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Innophos Holdings, Inc. (NASDAQ:IPHS)

Q2 2008 Earnings Call Transcript

August 1, 2008 10:00 am ET

Executives

Bill Farran – VP and General Counsel

Randy Gress – CEO

Richard Heyse – CFO

Analysts

Jeff Zekauskas – JPMorgan

Mark Connelly – Credit Suisse

Edward Yang – Oppenheimer

Christopher Butler – Sidoti & Co.

Chris Shaw – UBS

Arieh Coll – Eaton Vance

Donald Besser – Manchester Management Company

Alan Rosenberg [ph] – Spectrum Investments

Operator

Good day, ladies and gentlemen, and welcome to the Innophos Second Quarter Results Conference Call. My name is Caressa and I'll be your coordinator for today. At this time, all participants are in listen-only mode. We will be facilitating a question-and-answer session towards the end of this call. (Operator instructions) I will now like to turn the presentation over to your host for today's call, Mr. Bill Farran, General Counsel. Please proceed.

Bill Farran

Thanks for joining us today for the Innophos Holdings, Inc. conference call to discuss second quarter 2008 results. Conducting the call today are Randy Gress, Chief Executive Officer, and Richard Heyse, Chief Financial Officer.

During the course of this call, management may reiterate forward-looking statements made in our July 31 press release regarding financial performance and future events. We will attempt to identify these statements by use of words, such as expect, believe, anticipate, intend and other words that denote future events. These forward-looking statements are subject to material risks and uncertainties that could cause actual results to differ materially from those in the forward-looking statements. We caution you to consider the important risk factors that could cause actual results to differ from those in the forward-looking statements as contained in this conference call and in our earnings reports and filings we make with the SEC.

We will make a replay of this conference call available for a limited time over the telephone at the number set forth in our press release and via a webcast available on the Company website. In addition, please note that the date of this conference call is August 1, 2008. Any forward-looking statements we make today are based on assumptions that we believe to be reasonable as of this date and we undertake no obligation to update these statements as a result of future events. We also note that our release of factual business and forward-looking information in this call should not be construed as an offer to sell or the solicitation of an offer to buy any securities of Innophos.

Lastly, this conference call is the property of Innophos and any recording, reproduction or rebroadcast of this conference call without the express written permission of Innophos is strictly prohibited.

Now, I'd like to turn the call over to Randy Gress, CEO of Innophos. Randy?

Randy Gress

Thanks, Bill. Good morning, everyone. I would like to update you on our extremely successful second quarter and the issues that have played a role in our results. Then, Richard Heyse will discuss highlights of the quarter. I will then give you a brief update on our outlook for the rest of the year and into 2009. After closing remarks, we will take questions.

In our first quarter conference call, we said that product price increases in excess of cost increases were going to show up in our results. In the second quarter, as expected, that effect was realized. Innophos, therefore, produced outstanding financial results in the second quarter, which included revenues of $264 million, operating income of $90 million, net income of $59.3 million and, most importantly, earnings of $2.74 per share. We attained these outstanding results by focusing on achieving full value for our specialty phosphate products in a fast-moving market environment. In the second quarter, we accelerated our implementation of price increases and got further ahead of raw material cost increases.

These are unusual times for our industry, but we are continuing to strive to deliver what the specialty phosphate business demands – excellent customer service, high quality product supply, and improved efficiency and supply chain strength for our customers. Remember that unlike the agricultural markets, our products are mainly sold in consumer, non-discretionary businesses with stable demand. This was definitely the case in our Specialty Salts and Specialty Acids business, where market demand remained strong and our efforts to grow the business were again successful during the second quarter. And in Mexico, where we were able to achieve the great majority of our targeted price increases.

We believe that global supply continued to tighten during the second quarter, especially phosphate applications continued to compete with phosphate fertilizers for key raw materials. And we do not expect that Chinese suppliers, due to anti-dumping duties and internal factors, will be significantly impacting the U.S. markets in the near term.

We have seen some limited reformulation in detergents using STPP, but our overall customer demand together with our growth initiatives for specialty salts has been strong.

Spot market prices for sulfur, phosphate rock, and sulfuric acid continued to increase in the second quarter for reasons, which I believe, you are already aware – robust grain demand and prices, international demand for higher food crop yields and for biofuels, and continuing strong demand for metals. For our entire basket of key raw materials, we expect that our long-term raw material supply contracts will continue to buffer us through the end of 2009. And to the extent we can, we will continue to raise prices ahead of raw material cost increases. We implemented a price increase in June and we already announced another effective today, which we expect to be fully realized by the end of the fourth quarter 2008.

Many of our investors have expressed concern whether we can achieve the kinds of product price increases necessary to cover such unprecedented levels of worldwide raw material cost movements. In the first quarter of 2008, we achieved a 30% price increase over the first quarter of 2007 levels. The year-over-year price increase we achieved in the second quarter was 83%, excluding the pricing realized that was retroactive to the first quarter shipments. By the fourth quarter, we are targeting this amount to reach at least 120%. These figures clearly demonstrate we are accelerating our progress on the pricing front. Assuming that no significant demand destruction occurs in our markets, which is what we have observed so far, we believe that Innophos will continue to take the full benefit of higher product prices ahead of actual raw materials price increases to our bottom line, which will result in continued strong earnings.

