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Ashland Inc. (NYSE:ASH)

Q3 FY08 Earnings Call

July 24, 2008, 09:00 AM ET

Executives

Eric Boni - Director of IR

Lamar M. Chambers - VP, Controller

Samuel J. Mitchell Jr. - VP; President - Ashland Consumer Markets

James J. O'Brien - Chairman of the Board, CEO

J. Marvin Quin - CFO, Sr. VP

Analysts

Laurence Alexander - Jefferies & Co.

Jeffrey Zekauskas - J.P. Morgan

Michael Sison - Keybanc Capital Markets

Operator

Good day ladies and gentlemen and welcome to the Third Quarter 2008 Ashland Earnings Conference Call. My name is Eric and I will be your audio coordinator for today. At this time, all participants are in a listen-only mode. We will facilitate a question-and-answer session towards the end of the conference. [Operator instructions].

I would now like to turn your presentation over to Mr. Eric Boni, Director of Investor Relations for Ashland. Please proceed.

Eric Boni - Director of Investor Relations

Thank you, Eric. Good morning and welcome to Ashland's third quarter fiscal 2008 conference call and webcast. We released our third quarter results at 8'o clock Eastern Daylight Time today. These results are preliminary till we file our 10-Q in August. Our speakers here today are Jim O'Brien, Ashland's Chairman and Chief Executive Officer; Lamar Chambers, Senior Vice president and CFO and Sam Mitchell, President of Ashland Consumer Markets.

On slide two, we provide our cautionary language regarding forward-looking statements. Statements made during the course of this presentation that constitute forward-looking statements as that term is defined in relevant securities law. Ashland believes its expectations regarding its operating performance and the Hercules transaction are based on reasonable assumptions, but cannot assure that those expectations will be achieved. Therefore, any forward-looking statements may prove to be inaccurate. You will also see the mandatory additional information we must provide in connection with the proposed acquisition of Hercules.

Please turn to slide three. Before we get started, I will give you an outline of the call. First, we will review Ashland's overall results and then get into the specifics of our businesses, including a more in-depth review of Valvoline by Sam Mitchell. We'll then discuss our progress on cost structure initiatives and conclude our prepared remarks with an update on the Hercules transaction. After that we will take your questions.

Let's go to our third quarter highlights on slide four. Ashland's overall results for our 2008 third fiscal quarter were solid, with operating income increasing 19% on an apples-to-apples basis, versus the June 2007 quarter, which included certain key items I'll talk about shortly. In aggregate, Ashland's volume was down several percentage points and we experienced approximately $80 million of raw material cost increases during the quarter.

We will discuss our plans to recover these costs later in the presentation. In light of the difficult economic environment, we are encouraged by our performance in the quarter. Ashland's Performance Materials was most affected by these macro economic factors and reported a 44% decline in operating income. Valvoline's results were also affected by rapidly rising raw material costs, which outpaced price increases, leading to a 6% decline in operating income versus the year-ago quarter. On a sequential basis, Valvoline's operating income did improve over March quarter earnings, benefiting from the traditionally strong summer driving season.

Ashland Water Technologies improved its results for the June quarter, although they were enhanced by certain items that are unlikely to repeat going forward. We are encouraged by Ashland distribution's performance in the quarter and its continued focus on margin improvement led to a 70% increase in operating income versus the June 2007 quarter. The quarter descended also marked the third consecutive quarter in which distribution increased its income sequentially. It is particularly worth noting that we increased our EBITDA by 3% versus the year-ago quarter to $121 million. Also, our focus on working capital continues to show results. We achieved an additional 46 basis point reduction sequentially in our operating segment trade working capital as a percentage of sales excluding the effect of acquisitions.

Now, let's turn to the financial results on slide 5. Revenues increased 11% to $2.2 billion in the third quarter of 2008, driven by significant price increases versus the year-ago quarter, 4 percentage points of the increase were attributable to currency translation. Cost of sales increased at a slightly faster pace going up 12%. Gross profit dollars increased by $17 million or 5% although our gross profit percentage was down 90 basis points. Selling, general and administrative expenses grew 9% versus the 11% increase in sales, resulting in a 20 basis point reduction in SG&A as a percentage of sales. Approximately 5 percentage points of this increase were due to currency translation. We will discuss the increase in SG&A in more depth shortly. Our reported operating income declined 4% versus the year-ago quarter, but as I mentioned earlier, when key items in the June 2007 quarter are excluded, operating income increased 19%.

Please turn to slide 6 to see the key items affecting our operating income. This chart summarizes our operating income by segment versus the same quarter last year and shows the impact of key items on operating income. In 2007, each of our businesses was impacted to some degree by unusually large environmental reserve and employee benefit income adjustments. The yellow all other operating income line for 2007 therefore represents our underlying performance. While we also had these types of items in 2008 they were at historical levels, and do not warrant specific adjustment. And thus the all other operating income and operating income lines are identical. On a comparable basis all other operating income increased by $13.9 million or 19% versus the year-ago June quarter with a combined $15.2 million improvement in distribution and Water Technologies as well as a $12.2 million improvement in our unallocated and other line. More than offsetting the $12.8 million decline in performance materials. We will discuss the operating income performance of each of our businesses in detail later.

Let's move to slide 7 to look at Ashland's income bridge. Operating income declined by nearly $4 million to $86.8 million in the June 2008 quarter as compared with the year-ago quarter. Currency translation contributed positively to the quarter by $5.6 million. Volume had a $1.1 million positive impact to earnings as increases in the water and Valvoline businesses offset volume declines in Performance Materials and distribution.

