to a few million expense, offset on occasion with the benefit from a settlement or sale of excess real estate. They can work the other way too, don't forget, but the main takeaway is that we are actively working on these items.

Interest expense was down due to the lower debt balances from the year ago period and our income tax provision for the quarter increased about 1% versus the second quarter of 2007. That increase is primarily due to an earnings mix towards higher tax jurisdiction and the expiration of the U.S. R&D tax credit effect to December 31, 2007.

Moving on to cash flow for the quarter, cash flow from operations was $44 million down from the prior year of $67 million. The increase in our trade accounts receivable dollars is primarily due to the impact of higher selling prices and sales volumes. But our days are flat at 58.

Our inventory value increased due to the higher raw material cost we have been talking about and our days were up one at 73. We are however, taking a hard look at working capital levels, as we believe there is ample opportunity to improve our cash flow here.

Capital spending for the quarter was $43 million up from $25 million in the second quarter of 2007 with almost all of the increase due to investments in our engineered material segment as we continue to invest in this growth business. As you have heard us say before in 2008, we'll be significantly ramping up capital spending in our engineered material segment and our expectation for the full year remains at $180 million to $200 million.

Our balance sheet is in good shape and our uses of cash remain the same and are in this order; safety and maintenance of business capital, capital for fast payback cost reduction projects and capacity expansions in our growth product lines, bolt-on acquisitions which must pass our stock buyback test followed by stock buybacks and dividends.

Speaking of stock buybacks during the quarter, we repurchased 232,000 shares of our common stock for about $14 million and that's $72 million left on the current authorization.

Our expectation is to be in the market with share repurchases for the remainder of the year with the modest goal of keeping our diluted share count flat to declining slightly.

With that, let me turn over the discussion to David.

David Lilley - Chairman and Chief Executive Officer

Thank you, Dave. And now let us outline our expectations for the full year. For surface specialties economic conditions have unfortunately [ph] deteriorated, particularly here in North America. Our coating customers are reporting reduced demand with automotive and housing sectors particularly hard hit.

Recent industry data indicates that is an overall 7% to 10% decline in the overall U.S paint market with architectural coatings down 5% and OEM coatings down by more than 5%.

We're also being adversely impacted by escalating raw material costs, particularly from propylene derivatives such as acrylic acid and Neopentyl glycol and also from an increasing energy and freight costs, and we do not expect any relief for the balance of the year.

We've initiated selective but significant product price increases to offset these cost increases and we expect to loose some volume because of these pricing initiatives. We have little option given the rapid rise in our cost base.

We continue to seek to accelerate growth of our new eco-friendly technology, and I'm pleased to report that we have completed a customer qualification phase for the first phase of the Wallingford waterborne expansion, now the commissioning of acrylates production in Fengxian, China has been completed.

After the mid-term future, our customers are basically advising us that any significant improvement in demand will probably not be realized until 2010. Given that projection we have imposed a higher level of scrutiny on all our discretionary expenses and made reductions in a sensible manner to assist in achieving a of short term earnings goals with otherwise impacting our long term growth prospect.

In addition, the loan on escalated product demand plus the capacity increase is gained through lean manufacturing efforts may give us some opportunities to rationalize manufacturing further and we're presently investigating some potential projects.

We believe that our pricing actions can compensate for the increases in raw material, energy and freight cost. But a reduction in basic demand will have an adverse impact on our earnings.

Previously, we'd expected overall sales growth of the year about 6% with about two-thirds of that from volume. Given the weak economic situation and the inputs from our customers, we now expect flat volume sales year-over-year for surface specialties.

We expect to raise product prices to cover raw material cost increases and we'll do so as I said previously in a selective manner.

Our people are making the right choices in terms of expense management to improve 2008 results, but not sacrifice growth in the future. But net of this, is that we now expect operating earnings to be in the range of $90 million to $95 million based on the lower than previously expected sales volumes. And this compares to our product's reputations of a 10% to 15% earnings improvement.