I should also point out that in the second quarter 2008, our Mexican business received, as expected, our full allotment from our phosphate rock supplier, OCP. They have been a reliable supplier to Innophos and we expect them to continue in this tradition. Those of you who have heard us speak about our phosphate rock contract with OCP know that there has been no change in our situation. Our assumptions concerning the impact the phosphate rock, phosphoric acid, sulfur and sulfuric acid cost increases have been clearly communicated in our disclosures.

Our phosphate rock supply agreement, along with our other long-term raw material supply agreements, have buffered us from rapidly rising raw material costs in 2008, a trend we expect will continue in 2009. Prior to 2008, these contracts did not provide any significant material buffering effect due to the relatively stable market prices for phosphate rock and sulfur.

Assuming 2009 raw material markets are stable, we expect the most likely case is that we will return to a more neutral footing on raw material costs in 2010. While things are moving fast in our markets, we are keeping our focus on what this period of greater profitability will enable us to put in place for the future – developing greater production efficiency and manufacturing flexibility, developing proprietary products with growth potential, all of which we have talked about with you before revenues and prices accelerated so rapidly.

We are now in a stronger position where we can consider the best way to invest in long-term manufacturing capability to make our operations more flexible and ready to ship production and sales to the mix that offers the greatest value in the near and long term. We are also estimating where future demand will be strongest and are investing appropriately. We expect to be more specific about those investments and our growth plans in general during our third quarter conference call. For example, we have recently invested to de-bottleneck our sodium hexametaphosphate, or SHMP, and tricalcium phosphate, or TCP, specialty phosphate salt plants.

We have also recently made investments in our Canadian facilities to expand our food-grade phosphates production and reduce our dependence on the U.S. technical grade STPP market. As a result, you saw during the quarter that we grew our Specialty Salts and Specialty Acids business.

I would also like to remind you that before the current flare up in raw material prices took place, our margins were healthy and we had a stable cash flow business dominated by consumer non-discretionary end markets that benefit from stable, but rising demand. Going forward, we are going to run our business in a way that capitalizes on our technical expertise and customer relationships that we have developed over many years, leveraging our strengths, as we strive to pursue the most viable long-term sources of growth.

Now, I would like to turn the floor over to Richard to give some highlights of the quarter's results.

Richard Heyse

Thanks, Randy. We again produced outstanding financial results with improved pricing across the board in all product lines and geographies. Selling price increases had a positive impact on revenue of 87.7% or $133 million. Included in these price increases were $6.6 million of revenue for second quarter pricing settlements that were retroactive to the first quarter. Volume and mix impacts upon revenue had a negative impact of 13.9% or $21.1 million, and occurred primarily in our STPP and other products, as Randy mentioned.

Purified Phosphoric Acid experienced a year-over-year volume decrease that was partially attributable to the planned outage at our Geismar, Louisiana acid purification plant. Finally, Specialty Salts and Specialty Acid volumes increased due to our focus on these products.

Innophos' operating income improved to $90 million versus $13.3 million in the same quarter last year. This was primarily due to the favorable pricing as we've discussed. Net income for the second quarter was $59.3 million, an improvement of $64.5 million over second quarter 2007 results of a net loss of $5.2 million. Our cash position at the end of the second quarter was $52.6 million. We were able to decrease net debt in the quarter by $45 million or 12%.

We also paid down the remaining $10 million balance on our revolving credit line in July. We expect to continue to increasing our cash balance in the third quarter. Our goal is to accumulate the cash that will be required to handle our anticipated first quarter 2009 working capital build as our raw material prices rise and mandatory bank debt free cash flow (inaudible). We anticipate limited possible voluntary debt payment in the fourth quarter.

Based on our expected financial performance and outstanding cash flow, we expect that we should no longer be categorized as a highly leveraged company as of the fourth quarter of 2008.

During the second quarter, we successfully completed a secondary offering of 4.6 million shares for Bain Capital. This offering went very smoothly and required only a three-day road show to fully subscribe and price. The offering has had the expected positive impact on liquidity with current typical daily trading volumes more than double first quarter levels.

We are making excellent progress in positioning ourselves for the current dynamic environment. We estimate that our raw material costs will increase relative to fourth quarter 2007 cost structure on an annualized basis, between 75% and 85% of 2007 sales or $435 million to $495 million per year by the second quarter of 2009. With the product price increases that are currently implemented or announced, our price increases are expected to increase revenues relative to our year-end 2007 levels on an annualized basis to between 120% and 130% of 2007 annual sales, or by $695 million to $755 million on an annual basis, by the fourth quarter of 2008.

Based on the factors we have discussed, particularly our success in pricing actions, and expectation that our long-term raw material contracts will continue to buffer us in 2009, we are targeting to maintain our financial performance at or near second quarter levels throughout the remainder of 2008 and during 2009. This target assumes demand and mix remains relatively stable through 2008 and 2009.

I will now turn the call back to Randy for the comments on 2008 and 2009 outlook and closing remarks.

Randy Gress

Thanks, Richard. We have told you over the past several quarters that we were responding positively to the dramatic raw materials cost changes in our marketplace and rapidly changing supply-demand dynamics. I believe you are seeing ample evidence of our success in our second quarter results. As long as demand remains stable, we will continue to work toward gaining full value for our products, while simultaneously strengthening our position in the market. As Richard mentioned, we are targeting to maintain Innophos' revenues, operating income, and cash flow at second quarter levels through the remainder of 2008 and during 2009, as we continue to see the momentum of our price increases more than offset our cost increases.

