H.B. Fuller Company (FUL) 2006 Q3 法說會逐字稿

Good morning. Good morning, and welcome to the H.B. Fuller's third quarter investors conference call. [OPERATOR INSTRUCTIONS] Management and attendants on today's call includes 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. Sir, you may begin.

Thank you, April, and 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 that the discussion of these measures is useful to investors because they provide insight into the ability of 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'd like to turn it over to John.

Thank you, Steven, and good morning to everyone. Our strategy to reposition the business has led to considerably improved financial results in the third quarter and progress towards all of our long-term financial goals. The significantly improved performance is the direct result of a global team effort across both operating segments. Our employees are raising the bar, transforming the Company into a more profitable specialty chemical company. For the third quarter, net revenue was $388.9 million, up 8.6% versus the third quarter of 2005. The net effect of acquisitions and divestitures and favorable foreign currency translation contributed 8.4 and 1.4 percentage points, respectively, to this year's third quarter net revenue growth. Organic growth, which excludes the impact from acquisitions and divestitures and foreign currency translation, declined slightly year-over-year by 1.2%, selling prices increased 5.8% and volume declined 7% year-over-year. The volume development is entirely consistent with our ongoing strategy to reposition the business and represents a sequential improvement versus the second quarter.

Gross margin for the third quarter was 28.4% compared to last year's third quarter gross margin of 27.3%. The 110 basis-point increase in gross margin was achieved by further repositioning progress and additional process and productivity improvements brought about through Lean/Six Sigma. Raw material costs, which increased approximately 7% year-over-year and 1.5% sequentially, declined as a percentage of net revenue, as a result of our portfolio repositioning efforts. SG&A expense was $75.7 million, up slightly versus last year's third quarter of $73.5 million. As a percentage of net revenue, SG&A was down 100 basis-points from 20.5% in last year's third quarter to 19.5%. Thorough cost controls, attrition management and productivity gains resulting from Lean/Six Sigma initiatives enabled the improvement. Included in this year's SG&A expense is $800,000 of stock-option expense in accordance with FAS 123(R). Operating income, which is defined as gross profit less SG&A expense, for the third quarter was $34.6 million, up more than 43% from last year's third quarter operating income of $24.1 million. Correspondingly, operating margin improved by 220 basis-points, from 6.7% in the third quarter of last year to 8.9% in this year's third quarter.

On a segment basis Global Adhesives continues to transform its business and deliver impressive results. Operating income for Global Adhesives increased from $16 million in the third quarter of 2005 to $23.5 million in this year's third quarter, an increase of almost 50%. As a result, segment operating profit margin increased from 6.5% in the prior year to 9.5%, an increase of 300 basis-points. The benefits of repositioning the business, process improvement stemming from Lean/Six Sigma, and an unceasing scrutiny of expenses led to the improved results. The Full-Valu/Specialty segment posted considerable growth and continued to improve the profitability of its business as well, despite the requisite acquisition integration and transition initiatives. Net revenue for the Full-Valu/Specialty segment increased close to 30% year-over-year and operating income increased nearly 40%, from $8.1 million in last year's third quarter to $11.1 million this year. Accordingly, segment operating profit margin increased from 7.4% in the third quarter of last year to 7.9% this quarter. This quarter includes the results of the Henkel's Insulating Glass Sealant business for 12 out of the 13 weeks. While it is still early days for the acquisitions just completed, integration remains on track and according to plan.

Interest expense was up from $2.9 million in the third quarter of 2005 to $4.6 million in this year's third quarter. The increase was primarily due to the high level of debt as a result of the Company's acquisition of Roanoke Companies Group earlier in the year. Net gains and losses on sales of assets was a loss of $14,000 in the third quarter of 2006, as compared to a gain of $278,000 in last year's third quarter. Other income expense net in the third quarter was $274,000 of income versus $25,000 of expense in the third quarter. The improvement was predominantly related to lower currency exchange losses and higher interest income. Pretax earnings of $30.3 million for the third quarter of 2006 was more than 40% higher than last year's third -- third quarter pretax earnings of $21.4 million. The effective tax rate for the quarter was 24.6% compared to 32% in last year's third quarter. This quarter's effective tax rate was adjusted down from a previously expected level of 30% for two reasons. First, we experienced a continued improvement in the geographic mix of earnings, and second, during the quarter we received a favorable tax settlement on tax audits in the amount of $850,000. For the fourth quarter we anticipate an effective tax rate of 29%, as the overseas operations are expected to sustain their improved profitability.

