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OMNOVA Solutions Inc. (NYSE:OMN)

F3Q08 Earnings Call

September 18, 2008, 11:00 am ET

Executives

Kevin McMullen – Chairman, Chief Executive Officer and President

Michael E. Hicks – Senior Vice President and Chief Financial Officer

Analysts

Jason Minor – Deutsche Bank

Analyst for Laurence Alexander – Jefferies & Company

Douglas Chuti – KeyBanc

Robert Kosowski – OFI Institutional

Tom Spiro – Spiro

Operator

Welcome to the OMNOVA Solutions third quarter earnings discussion. (Operator instructions) I now would like to turn the conference over to your host, CEO Kevin McMullen.

Kevin M. McMullen

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

Michael E. Hicks

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

Kevin M. McMullen

OMNOVA Solution’s third quarter was our strongest of the year as profits improved significantly from the first-half of the year. The Company posted much stronger profits overcoming unprecedented inflation in our raw materials during the quarter, many of which establish new record highs. Sales were up year-over-year due in large part to the critical price increases necessitated by the step change increase of raw material costs. End use markets weakened during the quarter leading to a year-over-year decline in OMNOVA’s volumes.

The situation in the residential housing, new construction market continues to adversely affect sales of chemicals for carpet backing and laminates used in kitchen and bath cabinets. There has been a slowing trend across other market segments as well. Despite this trend, OMNOVA has been able to successfully leverage our leading technology and design to grow above industry rates in key markets, especially paper chemicals and commercial wall covering.

Despite declines in the price of oil weight in the quarter, raw material costs did not abate and in fact continued to set new record highs. As of Tuesday, Hurricane Ike had caused temporary plant shutdowns across much of our supply base. This could cause further short-term increases in our raw material costs. However, industry forecasters expected following the hurricane recovery, oil prices should continue their downward trend, which long-term should help our raw material situation.

Late in the second quarter and during the third quarter, OMNOVA successfully implemented price increases across performance chemicals and decorative products with minimal customer losses. These pricing actions contributed to margin expansion in the third quarter, although clearly there is still work to do to increase our Company’s overall margins to more acceptable levels. While innovative product offering and strong technical service allowed OMNOVA to outperform our markets in key categories during the quarter, weakness in the U.S. economy contributed to lower volumes year-over-year in both business units.

Slowing demand has further exacerbated industry over capacity. Several competitors announced their intention to idle or close North American capacity. In the styrene, butadiene, and latex industry, six competitor plants have or will shut down by the end of the year. This should significantly improve industry utilization rates in North America. In a moment, I’ll provide greater details on individual business segment performance and opportunities. First, I’d like to summarize our third quarter financial results as reported in our earnings release.

OMNOVA Solutions had net income of $3.1 million or $0.7 per share compared to net income of $4.5 million or $0.11 per share in the third quarter of last year. This year’s third quarter results included restructuring and severance charges of $400,000 while we had $100,000 of these charges in last year’s quarter. SG&A expenses and percentage of sales fell to 11.1% from 12.2% a year ago. This year’s third quarter SG&A of $26.7 million included $1.9 million from our Asian businesses, whereas these former joint ventures were not included in 2007 SG&A results since sales were not consolidated last year. We remain vigilant in controlling all discretionary spending.

Third quarter consolidated sales were up $42.7 million from last year or almost 22% to $239.5 million. Performance chemical sales increased $18.1 million or 14.8% while sales in Decorative products increased $23.9 million or 34% with $28 million of the increase coming from sales in the Decorative Products Asian and European businesses. Gross profit was $39.5 million, up $2.7 million from a year ago. Gross profit margin was 16.5% compared to 18.7% in the 2007 third quarter.

Raw material costs during the quarter were up $26.5 million for the Company. Pricing actions achieved $31.9 million in product price increases, which helped for the quarter but has not made up for the prolonged impact of raw material cost increases. OMNOVA finished the quarter with total debt of $200.4 million, up $40.8 million from the third quarter of last year. Debt increased due to $32.4 million of borrowing and assumed debt to fund the acquisition purchase price and transaction fees of the buyout of the Decorative Products Asian joint ventures in January of this year.