In addition, we want to expand our pharma and food grade phosphates businesses and continue to broaden the markets we serve through geographic expansion. Finally, we will continue to make improvements in our supply chain capability in all of our operations.

In closing, I want to take a moment to thank all of our employees who did an incredible job this quarter responding to the unprecedented business conditions. It is thanks to their hard work and dedication that we have achieved record results.

I would now like to open the floor up for questions. Operator?

Question-and-Answer Session

Operator

(Operator instructions) Your first question comes from the line of Jeff Zekauskas from JPMorgan. Please proceed.

Jeff Zekauskas – JP Morgan

Hi, good morning. How are you?

Richard Heyse

Good morning, Jeff.

Randy Gress

Good morning, Jeff.

Jeff Zekauskas – JP Morgan

A few questions. At the beginning of July, management or upper management sold Innophos shares. That is – if you look at sort of the top managers, it wasn't a tremendous amount, but it was some. Why did you do that?

Randy Gress

Yes. Go ahead, Richard, please.

Richard Heyse

Yes, I think, I can't speak for particular managers, but I think some of the managers, like myself, I have financial planners and we sat down and put in financial plans. And we're just following through with those plans.

Jeff Zekauskas – JP Morgan

Were these 10b-5 plans?

Richard Heyse

Yes, yes. So–

Jeff Zekauskas – JP Morgan

So, these were 10b-5 sells?

Richard Heyse

Yes.

Randy Gress

Yes.

Jeff Zekauskas – JP Morgan

Okay.

Richard Heyse

And also, there are some sales that we have restricted stock that's vesting if people have sale plans that sell enough shares to cover their taxes as they vest.

Jeff Zekauskas – JP Morgan

Okay. Second question is, given that your rock contract with your supplier in Mexico sets the beginning of the year and in your relationship in the United States, I think, there's probably a similar structure with your partner. Is it the case that your rock prices go up during the year apart from the resetting of those contracts?

Richard Heyse

I think, there are times we might buy spot rock and that would be whatever at the prevailing market prices are, but otherwise, again, we would describe these raw material contracts have factors at both annual reset and quarterly resets. And the annual resets are the predominant one.

Jeff Zekauskas – JP Morgan

So, much of the raw material price inflation you're experiencing this year is really from sulfur and sulfuric acid then?

Richard Heyse

During the quarters, but clearly our rock price – our prices went up January 1st.

Jeff Zekauskas – JP Morgan

Yes, yes.

Richard Heyse

And, I think that's the disclosure we make where on the amount of cost increase we expect by the second quarter of 2009, that's why we went the extra yard and broke it into how much of that is occurring in the current year or that would to be in place by December 31st versus how much of that cost increase will occur next year. And that's not a required disclosure, but we thought that would be helpful to break apart so people could see how our – how those increases are expected to fall out.

Jeff Zekauskas – JP Morgan

In many specialty sectors, such as water treatment chemicals, where there's a very good product and there's a service element, it's very, very hard for companies to achieve price increases rapidly whereas you've obviously achieved a tremendous amount. What is it about your business that allows for such rapid price increase over a short period of time?

Randy Gress

Yes, Jeff, I think, there's a number of drivers there. One is us pushing hard to get the full value and use and the applications within the different markets. The other is just some of the overall supply and demand on a global basis. We've talked about how some of the demand within the fertilizer side impacts some of the raw materials for the usage within the specialty phosphates area. There's also been some impact, I think, from the anti-dumping success and the withdrawal of China from the markets. That being not just to the anti-dumping, but also with the barriers for imports due to the exchange rate changes as well as the higher freight cost. And we didn't give an overall price guarantee this year.

Jeff Zekauskas – JP Morgan

Okay. I have a few more questions, so I'll get back in the queue. Thank you very much.

Randy Gress

Okay, thanks, Jeff.

Operator

Your next question comes from the line of Mark Connelly from Credit Suisse. Please proceed.

Richard Heyse

Hey, Mark.

Mark Connelly – Credit Suisse

Thank you, just two questions. First, the volume mix changes in STPP have been negative, I think, for the last four quarters and Mexico for much of that, too. With those numbers running negatives to such an extent, there's obviously a material impact in the kind of business you're doing down there. Should we be expecting more changes? Or do you think this has run its course? So, that's my first question. And the second is a little more big picture. The original investment thesis in Innophos was a stable cash generator, able to pay down its debts on the dividend, that sort of thing. And one of the – one of the challenges at the IPO was a question about how well Innophos would be able to participate in some of the global growth opportunities. Obviously, all of that's out the window with the kind of numbers and cash flow that you're generating now. So, is – should we be looking at Innophos now as a global growth story?

Randy Gress

Richard, do you want to handle the first one on the STPP mix?

Richard Heyse

Sure. I think, one of the notes we have in our press release – a big part of the year-over-year volume mix impact in STPP, technical STPP and other products is simply, we had a very large order for our co-product fertilizer for the GTSP that was shipped in early July. And so, we built inventory in May and June. I think, it's probably one of the largest shipments we've ever made or orders we've ever had. So, that's the timing. And we have timing and choppiness in that product consistently. Also, on the technical STPP, as Randy mentioned in the script, we're shifting – we're trying to shift our acid toward specialty salts applications and becoming – be less reliant on technical STPP. So, some of that is deliberate. And we also have, as we mentioned, some limited reformulation in technical grade STPP. But, I think, overall, as far as Mexico and our volume expectations, demand is still strong and in the total portfolio of what we shipped this year, we would expect our volumes to be similar or slightly better than last year, because last year we had a large maintenance outage.

