H.B. Fuller Company (FUL) 2006 Q2 法說會逐字稿

Good morning and welcome to the H.B. Fuller second-quarter investor conference call. At the request of the Company, this conference is being recorded for instant replay purposes. This conference has been scheduled for one hour. 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, Senior Vice President and CFO; and Mr. Steven Brazones, Director of Investor Relations. At this time, I would like to turn the meeting over to Mr. Steven Brazones.

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.

Before 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 the discussion of these measures is useful to investors because they provide 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 report 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, I would like to turn it over to John.

Thank you, Steven. Good morning to everyone. Over the past few months, significant achievements have been made on the acquisition front, and the improvement in our financial performance has continued. Since the end of the first quarter, we have also executed on our strategy to grow the business profitably via acquisitions. On March 17th we closed on the acquisition of Roanoke Companies Group, and on June 9th we closed on the acquisition of Henkel's insulating glass sealant business. We expect to generate significant cross-selling synergies. As a result, we are following a meticulous integration process utilizing Lean/Six Sigma and deploying all of the necessary resources in order to foster collaboration throughout the process.

From a financial performance standpoint, gross margin expanded both sequentially and comparatively through a rigorous focus on mix shift and productivity improvement. SG&A expense was held roughly flat despite $2.6 million in product liability settlements and $1 million in stock option expense. Networking capital improved on a comparative basis for the ninth consecutive quarter, and free cash flow continued to grow. We are very pleased with the progress we have made. The hard work, dedication and training of our team members have enabled us to deliver these improved results that I will now review with you.

For the second quarter, net revenue was $388.5 million, slightly higher than the $387.9 million of net revenue in the second quarter of 2005. Acquisitions and divestitures contributed 3.5 percentage points to this year's second-quarter revenue growth. Unfavorable foreign currency translation resulted in a 1.1 percentage point reduction in growth. Adjusting for these factors, net revenue declined 2.3% year over year on a comparable basis.

Gross margin for the second quarter was 28.7% compared to last year's second-quarter gross margin of 25.7%. The 300 basis point increase in gross margin was driven by a further shift in mix to more profitable products, additional productivity improvements brought about through Lean/Six Sigma and through maintaining our disciplined approach to pricing. Included in this quarter was a 1.4 million non-recurring reduction in gross profit associated with the purchase accounting adjustments relating to the acquisition of Roanoke. These adjustments, which were fully anticipated by the Company, were primarily related to the step-up in the value of finished goods inventory, and as such will not recur in future quarters.

SG&A expense was $79.1 million, roughly flat versus last year's second quarter of $78.5 million. As a percentage of net revenue, SG&A was 20.3%, in line with last year's second quarter of 20.2%. Included in this year's SG&A expense is $2.6 million of expense associated with the product liability settlements the Company made during the quarter and $1 million of option expense in accordance with the newly adopted FAS 123(R).

Operating income, which is defined as gross profit less SG&A expense, for the second quarter was $32.6 million, up from last year's second-quarter operating income of $21 million, an increase of more than 50%. Correspondingly, operating margin improved by 300 basis points from 5.4% in the second quarter of last year to 8.4% in this year's second quarter.

On a segment basis, Global Adhesives again continued to show impressive improvement. Operating income for Global Adhesives increased from $15 million in the second quarter of 2005 to $23.9 million in this year's second quarter, an increase of 60%. As a result, segment operating profit margin increased from 5.5% in the prior year to 9.3%, an increase of nearly 400 basis points. This dramatic improvement was driven by a deliberate emphasis on mix shift as well as further productivity enhancements supported by additional progress on pricing.

Full-Valu/Specialty also achieved notable improvement. Operating income for Full-Valu/Specialty increased $2.6 million or more than 40% from $6.1 million in last year's second quarter to $8.7 million this year. As a result, segment operating profit margin increased from 5.3% in the second quarter of last year to 6.6% this quarter. Strength within the window division, combined with a continuation in profitability improvement in paints, primarily led to this result. Included in this year's second-quarter results for Full-Valu/Specialty is the impact from the product liability settlements made during the quarter.