Debt was negatively impacted by the calendar this year with quarter-end coming on the Sunday of Labor Day weekend, adversely affecting the timing of collections. As expected, debt dropped below $195 million several days into the quarter. Our debt is comprised of $144.2 million under our term loan B credit facility, $51.5 million drawn against our $80 million five-year revolving asset back credit facility and $4.7 million in Asia. Excess credit availability at the end of the third quarter was $35 million, up from the $28 million in the second quarter of 2008.

The weighted average cost of borrowing during the third quarter of 2008 was 5.5%, an improvement from the 7.8% for the third quarter of last year. You’ll recall that OMNOVA completed our refinancing in the middle of last year’s second quarter. As a result of the improved terms achieved through the refinancing and favorable Libor rate levels, the weighted average cost of borrowing has been going down over the past year.

Our term loan B covenant leverage ratio of net debt to EBITDA at quarter end was 4.3, well under the covenant limit of 5.5 and improved from the 4.4 times in the 2008 second quarter. Definitions of EBITDA and net debt are in our third quarter earnings release.

Turning to business segment results, first in Performance Chemicals, sales were $145.5 million in the third quarter, an increase of 14.8% or $18.8 million from a year ago. The increase was primarily due to higher selling prices, volume decreased by $10.7 million versus a year ago driven by weaker demand in several markets but especially Carpet Chemicals. Operating profit improved at $10.5 million from $7.9 million in the third quarter of 2007.

OMNOVA took aggressive action to counteract $24.1 million in new raw material inflation with critical initiatives that provided $29.5 million in improved product pricing. This clearly helped our third quarter results; however, it has not completely offset the prolonged effect of record high raw materials costs and higher freight and utility expenses. Our pricing actions have included changing index pricing where applicable, adding surcharges to provide more timely relief, and traditional increases. We will continue to take necessary actions to improve profitability through productivity initiatives, as well as necessary pricing actions.

OMNOVA’s latex volume for coated paper was down in the third quarter but better than the industry as a whole thanks to our innovative GenCryl Pt high stripe latex binder. Our lubricants and cross-looking chemicals for paper were also well received in the quarter. (Inaudible) activity remains strong for our latex and processing chemicals and new product development initiatives are uncovering some promising new technology enhancements.

Third quarter results also benefited from the work we completed in the second quarter to negotiate new pricing for our paper latex products. We retained all major customers. Looking ahead to the fourth quarter, all signs point to further weakness in coated paper demand. Several customers have already announced downtime at their operations, especially chemical sales were up 17% overall in the third quarter led by sales for applications in tape, non-wovens, tire cord, and graphic arts. Our advanced tape release (inaudible) continue to win new business for OMNOVA both in the United States and in Asia.

The strength of our products for tape, as well as tire cord and floor care, help boost Asian revenues 36% per performance chemicals in the quarter driven by a 24% increase in volume. The weak housing market, which has been in decline for over two years, is continuing to take its toll on the carpet industry. The carpet market was down about 13% in the quarter. OMNOVA is nearing commercialization of some exciting new products for the carpet market that will further enhance the value of our latex offering.

On the raw material front, our Performance Chemical business used oil based styrene and butadiene in various acrylics. Styrene costs are at an all-time high of 21% year-over-year. OMNOVA buys about 220 million pounds of styrene a year and penny-a-pound change in styrene impacts our operating profit by approximately $2.2 million annually. The pace of styrene inflation slowed in August but remains unpredictable. A further dynamic is the cost of benzene, a key input to styrene. Benzene climbed to $4.45 in the third quarter. Currently 60% to 70% of the styrene capacity is temporarily offline due to Hurricane Ike.

Butadiene was up 72% in the third quarter to a new all-time high and supply is tight. It started the year at $0.58 per pound and is now nearing $1.20 per pound. We purchased about 150 million pounds of butadiene a year and a penny-a-pound change impacts our operating profit by approximately $1.5 million annually. Due to shortages of a key raw material feed stock known as Crude C4, butadiene was on allocation by all major North American suppliers in the first and second quarters of 2008.