Mark Connelly – Credit Suisse

Okay, that's very helpful.

Richard Heyse

Some of it's just timing.

Randy Gress

Yes. And Mark, regarding your second question and more broadly about the business and the – some of the investment thesis, I think, if you look at our business, really the underlying strength and focus has really not changed. We're continuing to capture the value for our products here, which are providing some opportunities here that we're able to realize based on our ability to increase prices as well as get the positive impact of the buffering of the raw material supply contracts. I think what we were saying in how we could capture some of the global opportunities, we did say we were going to take some of our specialty products to the – capture some of the geographical growth and the higher demand for those products. And we did that with the in-sourcing of the pharma business and building a global distribution network to capture those opportunities. And we've been successful, I think, in making some of that switch to the specialty salts. So, I think, we continue to stay focused on what we're doing and have some continued opportunities of stronger performance there and growth.

Mark Connelly – Credit Suisse

Do you think that having a bigger base of operation outside the United States is something we should be thinking about for Innophos? Manufacturing on the ground facilities, rather than just distribution?

Randy Gress

Yes, Mark, our focus has been within the North American market and capturing some of those opportunities with our specialty products. And, I think, looking at maybe some bolt-on opportunities, but it's really what should be in place to support our existing, I guess, growth efforts there for the export business here from the North American manufacturing base.

Mark Connelly – Credit Suisse

Okay. Thank you very much.

Operator

Your next question comes from the line of Mr. Edward Yang from Oppenheimer. Please proceed.

Edward Yang – Oppenheimer

Hi, good morning.

Richard Heyse

Good morning.

Randy Gress

Good morning, Edward.

Edward Yang – Oppenheimer

It goes without saying with your stock up 30% today, but congratulations on a very strong quarter.

Richard Heyse

Thanks.

Edward Yang – Oppenheimer

My first question is just around your price increases. And clearly, you have very unique products. But if you were to compare your pricing actions versus some of your competitors like Astaris or Potash, at this point are you leading the market? Are you coincidental with the market? Or are you lagging?

Randy Gress

Yes, Ed, thanks for the congratulations on the quarter results. And if you look at the pricing and the actions there, we've announced a series of price increases beginning in the fall. And it's pretty much our focus to independently decide what the appropriate price level is. We've done a lot of work trying to determine the best value for our products in use. And that's a lot of work that has gone into what we are doing on pricing. And, I think, the commercial team across the business has done a great job in capturing that.

Edward Yang – Oppenheimer

And your competitors are also raising prices as well, correct?

Randy Gress

Yes, the – on the – for the market support, what we hear from customers, they're receiving price increases from them also.

Edward Yang – Oppenheimer

And it does seem like the customer acceptance for the price increases has been fairly high. Have you seen customers behave differently with the price increases? Have you seen any of them preordering or building inventory, because they know that future price hikes are down the line? Or are you seeing anything on the inventory chain?

Randy Gress

Ed, really, we haven't seen anything unusual there. I think, as we're raising prices, as there's been some continued global tightness in the overall supply-demand, I think, customers are certainly realizing and appreciating the value of reliable supply situations which we offer.

Edward Yang – Oppenheimer

And, Randy, following up on your earlier comments, you did mention that Innophos was – did have good profitability before these price increases and you expect to maintain a certain level of profitability once the raw materials is more on a neutral footing in 2010. Is there a floor level of EBITDA or operating income you'd be comfortable sharing, that you believe is sustainable once some of these – the raw materials catch up?

Richard Heyse

I think, at that point – right now, things are so dynamic for us. We've already reached out into 2009 and to try to speculate and reach out in 2010 is a pretty far reach. I think – we'll keep doing the disclosures we're making. Each – we'll reach out 12 – four quarters each call. And tell – try to tell everyone what we see going on as far as demand and supply. But, I think, as Randy said, we have an underlying – very mature, strong underlying business that is getting a great tailwind from a combination of a well-executed procurement strategy and a very tight market.

Edward Yang – Oppenheimer

Okay. Thank you for that clarification. Lastly, in terms of – I mean, you're generating a tremendous amount of free cash flow. Have your priorities changed in terms of how you would utilize those cash flows to grow shareholder value?

Richard Heyse

No, actually, I mean, pretty much our priorities are the same as we said in the last call. We still have a bank debt agreement that requires a free cash flow sweep. And the more successful we get, the more the mandatory cash flow sweep becomes. So, if you look at our priorities for cash in the near term, as we said last call, we want to pay off our revolver. We did that. Next, we need to accumulate the cash flow that will be – cash needed to pay the free cash flow sweep in the first quarter of next year. And then, in addition, due to raw material costs expected to increase, we'll need cash to cover expected working capital build in the first quarter of next year. We don't want to use a revolver as we did this year. So, our expectation is that we'll be accumulating cash through the third quarter to cover those needs and possibly in the fourth quarter, we may make some voluntary debt payments. But – and I think we’ll – but, beyond that right now, I think, we'll talk more about the third quarter and what cash flow looks like. But for the near term, the next couple of quarters, we simply need to build the cash flow required to get through first quarter demand.

