H.B. Fuller Company (FUL) 2005 Q3 法說會逐字稿

Good morning and welcome to the third-quarter year 2005 earnings release conference call. At the request of this company the conference is being recorded for instant replay purposes. The conference has been scheduled for one hour, and following today's presentation there will be a formal question-and-answer session. Instructions will be given at that time should you wish to ask a question. Management in attendance on today's call include Mr. Al Stroucken, Chairman of the Board, President and CEO; Mr. John Feenan, CFO and Steven Brazones, Director of Investor Relations. At this time I would like to turn the meeting over to Mr. Steven Brazones. Thank you, sir. You may begin.

Welcome everyone. Today's conference call will be available for replay approximately one hour after we are finished with the question-and-answer portion of our call. For a beginning I would like to inform everyone that certain matters discussed during this call will include forward-looking statements as that term is defined under the Private Securities Litigation Reform Act of 1995. Since such statements reflect our current expectations, actual results may differ. In addition, during today's conference call we will be discussing certain non-GAAP financial measures. Specifically free cash flow. Management believes that discussion of these measures is useful to investors because it provides insight into the ability of the company to fund such things as debt reduction and acquisitions. For more information please refer to our recent press release, quarterly reports on form 10-Q and annual report on form 10-K filed with the Securities and Exchange Commission. All of which are available on our website at www.HBFuller.com under the Investor Relations section. Now John Feenan.

Thank you, Steven. Good morning to everyone. This year's third-quarter performance showed a noticeable improvement over the prior year, and it marks the first time since the first quarter of 2003 that we have had a positive year-over-year gross margin comparison. This is especially encouraging given the difficult raw material cost environment we have been experiencing. It is a testament to the hard work and dedication put forth by our team members. We credit our enhanced pricing strategy, continued focus on reducing operating costs and ability to drive efficiencies through lean Six Sigma for this improvement, which is evident as we look at our third-quarter income statement.

For the third quarter net revenue was $358.1 million, 2.5% higher than the $349.5 million of net revenue in the third quarter of 2004. This year's third quarter excludes the results of our former Japanese operations, which if included would have culminated in net revenue growth of 5.4%. This is respectable performance, especially when taken into consideration the current environment. The components of the 2.5% increase in net revenue were as follows. Pricing increased 7.8%. Volume decreased 3.1%. Currency effects accounted for 1.7% increase and the deconsolidation of the company's Japanese operations accounted for a 2.9% decrease.

Gross margin for the third quarter was 27.3% compared to last year's third-quarter gross margin of 26.8%. The 50 basis point increase in gross margin was driven by both cost reductions and operational efficiencies at the plant level. Although continued sequential progress was made on the pricing front, price increases implemented during the third quarter still fell short of the increases in raw material costs, which increased at a double-digit rate year-over-year.

Selling, general and administrative expenses were $73.5 million, down $5.6 million versus last year's third quarter of $79.1 million. Last year's third quarter SG&A expense included $2.3 million related to a legal settlement. As a percentage of net revenue SG&A was 20.5%, down 210 basis points versus last year's third quarter of 22.6%. The decline in SG&A was the result of thorough cost controls across the entire organization coupled with productivity improvements.

Operating income, which is defined as gross profit less SG&A expense for the third quarter was $24.1 million, up sharply from last year's third quarter operating income of $14.7 million. This represents an improvement of over 60% year-over-year, bringing our operating margin from 4.2% in the third quarter of last year to 6.7% this quarter. On a segment basis, global adhesives operating income demonstrated a noteworthy improvement by increasing from $5.6 million in the third quarter of 2004 to $16 million in this year's third quarter. This represents an increase of over 400 basis points in segment operating profit margin. Disciplined pricing strategy, as well as a heightened scrutiny of costs throughout the segment has driven this improvement.

For our Full-Valu/Specialty segment operating income was $8.1 million in the third quarter versus $9.1 million in the previous year. The year-over-year decline was primarily due to raw material costs outstripping implemented price increases and a heightened competitive landscape in the paints and Powder Coating end markets.