We are naturally disappointed by this reduction in earnings expectation, but it is due to external factors. And we remain confident at the strength of our environmental systems to grow, as new regulations reinforce consumer preferences.

For performance chemicals, we are maintaining our previous expectations, where operating earnings increased about 10%. Mining chemicals demand remain strong, although pressure sensitive adhesives are experiencing some weak demand due to the U.S. economy.

We have already initiated some additional price increases, which should allow us to cover the cost increases and protect our earnings goal. For building block chemicals, chemical grade propylene price in the U.S. have risen a higher percentage rate even crude oil and gasoline. And today's price has moved to about $0.83 per pound, with a slight downward bias for the balance of the year.

We are passing through the cost increases in the acrylonitrile price but, this level we are seeing significant demand destruction, the acrylic fiber costs are longer competitive with polyester and cotton. This is limiting exports to Asia and reduce the acrylonitrile demand on the Fortier plant.

However, we have reconfigured the plant to make greater quantities of hydrocyanic acid at Evonik and optimize the accrual [ph] plant profitability. Melamine is in short supply, although we have taken a short maintenance outage in this quarter we expect to run this production unit at full throughput for the foreseeable future.

The net results is that we are increasing our fully operated earnings expectation of the segment to $20 million to $22 million, up from our prior range of $18 million to $20 million.

Our engineered materials remain bullish for both the long and the short term. We expect growth this year in all sectors particularly in commercial aircraft sector, as competitors continue their market penetration and find new applications in new platform.

The military sector growth this year is coming primarily from rotocraft platform with a Joint Strike Fighter only being in the early stages of its production ramp up. While we expect this program to accelerate in 2009 and in 2010.

The business jet sector is presently growing on a unit basis, an increase in the use of computer applications. We're also seeing new entrance in the region of jet sector which is Avec I in China, Sukhoi and Mitsubishi for developing new models.

So in combination, we expect increased potential of our materials. We have got up to a great start this year and we've met a surging customer orders as they build inventory in the first half of the year, to meet scheduled commitments.

For 2008 we are raising our targets we'll expect overall sales growth to be about 50% with about 2% of that from price. We continue to invest in the growth for this business and we now expect operating earnings to be in the range of $153 million to $158 million for the full year versus our prior expectations of operating earnings growth to be up about 10% to about levels of a $145 million.

There has been a lot of media speculations about the impact of high fuel costs on aerospace suppliers. It is reasonable to expect, that there will be some order deferrals of possible cancellations from cash struck airline. However, because of a large order backlog, we expect the major aircraft manufactures to continue with their production rates for the foreseeable future.

We're also hearing to open slots for a newer or more efficient models that opened up are being taken by airlines industry to improving the economics of their fleet. Please remember, that the primary value proposition for aerospace composites is that they've reduced late and improved fuel efficiency, such as this claim that a 787 reduced their fuel cost by about 20% compared to the equivalent sized plane of yesteryear.

With the enormous benefits, we expect continuing growth in orders for fuel efficient planes containing increased levels of composites. So perhaps there might be some short term issues to work through, but we still expect average annual volume growth in our engineered materials business in excess of 10% per annum for the next five years.

Our press release provided our updated guidance for the rest of the P&L. So, in summary despite the difficult external economic factors, we are reaffirming our prior guidance of $4.15 to $4.35 for diluted earnings per share after special items. We believe we have the plant in place and most importantly the determination of the Cytec people to continue to grow our company.

So, with that let me turn you over to Patrick, our moderator, so we can respond to your questions.

Question And Answer

Operator

Thank you, sir. [Operator Instructions]. And we'll go first to David Begleiter with Deutsche Bank.

David Begleiter - Deutsche Bank Securities

Good morning.

David Lilley - Chairman and Chief Executive Officer

Good morning, David.

David Begleiter - Deutsche Bank Securities

David, can you give us some more color on what you're seeing in Europe in your chemical businesses?

David Lilley - Chairman and Chief Executive Officer

I think we are seeing some softening in demand in our chemical business in Europe although not going into negative territory overall. In Southern Europe, notably Spain and Italy, we are seeing weakness and also in the U.K. where there is a similar housing situation compared to United States of America. So where we are seeing approximately 2% to 3% growth, six months ago perhaps we've seen 1% to flat at the moment.