Edward Yang – Oppenheimer

Longer term, would you ever have the appetite for transformational type of deals? I know you – in the past, you've mentioned sort of tuck-in opportunities. But given the amount of cash you're generating, would you ever evaluate a transformation deal?

Richard Heyse

I think, there's no update to what we've said in the past. As Randy mentioned, we're growing – things that might facilitate our growth strategies, accelerate them, we would consider, but really nothing new to update on that front beyond that.

Edward Yang – Oppenheimer

So, steady as she goes. All right. Thank you very much.

Richard Heyse

Thanks, Ed.

Randy Gress

Yes, thanks, Ed.

Operator

Your next question comes from the line of Mr. Christopher Butler from Sidoti & Company. Please proceed.

Christopher Butler – Sidoti & Co.

Hi. Good morning, guys.

Richard Heyse

Good morning, Chris.

Randy Gress

Good morning, Chris.

Christopher Butler – Sidoti & Co.

I was hoping that you might be able to speak to some of the mechanisms that you have in the – in your contracts, the resets for 2009. Give us some color on what's taking place that's going to create the buffering effect for 2009. Are there caps in there? What are we looking at?

Richard Heyse

I think, again, there's five major contracts. So, our disclosures about them in general. They each have somewhat different mechanisms. So, it's really hard to give a – each – we'd have to go through each contract in specific. I think, in general, it’s – there are just simply formulas in those contracts that in essence cause some delay between the spot market price – movement in spot market prices and the price we pay. And it is – in the previous – in 2006-2007, we really didn't give us any material significant advantage. But in a case like today, where raw material prices move up very rapidly, these set of contracts gives us this buffering. And that's why we've made that disclosure in total. What do we expect the outcome to be in trying to explain the numerous factors, we figured, it's just simpler to give you a number. And, as we said, we expect that our cost of materials will be still buffered relative to where the spot markets are next year based on today's trends. Where the prices in the markets are today, if we run those through our contracts, our expectation is that we'll still get buffering next year.

Christopher Butler – Sidoti & Co.

And could you speak to your relationship with suppliers? Give us – ease any concerns on the counter-party risk that would be inherent in this extraordinary situation?

Randy Gress

Yes. Chris, I think, our relationship with the suppliers has been long term. If you look at the rock, at the phosphoric acid, it's been long-term agreements that's been – they've been reliable suppliers. Continue to supply according to the plans. And have been good for both sides. I think, also with the sulfur supply, it's local within Mexico. And also, a long-term agreement on the sulfuric acid supply. So, they've been good arrangements and –

Richard Heyse

Very large corporations. Very deep, robust corporations as far as Pemex, OCP, Potash Corp. So, as far as the question of counter-party risk, these are all very large reputable companies.

Christopher Butler – Sidoti & Co.

And looking at the market environment that you have right now, where it seems that your customers are trying to grab as much as product as possible. Regardless of what spot prices do here for the rest of the year, what's stopping you from raising prices for the second half of 2008 that match the step-up that you're going to see in 2009 and give you gross margins that are similar next year to this year?

Randy Gress

Yes, Chris, as far as the price increases in the second half, as I said before, we did announce increases here effective today. And what we've done here is disclose what we expect to achieve successfully through the end of the year there. And then, as far as our ability to sustain this performance into next year with that pricing versus the cost.

Christopher Butler – Sidoti & Co.

Thank you. I'll go back in the queue.

Operator

Your next question comes from the line of Chris Shaw from UBS. Please proceed.

Chris Shaw – UBS

Hi. Good morning, guys. How you doing?

Richard Heyse

Hi, Chris.

Randy Gress

Chris.

Chris Shaw – UBS

How should we be looking the tax rate going forward? Is it right that you still don't pay any taxes in the U.S.? It's just mostly Mexican?

Richard Heyse

Correct. And we're working on an evaluation with our tax consultants. We may turn that corner fairly soon in the U.S. And when you transition from being – from operating losses to a taxpayer, it's actually fairly complicated. So, our expectation is that relatively soon, we'll become a taxpayer in the U.S. But we haven't crunched all the numbers to model that exactly. And how much of our NOLs we'll be able to utilize versus if we'll – there are some recovery limitation on our NOLs. So, we have to model that all out. So, I think, take that as by next year, we'll be a taxpayer in the U.S.

Chris Shaw – UBS

And what's the rate in Mexico?

Richard Heyse

The corporate tax rate is 28% in Mexico, but effectively the U.S. GAAP tax rate is in the low 30s, due to difference between Mexican tax income and GAAP income.

Chris Shaw – UBS

Okay. And then, it looked like Mexico is where a lot of the price increase came this quarter. Should we expect some bigger operating profit gains in the U.S. business in the second half?

Richard Heyse

Yes, if you look at our disclosures again, where we said Mexico, and what we just said in the script, Mexico is pretty close to their targets.

Chris Shaw – UBS

Right.

Richard Heyse

And as you can see, we're expecting that are year-over-year selling price improvement is going to expand. So I think a logical conclusion is that it'll be more heavily weighted toward the U.S. businesses and the Canadian businesses in the third–

Chris Shaw – UBS

Okay. Thanks a lot.

Operator

Your next question comes from the line of Arieh Coll from Eaton Vance. Please proceed.