Interest expense of $2.9 million was 8.2% lower than the $3.2 million for the third quarter of 2004. This decrease was primarily due to the repayment of private placement debt earlier this year. Net gains on sales of assets were $278,000 in the third quarter of 2005 as compared to $370,000 in last year's third quarter. Other expense net in the third quarter was effectively zero compared to $1.9 million for the third quarter of 2004. The decline was predominately related to lower currency exchange losses and higher interest income.

Pretax earnings of $21.4 million for the third quarter of 2005 was over double that of last year's third-quarter pretax earnings of $9.9 million. The effective tax rate for the quarter was 32% compared to 17.5% in last year's third quarter. Last year's third quarter tax rate included a favorable tax settlement on a previous tax audit. Accordingly, for the third quarter of 2005 net income increased from $8.9 million in the prior year to $15.5 million. Diluted earnings per share were $0.53 compared to $0.31 for last year's third quarter.

Based upon our third quarter performance, we now expect full year diluted earnings per share to come in at the upper end of our previously discussed range of $1.75 to $1.85 per share for fiscal year 2005. Before discussing the balance sheet I would like to remind everyone the following figures are subject to minor changes prior to filing our 10-Q. Cash at the end of the quarter totaled $112.8 million. Net working capital, which is defined as net trade accounts receivable plus inventory, minus trade accounts payable amounted to $256.4 million. As a percentage of annualized net revenue, net working capital was 17.9% for the third quarter. This represents a decline of 90 basis points from the previous year's third quarter. Improvements were concentrated in accounts receivable and inventory as accounts payable were essentially flat year-over-year.

Purchased property plant and equipment for the quarter was $5.6 million, effectively flat with last year's third quarter spend of $5.7 million. Given the level of spend year-to-date we now expect purchased property plant and equipment to be in the range of $25 to $30 million for the fiscal year 2005 versus our previously discussed range of $40 to $45 million.

Depreciation and amortization expense in the third quarter was $13.5 million. Total debt at the end of the third quarter was $150.5 million compared to $172.6 million at the end of the third quarter of 2004. This represents a decrease of $22.1 million year-over-year. The company's capitalization ratio was 20.6% at the end of the quarter compared to 24.6% at the end of the third quarter of last year. Free cash flow for the quarter defined as cash flow provided by operations less dividends paid and purchased property plant and equipment, was a positive $28.1 million compared to a positive $23.2 million in the third quarter of 2004. The components for the third quarter of 2005 were as follows. Cash flow provided by operating activities was a positive $37.3 million. Dividends paid were $3.6 million, and purchased property plant and equipment was $5.6 million.

In summary, the third-quarter performance was encouraging. Despite falling short on increasing prices to offset the increase in raw material costs, gross margin increased year-over-year for the first time in several years, and we continue to generate solid cash flow. The cost control processes we have put in place coupled with our disciplined pricing strategy have and will continue to strengthen the foundation of H.B. Fuller and provide enhanced flexibility in the future. I will now turn it over to Al.

Thank you, John, and good morning to all the participants on this conference call. If I were to summarize the past quarter for our company, I would say it was marked by continued progress in a challenging environment, confirming that our strategy and actions are appropriate and effective. Since our last conference call our expectations of continuing price pressure on our raw materials have certainly been confirmed. The additional strain caused by hurricane Katrina seems to indicate that it is unlikely that we will see a fundamental shift in the supply/demand picture in the foreseeable future. In other words, cost pressures are not likely to abate, but I will get back to this issue a little bit later.

Let me first share some observations with you about the third quarter. We made further progress with our pricing processes in all businesses and regions. In addition, we are seeing a solid positive mix impact as well. Part of that is due to formulation changes and switching customers to products that have a more acceptable contribution. In our adhesives business in particular we have shortened the reaction time between raw material increases and pass-through to the marketplace, reducing the negative margin impacts such time delays tend to create in an inflationary environment.

On the other hand, being quick to react to such changes can have the effect that we are sometimes losing volume to competitors that do not have the same capabilities or that have a different assessment of the projected raw material developments. Many of these particular situations are likely to only temporarily affect our volume development.

In the past I have mentioned as well that in some cases we made a conscious decision to walk away from volumes that were not generating as satisfactory profitability and were not supportive of our efforts to recover our margins. In an environment of tight supplies and rapidly escalating raw materials that constitute between two-thirds and three-quarters of our cost of goods, the indiscriminate leverage of capacity utilization is in our opinion, not an effective tool to recover profitability.