Minority interest swung from income of $312,000 to an expense of $259,000. This is the result of an improvement in the profitability of both the North American automotive and Chinese joint ventures. Income from equity investments increased by nearly $1 million year-over-year, from $650,000 in the third quarter of last year to $1.6 million in this year's third quarter. The increase was the result of the improvement in the financial performance of both our Japanese joint venture and our international automotive joint ventures. Consequently, for the third quarter of 2006, net income increased from $15.5 million in the prior year to $24.2 million. Our net margin increased 190 basis-points, from 4.3% in the third quarter of 2005 to 6.2% in this year's third quarter. Diluted earnings per share was $0.40 compared to $0.26 for last year's third quarter. This year's third quarter net income includes, on a pretax basis, $800,000 or $0.01 per share in stock-option expense associated with the adoption of FAS 123(R). In addition, it includes, on an after-tax basis, an $850,000 or $0.01 per share favorable tax settlement.

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 $123.6 million, up $10.8 million versus the third quarter of last year. Net working capital, which is defined at net trade accounts receivable plus inventory minus trade accounts payable, amounted to $226 million. As a percentage of annualized net revenue, net working capital was 14.5% for the third quarter. This represents a decline of 340 basis-points from the previous year's third quarter. Improvements were achieved across the board and in both operating segments. Included in this quarter's accounts payable balance is a one-time temporary bump-up of approximately $8 million for an acquisition-related payable. Excluding this item, net working capital would have been 15%. Capital expenditures for the third quarter were $4.4 million, down $1.2 million versus last year's third quarter spend of $5.6 million. As a result of the level of spend year-to-date, we now anticipate that full-year spend will be between $20 and $25 million.

Depreciation expense in the third quarter was $10.5 million, down $2.4 million from the prior-year's level of $12.9 million. Amortization expense was $3 million in this year's third quarter, up $2.3 million year-over-year. Total debt at the end of the third quarter was $287.9 million, compared to $150.5 million at the end of the third quarter of 200 -- 2005 and $318.2 million at the end of the second quarter of 2006. During the quarter we repaid approximately $30 million in revolving credit facility debt. Correspondingly, the Company's capitalization ratio was 29.8% at the end of the quarter, compared to 20.6% at the end of the third quarter of last year and 32.7% at the end of the last quarter. Free cash flow for the quarter, which is defined as cash flow provided by operations less dividends paid and capital expenditures, was $66 million, more than double the $28.1 million in the third quarter of 2005. The components for the third quarter of 2006 were as follows: Cash flow provided by operating activities was $74.2 million; dividends paid were $3.7 million; and capital expenditures were $4.4 million. Improved profitability, lower capital expenditure requirements and net working capital improvements all contributed to the increase. This quarter's free cash flow also benefited by approximately $8 million, due to the one-time temporary bump-up in accounts payable discussed earlier.

In summary, we are quite pleased with our third quarter results and the progress we continue to make. We will continue to stay focused and execute on our strategy of delivering consistent and sustainable performance.

I would now like the turn the call over to Al.

Thank you, John, and good morning to everyone. John went through most of the numbers with you, and as you heard, we had a pretty good quarter, continuing a pattern that evolved over the last two years. We are very pleased with the progress we are making, as it is a confirmation of the transformation the Company has been undergoing. It has been particularly heartening for me to see that, despite the renewed raw material increases that we saw coming through in the third quarter, our Company was able to react very swiftly. By combining product and price enhancements with operational productivity improvements in a timely fashion, our businesses continued on their path of significantly out-performing last year's results. The repositioning of our product line to products that are of higher value to our customers is a driving factor in our marketing activities and in our margin expansion in the last 24 months. When we decided to pursue this strategy, it was obvious that some of our products and their pricing points would come under severe pressure, both from customers that did not see a unique value in our products and from competitors that were apparently eager to pick up volume at a price level that we no longer deemed supportive of our business model. It is clear in a scenario like this that the drop off in volume from a customer's decision to switch is rather immediate and visible.

Finding new volume in a segment that does see value in the unique offerings that we put together requires a much longer sales cycle, yet it also tends to create considerably more value for our customers and for us in the longer term and is less susceptible to attack. Our teams, and adhesives in particular, have demonstrated great courage, determination, and ability in making those decisions in the way that allowed our Company to make such conversions without weakening the earning power of the Company during the transition. Quite to the contrary, they improved it significantly. Based on the questions that I get frequently from a variety of audiences, there seems to be an assumption that volume might have an overriding impact on our Company's performance profile. And, whereas that may have validity in a business that has a large fixed-cost basis, continuous manufacturing processes and a homogenous commodity-type product line in regard to pricing points, I think that our performance so far demonstrates that that is not the case for us.