Arieh Coll – Eaton Vance

Good morning, thank you. A question regarding your purified phosphoric acid, I did wanted to know if I'm approximately right regarding what the price per ton is going to be post this August 1st price increase. I was guessing about $1,200 per ton. Am I way off?

Richard Heyse

Yes, we normally don't get into volumes-specific prices, but, I think, a safe thing to say is generally, purified phosphoric acid sells for more than agricultural grade acid. And right now, agricultural grade acid is selling in the $2,000 a ton range.

Arieh Coll – Eaton Vance

So, $2,000 per ton for the agricultural grade and yours obviously is value added.

Richard Heyse

Correct.

Arieh Coll – Eaton Vance

And secondly, in terms of your volume per year for your purified phosphoric acid, is it like 800,000 tons per year? Am I off there too?

Richard Heyse

The volume for – again, we don't – we generally – we don't give tons disclosure. So, as far as we have our own acid plants, I guess, that's all on your question.

Arieh Coll – Eaton Vance

I'm just trying to do a sensitivity analysis. If the price of your acid went up or down 10%, what's the impact it would have on revenues?

Richard Heyse

Well, I think, we break out our purified acid sales in our disclosure. It's one of our three product lines, so if you're – just to looking at the impact upon revenue, that would be simple enough.

Arieh Coll – Eaton Vance

No, I understand, but your prices have been changing every other month. So, if I just have the volume number, it'd be easier to figure out.

Richard Heyse

Right, but we – just for competitive reasons that's – and giving our competitors hard numbers as far as what we ship and how much we ship, we don't disclose that. That would disadvantage us in the marketplace.

Arieh Coll – Eaton Vance

Okay, fine. And then, just to clarify your comments earlier in the call. You'd indicated that the $90 million in operating income earned in the June 2008 quarter, you felt confident that that could repeated for the next six quarters based on what you know today.

Richard Heyse

That's our target. So, the goal management is setting is to be similar financial performance at or near that level. And if you look at the disclosures in the press release and simply take the difference between the known trend of selling price increases versus the known trend of cost increases in next year, and kind of the average of those ranges, gives you about a $65 million per quarter impact. And if you look at our notes – we made specific disclosure – and that's for 2009. And for 2008, in our press release, we made specific disclosure that based on the known trends, management expects that the year-over-year selling price raw material spread improvement for the third and fourth quarter, we expect it to be at least $80 million per quarter.

Arieh Coll – Eaton Vance

Right, I understand. And then, interest expense for calendar year 2009. As you're rapidly paying off your debt, I'm just wondering how low you think that number will be? Will be it $15 million or even a lower number for all of next year?

Richard Heyse

Well, if you assume – again, we've got the – in our balance sheet, you can see in the short term debt that's current that there's about $10 million for our revolver and about $83 million or $84 million of expected free cash flow sweep. The safest – simple assumption would be that that $85 million gets paid off. And that's currently at LIBOR plus 2%. So, I think, from that perspective, the bonds would still be in place, so you can simply take the reduction in interest expense due to paying off the free cash flow sweep. The flip side is we're going to building cash, so we'll also have interest income from the cash on hand that we'll be carrying. If you net that off.

Arieh Coll – Eaton Vance

So, by the end of next year, you will have built up a cash balance, but you will still have the bond outstanding?

Richard Heyse

Correct.

Arieh Coll – Eaton Vance

And just –

Richard Heyse

And our two bonds are not callable until second and third quarter of next year. So –

Arieh Coll – Eaton Vance

Okay. But you can't call –

Richard Heyse

We haven't – and with the credit markets the way they are, things are still pretty unstable. So, we had said that probably by the first quarter of next year at the latest, we'd talk to where we see our capital structure going. But, at this point, with the way the credit markets are, it'd just be speculative to assume anything.

Arieh Coll – Eaton Vance

And lastly, with what you see amongst your competitors in the market, what do you think the probability is of the industry having another price increase after the one today here in the next four months?

Randy Gress

That's difficult to speculate. I think, what we have done is – as raw material increases are occurring, we have driven to capture those cost increases with the price increases. And these are not industry increases, these are our increases that we're implementing in the business.

Arieh Coll – Eaton Vance

Okay. And the last thing is, regarding reformulations. Clearly, prices are rising for your customers and they ask themselves the question, can we or is it worthwhile to try and reformulate our products. I know you sell to a myriad of end users. But do you have a sense for what portion of your volume might be – might decline next year by virtue of a reformulation as customers try to shift elsewhere?

Randy Gress

Yes, Richard.

Richard Heyse

Yes, we did an analysis. And in our first quarter and in our risk factors and recently, we did do an update. And in the risk factor, an economic reformulation, we said approximately 40% of our portfolio could be subject to some form of reformulation or substitution. As you mentioned, we do sell into a lot of applications. Specialty phosphates bring unique functionality. And so, often, the alternative is not a one-for-one switch. It's a chemistry that may not have the same functionality, same performance. And so, for a customer, they may have to make a tradeoff between reduced functionality versus cost. And so, we did our best to analyze where we thought there was some potential. And right now, our current thinking is 60% of our portfolio is pretty difficult to displace and about 40% of our portfolio, there is some type or possible alternative, but in not all cases is it a good alternative.