David Begleiter - Deutsche Bank Securities

I assume that's baked into your forecast for the year?

David Lilley - Chairman and Chief Executive Officer

It is indeed David, yes.

David Begleiter - Deutsche Bank Securities

And just in engineering materials your referenced some potential customer destocking in the back half of the year, give a little more color on that please?

David Lilley - Chairman and Chief Executive Officer

Well to reiterate, what I said before David in my remarks, engineering materials is performing extremely well in the first half of this year. And it has had sales growth in all sectors. Now for the second half, we still have higher year-over-year sales, we will assume say in your question we really get a lower rate in the first half. This is because many of our customers front loaded than annual requirements to ensure they met scheduled commitments. Now we continue to maintain a very good dialogue with customers on their requirements and so for example, we have the 787 delay impacts already build into our forecast particularly for the second half. Also in the second half for earnings, we will have initial cost, as we continue to invest in the R&D program and we are also going to add manufacturing headcount, as we're already ramping up production for 2009 towards the back end of this year.

David Begleiter - Deutsche Bank Securities

Thank you very much.

David Lilley - Chairman and Chief Executive Officer

Thank you, David.

Operator

We'll take our next question from Laurence Alexander with Jefferies.

Laurence Alexander - Jefferies & Co

Good morning.

David Lilley - Chairman and Chief Executive Officer

Good morning, Laurence.

Laurence Alexander - Jefferies & Co

I guess first on surface specialties could you discuss some of the moving parts behind why pricing is flat given that raw material pressure has been persistent for an extended period?

David Lilley - Chairman and Chief Executive Officer

I think in the first half of the year Lawrence there's been put and take, and some areas were actually some there's been some price... cost reductions should we say, particularly in the powders area, the powders supply chain. I said that then changed though toward the backend of this quarter, as we saw oil ramp up.

So, we're really seeing a situation where the first half the year-over-year our raw material costs were basically flat if you looked equal volume, but in the second half of the year its going to be something like $30 million to $40 million extra cost in raws, as we go forward. And that's why we are implementing... have implemented should I say price increases to more than cover that.

Laurence Alexander - Jefferies & Co

So the flat pricing was partly just a negative mix effect as baked in there?

David Lilley - Chairman and Chief Executive Officer

Yes, it was for the first half, yes.

Laurence Alexander - Jefferies & Co

Okay, and then can you just give some sense of the raw material lag that we're seeing in performance specialties and I mean what the magnitude is for the second half?

David Lilley - Chairman and Chief Executive Officer

I think there's two lags if I may suggest to you. I think first of all, we've been pretty effective, I think let's say on the 30 day basis getting our price increases into what we believe the new level of raw material costs are.

However, on a competitive basis we are seeing the followers being a bit negatively. So typically speaking we're seeing, Cytec has markedly the raised prices and competition being two to three months behind us. I am so not well indicative and we may get penalized a little bit on the volume side.

Laurence Alexander - Jefferies & Co

And then I guess lastly from me what was the hitch for the quarter on Fortier from the maintenance turnaround?

David Lilley - Chairman and Chief Executive Officer

There were no hitches, there was a superb turnaround so certainly from a safety perspective it was our primary concern that was very, very good. And they met the scheduled commitments. I think, previously we've given an estimate that we'll be slightly above breakeven, what we haven't seen was really half the benefits of our aggressive price increases. So I'll give the guys all credit for being very aggressive at seeking opportunities to earn extra profits from appropriate pricing to get... as their return for our investments.

Laurence Alexander - Jefferies & Co

Okay, thank you.

David Lilley - Chairman and Chief Executive Officer

Thank you very much.

Operator

We will take our next question from Chris Shaw with UBS.

Chris Shaw - UBS Securities

Yes, good morning guys. How are you doing?

David Lilley - Chairman and Chief Executive Officer

Good morning, Chris.

