KMG Chemicals, Inc. F3Q09 (Qtr End 5/31/09) Earnings Call Transcript

| About: KMG Chemicals, (KMG)
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KMG Chemicals, Inc. (NYSE:KMG) F3Q09 Earnings Call June 4, 2009 10:00 AM ET


J. Neal Butler - President, Chief Executive Officer, Chief Operating Officer, Director

John V. Sobchak - Chief Financial Officer


David Yuschak - SMH Capital

Alex Silverman – Special Situations Fund


Welcome to the KMG Incorporated third quarter 2009 conference call. We would like to being by reminding you that the information in this conference call includes certain forward-looking statements that are based upon assumptions that in the future may prove not to have been accurate and are subject to significant risks and uncertainties including statements as to the future performance of the company.

Although the company believes that the expectations reflected in its forward-looking statements are reasonable, it can give no assurance that such expectations or any of its forward-looking statements will prove to be correct. Factors that can cause results to differ include but are not limited to the loss of primary customers, successful implementation of internal plans, product demands, the impact of competing products, increases in the prices of raw materials and active ingredients, successful acquisition and integration of additional product lines and businesses, the condition of capital markets in light of interest rate and currency fluctuations and general economic conditions, environmental liability, the ability to obtain registration and re-registration of products, increased environmental compliance cost of products, and general political and economic risks and uncertainties.

With that I would now like to turn the call over to Neal Butler, President and CEO.

J. Neal Butler

Welcome to KMG’s third quarter 2009 conference call. John Sobchak, our CFO and I will take you through financials, provide an overview of each of our businesses and address any questions you have. Our earnings release was filed earlier today and I hope all of you had an opportunity to review it.

First, I’d like to point out that despite continuing adverse economic conditions, we turned in a very good third quarter. If you were on our last conference call you will recall that we forecast a much stronger second half than first half. The bottom line improvement was partially due to cost cutting initiatives that not only helped us achieve the 66% gain in net income but will position us for continued improvement when things normalize in our most impacted industries.

The other key contributors in the increase in profitability was the strength of our wood treating preservative segment, the reduction in commodity prices resulting in a decrease in some of our raw material costs and the elimination of costs related to our electronics chemical acquisition. For the fiscal 2009 third quarter we reported operating income of $5.4 million, up 40% compared to $3.9 million in the third quarter of last year. Net income was up by 66% to $2.8 million, or $0.25 per diluted share compared to $1.7 million or $0.15 per diluted share in the same period last year.

As we reported, net sales were down to $45.9 million versus $50.3 million in the third quarter of 2008. We experienced a significant decline in demand for our electronic chemicals due to decreased production levels in the semiconductor market greatly driven by deleveraging and associated inventory reductions of virtually all industries that rely upon semiconductors in their manufacturing. Both our US and European sales were negatively affected.

Based upon our financial results for the first nine months of fiscal 2009 which reflects a 38% increase in net sales and a 10% increase in net income, we believe we’re still on track to achieve our previously stated guidance of 20% revenue growth and notably improved profitability for fiscal 2009 versus fiscal 2008.

Now, I’d like to discuss the performance and outlook for each of our businesses. Our wood preserving business was strong in the third quarter. Creosote sales increased 27% to $18.2 million due to consistent demand by the railroads for cross ties treated with creosote as well as price increases that we implemented earlier in the year. As you may recall, during our second quarter conference call we forecast that we might see a decrease in rail traffic in the third and fourth quarters which typically leads to reduced maintenance programs and less demand for our products.

However, based upon our experience thus far this year we believe that our creosote sales will remain relatively stable for the remainder of the 2009 calendar year. Penta sales increased 17% to $6.9 million during the quarter due to higher volumes. Utility maintenance programs continued to run at a relatively steady state thus we saw some demand increase driven by hurricane and Midwest ice store damages.

With respect to our electronic chemicals segment, the downturn trend that we saw in the second quarter worsened in the third quarter with the dramatic and sudden decrease in sales volumes. Industry wide semiconductor demand has declined and associated production at fabrication facilities has dropped by 30% or more according to our sources. We responded quickly to the new market conditions by implementing cost cutting measures at our manufacturing sites as well as efficiency improvements and associated cost reductions in our supply chain. We were also successful at reducing the inventory and working capital requirements of the business.

We saw contractions in all electronic chemical market volumes across the globe with the most notable decline in Asia which is less than 2% of KMG’s sales. The US market where we have an estimated 40% market share suffered the least severe disruption. In Europe, where we have an estimated 15% market share also suffered a dramatic contraction in the semiconductor market although not as severe as Asia.