During the quarter we were particularly volume impacted in July. Since then we have seen a decent pickup. We have also observed that some of our European mainland competitors have raised their prices, and I believe that given the impact the hurricane has had on some of the supply chain fundamentals that trend is likely to continue. As you can see from our margin development, as well as from our absolute profit generation numbers, we seem to be making the right decisions in this challenging environment.

In our Full-Valu/Specialty businesses we were also effectively raising prices. In our Paints and Powder Coatings businesses our volumes were weaker than expected because that is where we have the highest price increases. In our construction related activities volumes and prices were up, reflecting generally strong demand and increasing raw material costs. But overall in Full-Valu/Specialty we are trailing behind the raw material escalation curve, and we are taking steps to correct that time lag.

While there can be no substitute for effective market segmentation and an effective pricing strategy, we do not neglect the opportunities we have within our own organization to become more productive and cost-effective. We have seen very positive contributions from our manufacturing operations, as well as from our sales and administrative functions. Whether it is lab expenses, selling expenses, G&A or MOH, all are below last year's numbers in absolute terms, as well as a percentage of sales. Despite absorption of $1.5 million of additional pension expense for the quarter.

Many of these productivity improvements are supported by our lean Six Sigma efforts, and we feel that there are still lots of additional opportunities to pursue in the future. Now let me give you a quick overview of the trends in the regions. In Asia-Pacific our joint ventures with Sekisui in Japan and China are off to a good start, and we are confident that we will be able to get some additional positive momentum in the region going forward. Prices and volumes improved in the region and as a result we have seen a very nice positive impact on our results.

Latin America has made tremendous progress from last year. There have been solid increases in our prices, which really is only logical as in times of tightened raw material availability, this is also the region that sees the highest raw material inflation rates. Our people in the region have taken on this challenge and we are very pleased with the results.

Despite the sluggish economic environment, our European performance was especially strong compared to prior year. And a whole set of factors like pricing, MOH, selling expenses, administrative cost, market segmentation -- our associates in Europe have improved our company's performance significantly, in some cases even dramatically. And I normally shy away from hyperbole.

In North America where we have also seen solid price increases we had a significant volume impact. The combination of continuing and substantial raw material price escalation and the mixed reaction to this environment by competitors has created situations where we have lost volume. Some of this volume, as I mentioned earlier, was not at very attractive conditions. From an overall aspect we believe we made the right decisions for our company, and we are seeing a very positive impact on our results.

Our actions here are also supported by the many benefits we derive from lean Six Sigma and our general productivity improvements. Let me now move on to the general business conditions, as well as the more recent events and the potential impact they may have on our company. The demand picture in all regions in our view will continue to improve. We would certainly expect the absolute growth rates in North America and Latin America to move at a somewhat lower pace than during the last 18 months when they came out of a period of low or no growth. But still a solid expansionary environment.

Asia-Pacific will continue in much the same way we have seen the demand develop there over the last couple of years. And Europe in our opinion will do reasonably well next year coming from a very prolonged economic hibernation. Katrina's impact, especially here in the U.S. has been quite severe with regards to immediate availability of certain key raw materials, and longer-term is likely to put continued upward pressure on these base chemicals. In certain product lines the effect is even more pronounced as a significant portion of the global available capacity is impacted by for instance in titanium dioxide.

Equally, the price for natural gas, a key feed stock for most of our large volume raws is going to stay at a high level through most of the winter because of the disruption caused by the hurricane. As of 9/15, September 15th that is, 35% of the Gulf Coast's natural gas production remained down, and it is expected that it will take three to six months for a complete recovery. These latest developments have put additional emphasis on the general trends of tightening supplies and higher costs that in our opinion mark a definitive departure from the longer-term deflationary trend we observed in the 15 or so years prior to 2003 in the specialty chemicals industry. Such a trend change requires different approaches in our sourcing, marketing, pricing and cost management strategies and tactics.