Interest expense was up considerably from $2.9 million in the second quarter of 2005 to $5 million in this year's second quarter. The increase was primarily due to the higher debt in conjunction with the Company's acquisition of Roanoke. Net gains on sales of assets were $32,000 in the second quarter of 2006, as compared to $5 million in last year's second quarter. Last year's second quarter included a $4.8 million gain related to the sale of a 20% equity interest in our China operations to Sekisui Chemical Company.

Other income and expense net in the second quarter was $493,000 of expense, roughly even with the $462,000 of expense in the second quarter of 2005. Pretax earnings of $27.2 million for the second quarter of 2006 was nearly 20% over that of last year's second-quarter pretax earnings of $22.7 million. The effective tax rate for the quarter was 30% compared to 32.7% in last year's second quarter, and the improved tax rate was largely due to a more favorable geographic mix of earnings.

Consequently, for the second quarter of 2006, net income increased from $16.2 million in the prior year to $19.5 million. Our net margin increased 80 basis points from 4.2% in the second quarter of 2005 to 5% in this year's second quarter. Diluted earnings per share were $0.65 compared to $0.56 for last year's second quarter.

As mentioned before, this year's second-quarter net income includes, on a pretax basis, $2.6 million in non-recurring charges associated with legal settlements, $0.06 per share, and $1 million in option expense associated with the adoption of FAS 123(R), $0.02 per share. In addition, as anticipated, this year's second-quarter net income includes, on a pretax basis, a $1.4 million non-recurring reduction in gross profit associated with the purchase accounting adjustments related to the acquisition of Roanoke of circa $0.03 per share. Last year's net income included, on a pretax basis, a $4.8 million gain on the sale of a 20% equity interest in our China operations to Sekisui, $0.11 per share, and $2.9 million in severance and other expenses associated with the outsourcing of a portion of the Company's IT organization and other business reorganizations of $0.07 per share. Based on our performance year to date and the confidence we have in our strategy, we reaffirm our previously issued expectation to earn between $2.49 and $2.59 per diluted share for 2006.

Prior to discussing the balance sheet, I would like to remind everyone that the following figures are subject to minor changes prior to filing our 10-Q. Cash at the end of the quarter totaled $121.6 million, down $46 million versus the previous quarter. The decrease in cash was primarily due to the use of $95 million for the acquisition of Roanoke and $25 million for a repayment of private placement debt. The positive free cash flow generated during the quarter partially offset these payments.

Net working capital, which is defined as net trade accounts receivable plus inventory minus trade accounts payable, amounted to $248.3 million. As a percentage of annualized net revenue, net working capital was 16% for the second quarter. This represents a decline of 70 basis points from the previous year's second quarter.

Improvements continued in accounts receivable and inventory, which combined declined by $21.5 million or 140 basis points. Accounts payable regressed, declining $10.3 million or 70 basis points.

Capital expenditures for the second quarter were $4 million, down $1.3 million versus last year's second quarter spend of $5.3 million. As a result of the level of spend year to date, we now anticipate that full-year spend will be between $25 and $35 million.

Depreciation and amortization expense in the second quarter was $12.9 million, down $1 million from the prior year level of $13.9 million.

Total debt at the end of the second quarter was $318.2 million, compared to $150.7 million at the end of the second quarter of 2005 and $145.4 million at the end of the first quarter of 2006. In the second quarter, we closed on the acquisition of Roanoke, thereby taking on an additional $195 million in debt. Offsetting this increase somewhat was a $25 million scheduled repayment of our private placement debt.

Correspondingly, the Company's capitalization ratio was 32.7% at the end of the quarter, compared to 21% at the end of the second quarter of last year and 19.2% at the end of the first quarter of 2006. Earlier this month, we closed on a new seven-year unsecured $75 million term loan facility, with all banks in our existing bank group participating. This facility carries with it the same pricing as our existing revolving credit facility, LIBOR plus 62.5 basis points. This significantly increases the short-term liquidity available to us on our existing revolving credit facility, giving us greater flexibility.

Free cash flow for the quarter, which is defined as cash flow provided by operations plus dividend paid and capital expenditures, was a positive $38.6 million compared to a positive $26.2 million in the second quarter of 2005, an increase of almost 50% year over year. The components for the second quarter of 2006 were as follows. Cash flow provided by operating activities was $46.3 million, dividends paid was $3.7 million and capital expenditures were $4 million. Improved profitability, lower capital expenditure requirements and net working capital improvements led to this result.

