H.B. Fuller Company (FUL) 2010 Q3 法說會逐字稿

Good morning, and welcome to the HB Fuller third quarter 2010 investor conference call. This event 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 includes Mr. Michele Volpi, President and Chief Executive Officer, Mr. Jim Giertz, Senior Vice President and Chief Financial Officer, and Mr. Maximillian Marcy, Manager of Investor Relations.

At this time, I would like to turn the meeting over to Mr. Maximillian Marcy. Sir, you may begin.

Thank you, Yvonne, and welcome, everyone. Today's conference call is being webcast live, and will also be archived on our website for future listening. 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 operating income, earnings before interest expense, taxes, depreciation expense and amortization expense, or EBITDA, and return on gross investment, or ROGI.

Operating income is defined as gross profit less SG&A expense. EBITDA is defined as gross profit less SG&A expense, plus depreciation and amortization expense. And ROGI is defined as trailing 12-month gross cash flow divided by gross investment. All of the non-GAAP measures discussed today should not be construed as an alternative to the reported results determined in accordance with GAAP.

Management believes that a discussion of these measures is useful to investors because it assists in understanding the operating performance of the Company, and its operating segments, as well as the comparability of results. The non-GAAP information discussed today may not be consistent with the methodologies used by other companies. All non-GAAP information is reconciled with reported GAAP results on the last pages of our presentation.

For more information, please refer to our recent press release, 10-Q filings of March 21, 2010, and June 30, 2010, and the annual report for the year ended November 28, 2009, on form 10-K as amended, filed with the Securities and Exchanges Commission, all of which are available on our website at www.hbfuller.com under the Investor Relations section.

I will now turn it over to Michele.

Thank you, Max. Good morning, everyone, and thank you for joining us today. After posting six consecutive quarters of steadily improving business results since the global recession accelerated in late 2008, we hit a few speed bumps in our third quarter, which had an adverse impact on our financial results. The most significant challenges were the ongoing raw material price escalation, and persistent supply shortages. Typically in an environment of rising raw material costs, we are able to manage profit margins through a combination of price adjustments, product substitutions, and product reformulations.

Instead, in recent months, the extremely tight supply of a wide range of raw materials has limited our ability to substitute and reformulate. We executed with price increases, but without the additional benefits from reformulation together with higher than expected material costs, margin compression occurred.

Going forward, we expect the severe tightness in supply to abate somewhat, while additional price increases are being implemented. These factors together should lead to improved margins in the fourth quarter.

In addition to the raw material inflation, North American markets experienced a significant demand dip at the beginning of the third quarter. It appears that demand was pulled forward into the second quarter based on customer concerns over potential product shortages, and some pre-buying in front of price increases. As the quarter completed, demand somewhat improved. Since our North America Adhesives business is our most profitable business segment, the lost volume had a notable impact on our bottom line in the quarter.

Let me now share with you some of the notable items from our third quarter. First, on a consolidated basis, net revenue grew over 7% year-over-year to $359 million, as our investments for growth continued to produce results. Organic growth was higher, 9%, driven by strong volume gains and higher prices.

We believe that our solid volume growth across the Company reflects the initial returns on our strategic investments towards differentiation, innovation and volume. Notable areas of growth in the third quarter were EIMEA with 16% organic growth, Latin America Adhesives with 13% organic with growth, and Asia Pacific with 8% organic growth.

Second, as I mentioned earlier, our margins were compressed in the third quarter, and we are not satisfied with our results in this area. With that said, our year-to-date adjusted gross margin remains at a historically high level of 29.8%, in spite of continued raw material cost inflation.

Third, our total operating expenses for the third quarter declined relative to the second quarter level. Our spending trended upward over the past four quarters as we invested in technology and customer (inaudible) resources to support our strategy transformation toward differentiation, innovation and value. Our investments in our strategy are not complete. Actually these investments will continue indefinitely, but the initial wave of investment required to change our positioning in the marketplace is mostly in place, and further investments will occur at a slower pace.

So far, we feel good about the investments we have made, and the growth momentum that has already been achieved. As we go forward, continued growth in revenue, combined with a more measured pace of new investment, should create operating leverage and improved profit margins.

Finally, we are pleased to report that the acquisition of Revertex Finewaters in Malaysia is complete, and the integration of this business into our global network is in full swing. The acquisition has provided us with critical mass in the southeast Asia region, and is expected to be one of the platforms for accelerated growth in the region over the coming years.

I'll come back later in the call with some perspective on the future trends for our business, but for now I will turn the call over to Jim for a review of our financial and operational performance.

Okay. Thank you, Michele, and good morning. As we've done each quarter, I'll start with a quick review of our financial score card on the five-year financial targets that we originally set at our investor day event in 2007, the beginning of our strategic transformation. We review these metrics each quarter not just as a snapshot of quarterly financial performance, but because we remain committed to delivering on these strategic goals.