I elaborated at the last meeting about the reasons for this departure from long held and sometimes even cherished beliefs, and I am not going to bore you with another recitation of those factors, but let me try to put it into another perspective for you. I asked our team to compare our performance against four leading publicly-traded companies in the adhesives arena in the periods leading up to and including the second quarter of this year. Because of some differences in how the companies report, we had to make some simplifying assumptions and adjustments. The analit -- the analysis was really quite insightful. The sales development in the first half of this year showed that, in most cases, our competitors were racking up impressive increases in organic sales/volume. Some even solidly in double-digit territory. What is interesting, however, is that their profitability, when you look at it over the last 12 months, does not reflect a similar increase in terms of improvement in operating margin. H.B. Fuller handily out performed all of them. Even more intriguing is that, in terms of operating profit dollars, our improvement is higher than the improvement of all four competitors combined. In my view, that does not present a very convincing case for the validity of the volume-first theory in our business. Quite to the contemporary.

Another factor that is helping us in moving to a higher-profitability profile is the sheer of new product sales in our portfolio. I have reported in the past about the noticeably higher margin these products tend to generate. Despite the fact that our base profitability has improved considerably, these new product sales, which this quarter accounted for 16.3% of total sales, continue to generate gross margins 300 to 500 basis-points above the consolidated average. For the products that make up these 16%, the year-over-year growth rate in sales was about 45%. We grow where it counts. By moving into the higher margin segments of the market, we are also going to make some investments in our marketing and technical support structures. We will do this gradually over the next four quarters, and it is part of our planning process for the coming year.

The pipeline for M&A is pretty active, and we trust that some of the projects will come to fruition in the first half of next year. The pipeline includes opportunities in both adhesives and Full-Valu/Specialty, and they are geared towards the overall repositioning effort. Our strong cash flow and, as I already mentioned last time, potential divesture of parts of our portfolio that no longer add to the positive margin development for the Company will allow us to do that, while maintaining a solid and strong balance sheet. We completed the acquisition of the insulating glass sealant business from Henkel and are working our way through the integration process. We are progressing well with the incorporation of the Roanoke business, and the integration expenses and the earnings per share impact for both acquisitions are well within the expected range.

Our Full-Valu/Specialty business saw solid growth in several of its businesses. The slowdown in housing starts appear not to have had a significant impact in the overall market demand picture in the third quarter. We are seeing some inventory adjustments in the supply chain, but the balanced range of products in relation to new construction and renovation combined, with our geographical spread of the do-it-yourself and paint portfolio tends to considerably soften the impact of the reported weakness in the new residential construction here in the United States. Our powder coating sales stabilized in the third quarter following some quarters of volume deterioration, which was driven by competitive bidding on the ongoing relocation of the manufacturing customer base to Asia. Despite this environment, our powder coatings team was able to substantially improve their results for the third quarter, as well as year-to-date.

Concerning our adhesives business, I already commented on the great work the team has been doing. The improvements we are seeing range across all regions, and many of the geographic differences and contribution margins are narrowing significantly. The emphasis on new products and more value-oriented relationships with customers is developing well, and we expect that some of the longer selling cycle opportunities will come to a successful conclusion in the following quarters. We believe this will give us some additional push towards the repositioning effort. In Japan, the Sekisui/Fuller joint venture is progressing well and the improving results are reflected in the income statement. Our automotive business, under its new leadership, has made a dramatic improvement compared to last year. In particular, in light of the travails of the automotive industry, this has been a remarkable performance. Not surprisingly, it is in this business that we have seen significant volume drops. I am convinced that our EFTEC business is on the right path.

Now let me look forward. The continuing raw material inflation has not reversed, contrary to the general impression you might get when you look at the prices of gasoline. The third quarter saw further increases, and some of those will only fully manifest themselves in the fourth quarter because of the timing of the changes. As a result, the sequential cost pressure will increase rather than decrease. When I talked to you last time, I projected the raw material increases to be close to 6% for 2006 versus 2005. With the information we have today, we now see that number somewhere in the 7% to 8% range. Yet, the results of the third quarter have increased our confidence level in the outcome for the remainder of the this year, and we are pleased that we can increase our earnings per share outlook for the full year. When you compare our expectations for this year with 2005, you will have to keep in mind that last year included an extra week in the fourth quarter and the full-year results for 2005 contained a pre-tax gain of $4.8 million related to the creation of the Sekisui/Fuller joint venture in China. We now expect the year to finish between $1.44 and $1.46 per diluted share versus the previous range of $1.25 to $1.30 per share. Regarding next fiscal year, we will provide our outlook for 2007 when we report on our fourth quarter results.