I believe our Company has made those changes, and even though it does at times require us to make difficult choices, we are very pleased with the progress we are making. This is not a business as usual situation. The results in the third quarter were giving us a good deal of confidence for the remainder of the year. Katrina may have tempered our confidence level of that forward momentum somewhat by putting additional cost increases into the mix. Yet we feel we have a good handle on the situation with the process discipline we have in place. Our supply needs for the fourth quarter appear to be covered. We are actively out there with significant price increases in virtually all businesses and regions. Some are already effective in September. Others will take hold in early to mid-October.

The fourth quarter for us this year will consist of 14 weeks versus the usual 13. In light of the strong performance in the third quarter the pricing steps we have taken and the continued productivity improvements, we are confident that we will finish the year at the high end of the range we gave on the last conference call of $1.75 to $1.85 per share, on the diluted basis. With that, I'll open it up for your questions.

(OPERATOR INSTRUCTIONS) Ray Kramer, First Analysis.

The question first on the raw material price issue. You say you are still behind the curve. Obviously at least looking at gross margin you have made a significant improvement. Can you comment sort of on your progress catching up with Raws, and maybe what magnitude of price increases you think you still have to push through to catch up?

I think as we have seen over the last year and a half this is a continuing effort with continuing new sets of numbers every quarter. I believe that one of the benefits that we have seen in the past quarter is not only that we have some decent price increases, but also that the productivity improvements, whether it is yield improvements, whether its operating expenses and so on is concerned has of course helped us with that closing the gap. Now moving forward, we are confident that based on the experience that we've had over the past nine months or so, that we have the tools in place to get the increases that we need to cover the additionally expected raw material inflation.

What we are presently putting in place in September and in October ranges and of course, we have a whole range of products, but it ranges between 4% and 12% of price increases, and that is actually achieved price increases, not just the typical process of throwing out a number there and then expect we get part of it. Because I think it is quite obvious that in the discussions that we've had with our customers over the past nine months as well, they are very well aware of what is happening in the raw material area, and therefore the discussions have become much more rational and with people looking at the same set of data.

Okay, and then with that sort of level of price increases, and I guess what sounds like a competitive environment that maybe getting at least a little bit better in the U.S., what sort of volume decline expectations do you have for the next quarter or going forward?

We are not, of course, generally forecasting the volume because again, given the wide range of products that we have there is a significant issue that you have to take into account whether you sell a product at $0.30 or $0.40 a ton or where you have some products that we sell at $11 and $12. So the total volume by itself is not really necessarily indicative of what we expect for the quarter. I think that we will most probably, as we always do when you are out with price increases see some reluctance on customers. We have to make some firm commitments for some volumes. But as you have seen over the past twelve months or over the last nine months of this year, we are pretty flat with our volume compared to last year. And I would expect that we see something similar in the next quarter.

What was volume sequentially in the quarter? You gave the year-over-year number but I didn't hear a sequential?

I think the sequentiality of the year you also have to take into account that we have some cyclicality. For instance, the third quarter typically of course has the vacation time in Europe in there and so you have to keep that in mind, as well. I think that if you really look at the quarter-over-quarter number, I think overall volume was lower. But overall sales were lower, too then in the second quarter. But that is just an indication of the typical cyclicality.

Okay. Thanks a lot, Al.

David Begleiter what Deutsche Bank.

Al, on the volume decline how much do you think is permanent? How much is temporary, and how long will it take to get back from that lost volume if you so choose to get it back?

Well, that of course requires a lot of guessing, David. Because, as I said everything is in a state of flux at this point in time. And as we have seen in the past three quarters a customer that you lose in one quarter suddenly shows up again in the next quarter. I would be hard pressed, but if you really want a guess, I would say half and half.

Fair enough. Also, you seem a little more optimistic on the longer-term state of the industry given the new dynamic from a pricing standpoint. Are you feeling better about the adhesive business longer-term given what has happened in the last 6 to 12 months from a pricing and feedstock perspective?

Well, of course I cannot speak for the industry because, as you already saw from my comments, there still are some little mixed signals that are out there from the various players in the marketplace. I believe that as far as H.B. Fuller is concerned we certainly have increased our level of confidence in our capabilities of making this a more rewarding and profitable business for our company then it has been over the last four or five years.