In summary, through the implementation of our multifaceted strategy, we are improving the profitability of our business and we are extending our presence through mergers and acquisitions that make both strategic and economic sense. We will not diverge from the path we are taking in the quarters ahead, and we will remain focused on continual improvement and profitable growth.

I will now turn it over to Al.

Thank you, John, and good morning to our participants on this conference call. You have heard or seen the numbers, and they tell a solid story of continuous improvement and delivering on the expectations that we had for the first half of this year. Not only have we been able to demonstrate a consistent trend to improved margins since the beginning of last year, we have been able to bring about a margin improvement across businesses and geographies. We have done this in a time period of dramatic raw material increases and shortages that historically meant compressed margins for our company.

Many of you are astute market followers and have access to public information released by other participants in this market space. And you may have better information than I have, but I am not aware of a similar improvement and results during this time period by any other global company in the adhesives field. When observers are looking at the performance of our company over the last 18 months or so, I very often get asked the question, what has changed at H.B. Fuller, or how much of the improvement is due to actions by the Company rather than the typical effect of a rising tide raises all ships? We have tried to bring up those issues that we believe are making the difference in our performance in the course of our past earnings releases. But perhaps now is an appropriate time to draw a summary of the fundamental shifts that all these changes are causing and the effect this has on the financial performance of the Company.

First, let me comment on the data-driven and fact-based decision-making processes that we have instituted through the application of Lean/Six Sigma. This change has enabled us to have commonly understood and applied criteria, as well as processes on how we arrive at conclusions or decisions. Our employees at all levels of the Company are now addressing problems and opportunities fairly independently and implementing their decisions. This level of expertise and confidence in the data leads to time compression and a highly motivated workforce. This has not just been a change to a different approach or process; it has truly been a culture change in our company.

Secondly, this data-driven and fact-based approach has led us to challenge long-held and fairly ingrained beliefs as they relate to the adhesives industry. This certainly is not the forum to get into great detail about all of them, because there are quite a few. But if you don't mind, I would like to address one of them that very often also finds its way in how industry observers evaluate adhesives companies, and that topic is volume sensitivity.

Fact one is the industry is operating at well below the 50% capacity utilization level, and has done so far many years. Fact two is raw materials and other variable costs, especially in the price-sensitive product lines, account for approximately 85% of cost of goods sold. Fact three is real fixed costs for conversion tend to be less than 10% of cost of goods sold. It doesn't take rocket science to surmise that a 5% variable cost increase requires a virtual doubling of the volume to just make up for the increase. Therefore, when your variable costs, driven by raw materials, increase by 15 or 20%, volume-driven market approaches do not bode well for the Company or its investors.

Let me give you a data point that I looked at the other day. In one unit, our decisions led to a $7.5 million drop in sales. Concurrent with that drop in sales, we saw a drop in raw materials and containers expense of $7 million and a simultaneous drop in manufacturing overhead and delivery expenses of $2.7 million. So a $7.5 million drop in sales resulted in a $9.7 million drop in costs. Our conclusion is that volume orientation is perfectly appropriate for a capital-intensive industry. But adhesives do not categorically fall into that sector, and our actions are focused on reducing unprofitable volume, as you can see from the example I just stated.

Thirdly, we create value for our customers and ourselves by our knowledge of the applications at our customer base, and very often even further downstream. The focus of our activities, therefore, has been to concentrate on working together with our customers to develop products and solutions that lead to significant improvements for their processes. Admittedly, those efforts have a longer gestation period than running around with a match to a competitive product at a lower price. But we believe that they will lead to a more secure supplier position and a considerably higher value for our customers and for our shareholders. This is key to keep us moving to a profitability profile that will get us beyond the one we have already achieved.

The fourth point is related, but fits into a category of its own. Our innovation dimension has added significantly to our margin improvement. I have in the past mentioned the percentages of sales of new products and the expanded margins these products tend to generate. To qualify as a new product, they need to fill at least three criteria. One, they have to be launched less than five years ago. Two, they have to have a growth rate above the company average. And three, they have to have a profit margin above the company average. When a product fails to meet any of these criteria, it will be removed from our new product consideration.

Accordingly, since one of our successful introductions, Advantra, passed the five-year mark, it has been removed from the category. Our new product sales in the second quarter now are close to 17%, with the remaining products in the group growing and well over 35% versus the same period last year and our profit margins exceeding the company average by 20%.