Thanks again for your confidence in our Company and in the capabilities of our people. I will now open it up for your questions.

Thank you. [OPERATOR INSTRUCTIONS] Your first question comes from Allan Cohen with First Analysis.

Good morning. This is actually Mike Harrison sitting in for Allan. Nice quarter, guys. Had a quick question on revenues. In terms of the price and volume numbers, do either one of those include the mix factor? Is there any way that you can separate price volume and mix?

The volume number does include the mix factor.

So if I assume that mix was positive in the quarter, then volume would actually have been down even more than the 7%?

Logically that would be correct, yes.

Okay. Thank you. On the -- with the housing market slowing and in light of the negative outlook yesterday from Lowe's, how has the Roanoke acquisition faired, and do you look at that acquisition any differently now than when you bought it?

No, absolutely not, and as I said at the last meeting, the benefit of the business portfolio that we have is that much of the product that we sell is being used in new construction, as well as in renovation. So typically, we are seeing in times of a subdued new construction area, we see increased renovation efforts. That does not mean that it always happens exactly synchronously at the same time, but certainly over a longer period of time, and that's why we're very confident that what we had in mind when we made the acquisition is going to work out very well for us.

Okay. And then on the pricing environment, what sort of pricing behavior are you seeing from competitors? Do you still consider the pricing environment pretty favorable?

Well, I mentioned to you some of the volume comparisons and the results comparisons. It's apparent that some of our competitors are following a different strategy. I think we're following one that is most beneficial to our shareholders, and I would expect that. if the price pressures in raw material continue in the way we're seeing it. at least for the coming quarter. that these pressures will not pass our competitors by, so I would say. eventually their hand is going to be forced. as well.

Okay. In terms of how your pricing has worked with customers, a lot of times the normal course of events involves, you know, a price increase that you kind of over shoot initially, and then you offer some customers a break from the higher price in order to retain their business. Even though price was up 5.8% over last year, to what extent have you had to go through this process with certain customers?

Well, we ha -- Mike, we have a fairly elaborate pricing process in the organization, which I think has some uniqueness to it in regards to the exactness and precision with which we can make our determinations. And so, what we have seen in the past is that, in those areas where we are -- or have lost business, it was mainly due to competitive action, not really because we placed our price incorrectly. And fortunately, I have to say we are seeing some of those customers also coming back, and I think that is going to play a significant role going forward to see how much that trend is going to continue or possibly strengthen.

All right. Thank you very much.

You're quite welcome.

Your next question is from the line of Rosemarie Morbelli with Ingalls & Snyder.

Good morning, all, and congratulations.

Thank you, Rosemarie.

You talked about -- well, first of all, following up on this last question and on the pricing, the price increase is lower sequentially in the third quarter than what you obtained in the second quarter. Do you feel that the pressure -- I mean eventually there will be pressure on the raw material costs coming down, and do you feel that you will be able to hold onto those price increases or will you have to give some up, based on the new way of doing business at Fuller?

Well, Rosemarie, it is very difficult, of course, to make predictions for the future and future behavior of the marketplace, but if I look back at what we have seen in the past 15 or 20 years as a normal pattern, and the pricing methodology and tools that we're using at this point in time, I am pretty confident that we will not have a similar pattern that we had in the past, which would basically see these raw material benefits almost automatically flow through. I think we have a much better understanding of the value of our products, and that allows us to make a much more measured determination of where price may really influence the pricing decision and where price is, perhaps, a secondary or a tertiary consideration.

So, in other words, because you are now selling your products on the value basis, you feel that, well, regardless of your cost of raw materials, the value is the same and, therefore, customers will agree to continue paying the same amount regardless?

Yes, I think if you really look at it fundamentally, a lot of the so-called specialty chemical business in the last decade was behaving like small cyclical. I think what we are seeing now and what we've been seeing in the last two years is that we really have gone back to be more of a specialty chemical company, where your pricing in the market is not directly reflective and driven by the raw material price.

Okay. And looking -- still again regarding this last question, you said that you were seeing some customers coming back. Do you have a feel for the percentage of the 7% volume decline, for example, what would have it -- would it have been -- if I can talk -- if you plug in, you know, the customers who came back? Would you have -- would it have declined by 9%, but you got back 2%? Can you give us a better feel for that?