Similarly, significant margin increases in distribution were offset by margin declines in our other businesses. SG&A increased by $10.4 million excluding currency impacts. Let's turn to slide 8 for more detail on the SG&A. Reported 2008 third quarter SG&A increased by $24 million versus the same prior-year-quarter on an as reported basis. $5 million of this increase was attributable to adjustments to incentive accruals in the Ashland distribution business. Additionally, certain portions of the environmental reserve and employee benefit adjustments noted on slide 6 were included in the SG&A line and totaled $18 million. When taken into account with the $13 million of currency translation, all other SG&A expenses declined by $12 million or about 5% versus the year-ago quarter.

Now please turn to slide 9 for a review of our preliminary earnings per share chart. Looking at this chart, you'll see that net interest and other financing income for the third quarter declined by $4 million. This primarily reflects lower interest rates on Ashland's cash and securities. Income taxes increased by $12 million giving us an effective tax rate of 29.4% in the June 2008 quarter versus 15% in the 2007 quarter. The tax rate for both periods included the net favorable effect of adjustments to the estimated annual tax expense. In the unusually low 15% effective tax rate in the year-ago quarter also reflected favorable developments with respect to settlements for certain tax matters.

Discontinued operations in both periods include net favorable adjustments to asbestos reserves, primarily to related insurance receivables of $6 million in 2008 and $16 million in 2007 as well as other smaller items. On a reported basis, our earnings per share from continuing operations amounted to $1.03 as compared with $1.35 in the year earlier quarter.

Let's go to slide 10 to see our EPS on an adjusted basis. When the previously mentioned key items are excluded from the prior period, our diluted earnings per share from continuing operations for the June 2008 quarter were $1.03 as compared with $1.18 in the June 2007 quarter.

Let's turn to slide 11 for a review of our cash flows. Ashland generated positive operating cash flows after capital expenditures at $75 million in the June 2008 quarter, an increase of $20 million or 36% versus the prior-year quarter. This brings total year-to-date cash generated to $216 million versus the use of cash of $94 million through nine months last year. This dramatic increase of more than $300 million is a direct result of our increased focus on working capital management throughout the company. EBITDA for the June 2008 quarter increased by $4 million or 3% over the year-ago quarter.

Please turn to slide 12 for a more in-depth look at our trade working capital. Our internal benchmark of operating segment trade working capital to sales decreased sequentially by nearly one-half of 1% of annualized sales in the June quarter, excluding the impact of working capital added through acquisitions. We continue to make progress on managing inventories, reducing them by an additional 61 basis points versus the end of the March quarter. All of our businesses contributed to this improvement with Water Technologies' especially noteworthy reduction of more than 350 basis points in one quarter. We are starting to realize a reduction in our accounts receivable as a percentage of sales in all of our businesses most notably in the Valvoline organization. However we have not achieved the hope for progress in increasing our payables as a percentage of sales. We are continuing to focus on ways to improve this metric. Overall, we are pleased with our progress and look forward to achieving further reductions in the working capital requirements of our businesses. Now I'd like to turn the presentation over to Lamar Chambers to discuss the performances of our businesses. Lamar?

Lamar M. Chambers - Vice President, Controller

Thank you Eric and good morning everyone. Let's turn to slide 13 to look at the results of our Ashland Performance Materials business. Volume per day declined 4% as compared with the year-ago quarter, including a greater than 10% reduction in volume in the Americas primarily in our composite polymers business. As you are well aware the US residential, construction and transportation markets continue to struggle, impacting volumes in our largest markets.

Sales of larger vehicles such as SUVs and pickup trucks, just proportionally impact Performance Materials particularly in composite polymers unit. The precipitous drop-off in large vehicle sales has had a real impact on our recent performance. That said, we continued to experience significant growth in Asia with a nearly 30% increase in volume versus the prior year. Asia now represents nearly 9% of Performance Materials total volume. We also continue to achieve some volume growth in Europe albeit at reduced levels, primarily the result of strong growth in our casting solutions unit.

Additionally, our premium business such as our Derakane and Hetron resins, which are sold into markets such as infrastructure and energy continues to generate strong margins and provide some underlying stability for profitability. Sales of operating revenues increased by 6% to $425 million as currency translation and price increases helped to offset reduced volume. The lag in achieving price increases is the primary cause of our reduction in gross profit percentage. We have also been targeting lower margin business to help recover some of the volume lost due to our customers reduced production, which is also contributing to the gross profit percentage reduction.

Selling, General and Administrative Expenses increased 5% versus the year-ago quarter [inaudible] an adjusted performing currency translation, SG&A increased by only approximately 1%, a direct result of severance charges related to our cost structure efficiency initiatives. Overall operating income fell by 44% primarily a result of reduced margins. Increases in casting solutions income were offset by significant reductions in our composite polymers unit.

Now let's go to slide 14 to review the components of our change in operating income for performance materials. Volume reductions accounted for roughly $6 million of the operating income decline in the quarter. Margin pressures in the quarter were more pronounced and accounted for $12 million of the decline in operating income as compared with the June 2007 quarter.

As raw material costs have increased we've only been able to recover approximately 80% of these increases thus far. However, we have announced price increases for July and August, but do not expect to fully recover the raw material increases until about the end of the September quarter. As a result of these factors and the normal seasonality of business we expect Performance Materials operating income to be down significantly versus the June 2008 quarter. We do however, expect some upside earnings potential from the significant cost structure improvements underway which we will discuss further in a few minutes.

Let's turn to slide 15 for a look at our distribution business. Distributions volume per day declined 5% versus a year-ago quarter. Note that this is the first quarter that we do not have an impact on the quarter-over-quarter comparison from the terminated Dow Plastics contract in North America. Meanwhile, sales increased by 12% to nearly $1.2 billion. Gross profit has significantly improved both on a percentage basis and in absolute dollars and was a primary contributor to the 70% improvement in operating income. While SG&A increased by 15% over 2007 quarter, as we noted previously the prior-year was unusually low due to adjustments to incentive accruals. Exploiting this adjustment with the effect of currency translation SG&A increased only 3%. Let's turn to distribution's income bridge on slide 16.