Market supply of butadiene improved throughout the third quarter and the allocation percentage from suppliers was increased. Performance Chemicals has been able to meet all customer needs; however, industry forecasters say butadiene prices will increase in the fourth quarter. As of Tuesday, 70% of butadiene production was temporarily offline as suppliers cleaned up the aftermath of Hurricane Ike. Other raw materials, especially Acryl (inaudible) have also increased dramatically during the year. Certainly, we are closely monitoring the effects of recent hurricanes on the Gulf Coast.

The impact of possible outages there is as of yet unknown; however, we are encouraged that damage was less than anticipated for many of the petrochemical assets in the Gulf. While there could be near-term supply disruptions as a result of plant closures in advance of the hurricane, we believe that material flow will be restarted in the coming week or two. A timely resumption in raw material production combined with a recent downward trend in oil could have a longer term positive effect on our raw material costs.

Performance chemicals continues to focus on cost reduction and to drive operational improvements in productivity gains through LEAN SixSigma efforts and by leveraging investments in our SAP Enterprise Business System. Inventory turnover is well above 2007 rates thanks to excellent inventory management practices by our operations and, of course, evaluation of necessary pricing actions is ongoing.

Turning to the Decorative Products business, sales in the third quarter were $94 million, up 34% from the prior year. The increase included $28.1 million in sales from the Asian businesses that were acquired in January of this year. Sales from these former joint ventures were not consolidated in 2007. Sales in Europe were up a half-million dollars year-over-year. Our weak domestic markets resulted in a $7.1 million decline in North American sales. The segment posted an operating loss of $2.2 million in this year’s third quarter compared to operating profit of $2.3 million a year ago.

Key factors affecting the decline were higher raw material costs of $2.4 million, $1.3 million in lower profit from the Asian businesses, $3.1 million in lower volumes and absorption, and $400,000 in LIFO inventory expense. In addition, Decorative Products took a $400,000 restructuring charge during the quarter. Sales prices increased by $2.4 million helped to partially offset the negative cost impacts.

As with our Performance Chemicals business, clearly the priority for Decorative Products is to improve profit margins. This business has also been impacted by increased raw material cost. Market prices for PVC resin are up 30% year-over-year and plasticizer is up about 40%. Price increases have been implemented across most product lines and were able to offset the raw material increases in the quarter.

Weakening market conditions have affected most of our Decorative Product markets in North America. Sales of laminates in the kitchen and bath cabinet applications continues to be especially hard hit due to the weak residential housing market. The housing market slowdown, lower consumer spending, and the high price of gas are also having an impact on the floor and ceiling tile, marine, and recreational vehicle markets; however, we have still been able to gain share in these markets in 2008. Global wall covering sales were up year-over-year. Sales in our domestic contract interiors product line, which includes commercial wall covering and upholstery were flat but above industry trends.

Sales of our unique digital wall murals were especially strong. Digital murals are a prime example of where we are leveraging our expertise to expand in the new related applications. Recent ones include a major hotel chain. In addition, trials and sampling are ongoing at several large hospitality and retail accounts. OMNOVA has several exciting new products for the wall covering market that will be rolled out over the next few months.

One example is our new ECORE wall covering line. This truly innovative offering is designed to appeal to those designers and specifiers who have been looking for a recyclable, substrate that delivers comparable performance to traditional vinyl wall coverings. ECORE wall covering features a strong environmental profile. They have low VOC emissions, utilize a water-based ink system and are 100% recyclable.

Vinyl wall coverings remain the product of choice for most designers and specifiers, especially in healthcare and hospitality. With ECORE, we are offering an industry’s first alternative to vinyl wall covering without any compromise in performance and design. It’s important to note the long selling cycle typical of Decorative Products markets. While there has been great interest in the new ECORE offering from the market, we don’t expect sales for this product to fully ramp up until into 2009.

Sales in the coated fabrics product line declined about 3% due to reduced market demand for transportation and marine upholstery. Our coated fabrics business includes a wide variety of end-uses, and we have worked hard to expand our presence in the existing and related applications through innovative products and by seizing opportunities as competitors have exited the market.

In 2008, we have continued doing new business in marine seating and trim with the nation’s top boat builders. Our versatile Boltasoft upholstery, along with our well known Nautolex brand upholstery is sold into the marine market as well as transportation.

OMNOVA’s brands are known for outstanding clean ability and abrasion and stain-resistance, as well as leading designs.