No, I don't have that cost and that precision. And I think that, perhaps, is something that we can address more meaningfully when we have a full year behind us.

Okay. If I may, while your gross margin really improved versus last year, sequentially it is showing a decline. Could you give us a better feel for what this is happening? Have you not been able to get the full cost increases back, and do we expect a sequential decline because you are looking at your raw material cost coming up and you may not get that full value in Q4?

No, I think some of that has to do with acquisition accounting and integration costs for the two acquisitions, Rosemarie. If we take those out -- I don't have the exact number, perhaps John has that -- I think we saw a slight increase in the gross margin.

Rosemarie, in Q2 we were at 28.7 --

Right.

-- and if you factor in the comments that Al just made, we'd be slightly ahead of that, right around 28.8 for the quarter.

Okay. That is great. And one last question, actually, if I may. Everyone is seeing signs of housing slowdown and so have you, but so far you haven't been affected -- if my memory serves me right you may lag on that. So question, how much do you usually lag and then are you seeing a slowdown in other areas in the U.S. and then in other geographic regions?

Well, typically, the part of our business that's the most cyclical is the part that goes into the durable goods sector, and we do not, certainly at this point in time, see a wholesale change in the durable goods sector. If I look at construction and construction-related businesses, percentage wise I think it may be somewhere between 10% and 15% of our total sales, and I would say about half and half of that is new construction and renovation, and I think there is a good balance there. And I don't think that we really can serve as a bell weather for what's going to happen in the construction industry. I don't think it's going to dramatically influence the results of our Company.

And geographically, same picture every where?

Well, geographically, of course, as I already mentioned in my comments, we are benefiting somewhat, as well, by having a considerable portion that may be interpret -- or that we interpret as construction-related, which is the paint business in central America, which really moves independently of North America, as well as in Australia, which also moves independently of North America. So we have a balance between new construction, as well as the renovation, and a balance geographically, as well.

Your next question is from the line of Jeffrey Zekauskas with JPMorgan.

Hi, good morning.

Good morning, Jeff.

First question is you talked about your volume -- the organic volume decrease, which is about $25 million in the quarter, and you also talked about your sales of new products, which, by my calculation, went up about $20 million. So, in the quarter you lost about $50 million of business -- 45, 50, whatever it is -- so there must be big chunks. Can you talk about the areas in which were you were seating share, and what the nature of that sort of $45 or $50 million chunk is?

Well, I think if I look at where is the biggest impact, you would find it in the more commodity-oriented businesses, and that's the converting business industry, where we, basically, are competing on the basis of water-based products and where there are alternatives, in many case,s readily available. And also I indicated already in my comments, the automotive industry saw a very significant drop in consumption overall and also based on some of the decisions that we made with regard to customer relations.

Second question is, in the quarter, was there a positive pricing dynamic through the quarter? I know that the comparisons are more difficult for you, in that, on the one hand you've talked about how raw materials are going to be higher than expected and you've increased your earnings expectations for the year, so presumably the margin differential should improve in the fourth quarter. Is that seasonal or is that a function of the pricing you've put through?

No. I think seasonally, if I look back over many years, the third quarter generally showed some weakness compared to the second quarter. I think what you're seeing, Jeff, and I think that's one of the conundrums that you were trying to solve last time, as well, you see raw materials -- or hear us talk about raw materials going up, yet raw materials, as a percent of sales, is going down or stable, and I think the issue is really related by upscaling our product line to products that have higher margins and, as a result, also the raw material content is smaller. So even if raw materials are increasing, still as a percent of sales you would not see that reflected.

Okay. Thank you very much.

You're welcome.

Your next question is from the line of David Begleiter with Deutsche Bank.

Yes, this is James Sheehan sitting in for David today. With your volume decreasing 7% versus 9% last time, it seems to be improving a little bit, and you also mention that you're putting in place a new marketing program. When do you think we will start to see volumes improve again?

Well, I believe that some of the longer-selling cycles are coming to fruition over the next quarters. I also have seen, together with the people and the various teams, that the opportunities are greater than we had initially assumed, and, therefore, it requires additional personnel to cover those opportunities. And that's going to be a graduate process that we'll move into over the next couple of quarters.

Thank you. And also on the Roanoke acquisition, you've had a little more experience with that now. Can you tell us with regard to synergies, are synergies coming through better than you first expected?