The margin improvement that you see here was broadbased with all of our US business units and distribution contributing to the increase. Let's take a look at the trends, in distribution's recent operating income performance as you can see on slide17. The June quarter represents the third consecutive quarter of operating income improvement and we have fully recovered from the impact of the terminated North American plastic supply contract. The business has demonstrated its ability to quickly recover product cost increases. Our new plastic process, which focuses on a more disciplined, centralized, price book approach to cost recovery is helping to drive these improvements. We are carrying on further improvements in this area to help us achieve our targeted 3% operating and income margins for distribution.

While we're recently pleased with distribution's results for the June quarter, considering the difficult market conditions, we recognized that there is more to do and continued to focus on improving this business' margins and reducing working capital requirements.

Distribution's fourth quarter performance will continue to be affected by weakness in North American industrial output. That said, we expect to significantly improve our results versus the weak fourth quarter last year. Although it is unlikely that we will achieve another sequential quarterly increase due primarily to seasonality.

With that let's turn to slide 18, and our Water Technologies business. Sales and operating revenues increased by 21% or approximately 9% excluding the impact of foreign currency translation and the transfer of certain sales from Performance Materials to Water Technologies. Water Technologies more than doubled operating income to $12.5 million in the June 2008 quarter, which benefited by $5 million from the completion of certain large sales contracts and from favorable adjustments to estimated liabilities. These items are not expected to repeat going forward. While SG&A was unfavorable by $8 million for the previous year quarter when adjusted for comparability SG&A increased by only one half of 1%. Please turn to slide 19 to look at the factors impacting Water Technologies' operating income. Continued strong organic revenue growth drove the operating income increase in the quarter. We are also starting to realize the benefits of our cost structure initiatives as SG&A had only a $1.5 million negative impact on the operating income comparison.

As you may recall in the second quarter SG&A expenses were a negative $9.4 million on the comparable income bridge. The business continues to fill raw material cost pressure particularly on its hydrocarbon-based inputs. Our price increases announced in June should fully offset raw material cost increases announced for the fourth quarter and we should be able to start increasing our gross profit percentage closer to historical levels. Please turn to slide 20 for an update on the action items from improved profitability that we talked about in our March quarter conference call. As you'll recall, we discussed five specific action items to improve the profitability in Water Technologies. We made good progress in the quarter, the first item was to fix certain operating issues concerning invoice accuracy and the sales of products manufactured in Germany and sold to customers and affiliates outside the European Union. We experienced an improvement in invoice accuracy during the quarter with a $600,000 expense reduction compared with the March quarter. We have also begun selling and sourcing products in local geographies where financially viable to reduce the impact on profitability of currency swings. We have experienced some improvement of pricing process and are currently implementing our June increases of 10% to 30% depending on the product line.

We reduced our cost structure by $8 million on an annualized run rate basis. This includes the termination of consulting arrangements related to our business redesign work, reductions in travel and entertainment and the elimination of 11 sales positions in the Americas through attrition. These positions will not be replaced. All of these cost structure reductions produced $1 million on additional income in the June quarter. We were able to renegotiate several raw material contracts during the quarter as well, which should produce an annualized run rate savings of approximately $3.5 million.

Finally, we have restructured the incentive plans for Water Technologies leadership to line with those of our other businesses. We continue to press forward with these action items and our commitment to making these improvements is not altered by the pending Hercules transaction.

With that, I will turn the proceedings over to Sam Mitchell, President of our Valvoline Business. Sam?

Samuel J. Mitchell Jr. - Vice President; President - Ashland Consumer Markets

Thank you, Lamar. I appreciate the opportunity to update everyone on the Valvoline Business.

Looking at slide 21, we increased lubricant volume by 1% over the prior-year quarter. We believe the overall market declined more than 4% during the same period. Our comparatively strong performance is a result of growth in our large national account business in our Do-It-For-Me or DIFM channel and strong marketing plan execution in our DIY channel. Sales and operating revenues have increased 5% primarily from price increases. Gross profit as a percent of sales declined by 120 basis points, the result of both higher selling price, and lower unit margin as raw material costs climb rapidly throughout the quarter. Business in both our DIY and DIFM installer channels experienced margin declines due to the lag effect of price increase implementation following the impact of cost increases. The other channel within our DIFM market is our Valvoline Instant Oil Change unit, which grew operating income by 3%. Altogether, our business has posted solid results in a challenging environment generating $26 million of operating income in the quarter, a 6% decline versus the prior year quarter.

Let's look at slide 22. The operating income decline in the quarter was a result of margin decreases, driven by the time lag between our seed of raw material cost increases and the full implementation of price increases into the marketplace. Meanwhile, our international business continues to be a solid contributor to results with operating income up 31% for the quarter and 113% for the first nine months.

Please turn to slide 23, for some insight into current market conditions. Valvoline continues to be greatly impacted by the volatile crude oil markets. Announced base oil cost increases between May and July have totaled approximately 36% on a product that sold for about $4 a gallon at the beginning of the period. Additives likewise have increased significantly and the market has announced two increases totaling 28% to take effect during the fourth quarter. Meanwhile supplies of base oil remained fairly tight, despite increases in global group two production as group one capacity closures have shifted demand to group two supplies. Against these cost issues, we are also experiencing lower demand on a short-term basis versus our long-term expectation of flat to slightly declining lubricant demand. Demand will likely remain weak in the calendar year 2009.