Arieh Coll – Eaton Vance

And if there is a displacement alternative, to what degree is it a solution? Sometimes it's just simpler for the customer to raise prices for the final end market good by 1% or 2% to cover the effect of cost increase they're getting from you.

Richard Heyse

Well –

Randy Gress

Yes.

Richard Heyse

Generally, in the marketplace, there's a lot of reports of that happening. But again, we sell into so many different applications, I'm not sure how we could speak to every particular customer's ability to pass costs through.

Randy Gress

Yes and just if I could add. I mean, so many things are happening across other raw materials and ingredients that customers are seeing. And in a number of the recent earnings reports, I think, with a number of the customers we've seen them being successful also in increasing prices within the market. At least, it's exhibited in their results.

Richard Heyse

And one other on this point, we have talked about the auto – the consumer auto dish market – soap market in the U.S. and Canada. And there is some government legislated reformulation that's occurring in those products. And as Randy discussed, we've been making investments in our Canadian plant. And we're moving our portfolio away from technical STPP in that plant toward more food grade products and leavening products, for example. So, in addition to potential, again, we said, we're raising prices to levels that the markets have never seen before and we are clearly disclosing there is some potential for economic driven reformulations. And there's been in addition, we do have that legislative initiative in technical STPPs and, we think, we've got a pretty good plan and we're coping with that very well.

Arieh Coll – Eaton Vance

Thank you and enjoy the good results.

Richard Heyse

Thanks.

Randy Gress

Thank you.

Operator

Your next question comes from the line of Mr. Donald Besser from Manchester. Please proceed.

Donald Besser – Manchester Management Company

Good morning. Two questions. The 10-K refers that the contract with OCP was being negotiated. I take it from your projections that it's totally finalized now for this year. Is that correct?

Randy Gress

As far as the contract being negotiated, it's actually the pricing for 2008 and beyond. And we're still operating under an interim basis.

Donald Besser – Manchester Management Company

So when is –

Randy Gress

What we've included is our expectations –

Richard Heyse

We have a long-term supply contract where pricing is – there's a pricing formula. And as Randy mentioned, we're working just – the two parties can't quite agree how the formula works and we're working on an interim price. So, it's not that the whole contract is reviewed – the contract goes through 2010.

Donald Besser – Manchester Management Company

Good. Okay. I understand that this is a small component of your end customers’ costs, but you can give – this is a huge price increase that you're putting through. Could you just give us an example of how it's used in one product and what the end price is? So, is it like, as the gentleman just before referred to as a 3% of the end product price before these price increases? Or was it maybe 5% to 10%? Can you give us some range of percent as to what its cost of the end product was before?

Randy Gress

Yes, as far as the many applications, just pick one example that we often share is in helping and like a chocolate cake formulation, where our leavening phosphate helps in the performance and the texture of the cake mix. And in a situation like that, it's in their 1% range as far as the overall cost structure for the end product there.

Richard Heyse

And, I think, that's a generally across the board. We're selling functional additives that are generally a couple percent of product cost. The two exceptions we've pointed out are in the toothpaste applications, where the specialty phosphate is a significant portion of the cost and likewise in detergency. So, our detergency applications, the technical grade STPP can be a significant portion of the cost also. So, when you – if you go back to our 10-K and look at the various end use markets that we sell into, it's really those two are the ones that stick out, where it's not just a simple additive. With the majority of the products, it is a small portion of the customers’ cost.

Donald Besser – Manchester Management Company

Okay. Thank you.

Richard Heyse

And it's (inaudible) a critical function.

Donald Besser – Manchester Management Company

Thank you very much.

Operator

Your next question comes from the line of Alan Rosenberg [ph] from Spectrum Investments. Please proceed.

Alan Rosenberg – Spectrum Investments

Good morning.

Randy Gress

Good morning, Alan.

Richard Heyse

Good morning.

Alan Rosenberg – Spectrum Investments

I've got two questions. First, I thought that you'd said earlier that you expect operating cash flows to remain fairly stable through second quarter of this year and on into 2009. And then, it seemed like after – in the first or second question, you were saying something different. So could you please let me know if my memory on that is correct? And then, the second question is, it appears that you have about 60% gross margin this quarter. Is there a business case in which you can sustain that? And, if not, how do you expect gross margins to change over time?

Randy Gress

Yes, Richard.

Richard Heyse

On the cash flow question, again, our cash flow is – free cash flow – we're – frankly, we're outstanding at generating free cash flow. Our cash flow expectations clearly are going up with our earnings and they have. As far as CapEx, no change in what's happening there. As we talked earlier on the call, we expect in the next couple of quarters, we will become a taxpayer in the U.S.. The only, I think, significant issue on just use of free cash flow is we do have a bank debt agreement that has a mandatory annual free cash flow sweep. And that number, as we're successful is, of course, increasing rapidly. So, it's now at an expected use of cash that'll be mandatory in March of next year is approaching $85 million. So, I'm not – as far as operating cash flow, if anything, our expectations are moving upwards as we use our – as our team really delivers on the results. And what was the second question?

Randy Gress

Gross margin.

Richard Heyse

Gross margin, again. We're giving specific known trend disclosures. We are right now benefiting from a raw material procurement strategy that in essence isn't damaging us in the near term. But, as we said earlier in the call, for us to speculate on what the markets look like in 2010 is a tough call. And as Randy said in the script, if raw materials stabilize, we would expect that our costs for raw materials become – move back to more market normal levels. And, at that point, we would no longer have the benefit of this buffering from our raw material contracts. But, as we said, we don't expect that – we expect in 2009 that we will still have benefit from the – in essence, in the money raw material procurement strategy.