And finally, our merger and acquisition activity is picking up and helping us move into product lines or market segments with a more attractive growth and margin profile. And John already talked about two acquisitions we completed, and we expect additional ones to follow. We both support that activity by divesting parts of our portfolio that no longer contribute to the positive margin development, and for which we can readily find alternatives that strengthen our lead positioning efforts.

We believe that the above points summarize the major differences between H.B. Fuller today and the Company you may remember from the past. Now, don't misunderstand me; we're not yet finished with our work. We have only started. And even though that means there is an element of risk to the successful completion of our transition, it also means that there remains a lot of opportunity to improve from where we are today.

You have heard me say in the past that one of our longer-term targets has been to achieve a net return on sales of 5%. I also stated on those occasions that our portfolio needed to change if we expect to move beyond that number. We are now close to achieving this long-term objective. Our projection for this year is reflective of that opportunity, and it also sets the pace for additional progress. The changes we have been making are enabling us to reposition our business to achieve an even higher performance level in the future.

I will now open up the call for your questions.

(OPERATOR INSTRUCTIONS). Ray Kramer, First Analysis.

This is Allan Cohen, here with Ray. While your comments were perhaps self-congratulatory, I would like to comment, having covered the Company for 17 years. I would view them as quite modest, given where the Company started.

In terms of a question, as you look forward, which additional areas might you like to get into? You have strengthened retailed recently to some extent. And how much further might you take that? And when you talk about a lot further to go in terms of net margin or operating margin -- however you wish to define it -- where do you see, if you will, upper limits by some comparison?

Allan, thanks for your comments. I believe I have stated in the past that, in my view, a true specialty chemical company should be able to generate a net return on sales of around 7 to 8%. And we are still quite removed from that area, even though we certainly have components in our portfolio that are reaching or exceeding those targets.

If I look at the opportunities that exist for us to move into additional areas, you have, of course, seen some of the acquisition activities in the last couple of months. But I believe as well that it is important to realize that as you look at the Adhesives segment itself, it has so many areas and segments that are not necessarily reflective of the more commodity-oriented segments that a lot of people have been focusing on in the last couple of years, that we see plenty of opportunity in the adhesive area as well for expansion and acquisition. And there, too, we are seeing in our own portfolio and in what we have demonstrated over the last 12 months basically an organic shift, just taking it and using our existing customer base and focusing more on those parts of the business that generate more income, a dramatic change that we can have.

If we promote that further and go beyond where we are today, either through an acquisition or by additional activities in those adjacencies that we have found to be very attractive, it it is a fairly rich field of opportunity. Because, if you look at our market share -- and admittedly, we are one of the market leaders in the adhesive industry globally -- still, our percentage share is only 4%. So there is a huge amount of business outside of the business that we have been holding in the last couple of years, and so there is a very rich field for opportunity and to progress significantly beyond where we are today.

If I choose two examples of perhaps more specialty adhesive companies and those in a little different area than you, I think one would be [Research Adhesives] and another would be LORD. Any thoughts, or could you comment on how either one of those or both represent directions you might prefer to go to?

Both of these companies are, as you very well know, in very attractive market areas, and they have been extremely successful. And I think that if you look around, there are many more that have a similar profile. And I think that, clearly, the focus of their activities and the center of their activities has been more in the area of products and markets that we certainly also find more attractive.

David Begleiter, Deutsche Bank.

Have you seen any signs of economic weakness in any of your key manufacturing markets in the US or Europe?

Could you please repeat your question?

Any signs of weakness, volume softness, in any of your key markets in the US or Europe?

No. I think what we're seeing is a lower percentage of growth than perhaps we saw last year in North America. But that is somewhat masked and aided by a more vigorous economic activity in Europe in the last couple of months, which is certainly also being helped by an increased export market out of Europe into other sections of the world.

I believe that, overall, what we are seeing is that demand remains at a fairly good pace, and that is also reflected in the tightness on certain raw materials and the upward price pressure that we continue to see in raw materials. I would certainly expect that we will continue, at least for the next 6 to 9 or 12 months, a fairly vigorous economy. It may not be growing at 4.5%, perhaps only 3.5%, but that still is nothing to sneeze at.