Please turn to slide 24. This chart shows the change in Valvoline's total US branded raw material cost through June 2008, as shown on the bottom solid red line. The top solid blue line is a change in net sales price, a gap between these two lines essentially represents our unit gross profit margin. The best portion of these lines represents our estimates for the next few months. The narrowing and winding of the gap between the two lines shows the impact on margins of raw material costs. During fiscal 2006, rapid run-ups in cost squeezed margins, while in fiscal 2007 our cost stabilized enabling our price increases to catch up with cost and leading to a record year. It is important to note that while the impact of raw material cost increases can be felt within weeks, it can take two to three months to fully implement price increases in some markets due to competitive pressures and promotional commitments.

Similar to 2006, we are experiencing the negative effects of this timing lag in the implementation of price increases in fiscal 2008. This will particularly affect our fourth quarter where you can see the sharp rise in cost is not fully recovered by pricing during the quarter. Specifically we have announced price increases for the US market in June and July, that will be effective with customers in August and September. We expect these increases should enable us to offset the cost increases allowing margins to return to more normalized levels during the early part of fiscal 2009.

All that said despite the negative impact we are projecting in the fourth quarter and the challenging market conditions, we have a strong brand and we're confident in our plans to deliver earnings growth in 2009. I'll now turn the call over to Jim O'Brien who will provide an update on cost structure initiatives. Jim?

James J. O'Brien - Chairman of the Board, Chief Executive Officer

Thanks Sam. You'll note on slide 25 that as we discussed this spring we're focused on achieving cost structure efficiency throughout Ashland. Our target was to reduce cost by $14 million by the end of fiscal 2008, on an annualized run rate basis and by $40 million by year-end fiscal 2009, also on a run rate basis. In addition, we announced that we're targeting another $25 million of year-end 2009 run-rate savings through changes in our business models in Performance Materials and Water Technologies.

We are significantly ahead of plan in achieving our run-rate annualized cost savings of $40 million. Through the June quarter, we've achieved run-rate savings of $22 million primarily in our Water Technologies and Performance Material businesses and we expect to have run-rate savings well in excess of $40 million by the beginning of the December quarter. I've asked Lamar to provide more detail on the proposed Hercules acquisition before we take your questions. So, Lamar?

Lamar M. Chambers - Vice President, Controller

Thank you Jim. As we've been now talking about the Hercules transactions... transaction we've heard a number of recurring questions. I hope to provide you with some of the answers in the next few slides. The chart on slide 26 provides the estimated sources and uses of funds for the Hercules transaction. We plan to utilize about $1.4 billion of senior credit facilities, $750 million of notes, $900 million dollars of cash on hand and $500 million of new Ashland stock to fund the transaction. The sources say, we'll presume, we'll continue to hold our $275 million of student loan auction rate securities. To the extent we are able to liquidate these securities, our need for debt financing will of course be reduced.

That said, when the transaction is complete we expect to add $2.4 billion to $2.5 billion of debt including $2.2 billion of new debt and $215 million of assumed debt from Hercules along with some or all of Hercules' relatively small amount of foreign debt. The $215 million represents 6.5% junior subordinated deferrable interest debentures due 2029. Hercules other debt is expected to be retired at closing. We expect the debt to trailing EBITDA ratio to be 3.2 to 3.3 times immediately upon close. You will know on the user side of the table that $172 million will be satisfied to retire a cross currency swap arrangement as Hercules has maintained.

We plan to pursue our options with these swaps and will consider maintaining some or all of them post closing but for purposes of conservatism we have assumed that we will use funds to close these instruments out at the time of closing. The current expected blended interest rate is 7.25% to 7.5%. Of course, the credit markets continue to move and rates will not be locked in until the syndication of the credit facilities is complete. For your modeling purposes, you may want to consider a range of 7.25% up to 8.25%.

Now let's take a look at additional details of the transaction economics on slide 27. The Hercules acquisition is expected to generate significant shareholder value based upon our estimated internal rate of return. When the final book evaluation for each asset acquired... while the final book valuation for each asset acquired often requires up to a year after closing to determine our preliminary analysis of the amount of the increase, annualized amortization and depreciation due to purchase accounting is approximately $120 million for the first several years and after the transaction.

Of course D&A will scale down after the useful life of each asset is surpassed. We are anticipating an asset write-up of amortizable intangible assets and property, plant and equipment of approximately $1.6 billion to $2.0 billion. Further details on the transaction are covered on slide 28. Based upon the debt levels that we showed on slide 26 and assuming weighted average interest rates of 7.25% to 8% or so, initial total gross interest expense is forecast to be $175 million to $200 million.

Ashland interest income will be of course substantially reduced since we will be using the large majority of the existing Ashland and Hercules cash for the acquisition. As a part of the transaction we will issue approximately 10.5 million new shares of Ashland common stock thus increasing Ashland's shares outstanding to approximately $75 million. Regarding an expected tax rate due to Hercules' foreign tax credit carryover, Ashland should benefit from a lower effective cash tax rate during the first five years or so following the acquisition. So simply, it should be less than the low 30s that we have provided as long-term guidance for Ashland's tax rate.

Now let's turn to slide 29 to discuss expected synergies and integration costs associated with the acquisition. We announced in our July 11 call regarding the Hercules acquisition that we expect $50 million of synergies to result from the transaction. In discussing synergies we're choosing to focus on those that we have direct visibility into at this time. Approximately 75% of the estimated $50 million of synergies that we have initially identified are in the area of general and administrative expenses. We included low potential revenue synergies in our figures. We expect to achieve at least 60% of the synergies on a run-rate basis by the end of the first year after closing of the transaction. We expect the integration team to uncover additional opportunities both on the revenue and saving sides as well as identify opportunities to accelerate the realization of synergies. In total, the integration team is targeting an additional $30 million to $70 million of synergies beyond our initial estimate.