I think that the synergies that we had calculated as hard factors for impacting the income statement are clearly coming through at the rate that we had expected. There are additional synergies that we're seeing, which we potentially had under estimated, and that's the experience that we have brought on board in this market segment, and that may allow us to address. And access additional customers that we, in the past with our construction business, were not able to penetrate, because the level of marketing experience and knowledge that we have brought on board is helping us considerably in that area. Now that's not going to happen in one quarter. That also is going to happen over time, but I am hopeful that we will be able to report something positive there.

Okay. Thank you very much.

Your next question comes from the line of Christopher Butler with Sidoti and Company.

Good morning, gentlemen.

Morning, Chris.

Just wanted to follow up with the acquisitions question. With these -- the synergies that you're finding and potential new synergies for the third quarter, would you estimate that these acquisitions were accretive?

Chris, this is John. No. They were slightly dilutive, but let me go back and reiterate what we've said because we're getting a lot of questions there. We had said at the time of the acquisitions, both for Henkel and Roanoke,e that we expected them to be slightly dilutive for the full year of 2006, and as we've stated, these are early days and we're right on target where we want to be. We also stated that, for '07, we expected these transactions to generate accretions to the tune of $0.06 to $0.09, and, again, that's on a split adjusted-basis from our earlier comments. We have not wavered from that. We continue to work on those very diligently, and we're quite confident that we'll continue to execute there just like we have with the ongoing business.

Okay. And would the 30 million in debt that you paid down over the quarter, is this something that we could expect again here in the fourth quarter or moving into 2007?

I would expect that to continue.

Okay. Could you also give me a little bit more color on the SG&A expense line? As a percentage of revenue, it dropped considerably year-over-year, and I was wondering if you could add a little detail to that point?.

Well, we continue to manage the expenses very aggressively. We're doing a very good job on the-- on the attrition as far as managing our headcount. And we just have very rigorous internal processes to make sure that we're doing more with less, and it continues to be a metric that we manage and something that's very close to where we should be. Also keep many mind that the common theme throughout the organization, not just in the manufacturing side but in the SG&A, is that numerous Lean/Six Sigma projects that is are cutting across all functions, whether it's the finance function, the HR function, the IT function. And when you have the incr -- when you have combined benefit of those multiple programs kicking in, we continue to strive towards our long-term goal of 18%.

And if you compare the third quarter of last year with the third quarter of this year, we basically have held or had come stable, despite acquisitions that we have taken on board.

And my last question is concerning the lowering of your 2006 guidance for capital expenditures. Just wondering are there specific projects that have been delayed or scrapped, or is this -- could you describe that a little bit for me?

No, I think we have a fairly solid regimen in approving products -- projects and the projects that had been presented did not really make economic sense, and, therefore, we have come to the conclusion that we will not be spending as much money as we had initially anticipated, because many of the steps that we have taken through our Lean/Six Sigma initiatives have allowed us to increase productivity in a variety of plans without touching capital.

The other point, Chris, that I would add to the capital expenditures is keep in mind that we outsourced our IT function. Historically you've had a, I would say, a significant spend percentage in IT, and we've done a much better job of managing that now with it being outsourced.

All right. Thank you very much.

You're welcome.

Your next question comes from Frank Dunau with Adage Capital.

Yes, first I'd like to congratulate you guys. I mean, I'm maybe one of the few people old enough, but the transformation this Company's gone through in the ten -- last ten years is remarkable.

Thank you, Frank.

Second, you know, you ha -- in some ways it's a good -- I mean, I'm not worried about the volumes, because my guess is if you look at your -- you know, at some point in the last couple years, you looked at your businesses and your sales and yours revenues, because you probably asked yourself why are we doing that. And so my question is what -- you know, either a dollar amount or percentage of sales, how much more do you have where you still stare at your reports and go, why are we doing this? I mean, --

Well, it has, of course, been significantly less and then you see that in the overall margin improvement. I would assume that, as the overall level increases, products and relationships that perhaps looked pretty good in the past will get questioned, a little bit more details, and I think, though, that it will be not having such a dramatic impact any more as it may have had in the last year-and-a-half on volume, because I believe that it would be much more difficult to find either ready replacement or ready alternatives for the customers that buy these products. So I think, if I look at the opportunity to continue to reposition our business and upgrade our profitability profile, I believe we have clearly seen the most significant impact because those were the easiest transitions to be made for those customers. But I think there still is work to be done in our existing portfolio because there is a distribution, as in any business, and we're working on the lower end of that distribution, on the tail.