And just on pricing, can you comment on the pricing dynamics in the industry in terms of competitor support for some of the pricing initiatives?

Yes. We did see around April, early May of this year, suddenly a very vigorous activity in pricing from quite a variety of competitors in the marketplace. And I think that, of course, is also reflective of what we have been saying for the last couple of calls, that we feel raw materials continue to increase. And I think more and more of that is showing up in the income statements, and I think people are taking corrective actions to deal with that situation.

And if you were to see some easing of raw materials, could you hold onto these recent price gains?

I think, if you really look back in the past, and you certainly recall that situation, generally what we saw was margin compression where raw materials were going up and then margin expansion where raw materials went down, at least for a couple of quarters. What we have seen in our case this year is quite atypical from the past, but there is a reason behind this, because we're using some fairly well-developed instruments on making calls and decisions on the data and then the information that we're collecting on a regular basis. It has helped us tremendously in not falling into the pattern of the past on the way up.

I think it will also be of tremendous help in stabilizing our prices when, perhaps sometime in the future, raw materials would tend to flatten or tend to drop off, because the insights that we have gained and the analysis that we do are much more, as I indicated, fact-based rather than instinctive. And I think it gives us a very good opportunity to benefit, then, from a reduced cost structure rather than to just follow the market down.

In Global Adhesives, how much of that business would you consider low-margin, sub-par business that you could, over time, walk away from?

I think we have seen a significant portion of it already moving out. We are also recognizing that with what is happening pricewise from our competitive environment, that may possibly change a little bit the tendency that we have seen in the past, and some of these businesses may come back. But I would say, if I look overall at the adhesives market segments, the two or three most critical areas where there has been a lot of margin compression in the past and continues to be very difficult market conditions certainly would fall in the areas of converting, would fall in the area of water-based large-volume applications in general and also hot-melt large-volume applications are not immune to that.

So to put a percentage to that is, of course, very difficult because it varies from company to company how much emphasis they have on the [one or other plays]. But I think that we certainly have seen, as far as our company is concerned, the most significant impact of that already occurring.

Rosemarie Morbelli, Ingalls & Snyder.

Good morning, all, and congratulations. And obviously, you are changing the Company. In the early '90s, if my memory serves me right, you had reached the 4% margin for one year, and then a trickle-down to, again, 2.8% a couple of years ago. How comfortable are you that in an economic -- and I know you have kind of answered that, but I guess I would like a little more detail. Having followed the Company for many, many years, it is hard for me to switch from a good year and then five bad years because of the economic environment and the competitive environment. How comfortable are you regarding the fact that you can actually keep not only getting gross margins higher but at least keeping them around the 5%?

Your sentiments are not unusual sentiments that get expressed to me because long-term observers, of course, also have a long-term memory. And it is, therefore, sometimes also a bit difficult for us to really come across convincingly that it's really changing, because ultimately only time will tell, truly.

Yet, if you look at the last six or seven quarters, and you look at the progression, I think it is quite obvious that we are not zig-zagging with what is happening in the marketplace. There is a very clear path, and there is a very clear determination and execution on what we said we were going to do. And directionally, it's clearly moving towards where we need to be as a company.

The instruments that we have put in place, the ones that I referred to in my comments and the ones that I just referred to when I was talking to Allan and to Dave Begleiter, I think also are indicative of the confidence level that we have that we have a much greater control today over our own destiny and over where we want to be active and what the results are going to be for our company than we have had in the past.

Thirdly, I believe there has been also a fundamental shift, and I may have addressed it earlier, so forgive me if I'm repetitive. But I think that the increases that have occurred in the marketplace in raw materials and the availability issues in raw materials in the past couple of years have given us a unique opportunity to really reposition the Company. It was really based on that fundamental shift that occurred that we said this is the time, this is the opportunity to reposition. And today, our product portfolio of products is a product portfolio that is much more stable, with regards to pricing influences and cost influences than perhaps the one that we had still two years or three years ago. And that gives me quite a bit of confidence that what we have in place is very solid as a base, and that the talent and the capabilities that we have created in the Company is clearly geared towards driving this forward. And I do not expect that we will again be somewhat like a cork on the waves that perhaps we were in the past.