Sales in laminates were down from a year ago to extremely weak demand in the kitchen and bath, manufactured housing, and recreational vehicle markets. We continue to concentrate on developing new products that will differentiate our laminate product offering. At the big International Woodworkers Fair in Atlanta in August, we introduced new products in our three dimensional and SURF(NYSE:X) flexible, high durability laminate lines, which match designs of major melamine producers.

Cabinet and closet makers would typically use laminates on high-use surfaces such as doors as a compliment to the melamine on other surfaces. Also at the woodworkers show, we rolled out our extensively revamped flat laminate stock line, which reflects current design trends. These laminates are typically used on retail store fixtures, kitchen and bath cabinets, and commercial appliances.

In Asia, OMNOVA posted its second fully consolidated quarter as the sole owner of its former Decorative Products joint ventures in China and Thailand. An operating loss of $900,000 was disappointing after recording an operating profit of $800,000 in last year’s third quarter. This year’s loss was a result of a number of factors, including increased raw material costs, volatile foreign currencies, especially in Thailand where there is current political unrest, and higher quality claims for product made before we controlled these operations.

We are taking action to address the operational issues, position the business for profitable growth and drive a performance culture in Asia. Earlier in the year, OMNOVA named an ex-PAT executive to general manager of the business in Thailand. In the third quarter, the Company implemented a management restructuring in China, which included name a 13-year company veteran with extensive experience and knowledge of the Chinese market as a the general manager.

Additional measures include pricing actions, product rationalization to provide a more profitable focus to the portfolio, capital improvements that create efficiencies and a reduction in discretionary costs. Also OMNOVA has secured several new accounts in marine and transportation upholstery and laminates, which are currently ramping up in volumes.

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

Returning to domestic operations, OMNOVA announced the closure of its Dupo [inaudible] facility, which will help to reduce fixed costs and decorative products. This was a satellite facility that developed thin gauge vinyl film for a major customer. When that customer decided to buy paper-based laminates produced in our Monroe, North Carolina facility instead, we made the decision to close Dupo and consolidate this capability. The Company took a charge of $400,000 in the quarter for asset impairment and facility closure costs. An additional $400,000 in charges is expected over the next two quarters related to severance and the relocation of selected equipment to our Jeannette, Pennsylvania Decorative Products facility.

OMNOVA reached a key milestone during the third quarter as the third of our four domestic decorative products facilities was brought into our SAP enterprise business system. All the performance chemical plants have already successfully converted to the SAP platform. We’re seeing increased efficiencies, cost reductions, and improved access to business information as a result of the Company’s implementation of SAP.

In summary, OMNOVA was able to overcome challenges with record high raw material costs and a weakening economy to post our strongest quarter of the year. While we are encouraged by the progress, we clearly have more work to do to further enhance margins. Our pricing initiatives helped to offset raw material inflation in the third quarter and improved profitability in performance chemicals, however margins remain compressed and our challenge going forward will be take to every action within our control to drive margin improvement. More than ever, our associates are focused on increasing productivity, streamlining processes, driving lower discretionary spending and developing new products that deliver innovative solutions that enhance the value OMNOVA brings to its customers.

Our management is focused on driving greater operational discipline, especially in our Asian businesses and we are taking actions, such as those described earlier. While the environment is challenging and dynamic in pursuit of our priority to improve margins, we are leveraging strong positions we have worked hard to establish. These positions include leadership in our key markets, typically number one or number two. We demonstrated ability to grow at above market rates in key categories through innovative new products and leveraging industry consolidation, entrance into new related markets that leverage our competencies and open up a broader array of opportunities, our greatly enhanced global position, a cost structure that excluding rate materials is the lowest in our history and lastly an integrated and enhanced SAP business system that provides opportunities to streamline key business processes. All of our 2,700 associates are committed to taking action to improve our profitability and returns to shareholders.

I would now be happy to answer any questions that you may have.

Question-and-Answer Session

Operator

(Operator Instructions) Our first question comes from Jason Minor from Deutsche Bank.

Jason Minor – Deutsche Bank

Just to start off, Kevin, there have been a few ominous signs on non-residential construction lately. Just wondering if you’re seeing ominous signs in refurbishment or office construction in decorative products?