Chris Shaw - UBS Securities

Actually the follow-up on the planned turnaround. Did you built up inventory ahead of the turnaround, ahead of those four-weeks that you would still have material to sell?

David Lilley - Chairman and Chief Executive Officer

Yes we attempt to do that but there's a limit to that. And typically in a commodity chemical business we can organize swap with all the suppliers. So when we're in turnaround mode we can provide the material and vice-versa. So volumes should not be dramatically impacted by a turnaround because of those swap.

Chris Shaw - UBS Securities

Did that help profit at all because did you... did you maybe... did you make acrylo [ph] before hand and before the cost went up and then got the pricing that you increased later?

David Lilley - Chairman and Chief Executive Officer

A small amount, but nothing up significant. I think the aggressive price increases is predominantly in the melamine area where there is a shortage and we believe we've got to raise prices together as I said before, a fair return on our investment.

Chris Shaw - UBS Securities

Okay. And then, the recent news about Bombardier and their new jet, what's the impact for you guys... have they already decided whose the supplier of that jet? And how big is it?

David Lilley - Chairman and Chief Executive Officer

Well, I think usually in the early stages of development there, so I think we're just talking about the C-series and then some planes like this.

Chris Shaw - UBS Securities

Right.

David Lilley - Chairman and Chief Executive Officer

And I think we will benefit given our strong relation with them and the value we provide over time. So, I think it's just one at many situations there may say Chris we're citing in engineered materials is going to benefit from additional penetration of composite into plane. So that's a good one, on the jets it's going to look a good one, things like this. So we've got some good examples and all in total and aggregate of the add up to a very successful situation and great potential for the future.

Chris Shaw - UBS Securities

Okay. And then one last one quickly, in surface specialties in Europe how much is sort of the balance sales Western versus Eastern Europe, did you do much in Eastern Europe?

David Lilley - Chairman and Chief Executive Officer

I haven't got that the numbers on my finger tips. We're increasing our sales into Eastern Europe, its not a large amount for the moment, but we're seeing a lots of our customers move facilities there.

We don't feel we have to move our production there because we can service it from both Germany and Austria. So which are obviously close by. So I think the impacts I think we're seeing some reduction demand in Western Europe, but Eastern Europe seems on a percentage basis to be going up albeit of a low base.

Chris Shaw - UBS Securities

Sure great, thanks a lot.

David Lilley - Chairman and Chief Executive Officer

Thank you, Chris.

Operator

We will take our next question from Bob Koort with Goldman Sachs.

Unidentified Analyst

Good morning,this is Amy Chasen [ph] for Bob. A couple of quick questions. The first one, can you just remind us what are the key raw materials that were used in your performance chemical business? And also during the quarter what raw materials that hurt you most in that segment?

David Lilley - Chairman and Chief Executive Officer

We buy, I would say a variety of specialty chemicals for our performance chemicals base. But having said that they all ultimately come from oil from a petrochemical source. And so, we were seeing the $130-$150 oil come through that supply chain.

Unidentified Analyst

Okay, understood. And second question is as you may know there is a consolidation among your acrylic suppliers. So what would be the impact on Cytec going forward; do you anticipate both suppliers down and how it'll be more aggressive in terms of raising prices on acrylic products and that will actually have an additional amount of impact on Cytec going forward?

David Lilley - Chairman and Chief Executive Officer

Well, we purchased significant quantity of acrylic acid and its derivatives from each of [indiscernible] and we believe these markets are already quite concentrated. So, we are really concerned about the potential for reduced competition, and if you'll feast [ph] this of increased prices is a consequence of this acquisition, we would be even more concerned. So, we intend to follow the regulatory approval process very, very closely, such that a dominant position could not be build up. So, that there could be over aggressive pricing in that marketplace.

Unidentified Analyst

Okay. Thank you.

David Lilley - Chairman and Chief Executive Officer

Thank you.

Operator

We will take our next question come from Mike Sison with Keybanc.

Michael Sison - Keybanc-McDonald Investments

Hi, guys nice quarter.

David Lilley - Chairman and Chief Executive Officer

Good morning, Michael. Thank you very much.