Likely areas for these additional synergies would include efficiency opportunities within the commercial organization of the combined Hercules paper and Ashland water businesses, and additional supply chain savings. Revenue synergies are likely to be identified in several areas most notably selling the Ashland water products such as [inaudible] to paper companies with which Hercules already has a strong relationship. All of these savings are in addition to the $65 million of cost structure efficiencies from our existing businesses that Jim mentioned previously. So taken altogether we are targeting combined savings and synergies of $145 million to $185 million from Ashland and Hercules as compared with the recent individual performances.

Please turn to slide 30 for a discussion of the merger agreement and financing commitments. The merger agreement will sign July 10 and the merger agreement and financing commitment documents were filed with SEC on July 14. We have had a lot of questions about the financing help for Ashland. First, let me just emphasize that both Ashland and Hercules look forward to closing the transaction. However with regard to financing, the basic principle is if Ashland cannot obtain the funds, we cannot be required to close. We're very happy to be working with Banc of America and Scotiabank, two of our long-term relationship banks and obtaining the debt financing for the transaction. The debt commitments are in place until December 31. If closing were to occur after December 31, we wouldn't attempt to obtain financing on comparable terms first with these banks or if unavailable, from other sources. If we don't obtain financing, we don't have to close, but we would have to pay a $77.5 million reverse breakup fee and the agreement will terminate.

Ashland would have no other obligations or payments other than the reverse breakup fee. There are several standard conditions precedent to closing, which is shown on the slide. As you see, we'll need to declare effective the Form S-4 that Ashland will be filing. While we don't anticipate any issues we will closely monitor the progress and timing of this progress... this process. With respective to other [ph] trust approvals we do not believe we should have any issues. The portions of the business that even in the broader sense could be considered to overlap are very small and the reality is that Ashland Hercules are not competitors in the marketplace. The transaction does require a two-thirds approval from Hercules shareholders. As a standard there are material adverse change causes in OPEC. But there is not a general market out.

Let's turn to slide 31 to review the anticipated timing of the transaction. We will make our HSR filing within the next few days and plan to make the EU filing in mid-August. We will also have a Canadian filing, and are investigating several other jurisdictions, where a filing may be required. The plan to file the S4 with the SEC in early August anticipate that the SEC will complete its review by late September. We also are anticipating our trust reviews to be completed in the similar time frame.

We currently anticipate that the Hercules special shareholder meeting to vote on the transaction will occur in late October or early November with closing occurring five days following shareholder approval. Jim?

James J. O'Brien - Chairman of the Board, Chief Executive Officer

Thanks Lamar. I appreciate you going through the details of the Hercules transaction. I know that it's a fair amount of technicalities, but I also know that many of our investors and analysts are interested in these items. So, all that said let me be clear. We plan and we want to close this transaction, we look forward to the combination of Ash and Hercules and the new opportunities that it presents.

With that let's go to the next slide and we will take your questions on our third quarter performance or the transaction.

Question and Answer

Operator

[Operator Instructions]. Your first question comes from the line of Laurence Alexander with Jefferies. Please proceed.

Laurence Alexander - Jefferies & Co.

Good morning.

James J. O'Brien - Chairman of the Board, Chief Executive Officer

Good morning, Lawrence.

Laurence Alexander - Jefferies & Co.

I guess first of all on the water business, can you give a little bit more granularity on the sequential headwind that will be faced in Q4?

James J. O'Brien - Chairman of the Board, Chief Executive Officer

As we look at the fourth quarter, the primary focus has been on the pricing model. Again the prices into our customers and look at the segmentation so that we can get as much price as possible. So, we will continue to work that particular issue. As far as the redesign we will continue to execute the decisions that have been made around staffing the size of the business organization. All of that will hopefully be fairly complete through the quarter, and I do not want much to spill over into the new fiscal year that will start on October the 1st. So the headwinds as you saw in the business, the business is doing very well on their volumes, they are executing well at the customer sites, so I think the biggest challenge the business has is doing their pricing. I think they have a good process now and they have good visibility and the achievement of that and the management is taking control of that situation so that they can measure it and monitor and assure that we are getting that.

Laurence Alexander - Jefferies & Co.

And, I guess secondly with respect to Hercules assets, I think at the last conference call you discussed the core assets, but what's your view on the JV, the particularly fiber visions?

James J. O'Brien - Chairman of the Board, Chief Executive Officer

The fiber vision JV had its purpose and they are trying to achieve a certain result and I would... my discussions with Craig, I would support what they have done, and I would support their strategy going forward on how to resolve that.

Laurence Alexander - Jefferies & Co.

Okay. So there is no change in terms of the longer-term objectives?

James J. O'Brien - Chairman of the Board, Chief Executive Officer

No.

Laurence Alexander - Jefferies & Co.

Okay. And finally on distribution you've given the environment that we are in now what's... how aggressively do you think you can drive margin expansion in 2009, 2010?

James J. O'Brien - Chairman of the Board, Chief Executive Officer

The environment that is out there today, as far as pricing is fairly robust, let's say, everybody understands that the crude situation is strong and volatile and that the petrochemical producers and especially the companies that are selling commodities are under great stress and that they are accepting to a great degree the cost increases that are coming through. The challenge next quarter will be as crude kind of settles out not only you recover the actual cost but can you recover more margin and that is what they have to work on the next quarter and I would anticipate that we'll continue to raise prices and the challenge will be to get that additional margin above the cost to get a margin that's more appropriate for returns of the business. And, we think that that's going to take some stability in the marketplace to achieve that and but in the meantime, we plan to add a minimum and get the cost through so that we recover the total cost of the inputs.