And when you last talked about acquisitions, or at least a little while back, the acquisitions were mostly going to come on the Full-Valu side. What have you seen in the marketplace which made you change your mind and decide to go after some adhesives business? I'm sure that those opportunities were there one or two years ago, when you were talking about acquisitions, mostly in the Full-Valu. Have you seen a difference in pricing, in availability?

No. I think it also has to do with what I commented on, that we have tossed aside some long-held beliefs in this industry and have really fundamentally looked at the data and what the numbers are telling us. And that shows us clearly that there are quite a few attractive segments in the adhesive industry that in their performance and also in their growth profile are a close match to what we see in our Full-Valu/Specialty area. And going about five or six years back, when we made the determination at that point in time to split into an Adhesives and Full-Valu/Specialty area, we were very tempted at that time to take about 30% of our Adhesives business and attach it to Full-Valu/Specialty, because at that point in time, that was really an area that was outperforming and had a specialty profile. But because of the backward integration with other adhesive activities, we decided at that point that it didn't make any sense.

In the last year and a half and two years, we have spent a much greater deal of focus now on on looking at the Specialty segment and say, how expandable, increasable is this area for us? And that is really what has given us a much richer opportunity for acquisitions than perhaps we have focused on in the past.

So, if we look at Dave's question about the percentage of commodities, do your comments translate into about 70% of your adhesives business is commodity?

I think that has dramatically shifted in the last two and a half years. I would certainly, in this point in time, looking at the overall performance of our Adhesives group, would be challenged to even put 30% still in this category.

It will be higher?

Yes, it's much higher. The 30% would still be commoditized or would be more susceptible to market forces rather than value that we create for our customers. So that has dropped significantly off from where it was a couple of years ago.

And in the industrywide, is anyone eliminating capacity, that you can see from where you stand, and more or less going through the same exercise you are? In other words, they are getting smarter?

Well, I hope they are not getting smarter. That's to our competitive advantage. But I do recall hearing that one of our large competitors is going through some significant restructuring again, and I would assume that it has an impact on cost structures in general; whether it's capacity or people, I don't know. One (technical difficulty) announced one a year and a half ago or two years, so the industry is generally moving in that direction. But you will recall that we had our last one perhaps four years ago or so. And as I mentioned at the last conference call, we are today more proactively looking at these things, and basically are treating them as a cost of doing business on an ongoing basis. And that allows us to make adjustments.

Now, with regard to capacity and capacity utilization, per se, this is not a capital intensive business. It's very easy to build a very large-scale adhesive facility for not much more money than to build only 50% of that capacity. The real cost of the adhesives industry is in the conversion and in the variable components of the cost factors. And as you saw from the example that I mentioned, we can sometimes make more money by being very judicious about what volume we are willing to take on and to rather have a focus on filling the plant.

Equally, I think we have been able to adjust our use of shifts effectively to adapt to the reduced requirements that we may find from time to time in one facility towards the other. So I think we have the built-in flexibility to breathe in and breathe out with the market demand.

And lastly, if I may, of the negative 2.3% in sales, what are the volume and price components?

That would be very difficult to determine, as I had mentioned at the last conference call, given the huge variability that we have in our product lines. But certainly, if I look at the pricing component and shift component, you're talking about somewhere in the range of 7 or 8%, if I recall correctly.

Jeff Zekauskas, JPMorgan.

I guess one of the puzzles in the income statement for me is the cost of goods sold line. And that cost of goods sold is down in absolute terms about $12 million. And if, in general, raw material prices are up -- call it 5%, and last year your cost of goods sold was about 288, so maybe raw material costs were 230. So the increase would be about $11 million from raw materials, which would mean, all things being equal, your cost of goods sold number this year should be about 300 million instead of the 276 that you reported. And so it just looks to me like you must have found a way to keep your raw material prices basically flat. Are there tremendous raw material cost synergies that you're finding? Because your cost of goods sold is just so much lower than the previous year in absolute terms.

I think it's exactly a reflection of what I said. It's basically a shift to more profitable products, and that basically means we're getting higher margins. Raw materials, per se, as a percentage of sales tend to drop off even though perhaps the raw material components may be higher-priced than the raw material components that we are no longer buying. And then, of course, some of the volumes that we have shed are volumes that were not generating profits. And therefore, that really has a significant impact.