While it’s not possible to accurately predict the timing of a turnaround in the semiconductor industry, we may now have passed through the trough and are seeing some positive actions in the marketplace as we have experienced a pickup in orders in North America late in the third quarter. Having reduced costs in our electronic chemicals business as well as taking steps to optimize operations and improve unit margins, we believe we’re effectively positioned for the future rebound of the semiconductor market.

We believe that it will indeed rebound, however, the timing is uncertain. So while cost reductions at manufacturing sites have been made, we were careful not to reduce critical headcount to ensure that we’re prepared to react and efficiently meet any uptick in demand. When semiconductor demand increases our products typically are on the front end of supply chain needs and our customers expect us to meet quickly changing requirements. That is one of the value added components that we bring to market. We also continue to pursue attractive expansion and acquisition targets in this sector.

In our animal health business, third quarter net sales were $3.5 million compared to $4 million last year. While down from their highs of 2008, feed, fuel and fertilizer remain expensive and cattle growers have left discretionary spending for parasitic fly and pest control products. The use season for ectoparasiticides which is the category for our animal health products is late spring and summer and we did not see the seasonal upturn in sales until the latter portion of our third quarter. Livestock, dairy and poultry markets have been under stress and animal health distributors have been reluctant to build inventory.

Nonetheless, we anticipate 2009 fourth quarter revenue to exceed Q4 of 2008 and we have notably downsized the cost structure of this operation which represents approximately 6% of KMG’s total revenue. As many of you know animal health is a seasonal business with sales weighted to our fiscal third and fourth quarters. We continue to take steps to expand and diversify our sales and geographic distribution which will help reduce the seasonality. Our Avenger and Patriot tags maintain a dominate position in the US.

Also, as mentioned in our last call several Latin American registrations have been obtained this fiscal year and although initial volumes of comparatively small product shipments have been made to five countries and we have additional registrations pending in other Latin American markets. The critical first steps are obtain registrations and establish a sound distribution network. Distribution is in place and our regulatory efforts continue in all key Latin American countries.

I’ll now turn the call over to John to provide some additional information on the third quarter and our financial position.

John V. Sobchak

Thank you, Neal and good morning, everyone.

Revenues in the third quarter declined by $4.4 million or 9% to $45.9 million versus the year earlier period. The reduction in revenue was led by electronic chemicals which experienced an $8.8 million or 34% decline due to a dramatic recession induced contraction in the market. Also, animal health revenues declined by $500,000. Those declines were partially offset by higher revenues in our wood preservative business.

While revenues declined in the third quarter, gross profits increased by $271,000 or 2% to $15.4 million. Gross profit margins as a percentage of revenue improved from 30% to 33% for that third quarter period. As Neil mentioned earlier our lower commodity prices and the impact that it had on our raw material costs was a major driver for that improvement as well as the efficiency and optimization initiatives undertaken in the electronic chemicals business following our integration of that business on to our platform this past October.

For the first nine months of the year, revenues increased by $39.3 million or 38% to $142.3 million versus the year earlier period. Electronic chemicals revenue increased by $30.3 million for that nine month period versus 2008 because the business was only owned for four of those first nine months in fiscal 2008. Animal health sales declined by $1.3 million during that period while wood preservative sales increased by $10.2 million. Gross profit margins as a percentage of sales were fairly flat for that nine month period at 31%.

SG&A was $9.9 million in the third quarter, that’s a 12% decrease from $11.2 million in the prior year period. As a percentage of sales, SG&A was 21.6% in the third quarter of 2009 and we saw a small improvement over the prior year. We include distribution expenses in SG&A rather than cost of goods sold. The electronics chemicals business has a much more complex supply chain than our legacy businesses resulting in a higher SG&A burden as a percentage of sales.

Most of the cost reduction initiatives that Neil mentioned earlier are focused on optimizing the supply chain in that business. We estimate that approximately a third of our SG&A is truly variable on a short term basis and most of that is associated with trucking, warehousing charges, etc. As discussed in earlier disclosures, the amortization expense associated with certain intangible assets in our wood preservatives business was reduced significantly beginning in January of 2009. That reduction totaled to approximately $1.2 million over the last seven months of the fiscal year versus fiscal 2008.

For the nine month period SG&A increased by $10.6 million or 47% to $33.1 million. Most of that increase was associated with the ownership of the electronic chemicals business for a full nine months versus just four months in the year earlier period. We also estimate that we incurred an additional $1.1 million in costs associated with the transition and integration of that acquired business on to our platform during the first quarter of fiscal 2009.

Interest expense in the third quarter reduced to $732,000 from $1 million in the prior year. The third fiscal quarter of 2009 benefited from lower interest rates as well as lower debt levels as we repaid borrowings associated with our electronic chemicals acquisition. For the nine month period, interest expense increased to $2.4 million from $1.8 million because the acquisition occurred five months in to fiscal year during 2008 and prior to the acquisition the company had significantly lower debt.