And just on a last point going forward perhaps potential for further consolidation in the industry?

Well, as you know, David, the industry has many players. I think 400 here in the U.S., 500 in Europe. But there is only really a handful of large, global players. And I would believe that any noticeable consolidation that really is going to impact the dynamics of the industry would have to come among the top range of players. I don't think that we really see a significant benefit from having 10 or 15 smaller manufacturers going out of the marketplace. I don't think we would even notice.

Tita Sundrum (ph) with Cardinal Capital.

The first set of questions is on the cost driven profit growth. Could you give some more specifics -- there are three parts to this. Give some (indiscernible) color or specifics and kind of what went right with those cost controls and efficiency initiatives. Secondly, how sustainable -- is it a onetime (indiscernible) is it a permanent sort of increase or sort of decrease in the cost ratio but then no further improvement? How sustainable is it? What can we extrapolate from this quarter? And thirdly, what were the costs to generate those savings? Because when you look at Six Sigma in some other companies for example, typically after a period of time you will start seeing SG&A tracking up because use of consultants and so many other different paraphernalia. So could you just give some discussion on those three points, please?

All right. As I had indicated, certainly a lot of our productivity improvements as coming from using the tools that we have been implementing with regard to either project management or with lean Six Sigma. Now we expect that the effects and the ability to even improve upon that is certainly clearly given based on the projects that we presently are working on and that we have in the pipeline. We are also making progress by making lean Six Sigma a fully integrated part of how we just go about our business and do our business. So I'm sure that over a period of three years or four years it is going to be very difficult to really delineate exactly what is lean Six Sigma and what is just business as usual. But at this point in time we are, of course, still tracking the cost and the benefits and last year I believe we had costs of around $2.9 million or so for the implementation of lean Six Sigma. And we had an expectation last year and an actual result that exceeded that expectation of paying for the investments that we made.

The cost again this year for lean Six Sigma are also around $3 million or so year-to-date. And again, our benefits that we are generating are significantly surpassing that number. And that is really where we are seeing the positive impact on productivity and then on a whole slew of call centers that become very difficult to monitor individually.

Could you sort of identify the focus areas? I mean for example and I am fairly new to this company, so you might have discussed this in the past, but is it procurement? I know procurement probably is an important part of this, but can you just sort of delineate what are the key focus areas and where you kind of got to a point that is about --.

Contrary to what you might expect, procurement was not necessarily the focus area because we already instituted a strategic sourcing process about four years ago in the company. So that has had quite a bit of process and program attention already over quite a number of years. What we have been setting as a target is that 50% of our projects should be customer focused projects. That means projects where we either are able to improve our services, our capabilities or even our customers' capabilities working together with them in using our products. And the other 50% of our projects are geared towards overall process improvements around a whole slew of issues in the organization. Some of whom are cost avoidance or cost reduction. But most of them are basically just doing things more effectively and more productively. And therefore either use less resources to accomplish the same targets or get a higher benefit from the actions that we are doing because we realize the value that we're creating with those actions.

The one point I would add to that, and Al alluded to it in his discussion earlier, is that it has been a cultural shift for the organization and we are going through the entire organization and scrutinizing every cost. So it is not just in the manufacturing side. It is also through every SG&A expense, both the whole P&L and then also how we manage the balance sheet as well. So it is really encompassing the whole entire organization on a global scale.

And on the procurement side the progress that you've made in the last three or four years, does that position you? Do you feel better position going into such extraordinary times you're facing right now in terms of raw material supply demand and pricing from the hurricanes and so forth?

Well, whatever your processes are and your process improvements are you still of course have to operate in the changing global environment that is somewhat beyond our control. So if we were focusing, perhaps, two years ago on making sure that we have the most effective cost structure in our supplies, that does not always mean the lowest price but that means sometimes also better yields or better efficacy in using the products, that certainly in the last year has shifted somewhat to making sure that we have supply available. And so you just use the process, the same process but you use it to achieve different strategic goals and objectives.

And just one last question on the product mix. You talked about how your strategy in walking away from the margin business might have engendered some volume declines. Do you feel that your product mix is now streamlined sufficiently so that your whichever products you are, they are products that you want to be in, or if not kind of how far along are you in streamlining that mix?