Now, on top of that -- and I had mentioned that in the last conference calls as well -- is the tremendous impact that we have on factory labor and manufacturing overhead. Number one, it goes back to the point I was just explaining to Rosemarie, that we have variability in factory labor and manufacturing overhead, so we can breathe in and breathe out with the demands on our plant. And if the volume is not contributory to the profit, then we can make a fairly easy determination and choice of what we should do.

The other part is Lean/Six Sigma that has really had a tremendous impact on the productivity that we can generate within the Company, and that of course is a huge cost component. Then, perhaps, to shed a little bit more light on the pricing component, because I get questions on that fairly often as well, we have a tool -- we call it the price waterfall -- which basically allows us to go to each individual transaction, and therefore also to each individual customer, and really determine the cost of doing business with that customer. And it looks at cost of order handling, it looks at traffic, at delivery, it looks at rebates, it looks at payment terms, it looks at conflict resolution -- all kinds of stuff, and it really makes a very clear case on where we are wasting money and where we are not creating value for the organization. And that, in combination, of course has a huge impact on the relative cost structures to the sales that we're generating.

That's very helpful. Maybe another way of asking my question is, if you look at the change in mix, and if you look at the elimination of some of your unprofitable customers, did the aggregate amount that you paid for raw materials in this quarter rise year over year?

Yes. The average cost of the raw materials that we continue to purchase is increasing. And it is increasing, and we expect it to continue to increase for a full increase this year, I think I mentioned at the last conference call, between 5 and 6%. And right now, it looks like it is [most likely] going to be closer to 6%.

Can John analyze the $12 or $13 million drop in cost of goods sold?

I think I just gave you the explanation. If you are shedding significant volume, that also given the fact that 85 or 90% of the cost of that volume may be raw materials, so of course it has a tremendous impact versus picking up volume that may have only a 40% raw material cost component attached to it.

Did your prices sequentially rise or go down?

Yes, our prices did go up year over year by about 6%, I think. It was about --

6.5, Jeff, was the exact number.

And sequentially, did that go up or down?

Well, sequentially, prices were fairly stable.

Was the Roanoke acquisition dilutive in the quarter?

Yes, in the quarter, of course, absolutely. (Multiple speakers).

(Multiple speakers) purchase accounting.

If you exclude the purchase accounting adjustment, was it dilutive?

It was very, very close, Jeff. We did that analysis, and if I stripped out the impact of the purchase accounting we recognized in the quarter, it was slightly dilutive. But I am carrying it out three places.

And when you look at the pro forma volume of Roanoke versus whatever historical data they gave you, did volumes grow or did they shrink? How did that operation do on some kind of pro forma basis?

Well, based on the -- we only had six weeks or seven weeks in there.

Very early days.

So I don't know exactly how much of that is really indicative of a trend. But from indications that we have, it was slightly up compared to last year.

Did Roanoke -- if I remember correctly, you said that your depreciation or your depreciation and amortization was 12.9 in the quarter. How much of that was Roanoke?

The portion of that that was Roanoke was slightly under 2 million. But again, recall that is not reflecting the full quarter.

So pro forma, it would be a little under 2, but it's less this quarter? Is that right? Is that what you said?

Yes, it is less this quarter. It's 1.9 million if I include depreciation and amortization.

Remember the bridge I gave you last quarter? When we looked at our D&A on a full-year basis last year, it was around 55 million -- 52 to 55 million. Recall that we said that we had a number of fully-depreciated assets mainly around our systems that were coming off. That was to the tune of 6 or 7 million, and that was going to be offset by the increase of the depreciation and amortization of the acquisition. The bulk of that increase is amortization. That number is somewhere, combined, 8 to 9 million, hence our full-year outlook that we talked about of 50 to 55 million; we still hold by those numbers.

So the Fuller number, strictly speaking, was about 11 million in the quarter?

That's correct.

Chris Butler, Sidoti & Co.

I was just hoping you could talk a little bit further on the divestitures that you mentioned that you had brought up a couple of businesses that had lower margin, being the converting water-based and the hot-melt. Would these be examples of something that you may consider divesting here in the future?