And would that apply maybe -- as you do this, I assume you didn't need to do -- you could get away with less CapEx than you might normally, just because you're using the same production lines to make something that's making you more money than in the past? As you --

At least -- at least at this point in time that's been the pattern that we have seen, and that's why our capac -- why our capital expenditures have gone down considerably over the last five or six years. And, Frank, you also recall me talking about the low absolute capacity utilization that this industry goes through, and I think it's a folly to put more money into additional capacity unless it is a new technology that requires new equipment.

So the CapEx will stay relatively low going forward still?

Yes, I think where we will possibly see some CapEx requirements is in the faster-growing businesses where we have either a geographical compulsion to make the investment in a geography and cannot do it, or supply the product from other geography, but that would be it.

Okay. Thanks a lot.

Your next question comes from the line of Chitra Sundaram with Cardinal Capital.

Thank you and, again, congratulations, joining with everyone else. Great quarter. Just going to the CapEx point again, I think what you're seeing as net/net it probably is just a reallocation of dollars to the faster growing segment, correct? And we're not actually going to see a step up as you'll see some of these longer cycle contracts or segments come to fruition?

No, and if you look at it, Chitra, we have a depreciation and amortization expense of somewhere between $50 and $55 million. We are well below that rate, so I'd say, given also the profile of the capital needs of our business, if we have to make an investment in a new facility, it's not going to be tens of millions of dollars. It generally tends to be much more moderate, and I think we will be able, at least with the portfolio that we have at this point in time, to serve those needs without making dramatic changes in our capital expenditure.

Right. The last one on capital allocation, so as the repositioning's kind of hopefully getting to the point where you'll start seeing some of that step up from new markets coming to fruition and so forth, is it fair to assume that your thinking is. okay, we keep the capital for some of that M&A that might be in the pipeline? Kind of when does your thinking change in terms of, oh, we come back and do share buyback because we're kind of in a stable state?

Well, I think as we are moving clearly into new territory with regards to performance and also with regard to the segments that we are addressing, it is becoming obvious to us that there are very good opportunities for applying our capital in a fashion that is very beneficial to our shareholders. I'd say more beneficial than just paying the money out as extraordinary dividends or whatever have you. So I think we are fulfilling the promise to our shareholders that we know what we're doing with their capital and with their investment, and I think we see plenty of opportunity to make even greater progress in that direction.

Great, and lastly, the raw materials side, is it not fair to say that, perhaps as we go into 2007 -- fiscal 2007, some of these price decreases in the feed stock that we've been seeing and then increased capacity in various chemicals that seem to be coming out in the Middle East and Asia and China, particularly, that they might actually have some effect, but it would be more lagging going into '07?

Well, Chitra, I would be the last person to say that cycles are dead going forward. I think there still is going to be an underlying cyclicality of this business. I believe,though, there has been a new price level established and the cyclicality will move within that price level.

I see.

Now, we would certainly, looking at the raw material side, see that, at this point in time, some of our key raw materials do not behave in tandem with some of the basic commodity raw materials, like natural gas and oil. Like I look for instance at ethylene, propylene, benzene. All spiked in the third quarter, significantly. If I look at methanol, methanol presently is globally very tight because of some shutdowns, and the spot price of methanol, for instance, was up 100% in August from the beginning in August to the end of August, and I think the contract price is up by 30% or 40%. So I really think we're going to have to keep on looking at this overall environment very critically, and with a teams that we have in place we have the capability of doing that. And if, a year out, half a year out, two years out we are going to develop some cyclicality, I think we have the methodologies in place and means to deal with it in an adequate fashion.

Thank you so much.

Your next question comes from the line of Gregory Macosko with Lord Abbott.

Yes, thank you. Very nice quarter. If I could ask a little bit about the long-term goals with regard to the bottle. Both -- you're looking to improve both gross margin and decrease the expense as a percentage of revenue, as well. I can see the direction you're heading with your improved product mix to improve the gross margin, could you talk a little bit about how you make the next step down? You've done well this quarter, getting it down to around 19.5%. What kind of things could we look for in that SG&A line to help bring that down on a longer-term basis?

I have talked in the past that we have a fairly broad rollout and involvement of our employees, of our associates, in the Lean/Six Sigma activity, and we are just still amazed at the opportunities that we are finding to become more productive, to take out costs or to lever what we already have in place much more efficiently. And that has been a significant driver of where we have been moving towards in the last year-and-a-half. I would certainly expect that there is further opportunity to do that, and I have said in the past that our long-term goal was to bring our operating expenses to about the 18% level. Now, I have to say that assumption was made at the product portfolio that we had at that point in time.