I think that still is a work in process. We are putting quite a bit of emphasis on introducing new products with a significantly higher margin, which of course is going to raise the overall margin as the percentage of sales of these new products are getting closer to the 20% range. We are also seeing that in some cases a productline that may have satisfactory results today because of a significant raw material price increase may drop off that range and may below that target. And then of course it becomes an issue of what the market forces are going to be. Are we going to be able to then bump that particular customer up to a level that gives us again satisfactory results? Or are we going to find an interloper that takes that business away at a lower price or at a lower margin? And I think that is an ongoing, day-to-day, decision-making process.

Rosemarie Morbelli with Ingalls & Snyder.

Good morning, all. And congratulations actually on a very good quarter.

Thank you.

Only look forward to seeing that go on for the next forever, I guess. I was going to say the next few years but no, no, no, we want more than that. When you look at the volume and mix, if you were to eliminate the mix, how much was the volume actually down?

If I go and look at -- I only have a number on a corporate basis -- you are basically talking about actual tonnage of about 5%, slightly higher. But it's around 5.1 to 5.3%.

Now if you look at that and as you are going to continue streamlining your product lines and changing the mix and so on, are the fact that your tonnage is down 5% does that give you the opportunity of eliminating some additional capacity? In other words what is your capacity utilization today, and is there something else that you can do at that end?

Rosemarie, you know that we did so far in the last five or six years take out about half of the available capacity. Of the installed capacity. Now one side effect of that action of course is also that you reduce the number of product lines and you improve efficacy. So now we are even able in some of our facilities to produce even more volume than we had anticipated in the past with a different product mix. So your question is only logical. What else can you do then to take out installed capacity.

Now most of our processes, the preponderance of our manufacturing processes are shift-based or batch-type processes. And so we have other means of controlling our costs that are more significant but may still be there in depreciation and maintenance and maintaining the equipment, by either reducing the number of shifts or by taking other steps to take costs out that we don't need. Like for instance over the last two years we have taken out quite a bit of administrative costs in our individual plants which were all replications of each other with the same infrastructure. We have done some combined infrastructuring, sort of a variety of other means that we are using to get some benefits out of that reduced utilization at this point in time. But also I have to admit we, of course, have some expectations that we will regain some of that volume perhaps at a more profitable price level then we were willing to let it go at. And at that point in time we have to make use of those capabilities again.

And following up on that last comment you said that there are some -- during one given quarter you may lose some business and then customer will be back again the following quarter. What is the reason for that? Is it that whoever has lowered the price did not have the appropriate product? Is it that you eventually lowered your price because you managed to lower your cost? Can you give us a feel as to why this shift from Fuller to another supplier and back?

Well, it runs really the gamut and sometimes of course we also have to go by what we're being told by the customer, why he came back. And I think very often the stories that we hear it is either our quality, because in some cases to maintain the low price that the new supplier had given they were having to make changes in the formulation and then the formulation didn't meet up to the customer's requirements. Sometimes it is availability of raw material because the new supplier just doesn't have access to the raw material. And especially in some of the areas where raw materials are allocated or sales controlled, when they suddenly come with additional demands to a supplier of Raws as they will not have access to that raw material. And then customers comes back to us.

Very often we also hear that a commitment that perhaps was made by a salesman or a sales manager that eventually the corporate ladder got retracted and because of economics didn't make any sense. So it really runs the whole range of issues. At this point in time I would say most of the fluctuations that we are seeing in our volumes are purely price driven fluctuations. I very rarely see cases of either a new or convincing technology or significant higher improvement by a competitive offering as impacting our sales.

How much more do you think or are you willing to give up on volume?

It is going to be a continuing balance between our evaluation of how much is additional volume going to give us as far as cost reduction or cost benefit opportunity, and how much are we going to get out of price increases. But I mean, it doesn't really take rocket science to surmise that if you have 66% to 75% of your cost is in raw materials, and your raw material goes up by 5%, you just don't have enough leverage in your capacity utilization number to make up for any of that to any significant extent.

That doesn't seem to bother everyone, it doesn't seem to bother all of your competition.