Laurence Alexander - Jefferies & Co.

Thank you.

Eric Boni - Director of Investor Relations

Thanks, Laurence.

Operator

Your next question comes from the line of Jeff Zekauskas with J.P. Morgan. Please proceed.

Jeffrey Zekauskas - J.P. Morgan

Hi, good morning.

Eric Boni - Director of Investor Relations

Good morning, Jeff.

Jeffrey Zekauskas - J.P. Morgan

In your corporate other income, I think the numbers for the first three quarters go something like this, positive 3, positive 1 and then positive 10 for this quarter. How did you do that and what's the right ongoing number?

J. Marvin Quin - Chief Financial Officer, Senior Vice President

That's a somewhat difficult portion of our segment breakdown to predict as you might imagine being the unallocated category of our corporate expense that includes a variety of costs related to matters like incentive approvals, legacy environmental issues, all of our... a host of our support functions so we do have certainly a challenge predicting that from period to period, our basic philosophy is to try to achieve breakeven level results through the allocations that we charge to our commercial operating segments.

If we look at the... at the quarter we can see that SG&A overall for Ashland was down about $12 million and most of that difference did show up in our unallocated and other line and that difference in the quarter-over-quarter comparison was a combination of reduced resource group expenses where we have been able to trim back our ongoing costs of supporting the businesses through [inaudible] and staffing reductions we've been focusing on over the last year or so frankly and we had some unusually favorable effects from lower incentive compensation and deferred compensation costs in the quarter. So looking forward, we would expect that line to be more in the range of zero which is our philosophy.

Jeffrey Zekauskas - J.P. Morgan

Secondly, the Water business also has had income volatility and that I think in Q1, 5 million and 2 it was negative 2 and this quarter it was positive 12? What's sort of the normal run rate right now of the Water business going forward?

J. Marvin Quin - Chief Financial Officer, Senior Vice President

As we mentioned in the discussion earlier, we believe about 5 million of the 12 million in earnings for the quarter for Water was somewhat non-recurring items, contracts that got closed out that had normal effect, positive effect on the earnings plus some adjustments to accruals for various liabilities when we add those items up, about 5 million of that 12 would be on the abnormal levels of earnings, so I think you can take that off the top. In the other direction though as Jim mentioned in his discussion around our cost structure and the expense reduction initiatives we are seeing a significant progress made quickly in that business and we believe we're at about an $8 million run rate on those expense reduction initiatives for the Water business itself. So that's kind of counterbalancing that looking forward.

James J. O'Brien - Chairman of the Board, Chief Executive Officer

Jeff, I think we have kind of turned the corner on our Water business as far as all the initiatives that we've been talking about for sometime. In the second quarter we had production issues, because of how we handle polyacrylamide being produced in Europe and being shipped around the world. We changed our processes for a sourcing from various parts, we've arranged other contracts, I think we have gotten that fairly settled out, so we are not taking the currency as a moving production out of Europe through the rest of the markets that we serve. So that was a big improvement that really hurt us in the second quarter. So that's been fixed, the other was our pricing issue. We have been really focusing on our pricing processes and getting our pricing right and I think this quarter is the first one that we can fully accurately report that we've actually made progress and starting to show up in our results.

So I think that's a change that should be sustainable going forward and as the margins talked about, we are just now getting some benefit of the restructuring and cost reductions, which will continue to be ongoing but we've already made some changes there and that's starting to show up. So in our Water business, I think, the first time in some time I can report that we have positive momentum built in this business and I certainly hadn't felt that way for sometime, I know that you personally have challenged us in our reporting on that but I think that that's the big change we actually have some momentum built in the business and so we are on pricing, cost structure and getting our production right around the world as far as currency issues.

Jeffrey Zekauskas - J.P. Morgan

That's helpful and just lastly, it sounds like the fourth quarter is a little... is weaker than third on a sequential basis. Is the EBIT likely to look more like the first quarter or the second quarter, sort of what's the order of magnitude of weakness you expect in Q4?

James J. O'Brien - Chairman of the Board, Chief Executive Officer

I think the guidance we're trying to give you in our talk and the language we've used, is the third quarter reflects the price increases and the changes in the business that reflected crude until the last big run-up in the last really four or five weeks. So what we're facing through the fourth quarter is the magnitude of pricing that hasn't been taken to the marketplace is going to take as probably two to three months to fully recover that. So what we're trying to communicate in the fourth quarter is that's what's going to take place. So if we had a bigger choice one of the orders I would take the first quarter.

Jeffrey Zekauskas - J.P. Morgan

Okay. Thank you very much.

Operator

Your next question comes from the line of Robert Felix with [inaudible]. Please proceed.

Unidentified Analyst

Hi, guys. Just a couple of quick questions. First, I wanted to follow up on the Water business. You have talked about the near-term goal of getting that business to an 8% EBIT margin and you just mentioned that you think you have turned a quarter in terms of some of the initiatives. What kind of underlying run rate EBIT margin you think that business is at?

James J. O'Brien - Chairman of the Board, Chief Executive Officer

Today? Well, I think it's constantly changing month-to-month. So I think as we continue to get our pricing up, continue to get our cost down. I am hopeful that we're going to see continued improvement, what we've communicated in presentations in the last several quarters and months is our initial objective is to get it to 8% and that would be a threshold that I would hope that on a run rate basis we would be able to achieve by the end of this year EBIT. Then the forecast would be as we continue to improve that business and I am hopeful that once we combine it with Hercules business here in... sometime in the fourth calendar quarter, we should improve that even more, as it was actually additional change that we made to the business with the size and scale that Hercules brings and I will leave that up to Paul Raymond as he gets into it after we close in and he starts setting objectives for him going forward, as far as the integration team I would expect more.