We are not going to be dogmatic about it. If we, for instance, find an opportunity with a little bit more operating expenses to get businesses that are dramatically more profitable and that move us in the 40% gross margin or 50% gross margin range, then we certainly will not make the irrational decision of not pursuing that business because it would impact our operating expenses. So I think it is going to be a living process. We will make adjustments as we move on, but at this point in time, the target is still to bring it to 18%.

I see, very good. With regard to the adhesive -- global adhesives business, that has obviously been more commodity-like in the past, roughly speaking, what's the share of that business that is commodity-oriented or the lower-margin mix, and what kind of target should you look for there?

I think, Gregory, I touched on that at the last conference call. Historically, we have made the assumption that about 70% of that business, of the volume that we had was commodity-oriented, and was, therefore, susceptible to -- very susceptible to competitive pressures. I indicated at the last conference call that that relationship may have flipped and basically be now more in the range of 30% or possibly 35% for [commoditized] or commodity-like behavior in the marketplace. And I believe that has just made a dramatic difference in the performance of the Company and it also hs made a dramatic difference in the way our adhesives business is going about their opportunities going forward. Because if you really look at it, we have, on a global base, perhaps 4% market share, and even if I assume that on a global basis, there may be a 60 or 70/30 relationship of 70% commodity, 30% specialty, that means there still is plenty of opportunity in the expert range to increase our business, and that really is the direction that we're pursuing.

Your next question comes from the line of Jeffrey Zekauskas with JPMorgan.

I guess just some last issues. The first is that there are very large performance payments that will go to the owners of the business that you recently bought, and I was wondering how those performance payments will affect the income statement? That is, are they lumpy? Do they get them at the end of the year? Do they get them gradually? And second, you know, your stock prices has gone up a little bit, so probably management will get some performance payments, too, and I was wondering how that might affect the income statement in the coming quarters?

Well, let me talk about the payment for managers and the incentive process that we use, and then John can talk a little bit about the performance payment. We have and we do, of course, on a regular basis look at our performance and accrue appropriately for the performance that we are seeing and that we're projecting. We -- I can -- I don't have to make a secret about it that we certainly in the past have had a few years where there was no performance payout, and that's going to be different. And it has been different last year, it's going to be different this year, and that's very encouraging and very motivating for our people. But the payout is very strictly related to absolute performance and absolute improvement, and, in particular, it's related to improvement over and beyond what normally you could expect as a performer when you run your business in a decent fashion. So I think, by the performance level that we have achieved this year, it's going to be something that is going to allow to us reward our people adequately for the performance that they have shown. John may want to talk a little bit about the performance payments.

Jeff, regarding your initial question on the performance payments, anything that is related to the acquisitions is accrued as well in our full-year outlook, so it was reflected in the guidance that Al allude to do earlier.

So in terms of your earnings performance this year being better than expected and the stock price being higher, when you do the calculation, how much more will that affect the income statement and will it affect it in '06 or will it affect it in '07?

It will not. In fact, the income statement beyond what we already have published has expectations for this year.

Right, so will there be performance payments in the first quarter of '07 that have to do with --

Yes, that will affect the cash flow, but it will not affect the income statement.

It affects the cash out the door as far as the timing of the payment, but it will be reflected in our full-year P&L for '06.

Okay. And lastly, in terms of the new products that you have that grew from roughly $40 to $60 million, which end markets do those products serve?

That is fairly broad-based and had goes across adhesives, as well as Full-Valu/Specialty. I'm very pleased with the number, by the way, because we had a significant drop-off at the middle of the year because one of our more successful products, Advantra®, dropped off completely because it reached a time line where it would no longer qualify. And I would say that, typically we're seeing at least -- still at this point in time, but the trend is hopefully moving in a different direction -- a stronger ratio of new products in the Full-Valu/Specialty area than we see in the adhesives area.

Do you have price, volume, currency, acquisitions for the individual divisions that you can give us or do we need to wait for the Q?

I think we will report that in the Q because we want to make sure that we are absolutely correct before we release these data.

Consistent with past practice, Jeff, that'll be in the Q.

Ladies and gentlemen, we have reached the end of the allotted time for questions and answers. Speakers, are there any closing remarks?

Yes, thank you very much for your interest in the Company. I think we are very encouraged by what we have been seeing in the past quarters, and we're also very encouraged with what we see going forward. Thank you for your participation. And Steve?

Have a good day. Thank you.

Bye.

This concludes today's H.B. Fuller's third quarter investors conference call. You may now disconnect.