Fine, but I don't want to use our Company's and our shareholders' money in a way to maintain or to gain position in the marketplace that doesn't gain any benefit to the Company nor to the shareholders.

Good to hear. Could you talk a little more on about your products, what kind of growth rate? I know the goal is that they should be 20% of total sales. Are you increasing that particular goal? Are they growing? At what rate are they growing, and how long before they are fed actually the volume that you are giving that purposely?

The number that I got for the third quarter shows us to be about 19% over -- or 90% of total sales of the new products. And gross margin that we achieved in those products are close to 20% higher than the gross margin that we get on average from our business. So that shows you quite a bit of impact that we're getting. Some of the new products are, of course, also being driven at this point in time by the raw material situation. In some cases we are having to devise totally new product formulations to make up for either a raw material that has gone out of sight as far as price is concerned or just is not available. And I believe therefore we may see a bump up in some of those products; they do not necessarily open new markets for us, but they allow us to participate in existing markets at a more profitable basis.

What was the first number you gave us, Al, I didn't catch it.

19% of total sales are new products.

And it's your goal still to be at 20% or do you think that you can reach a point where even that you are losing some at the lower end that you are now comfortable with being able to get to 30% or is that an unreasonable number?

Well, some of my colleagues in our organization tell me that I'm always setting too stringent objectives and I should wait until we have reached the first one before I set the next one. And I want to wait until we get to the 20% and then possibly see what we can do more and what makes sense strategically as well.

And then lastly, given what is the Katrina impact on raw material costs and most likely on volume as well, is it reasonable to expect that gross margin in the fourth quarter would be sequentially higher?

That certainly is our target. Now we have looked at what the potential impact is going to be from Katrina. We have I think a pretty good handle on the availability. I think we also have a pretty good idea of what the cost impact is going to be. One other consideration that you have to keep in mind as well is that in the fourth quarter we generally have a stronger Full-Valu/Specialty component in the sales because that is the paint season in Central America and that tends to push up the percentage a little bit. So you have to take all of those things into consideration.

And the paint business has a lower margin or a higher margin?

No, the Paints business has a higher gross margin.

All right. Thank you.

(OPERATOR INSTRUCTIONS) Jeff Zekauskas, J.P. Morgan.

In general it seems that your success in raising prices was greater in adhesives than it was in Full-Valu?

Absolutely.

Can you talk about the dynamics behind that difference?

Yes, I think that number one, the raw material component in Full-Valu/Specialty is a lower percentage than in adhesives. So very often also in the Full-Valu/Specialty market you're dealing with branded products and so pricing is more geared towards what is happening in the marketplace and what is happening with regards to competitive offerings. On top of that, a significant component of Full-Valu/Specialty is in the paints-related businesses, and you know from your own coverage of the paint industries that they are having some problems in keeping up with the pace and that is impacting our paints businesses as well. Because it is putting some competitive pressures on the segments in which we participate.

Now I believe that the events of Katrina and most probably what is developing right now with Rita is certainly also perhaps creating a step change for those segments of the business. And that is why I think that with the steps that we have taken after we saw this development in the course of the third quarter and the overall environment at this point in time as far as raw material availability for the paint-related businesses is concerned we will most probably see that changing in the next quarter.

Do you view yourselves as relatively more successful in offsetting raw material price inflation in adhesives then in Full-Valu?

I would say in the first nine months of this year it was clearly in adhesives. That is a change. In the past we have always been able to be more successful because we had branded products. We have a more distributive customer base in Full-Valu/Specialty to do that. But I believe the change was brought about by the so-called brilliant (ph) platform that was created by the huge increase in raw materials and the significant portion that raw material represents in the cost of goods and adhesives. And perhaps that same urgency may not have been as deeply felt in the individual businesses that constitute Full-Valu/Specialty. But certainly that is changing.

In the raw materials area, what is always a little bit funny about looking at natural gas is that when you go out a couple of months, the natural gas prices are much higher than in the near month. So natural gas, let's call it $10 per MMBTU. But you go out two or three months and it's $12 or $13. So when you try to estimate whether you can offset your raw material price inflation with your price increases, how do you view that gap or what do you use for forecasting purposes in terms of trying to set your prices?