Kevin McMullen

Yes, I think we’re seeing some signs of slowing there. Office occupancy rates are weakening and hospitality, which had been relatively strong over the last couple of years, we’re seeing some slowing of project bids and the like. We are still gaining market share, but we’re seeing some signs of slowing in those segments.

Jason Minor – Deutsche Bank

That’s helpful. Sticking with end markets trends for the movement, if I could shift to Asia, are there any comments you could make on decorative products demand trends in Asia? Do things remain strong, or do you see any signs of weakening? Probably there’s a lot of speculation about possible weakening in Asia.

Kevin McMullen

Most of what we’ve heard is more speculation. I think demand has been fairly strong for our products. You can see the sales trend has been strong year-over-year. Our biggest challenge in Asia has been raw material inflation that we have not fully recovered with pricing. We have more work to do there, and we have some manufacturing costs challenges that we are working to overcome there as well. There was some one-time costs that were associated with us taking ownership of it that we’re working through as well. But I think so far at least what we’re hearing is demand is holding up reasonably well. Some signs in the automotive industry may have seen a slowing, certainly slowing of the automotive build in the month of August, but that was kind of a one-data point.

Jason Minor – Deutsche Bank

Jumping around regionally, sorry, back here, in terms of consolidation amongst competitors in decorative product markets is that any faster? I know it’s been happening for a while. You mentioned some shutdowns. Is there any way to gauge how much tighter or how much benefit the most recent round or current of shutdowns might be?

Kevin McMullen

There have been probably two or three competitors that have exited the industry over each of the last probably two or three years. Nothing in 2008. The industry consolidation or the manufacturing consolidation that I described earlier was all in the styrene butadiene latex industry where plant closures have been announced earlier in the year of basically six manufacturing facilities in styrene butadiene latex.

Jason Minor – Deutsche Bank

None in the decorative products competitors though?

Kevin McMullen

Correct. Not yet.

Jason Minor – Deutsche Bank

Right.

Kevin McMullen

We’re announcing today the Duop facility closure. That’s a relatively small facility, but I suspect with the demand situation there could be some in the future. We’ll have to see.

Jason Minor – Deutsche Bank

Just two more quick ones, and then I’ll get back in queue. You mentioned this customer who switched from a vinyl to a paper-based coating, why would one do that, and is that helpful or not from a margin point of view?

Kevin McMullen

I thing the primary reason that the customer made that decision to do that was over price issues. Vinyl is inherently more expensive than paper in many cases, this would be for kitchen cabinets. I think in a down market with what’s going on with residential housing, the customer probably made a decision to try to reduce their cost as a way of improving their margins by going to a lower performing product.

Jason Minor – Deutsche Bank

Very clear, I see. Then lastly, just to revisit GenCryl platinum, I know it’s, I think in the past you’ve spoken about being lower volume but helpful to margin to switch. First, is that having… I mean are those switches having any impact on overall volume, or is it still too small to really move the needle? The secondly in this environment, is it still margin positive to switch a customer?

Kevin McMullen

Yes, absolutely, it is margin positive to do that. The product is higher strength, higher performing and so customers are finding that they can use I think anywhere from five to ten to maybe in some cases 15% less. So we are seeing some overall volume reduction as a result of that, but clearly the value that it brings, we are pricing it so that it’s margin positive for us and we’ll continue to that.

Operator

Our next question comes from Laurence Alexander from Jefferies & Company.

Analyst for Laurence Alexander – Jefferies & Company

I’m wondering, what is your expectation for margins in Asia going forward with the different initiatives that you have in place?

Kevin McMullen

Well, we certainly are very focused on turning the operating lost we had this quarter to an operating gain as we go forward, and there’s a number of initiatives going on both in the marketplace as well as in our operations that we believe will drive improvement going forward. We don’t have individual forecasts on profitability, but we certainly have higher expectations than what we achieved in this quarter.

Analyst for Laurence Alexander – Jefferies & Company

Any expectation on a timeline?

Kevin McMullen

Well given that we don’t give forecasts, we’re reluctant to give specific timing on things. But we’ve had a new team in place in Thailand for two quarters now and implemented a management restructuring in China in the third quarter. We’re very encouraged by the capability of the new team that we have in place, and we believe that we’ll be able to certainly return historical profit levels in that business and they drive beyond that.