Michael Sison - Keybanc-McDonald Investments

Wanted to revisit a little bit, your... the confidence in engineered materials over the next five years, when you think about the 10% growth, is it somewhat equal across the different areas like military and commercial and regional business jets is it or all about the sort of similar growth?

David Lilley - Chairman and Chief Executive Officer

I think there's slight phasing Mike because as you're aware we've got this strong position on the Joint Strike Fighter the F-35. So that'll start around pops as I said in 2009, 2010. Then we'll see the European version come out in the '11 and '12, so partly we're seeing a 5% to 10% type numbers there. Of a low base we'll see I think a higher percentages growth pops in the business jet sector, which is now converting more and more to these materials, so you're seeing things like the Hawker 1000 coming along and things like that. So I think as you know on aggregate over those five years, probably all of them and it will be north of 10% growth.

Michael Sison - Keybanc-McDonald Investments

Then on the commercial aerospace side to feel to good about that plus 10% you must have a pretty good feel that delivery schedules from Airbus and Boeing through 2010 to 2015 would be fairly intact and in light of what you mentioned about the high fuel costs can you give us a little bit of color why you guys feel that sort of delivery schedule looks pretty good?

David Lilley - Chairman and Chief Executive Officer

Well in this case I'll really refer you to Boeing and Airbus, we've just come off, after performing at a air show Boeing is publicly updated its backlog and increased its expectations. Airbus is also being very, very positive, despite the U.S airline's troubled financial lows.

So all in the order they are coming in are coming in from the Middle East, Asia-Pacific and low cost airlines. Well I referred to you in our prepared remarks with a fact that you can't find a 737, A-100 for a lot of money at the moment. So the stretch versions, the bigger versions of 737 remain increasingly popular because they are the most fuel efficient version at the present time.

So yes, there maybe short term reduction in U.S the revenue passenger miles, but bigger, large wide-body planes are being flowing in Asia-Pacific over short distances. And those who are commuting sometimes from Moscow [ph] to Tokyo are flowing on Jumbo Jets and other wide bodies. So that's the new business model for those type of airlines and Being is reflecting that with Airbus in their projection. So we're hardened by their belief.

Michael Sison - Keybanc-McDonald Investments

Okay. Then shifting gears, real quick in surface specialties, it looks like you reduced your operating income outlook by about $20 million for '08 versus '07 based on your new guidance. Is the bulk of that decline just raw materials and then as we ahead into 2009 if you can catch up you sort of make that back?

David Lilley - Chairman and Chief Executive Officer

I don't think it is in raw materials, as you think, as we try and say in our remarks, we'll quickly cover the raw material.

Michael Sison - Keybanc-McDonald Investments

Okay.

David Lilley - Chairman and Chief Executive Officer

Our expectations were for a 4% volume growth. Now we're saying its flat, so this impacted the 4% and also what we're seeing is we do it in United States where we have good profitable position and because the reduction is heavy in the profitable areas, we're having a mixed impact as well.

So I think the simple take away if I may use headlines is, it's a volume and a mix issue which impacts our estimate and impacts our year-over-year comparisons and we can cover raws, I mean good position going forward into 2009.

Michael Sison - Keybanc-McDonald Investments

Okay. And just for my information what is the impact on raws in '08 versus '07 that you're expecting for surface specialties that you need to cover? Is that $30 million to $40 million -- ?

David Lilley - Chairman and Chief Executive Officer

$30 million to $40 million I mentioned before.

Michael Sison - Keybanc-McDonald Investments

Okay. So that's the same one. The last question on surface specialties, I know you noted that demand is going to be weak, potentially till 2010. Do you have the business in the right position to sort of generate better profitability and growth longer term? And do you need to do a lot more restructuring to sort of get it to where you want it to be longer term?

David Lilley - Chairman and Chief Executive Officer

I think first of all we need to focus on the environmentally friendly systems with our new regulations coming in force in 2010. Lower VOC levels in Europe and the United States where we can benefit from selling our eco-friendly systems. So, let's keep pushing that top-line because you've just seen in as your prior question, we have a 4% reduction, what I am looking for, we are looking for is that volume growth in the top-line.