Our income tax rate was 40.5% for the quarter versus 36.7% in the third quarter of fiscal 2008. Net income increased 66% to $2.8 million or $0.25 per diluted share in the third quarter compared to $1.7 million or $0.15 per diluted share for the same period last year. For the nine month period, net income was $5.3 million or $0.47 per diluted share versus $4.8 million or $0.43 per diluted share in the first nine months of fiscal 2008.

Moving on to our balance sheet, networking capital at the close of the third quarter was $33.9 million, that’s down 14% from the previous quarter. Included in that was $1.8 million of cash. We have worked diligently at reducing working capital requirements particularly in our electronic chemicals business. In total, debt on April 30th was $57.7 million which included $10 million borrowed on our revolving credit facility. That’s down from $66 million of total debt at the close of the previous quarter.

As of May 31st, we had reduced the outstanding balance on our revolving credit facility to $5 million having repaid $12 million of the $17 million borrowed on that facility as of the end of the second quarter. We expect to repay the remaining $5 million borrowed on the revolver before our July 31st year end. Now, as of April 30th we were in compliance with the three credit ratios required in our credit agreement. Those requirements were a maximum debt to EBITDA ratio of 3.25 and our ratio was 2.8. A maximum debt to capitalization ratio of 60%, we were 47%. And, a minimum fixed charge coverage ratio of 1.50, our ratio was 1.54.

For the next quarter’s calculations we will be rolling off a relatively weak fourth quarter of fiscal 2008. Also, as previously noted, we have made significant progress in paying down our debt so while our fixed charge coverage ratio in particular was tight for the third quarter, we anticipate all of our ratios improving significantly in the next quarter.

During the third quarter we paid an interest rate equal to 2.75% over LIBOR on our term loan borrowings which was $27.7 million at the close of the third quarter as well as the revolver. That interest rate calculation is reducing to 2.5% over LIBOR based on our improved funding debt to EBITDA ratio. The revolver is a non-amortizing facility that matures in December of 2012. The term loan is an amortizing facility that is fully paid off on that same date. We also have $20 million of non-amortizing notes for which we pay a fixed interest rate of 7.43% maturing on December 2014.

Shareholders’ equity for the 2009 third quarter was $64.9 million or $5.79 per diluted share. As of April 30th we had 11.1 million basic shares and 11.2 million diluted shares outstanding. Now, I’ll hand it back to Neil for closing remarks.

J. Neal Butler

I would like to reiterate how pleased we are with our third quarter results. Even with the slowdown in the electronic chemical segment we believe that we are still strongly to positioned in this economy to deliver on our earlier stated guidance of achieving higher earnings in 2009 versus 2008 and year-over-year revenue growth of approximately 20%. Our confidence in our ability to achieve these goals are backed by the benefits of the cost reduction initiatives we have undertaken, the inclusion of a full 12 months of the electronic chemicals business, post integration cost savings in that business, continued strength in our wood preservative business, lower commodity prices and raw material costs across most of our segments and $1.2 million reduction in amortization expense associated with our wood preservatives business.

We remain cautiously optimistic about KMG’s business prospects and are mindful of the economic uncertainties. As mentioned in our last call, we believe KMG’s attachment to key infrastructure industries provides some measure of stability though certainly no guarantee. Our electronic chemicals business has seen a dramatic and sudden decrease in revenues. We see no evidence that our markets will not eventually recover to their previous levels.

We will continue to closely monitor developments and take prompt action when necessary. Long term, we will continue to execute on the companies proven business model of acquiring, optimizing and growing specialty chemical businesses. The current economic environment could prove beneficial with regards to our acquisition efforts. We’re pursuing several acquisition candidates and are working towards closing our next acquisition in fiscal 2010.

We do appreciate your participation today and will now open the floor for questions.

Question-and-Answer Session


(Operator Instructions) Your first question comes from David Yuschak - SMH Capital.

David Yuschak - SMH Capital

As far as the preservatives segment guys, was there just some catch up here in the quarter relative to what the kind of depression we’ve seen in a lot of businesses in that December/January period? Was it more just a catch up that led to that type of thing or was there something different than what you may have expected in the way of this kind of outstanding results?

J. Neal Butler

No, it was not really a catch up. The volumes weren’t significantly up over prior quarters. We had some price increases that we had implemented earlier that obviously had a positive impact in the third quarter. Additionally, with some of the cost reductions we had with some of the raw materials we saw an improvement in the margins and I guess when I look at it we would say it’s probably more of a recovery than a catch up.

David Yuschak - SMH Capital

Looking in to this next couple of quarters, are you seeing demand starting to come back then as far as more volume versus the prices you’ve realized so far?