Analyst for Laurence Alexander – Jefferies & Company

How did the mix shift in performance chemicals during the quarter?

Kevin McMullen

I don’t think there was…I’m thinking here, there was not a huge mix shift overall. We probably had a little higher specialty chemical sales in the mix, lower carpet because of the weakness in the carpet industry.

Analyst for Laurence Alexander – Jefferies & Company

Just one last one: Any outlook on possible industry consolidation for decorative products in Europe?

Kevin McMullen

In Europe, not unlike North America where the industry is very fragmented, Europe also has a pretty fragmented industry and I wouldn’t be surprised if there isn’t more consolidation going on there as we look to the future.

Operator

Our next question comes from Douglas Chuti with KeyBanc.

Douglas Chuti – KeyBanc

I actually joined a few minutes so I apologize if I’m touching on anything that you’ve already answered. First question, you mentioned we’ve seen some facility closures on the latex side. Have you seen any pickup capacity utilization rates this quarter or is that more or less just taking out excess capacity?

Kevin McMullen

We believe from our sense of things in reading industry estimates capacity and the like that utilization rates are going up. By year end when all of these closures that have been announced take effect, that it should be up significantly from where it is year end 2007.

Douglas Chuti – KeyBanc

Secondly, can you quantify potential cost savings from the closure of the Dupo Illinois facility?

Michael E. Hicks

It’s a small facility, Doug, and we will have, we estimate about $800,000 in cost and then about one-year payback, so we will have that much going into about the third quarter of next year.

Douglas Chuti – KeyBanc

You mentioned in the release that you’ve been seeing some customer inventory reductions. Would you say these reductions are just in line with demand, or do you think there’s a potential for some acceleration here as we move forward due to depleted inventory?

Kevin McMullen

Not totally clear on that, but I would say probably in line with demand.

Douglas Chuti – KeyBanc

One last question: Is the market for laminates getting worse? I think you quantified it being about 24% in the third quarter, is that worse that we’ve seen or is it pretty stable declines?

Kevin McMullen

I think it is pretty stable. One of the things that has contributed to our volume or sales reduction is the transition that this one customer made from vinyl to paper. That’s a lower revenue type of product when they made the transition to paper, so it overstates our numbers versus I think what’s going in the market.

Douglas Chuti – KeyBanc

Actually just one more: You saw a nice rebound in performance chemical margins during the quarter, looks like you fully offset raw materials at least in the quarter and kind of caught up for the full year. Do you think these margin levels are sustainable as we head into the fourth quarter and next year, or do you see any other additional headwinds there?

Kevin McMullen

That’s certainly our objectives and that’s what our number one focus is maintaining and building margins to higher levels overall for our Company and more acceptable levels overall. Obviously in a slowing demand environment, that’s a challenge. The raw material situation is very dynamic. We all saw the trend in oil coming down. That’s kind of temporarily halted we believe with the hurricane adjustments that are being made. If raw material… If oil goes down we believe longer-term, that could have a positive effect on our raw materials and that should help so. Our intention is to improve the margins from where they are today.

Operator

We have a follow-up from Jason Miner from Deutsche Bank.

Jason Miner – Deutsche Bank

Kevin, I think you mentioned that we remain behind the eight ball so to speak on pricing of course for raw materials. So here’s my tricky what if: If we sort of leveled off on raw materials, when would we catch up, if that’s possible to kind of guesstimate?

Kevin McMullen

Well, we have a lot of momentum right now with the pricing actions we have taken, and we would continue to benefit from that if raw materials leveled off. If raw materials level off, we think that there’s certainly upside in margins. Historically the way it’s happened is raw materials level off or decline, we’ve seen margin expansion in the business. We do have more of our business on index pricing today than we have in the past so that could moderate some of that, but we still would expect margin expansion.

Jason Miner – Deutsche Bank

So assume that’s a shift in mix in the performance chemical side where you have like paper chemicals that are indexed now or where is that change happening?

Michael E. Hicks

We have 100% of our paper customers indexed with the major ones, and we did pickup additional non-paper customers onto the index formulas in the third quarter, some of it late in the third quarter. So I would estimate that about 60% of all reform chemicals customers are on an index and a number of the ones that are not on an index are at least on a surcharge for specific raw materials, particularly butadiene.