So a minimum of eight, and I think it goes to double-digit into the future. But yet we still like to have I think the initiatives in the combination with Hercules to achieve that. But I think it's something that can be achieved, because it is cost reduction, it's organization, and it's positioning and I think we'll have the pricing model in place to understand how to price and get price. So I am much more encouraged today than I have been for some time.

Unidentified Analyst

I guess what I am wondering in light of the momentum you see, you are building there, should we expect the path to 8%, to be linear or should we expect a step change in the margin structure in the coming quarters?

James J. O'Brien - Chairman of the Board, Chief Executive Officer

I think what you see is kind of a linear movement on the cost improvement. Is that something that is taking place month-to-month. But, on the pricing, I think pricing is more of a step change because, pricing is something you get, it's a lift and you get it pretty much all in the same period. So, I would see pricing as a step change move and cost more of a linear improvement.

Unidentified Analyst

So, opportunity as we look to the next fiscal year to see some kind of larger step change kind of improvement in margins?

James J. O'Brien - Chairman of the Board, Chief Executive Officer

That would be my expectation. Yes.

Unidentified Analyst

Okay. And then I guess looking over to Valvoline, in light of the weak end-market demand there, I was hoping you can delve a little deeper into competitive support, or competitive activity in the marketplace around pricing?

James J. O'Brien - Chairman of the Board, Chief Executive Officer

Yeah, I will speak first and then I will turn it over to Sam. He can give you more detail, but the thing that's interesting about that market, it's been a market that's been declining for the last 15 years, it is accelerated through periods like this as people start changing their behaviors, or a number of oil changes, but it shifts between markets, it goes from DIFM to DIY, back to the DIFM. And you also have weakness in several of the players, which are losing share. And as Sam, pointed out we gained 1% growth in a market that we believe declined by 4. So Sam won't say this but I will, but I fully expect them to maintain their volumes through this period, because they can take it from others and they have demonstrated it is that they have achieved that, so I have confidence they will continue to proceed. So with that let Sam give the details how he is going to do that. So Sam, you can give some description how to do that?

Samuel J. Mitchell Jr. - Vice President; President - Ashland Consumer Markets

Just say a couple more comments in the marketplace, certainly the market that Jim spoke of is declining, is the Do-It-Yourself market as consumers gradually shift over to the Do-It-For-Me market year after year, so we see that relatively good pricing discipline in the marketplace, competitors have been passing few price increases relative to cost, not so much including margin but definitely recovering cost but it's a very competitive market as some of the weaker brands try to salvage their business so there is quite a bit of promotional spend to be effective in growing the business and maintaining our business in a declining market and we have got to keep a close eye on the promotional expense there and the promotional support for the brand and I'm really pleased with our progress. They're working with our key customers and continuing to drive that business. On the Do-It-For-Me side of the marketplace there is a broader range of competitors, again fairly good price discipline as far as recovering costs difficult to recover margins.

The Do-It-For-Me market has been a relatively flat market over time, a little bit of increase over time too as we see that shift from DIY to Do-It-For-Me side. In this marketplace so we do believe it's declining that the 2008 market, we're seeing some pretty significant declines particularly with car dealers as car dealers have been selling fewer cars, they have also seen less traffic in their base so that's definitely impacted their market, a number of other installers that we provide product to and we track closely have certainly reported weaknesses so as we attract the Do-It-For-Me market it's largely driven by... the overall demand is driven by how much people drive and we have seen reports from Department of Transportation that with higher gas prices that people have cut back on miles driven in a 3% to 4% range. So we do expect that to continue to 2008 and to 2009 but we believe that's more of a short-term effect as consumers adjust to higher gas prices and we would expect longer term that DIFM market to stabilize.

Unidentified Analyst

So it doesn't tell like if I am understanding correctly that you think there is in light of the weak end-market demand there is any change in the time frame in which you would normally close your price cost gap?

Samuel J. Mitchell Jr. - Vice President; President - Ashland Consumer Markets

It's been pretty consistent in our work with both retailers in the DIY market and our distributors and installer customers in the Do-It-For-Me market that that time frame for implementing price increase has been pretty consistent.

Unidentified Analyst

Okay, and then I guess lastly Jim, I was hoping you can give us an update or progress report on how your SAP implementation is going. How that's progressed sequentially?

James J. O'Brien - Chairman of the Board, Chief Executive Officer

Sure, the SAP project for the most part to the operations is complete. We just launched China last month and they came through that very well, their inventories were off, I think $2.10 and the receivables off $1.10 and they took a collection to pay the company back because of their culture they didn't want to have any variance although that was kind of interesting. So they did a great job well so the operations are through it. And what we are starting to see is benefit now through this work, it's really helping us with our pricing models because without this... I think one instance across the world SAP we would have a much more difficult time getting our pricing through and more importantly, understanding what we're getting, so I think that's been a huge benefit by having it also the working capital change that we have experienced this year has been I think helped by having the information systems that we have in place now that we get much more transparency on a daily basis, it's managed more on a daily basis. So, we are starting to see, I think benefit in actual results coming back there. So, it was a big investment and one I think is now starting to pay off for us in how we managed the company. So it's behind us and now we are starting to use it to our benefit.

Unidentified Analyst

All right, great, thanks for taking my questions and good luck in the fourth.

James J. O'Brien - Chairman of the Board, Chief Executive Officer

Thank you.

Operator

Your next question comes from the line of Michael Sison with Keybanc. Please proceed.

Michael Sison - Keybanc Capital Markets

Hi good morning guys.

James J. O'Brien - Chairman of the Board, Chief Executive Officer

Good morning Mike.