J. Neal Butler

Well, it depends on the segment. We do believe that we’ll see that in the electronic chemical segment. As we mentioned, it’s a bit difficult to predict exactly when that will hit but the anticipation is that the semiconductor market will rebound. I think you’ll see in the wood preservative business that we expect pretty close to a steady state there and the animal health business for the fourth quarter will be up over the fourth quarter of prior year.

When you look at animal health you really have to look at it as a second half business and I’m talking about our fiscal second half versus a third quarter business or a fourth quarter business. The business can fall equally in to the third of fourth quarter and this year it’s just coming later than it has in prior years.

David Yuschak - SMH Capital

Then as far as the electronic chemical business because of this kind of run rate that you’ve got and kind of the economic conditions out there, are you seeing maybe some pricing pressure by others to try and take some market share during this period of time or has it just been no volumes at all from anybody to have any price competition from whoever?

J. Neal Butler

The entire market has been down. There are always some price pressures but I wouldn’t say that there is anything usual or A Typical in the pricing from a competitive standpoint right now. It’s just if you go across the board, I think you’ll find everybody that’s supplying this sector is seeing the same kind of downturn that we’re experiencing.

David Yuschak - SMH Capital

Now, during the time turn seen any reasons to see potential new business opportunities coming out of there as you kind of explore where you can initiate new programs to kind of mitigate some of this negative experience?

John V. Sobchak

We have been looking at other markets. We’ve expanded our sales in to the photovoltaic market in Europe which hasn’t been subject to the same levels of decline as the semiconductor market. In the United States these kind of disruptions always breed opportunities.

David Yuschak - SMH Capital

One last thing on your cash flow, good cash flow in the quarter, was some of that just because of the softness that your working capital needs abated enough to pick up some debt reduction there? What kind of prospects do you have for debt reduction in the fourth quarter?

John V. Sobchak

When we came off the transitional services agreement in October with Air Products where they were handling all of our back office operations and we brought that back office operations on to our own platform, we inherited some bloated inventories and receivables that we’ve been working very diligently at optimizing. We saw significant success of that in the third quarter and that was a larger driver for the increase in cash and our ability to pay down the debt as we had.

We’re not quite to where we want to be on that. Also, as we enter the fourth quarter we’re at that stage in the cash cycle for the animal health business which is it’s basically one inventory turn a year kind of business and those sales are converted in to cash in the fourth quarter generally so we’ll start to see some benefit there as well. So, we’re expecting to see continued cash generation in the fourth quarter.

David Yuschak - SMH Capital

Your priority will be to pay down the debt with any net cash generated?

John V. Sobchak



Your next question comes from Alex Silverman – Special Situations Fund.

Alex Silverman – Special Situations Fund

First, is there an opportunity to lock in some of these lower commodity prices at this point?

John V. Sobchak

The commodities that we’re buying are not kind of mainstream commodities and some of our raw materials are more index to those commodity prices in a loose way so there’s not much of an opportunity to hedge there. We’re also, in the big scheme of things in the chemical industry, we’re a very small consumer.

Alex Silverman – Special Situations Fund

Secondly, a large electronic chemical customer of yours was rolling out a couple of new lines which provided you an opportunity for new business. Can you give us a sense whether those lines have been put on hold or whether they continue to roll them out?

J. Neal Butler

I guess as a general statement Alex, we see no evidence that the lines are being put on hold. We do know that the fabrication facilities are not at this point running at full capacity. But, we have no evidence that some of the earlier stated intentions that they are backing off of those or moving away from it.

Alex Silverman – Special Situations Fund

The last question for me obviously, the Merck animal health assets are enormous that are being divested, do you have any sense whether they’re talking about breaking up any of those businesses and selling them in smaller chunks and whether there are opportunities there for you?

J. Neal Butler

Not that I’m aware of. All I’ve seen is that it is being put up for sale and it is being put up for sale as a unit. I don’t know that they would be breaking it up, I suppose it’s a possibility but I certainly have no evidence of it. When you look at the product lines that they have, they are really not very involved in the ectoparasiticides portion of the market which is the area, the niche that we tend to concentrate in.

John V. Sobchak

What I’d be interested in Alex is after the transaction occurs talking to the buyer about what portions of that they might not be interested in and if any of it fits with us.


There are no further questions. I will now turn the conference back to management.

J. Neal Butler

Again, we’re very pleased with the third quarter and we’re very optimistic or cautiously optimistic as I mentioned a moment ago for our fourth quarter prospects. We’d like to thank you all for joining us today and thank you for continued interest in KMG. John and I are both in the office and available should you have additional questions. With that gentlemen, thank you.


Ladies and gentlemen this concludes our conference for today. Thank you all for participating and have a nice day. All parties may now disconnect.

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