Well, we keep pretty detailed track of the inventory levels and the various demand spikes that may come like for instance if there is problem with railroad shipping coal from Montana to energy generating plants. We know it is going to have an impact on the additional natural gas requirements and we all include that in our modeling. And also in some of our raw materials contracts, we of course tie in the natural gas pricing and some of the formulary calculations that we have with our raw material suppliers. And they, too, because they are sometimes even depending more on natural gas than us. Keep pretty good track of what is happening and in our consultations and discussions with them, we've got a pretty good handle on what is going to happen.

Are you assuming $12 or $13 gas for the winter or are you assuming $10?

We're assuming $12 to $13 gas because at this point in time we clearly see on the inventory level it is already moved below the long-term trend whereas up until mid-August it was clearly above the long-term trend. And with still about 35% of the natural gas capacity in the Gulf Coast out of action, the clear expectation for us is that natural gas will be much more at the upper end of their typical relationship of 6 to 1 to oil than perhaps it has been in the past where inventory has mitigated that pricing somewhat.

In general when you look at your raw materials for your fiscal fourth quarter, what is the order of magnitude of price, raw material index step-up that you see? And were your prices at the end of this quarter very different from your average prices? In terms of what you sell?

Yes I think this quarter continued to go up compared to last year. I think quarter-over-quarter this quarter, this year and the quarter last year was I think a 12% or so difference in raw material costs. The third quarter last year, third quarter this year. I would expect that based on what we're seeing at this point in time we will mostly see another 3% or so impact in the fourth quarter.

I guess lastly maybe these questions are for John. Is the decrease in capital expenditures for this year or in your expectation a permanent decrease, or is it timing vis-a-vis next year? And then secondly, sometimes -- I mean you've done a lovely job in keeping your SG&A costs under control, but some quarters they are up and some quarters they are down. Can you solve the puzzle of when they are up and when they are down?

Let me answer your first question first on the CapEx. I think what you are seeing, Jeff, is a result of two issues. One, as you heard throughout the call, there has been a heightened focus on scrutinizing all expenses. So not only expenditures through the business but capital expenditures. So that is the first part of the equation. The second part is through the transition that we talked about last quarter to Accenture, we've definitely seen a slight decrease in the amount of capital expenditures that would relate to the IT which has historically has been probably a bigger chunk of our total spent. But I think going back and look at our historic rates, we were comfortable in the guidance of 25 to 30 because last year for instance we spent about 31. So for us I think that is the right level.

I think also, Jeff, if I can add and I think it ties back to Rosemarie's question earlier. We have really not a need to add additional capacity and capital in the facilities that we already have in place because of our productivity improvements. We are able to get higher throughputs without touching capital. And I think it does not make a lot of sense at this point in time to really put in additional reactors or additional mixers because we still have enough installed capacity. Now that does not mean that sometime in the future we may build a totally new plant somewhere, but certainly that is not at this point in time on the horizon. And I would expect that our capital expenditures will remain at the moderate rate that we have followed over the last three or four years.

And regarding the SG&A question, Jeff, as I alluded to earlier last year we did have a onetime item around a legal settlement. But our goal from a long-term basis, which we haven't wavered on is to get it out of the low 20s and down to the high teens. We have talked about 17%, 18%. I think with the initiatives that we have in place we are well on our way to achieving that goal.

And also, Jeff, as I said based on an earlier question, we do have some cyclicality in our quarters. And so last quarter, for instance, we had a higher sales number. But the expenses are mainly salary expenses and fairly stable costs. And so you have to take then sometimes the topline swings into account as well when you look at the percentages.

Okay. Thank you very much.

Tita Sundrum with Cardinal Capital.

Just a (indiscernible) question in response to I think Rosemarie's question you talked about volume decline being 5%. I didn't understand that. Was that excluding new products that had come out of -- what exactly does that 5% represent?

The 5% that I referred to was tonnage. Now if you look at the volume calculations that we generally provide in our financials, they include volume, mix, delivery and royalty as the culmination. So there are a slew of other things in there.

I am showing no further question at this time.

We would like to thank all those who took the time to participate in today's conference call. Have a good day.

Thank you. That concludes today's conference. You may disconnect at this time.