Now, having said that we'll look at the mix of our business and while we have businesses as well as product lines, which are not growing so rapidly we look can we manufacture them in other units and so restructure. So I think it's a full comprehensive program of top-line growth, fueled by R&D product with a cost discipline led by improving our return in net assets for each of our product areas within service specialties.

Michael Sison - Keybanc-McDonald Investments

Okay, great. Thank you.

David Lilley - Chairman and Chief Executive Officer

Thank you, Mike.

Operator

We'll take our next question from Dmitry Silverstein with Longbow Research.

Dmitry Silverstein - Longbow Research

Good morning, gentlemen. A couple of questions, a lot of have been answered already. The 2% negative volume impact from the wind out of the Kemira contract. When is it going to anniversary?

David Lilley - Chairman and Chief Executive Officer

I think at the end of this Dmitry is basically the conclusion of that. We only mentioned in the context of how it impacts our volumes and it will have a negligible impacts on earnings.

Dmitry Silverstein - Longbow Research

I understand that. I just want to understand is that going to accelerate as the year comes to an end or I mean are you... again is the 2% or that dollar equivalent kind of and whether I should be looking for the balance of the year or is there going to be some lumpiness to that?

David Lilley - Chairman and Chief Executive Officer

There is no real number but as you look back, and the volumes will decline month after month towards the balance of the year.

Dmitry Silverstein - Longbow Research

I got you. Okay and then the second question on pricing. I appreciate your confidence in getting the price increases up to raw material levels and your practice has been expecting some volume loss along the way. Going back to the first part of that, do you expect or is this statement based on what you've seen in raw material increases to-date or do you expect some of your key raw materials to continue to increase and you'll still think you'll be able to catch up with pricing by the end of the year.

David Lilley - Chairman and Chief Executive Officer

Well in essence saying the situation today will remain as it is for the balance of the year, so out of $30, out of $50 oil were there, propylene $0.83 possibly coming down at a tad small amount, but nothing significant. So the increase is above and beyond that then we'll have to go out again in a very proactive way with more price increases, so we're assuming that today's level will continue for the balance of the year.

Dmitry Silverstein - Longbow Research

Okay. Thank you very much

David Lilley - Chairman and Chief Executive Officer

Thank you, Dmitry.

Operator

We'll take the next question from John McNulty with Credit Suisse.

John McNulty - Credit Suisse

Good morning.

David Lilley - Chairman and Chief Executive Officer

Good morning, John.

John McNulty - Credit Suisse

A few questions on the engineered materials business, first of all have you seen any signs of a pick up in the A-380 business that you have on that platform?

David Lilley - Chairman and Chief Executive Officer

Yes we've seen growth in Airbus sales this year led by the overall fleet coming up inside and also some A-380 orders as well. But it's a slow ramp up John I would describe at the present time.

John McNulty - Credit Suisse

Okay its helpful. As far as looking at your outlook for engineered materials for the full year, it looks like you are modeling down a pretty or at least guiding down a relatively significant decline in the engineered materials margins. And I know there are definitely periods of lumpiness with regard to research and more maybe on the development side. Is there anything coming in the next quarter or two that should result in maybe that significant hit to margins and that maybe what you are guiding to?

David Lilley - Chairman and Chief Executive Officer

I think we're guiding on the earnings side for two factors. First of all, the volumes in the second half would be lower than the first half. So, you don't get that leverage through the P&L. And secondly, we will be starting to invest for the growth in 2009. So, for example, some of our plants are going to move to seven day working. We are going to need to increase our headcount, recruit more people, train them in advance of their working on the plant. So, that added costs. We believe that we will bear that in 2008 and get the benefit so to speak in 2009.

John McNulty - Credit Suisse

Okay great, I would now...with that, would that imply that in 2009, we should expect to see margins actually up from the 2008 levels in the engineered materials business kind of oils being equal?