Well, we're looking at all segments that we have within our company. And basically, we are not delineating by what category they fall in or delineating by what is the profit profile and the growth profile that they present to us. So clearly, much across the board is the scope of this analysis, what fits and what doesn't fit. I certainly can, at this point in time, similar to -- or let me create an analogy to mergers and acquisitions, not talk about what specific businesses we're looking at. Because I think it is time to do that when we have come to a conclusion, and sometimes in the process to get to that point, of course, there are dependencies and secrecy agreements with potentially interested third parties as well.

So I have to be a little bit careful and cannot identify the businesses specifically that we're talking about. But it is obvious that, as we are starting our orientation towards more profitable products and growth-oriented products, that there is going to be a certain group of businesses that we may have that do not fall in that category. And I think it's only appropriate that we then use that capital that is tied up in that business to support our growth.

Is it safe to say that there's a greater likelihood that this would be in the Global Adhesives segment?

No, I would say it is basically to be looked at across the board. And I think we have, on and off in the past, talked about certain other businesses that are not very satisfactory. And those certainly will be under scrutiny.

And looking at the Roanoke acquisition, now that we have almost a full quarter under the belt, could you comment on cross-selling opportunities that you see, and maybe sort of give some general numbers on what you might be able to achieve here at some point in the future?

Well, of course, the efforts are only in their infancy at this point in time, given the short period of time we have them on board. But we are very encouraged by the opportunities that we are pursuing at this point in time. But I would ask you to perhaps wait another quarter or two quarters before I at least can mention one or two examples that already have come to fruition.

And if we were to see an acquisition on the Global Adhesives side that you had talked about previously, do you think that would be more along the lines of like the Roanoke acquisition that we saw, or do you think that would be more of a fixer-upper type of business that you have a chance to really get in and squeeze out some efficiencies?

Well, perhaps this is the time to address an issue that also has undergone somewhat of a shift. You have heard me talk in the past that in the adhesive area we would be looking at consolidation plays, and basically create value out of the synergies and the synergistic opportunities that we can create for ourselves with becoming a larger company or having a larger footprint in the market in which we already are. Clearly, with what we have been able to achieve so far over the last year, year and a half, it is obvious to us that there are opportunities for acquisitions also in the adhesive scale that fit more in a Roanoke profile with regard to growth and profit opportunities. And that is certainly where we are focusing on today.

Now, that does not mean, if we get the opportunistic situation where there is a consolidation play that makes a lot of good sense and creates value for the Company, that we would pass it. But certainly, that is not directionally the focus of our activities.

Chitra Sundaram, Cardinal Capital.

Al, it has been a pleasure listening to you and the level of conceptual clarity you bring to all these issues. There were just two things, if I could just try to understand a little better. In listening to you, kind of where I am understanding the business developing is it's a formulation business; it's not capital-intensive, as you said. So what then becomes the barriers to entry? What has stopped other companies from entering those slivers of the business that are more profitable? Is it access to customers? or distribution channels? And so do you still remain M&A dependent to get into those more profitable businesses? Or is it just, in many ways, how you all develop new products and how you all run the businesses?

Let me try to respond to that. I mean, it's quite obvious, when you look at the description that I gave earlier about the cost components of our business, that we do not generate a lot of value in just manufacturing and converting product. So we have been trying to understand more fundamentally what really are our customers paying for? And we are finding more and more that it is our knowledge about their applications, combined with our knowledge about our products, that creates opportunities for productivity, opportunity for quality enhancements, opportunity for their market expansion that are much more valuable than just the molecules that we are providing.

And the strength that we have is, of course, that we have been engaged in this business for now close to 120 years. We have a lot of fundamental and deep-seated knowledge about many of these applications, many of these market segments. And that is going to be very difficult to duplicate for a new entrant. It is fairly easy to buy a mixer and to make water-based adhesives. But it is extremely difficult to take this water-based adhesives and bring it to a cigarette manufacturer, for instance, that has to manufacture 7,000 cigarettes per minute and still make that adhesive stick. And the dependency that these heavy capital-invested customers have on the reliability of the product, of course, plays a significant role in their decision making processes.

So the barrier has shifted from a physical and low capital barrier to a much more amorphous and difficult-to-overcome mental barrier and mental capabilities barrier, knowing about the customers, knowing about the applications and being accepted by your customers as a trustworthy partner. That really, I believe, has positioned us much more stable and quite different from, perhaps, where we used to be in the past.

We have reached the end of our allotted time for questions. Will there be any closing remarks?

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