Alan Rosenberg – Spectrum Investments

All right. Thank you.

Operator

Your final question comes from the line of Jeff Zekauskas from JPMorgan. Please proceed.

Jeff Zekauskas – JP Morgan

I have a few short questions. When you talk about your volume growth or volume contraction, is that shipment volume or production volume?

Richard Heyse

It's shipment volume. And what it is we talk to the effect upon revenue of shipped volume. And because our – we don't discuss unit volumes specifically because the range of prices we sell at is so broad from our very high-end pharmaceutical products that did sell for high prices per pound down through the co-products, fertilizer that the best approach for us is to discuss the overall impact of volume upon revenue versus the actual unit volume change. Because again, as we said, the fertilizer particularly sales are very choppy. And throwing that big bulk unit volume in with specialty products that sell for multiple dollars per pound could – would just cause confusion.

Jeff Zekauskas – JP Morgan

Okay. How large is your sales force?

Richard Heyse

Technical and sales and commercial, it's over 20 people.

Randy Gress

Yes. Over 20.

Jeff Zekauskas – JP Morgan

20 people. Okay.

Randy Gress

We also have –

Richard Heyse

Distribution.

Randy Gress

Distribution and partners for export businesses as we've built up the export distribution network.

Jeff Zekauskas – JP Morgan

Okay. Will you sell more GTSP this year than you sold last year, all things being equal, or is it the same amount?

Randy Gress

No, about the same.

Jeff Zekauskas – JP Morgan

About the same. If you had a manufacturing outage in your GTSP operation, would that mean that you would sell more purified acid for other purposes? Or is that acid not reclaimable or just waste acid that goes into GTSP? If that question makes sense to you.

Randy Gress

Yes, I think, for GTSP, we do have some product coming out of our purified acid operation that we use for that production. And we'd have to store it. But as far as outages in GTSP, we just typically have some short planned outages to support the business and shouldn't have any significant impact any different than even some delays in ships.

Richard Heyse

And about two years ago, we made some significant investments in our GTSP unit to improve the reliability. So, as far as that scenario you're giving, it's never happened, but, again it's been a very reliable unit.

Jeff Zekauskas – JP Morgan

I didn't mean to imply that it wasn't reliable. I was just wondering about how your volumes changed if you didn't make GTSP, that's all.

Richard Heyse

The gap would – we would have to store the co-product acid for awhile. It'd become an issue. Yes, we have to keep that unit running.

Jeff Zekauskas – JP Morgan

Okay. And then, lastly, do you have any views on sulfur in that sulfur prices have gone up in the United States, but they've kind of softened abroad. And some people think it will go up aggressively in price over the next few years. Other people think it will come down sharply. Do you have any views on sulfur?

Richard Heyse

No.

Randy Gress

Yes, as you said, we saw it go up here even more recently in the U.S. And there are wide ranges of speculation on where sulfur's going. We just continue to get some good strong support in our supplier from Pemex there and it's all local supply.

Jeff Zekauskas – JP Morgan

And then, the last question is, so what's the part of your product line that hasn't gone up in price yet? So, you've obviously achieved tremendous changes so far this year, but there's a new area or a new price increase you've got. What's the stuff that's going up in price?

Richard Heyse

Every sector –

Randy Gress

That's just about every thing. I think, you can see across our breakouts there. The Purified Phosphoric Acid, the Specialty Salts and Specialty Acids, the STPP and Other products have all realized the price increases.

Richard Heyse

And as I said earlier on that call, Jeff, Mexico as we said in the script is pretty close to their targets and the U.S. is moving more in a step-wise fashion. So, if you look more from a regional perspective, all are – we're raising prices on all our products, but the U.S. is unfolding somewhat differently than Mexico. But in the end, similar targets.

Jeff Zekauskas – JP Morgan

So is it a contract timing issue that the timing of things in the U.S. is a little different from Mexico? Or are – I mean, that is, are the Mexican products just much more expensive now than the U.S. products? Is that the meaning of that?

Randy Gress

It's really some different products, different mixes, different customer base across the business there that, I think, we have had some good success in rolling the prices out. It's just with Mexico, they've been –

Richard Heyse

Done a great job.

Randy Gress

They've been successful in implementing. I think, again, we're not giving a price guarantee for this year, but continue to implement to get the full value for our products in use.

Richard Heyse

I think, to our credit, I'm going to bang our own drum here, but Randy made the call and we did not – we as a rule didn't give the normal annual pricing guarantees that we would have. And we were proactive this year in preparing ourselves for an environment that customers become very focused on reliability of supply first and pricing second.

Jeff Zekauskas – JP Morgan

Okay. Thank you very much. Thanks for taking so many questions.

Randy Gress

Okay, thanks. With that, I'd like to thank everyone for joining our call today. And as we stated, we are very pleased with the results of the quarter and we certainly look forward to sharing our progress with you next quarter and some of the opportunities we have. Thank you.

Operator

Thank you for your participation in today's conference. This concludes your presentation. You may now disconnect. Good day.

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Source: Innophos Holdings, Inc. Q2 2008 Earnings Call Transcript
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