Michael Sison - Keybanc Capital Markets

In terms of the fourth quarter, the Delta between what might occur versus the third and the fourth in terms of operating income sounds like it's going to be down obviously, is the Delta largely going to be the squeeze in raw materials?

J. Marvin Quin - Chief Financial Officer, Senior Vice President

The Delta is specifically just a timing that it takes... it takes such a large chunk of cost increase and move it through the market. So the decrease that we're going to experience is not because of any other particular change in the market. It's just the process that it takes to get our customers to accept the price... to take the price and then to start paying us at that level.

Michael Sison - Keybanc Capital Markets

So, the Delta will come back in the first quarter?

J. Marvin Quin - Chief Financial Officer, Senior Vice President

That's right. So the whole point is, I think what the third quarter demonstrated is that we do get it. And it does show up in your earnings and it does show up in your performance but everybody has talked about this, it's almost old news now. This slug of cost everybody announced 3 or 4 weeks ago but the fourth quarter is going to be the time frame by which you have to actually execute it and what we're trying to communicate is that we will get it, we are confident we are going to get it because the pricing is going through, it's being supported, all that is not the difficulty, it's just the time lag of getting it in, getting the price and having it show up on your books. So, as you look at it month to month, it will get better as each week goes by but it's going to be pretty ugly and in the first couple of months of that quarter because you are not getting it in those months.

Michael Sison - Keybanc Capital Markets

And for the fourth quarter do you have a number or sort of a sense that you can share with us in terms of what the cost you have to recover is in total?

James J. O'Brien - Chairman of the Board, Chief Executive Officer

In total? Maybe Eric has.

Eric Boni - Director of Investor Relations

As we look at what happened in the third quarter, we talked about the raw material increases of roughly $80 million or so that we... that came through and as we look at this quarter and certainly oil has started to come up a little bit and want to see exactly how that impacts some of the potentially announced increases in August and September. But they are certainly; only to the macro level seems to be some momentum, which would suggest a number would not be that order of magnitude for the fourth quarter.

Michael Sison - Keybanc Capital Markets

They would not be as big?

Eric Boni - Director of Investor Relations

They would not be as big as [inaudible].

Michael Sison - Keybanc Capital Markets

I got you, okay. Then Sam, I am curious the... you are certainly outperforming the market in Valvoline on a volume basis, congrats there. When I take a look at 2006, when you had a difficult year, it was largely due to the inability to get pricing and the margins for the industry sort of got squeezed and I wonder if your market share gains might cause backlash, if you will and maybe just you can sort of answer it, is profitability really driven by the volumes or is it really driven by sort of the margins out there that the industry can attain?

James J. O'Brien - Chairman of the Board, Chief Executive Officer

Mike, the big differences in our profitability in 2008 versus 2006 has a lot to do with the work that we have done on our cost structure, we have driven a lot of supply chain efficiency and improved our cost structure quite a bit. The other big differences in our Valvoline Instant Oil Change, which was really struggling in 2006, the profits are many times greater than what they were in 2006 in the current environment. That business continues to grow for us as we report on a monthly basis. The international business is also performing much higher and so our portfolio businesses is just a lot stronger than it was in 2006 and then I am also confident that as I at look at our core business in the U.S. business with DIY retailers and independent installers that we're making solid improvements in that business. But we still have a lot of opportunities to continue to improve that business in the years ahead.

Michael Sison - Keybanc Capital Markets

So the business is certainly better on a structural basis than it was back than allowing you to get the better profitability, near term.

James J. O'Brien - Chairman of the Board, Chief Executive Officer

Yes, much better and that's why we're confident as we get these price increases through that we'll be in good shape as we start a new fiscal year and really expect to continue to grow the business.

Michael Sison - Keybanc Capital Markets

Okay, great. Thanks, guys.

Eric Boni - Director of Investor Relations

We have time for one more call.

Operator

Your next question comes from the line of [inaudible]. Please proceed.

Unidentified Analyst

Just a couple of quick question from me. In terms of looking at fiscal 2009 by your different businesses, where would you expect terms like in Water Technologies is probably where you have the greatest opportunity to expand margins. But, I would just look year-over-year, where would you say you would have the most difficulty in raising margins year-over-year?

Lamar M. Chambers - Vice President, Controller

I would say that the areas that we will have probably the best chance will be in our distribution business, our water business, and I think Valvoline continues to perform as it is. Probably the business that has even most difficulty, because it's been probably the biggest impact volume wise has been our composite business. I would say that that's going to require us to probably focus more and more internationally both in Europe and Asia, because as you look at the U.S. marketplace I don't foresee any recovery there in the near-term in the marine market or the automotive market or in the housing market. So, for that business to perform and get stronger, we are going to really focus on our European business and Asian business and put broader objectives there in investments in those areas.

Unidentified Analyst

And then one other question about the deal and if there are issues where you are not able to close the deal by year-end. I think you said you would need to try to secure similar financing, and I think if that's Ashland's discretion as to how similar the financing needs to be, is that the case?

James J. O'Brien - Chairman of the Board, Chief Executive Officer

Yes. I mean that was the whole purpose of that particular clause was to give us the flexibility to find financing that we believe was comparable and that we would be able to run our returns off of and give our shareholders the type of returns long-term based on how we would finance it initially.

Unidentified Analyst

Okay. Thank you.

Eric Boni - Director of Investor Relations

Well, thanks everyone for your interest and we look forward to speaking with you soon. Bye.

Operator

Thank you for your participation in today's conference. This concludes our presentation. You may now disconnect and have a good day.

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Source: Ashland, Inc.F3Q08 (Qtr. End 06/30/08) Earnings Call Transcript
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