Jason Miner – Deutsche Bank

So it’s largely in decorative products where there’s some more runway so to speak for prices to expand, is that fair?

Kevin McMullen

Probably 40% of our chemicals business as well.

Jason Miner – Deutsche Bank

Right. Got it. Very helpful, thank you.

Operator

(Operator Instructions) We’ll go to the line of Robert Kosowski with OFI Institutional.

Robert Kosowski – OFI Institutional

I was wondering if you could talk about, obviously you had some success with the new price increases. If you can talk about kind of difficulties or pushback that you might’ve had with trying to transfer people over to the index pricing, have you lost any volume, is there any kind of pre buy, any consequences that came along with this?

Kevin McMullen

Let me answer the last part of it. Pre buying in our chemicals business is not typically a significant issue. People don’t have storage for storing large volumes of this raw material so typically there’s not a lot of pre buying done. No price increase that I’ve ever seen is ever implemented without some pushback from customers. We had a lot of discussions with customers. We’ve been very open and transparent with them as to what the raw material situation is. We’ve been very open and transparent with them on all the productivity initiatives we’re taking to try to offset as much of that as we can, and we’ve been very candid with them about our need for raw material increases and so we were successful in implementing that and really with no customer losses to speak of at all. There may have been a few at the margin but nothing significant. The importance for us to have ongoing communication and dialogue with our customers so that when we get to these situations they are fully aware of what’s going on. We try not to surprise them. We try to give them notice, but we also try to be very clear that these are just absolutely necessary in this kind of environment.

Robert Kosowski – OFI Institutional

Did you notice any impact of the coded ground wood inventory builds on volumes in the quarter?

Kevin McMullen

Well volumes overall for the industry softened in the quarter and I think there was some inventory correction going on. I’m not sure if that answers your specific question.

Robert Kosowski – OFI Institutional

No, sure it does. I guess two other things. What’s on the list of things to do for the decorative products business in order to get it turned back to profitability?

Kevin McMullen

We need to get Asia operating at a higher performance level. Obviously the loss that we experienced in Asia in the quarter from an operating profit standpoint was a drag on the business. We need to get pricing actions more fully implemented across the business, and we need to get volumes turning in the right direction. At the same time, we need to look at our utilization rates and figure out ways of improving that either through industry consolidation or through taking other action.

Robert Kosowski – OFI Institutional

Finally is the Asian business, is they acceptable to I guess some more performance culture as you said, and kind of how is that kind of culture change going?

Kevin McMullen

I think we’re making progress. That kind of thing takes longer than making specific changes in the operations, but I think we’re making progress. As we speak we have LEAN SixSigma core team over there right now in Thailand that is going through five very focused projects and they are doing two things. One is training the local team on using the tools from LEAN SixSigma, which we think will be critical to get yield improvement and reduce operating costs, etcetera. But at the same, they’re making headway on these five projects that have been identified that are important kind of breakthroughs for Thailand. So more and more we will be able to leverage some of the capability we have and some of the practices that we have both in Thailand and China and that’s ongoing process, but certainly having full control and 100% ownership allows us to do that whereas with a partner that was the operating partner, it was more difficult to make that happen.

Operator

We’ll go the line of Tom Spiro with Spiro Capital.

Tom Spiro – Spiro Capital

I got on a moment late, I’m sorry if this has been asked already, but I was curious if any bad debt issues have arisen, late payments, or if you guys are tightening terms, that whole package of questions?

Michael E. Hicks

No, we watch our portfolio very closely, Tom, and DSO picked up about a day in the quarter, but that was really driven by the fact that quarter ended on Labor Day Weekend and we got those collections in the next week. The credit situation generally is pretty good. We do I think a good job monitoring that, and we don’t see any significant issues out on the horizon.

Operator

We have no further questions.

Kevin McMullen

I’d like to thank you all for joining us for our third quarter conference call. We’ll look forward to talking with you at the end of the fourth quarter. Have a great day.

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Source: OMNOVA Solutions Inc. F3Q08 (Qtr End 08/31/08) Earnings Call Transcript
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