David Lilley - Chairman and Chief Executive Officer

I'm not going to comment on the margins, because I've not seen the final date there. What I would comment is consistent with our view of five years of 10% plus growth. We would expect earnings improvement in 2009 to meet our target level.

John McNulty - Credit Suisse

Okay, fair enough, and then with the, we just have recently the big A-350 contract announcement it looks like that's probably half the planes contract has already been awarded. Do you see yourself as having a likely chance of getting some or reasonable amount of contract left kind of the way that you are looking at the platform right now.

David Lilley - Chairman and Chief Executive Officer

Yes our people in Europe are still working with Airbus and they are prime sub-contracted what we would call specialized applications, where we have unique profits at unique materials which add really value for the customer such as adhesive is another composite. So the plane is still at an early stage of design and we are participating with the Airbus designers to see where we can get some applications specified solely for Cytec.

John McNulty - Credit Suisse

Okay great. And just the last question, we're half way through the year you've maintained your range in terms of EPS guidance, which now given that there's only two quarters left is actually a pretty wide range and I am wondering what would it take for you to come in at the low end of the range kind of relative to your expectations and what would put you toward high end of that range?

David Lilley - Chairman and Chief Executive Officer

I think our concern is purely the volatility of the raw materials and likely timing. Let's say we're going to spike in raw materials in November-December, given it takes us 30 days to get things done with that. We couldn't recover in time, so I think the broadness of our range is due to our concern on volatility of raw materials, clear and simple.

John McNulty - Credit Suisse

Okay great, thanks.

David Lilley - Chairman and Chief Executive Officer

Thank you, John.

Operator

We'll go next toRobert Richard [ph] with NewCastle.

Unidentified Analyst

Just I wanted to get one understanding about your, when you made your forecast in the beginning of the year or the end of last year for this year relative to Western Europe, how much worse do you think the economic activity has and you expect or the situation, I'm just curious?

David Lilley - Chairman and Chief Executive Officer

I think Bob when we made our first view of expectations, across Europe we would say, we describe as modest growth, which we felt was 2% to 3%. We did not expect as we see now deflationary impact in the U.K., Spain, and Italy. So now we are talking about flat to 1%. So we're down a couple of points to basis points possibly in demand overall.

Unidentified Analyst

Do you think that I mean again I know you're not an economist I certainly I am not one, so the question I would ask do you think things are at a bottom or do you think it is like in United States just it is still could be going down just have no feel for the situation?

David Lilley - Chairman and Chief Executive Officer

Well I am not an economist nor a speculator, and I think we deal with the market as we're given it. So we are reacting to our customers concern and we'll watch those closely and make sure we're aligned in our outputs as compared to their requirements. So one hopes for an improvement Bob but I think, we should plan for the worse as we indicated overall on a global basis, our customers are telling is hang on till 2010, you should get back to then.

Unidentified Analyst

Okay, thank you.

David Lilley - Chairman and Chief Executive Officer

Thank you.

Operator

We have a follow-up question from Chris Shaw with UBS.

Chris Shaw - UBS Securities

Hi, and so did you guys mentioned briefly, I am just curious as Dow, Rohm & Haas [ph] have they approached you since the deal talk about and maybe a magnify any fears you might have of increased pricing?

David Lilley - Chairman and Chief Executive Officer

Absolutely not, and we will be horrified if anybody came to us with a question like that in light of a potential acquisition. And we would record that conversation and dispatch it through the appropriate authorities.

Chris Shaw - UBS Securities

Even after the announcement deal?

David Lilley - Chairman and Chief Executive Officer

I will stand by my comment.

Chris Shaw - UBS Securities

Okay, bye thanks a lot.

Operator

We have no additional questions at this time. I would like to turn the conference back over to Ms. Allen.

Jodi Allen - Investor Relations

Thank you for your participation in today's call. And if anyone has any follow-up questions please give me a call directly at 973-357-3283. Thank you.

Operator

This concludes today's conference. We thank everyone for their participation. You may disconnect.

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Source: Cytec Industries, Inc. Q2 2008 Earnings Call Transcript
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