In the third quarter, we extended our strong organic growth trend. Organic sales grew 8.9% year-over-year from strong volume gains, and positive pricing. Volume growth was accomplished by adding new business with existing customers, as well as key new customer wins. Our goal is to achieve and maintain a compound annual growth rate in organic sales of between 3% and 5%. In fiscal year 2010, we will exceed this goal. But more importantly, the investments we are making this year will support future growth within or above the target range.

EBITDA margin for the trailing 12-month period ending this quarter eased 100 basis points versus last quarter to 11.7%. The sequential decline was primarily attributable to gross margin compression, not fully offset with lower operating expenses. Our goal for EBITDA margin is to be between 14% and 16% each year. We will achieve this profitability goal in the future by slowing operating expense growth to a rate below revenue growth, thereby realizing the return on our infrastructure investments made in 2009 and 2010.

Return on gross investment in the third quarter declined 90 basis points to 7.7%. The decrease in ROGI was attributable to increased gross investment, primarily related to our acquisition in Malaysia, combined with lower gross cash flow on lower profitability. Our ROGI goal is to be between 10% and 12%. As with our EBITDA goal, we expect to reach our ROGI target over time, as the benefits from our investments are fully realized in the form of higher margins, and above market rate growth.

Our final metric is EPS growth. Our long-term goal is to maintain a five-year compound annual growth rate, and diluted earnings per share of between 10% and 15%. At the end of the third quarter, the five-year compound annual growth rate was 15.1%, still above our target range. For 2010 year-to-date, our adjusted earnings per share are up 18% from the prior year.

Now we turn to the balance sheet and cash flow. Cash on hand at the end of the period totalled $141 million, and total debt was $299 million. Net debt of $159 million was up approximately $27 million from the second quarter. The sequential increase in net debt was a result of the acquisition in Malaysia, which closed at the beginning of the third quarter. Cash on hand was used to fund this acquisition.

Net working capital in the third quarter increased 120 basis points year-over-year from 16.4% of annualized net revenue in last year's third quarter, to 17.6% this quarter. Sequentially, net working capital also increased on a percentage basis. Net working capital requirements were generally higher, specifically for inventory, driving an increase in days on hand.

Cash flow from operations in the third quarter was $11 million, down approximately $50 million versus last year's third quarter. This year's cash flow is lower primarily due to higher working capital requirements, and lower pre-tax profit year-over-year.

Lastly, regarding capital expenditures, we invested $9 million during the third quarter. This amount is approximately $4 million higher than last year's third quarter, as we continue infrastructure investments, and this amount is in line with previously provided guidance. Year-to-date we have invested $24 million, $9 million more than in the comparable period in 2009.

With that as a summary of our financial performance, I'll now provide you with a brief segment update. In the third quarter, all segments achieved positive organic growth, led by EIMEA and Latin America Adhesives, both of which achieved double-digit growth. In general, each segment benefited from easier year-over-year comparisons, new customer wins, and expanded business with existing customers. Profitability for all segments was lower year-over-year as raw material cost inflation compressed margins.

In North America, organic growth continued in both business components despite a significant contraction of most end markets at the beginning of the quarter. Adhesives grew 5.7% organically versus the third quarter of 2009, and construction products increased organic sales 1.9%. Growth in the Adhesives component came from increased volume with existing customers, and new customer wins across most end markets.

In construction products, many of our customers began moderating inventory levels during the quarter. Despite this headwind, the gradual improvement of end market conditions, and new business wins, helped to achieve positive growth.

The Europe, India, Middle East, Africa segment again delivered strong double-digit organic growth of over 15%. Core European countries delivered solid volume growth on improved end markets, while the emerging markets of Turkey, Middle East, Russia and Central Asia returned very favorable year-over-year volume. Much of the growth was due to market share gains with key customers in packaging and construction, combined with a generally stronger regional economy. The region posted these results despite the fact that we are winding down our polysulfide-based window sealing business. All these growth numbers would be three points higher if we just looked at the core business excluding the windows business.

Before I move on, I'll take this opportunity to mention that on Friday last week, there was a fire at our Mindelo, Portugal facility. We're pleased that there were no serious injuries, but a portion of the facility sustained significant damage, and has been temporarily idled. This facility produces both water-based and hot melt products. The portion of the plant impacted by the fire produces water-based polymers used to manufacture adhesive products. Damage was limited to the infrastructure around one production vessel. Other Company facilities in Germany and the UK produce water-based polymers, and are viable options for backup supply.

We are insured for events of this nature, and our loss retention is $2.5 million per event. Although we do not have accurate estimates of the costs that may arise from this event, it is possible that the total will exceed our maximum loss retention. At this time, we do not foresee any material negative impact from this event going forward.

Now moving on to Latin America, both business components delivered positive organic growth, with adhesives up 13.1%, and paints up 2.2%. The positive volume progression in adhesives continued during the third quarter despite difficulty sourcing raw materials. Our paints business posted modest organic growth for the first time since the fourth quarter of 2008, indicating some stabilization of local market conditions.

And finally, Asia Pacific continued its strong organic growth trend, up 7.6% from last year's very strong third quarter. Growth continued across all geographies and market segments, as the economic expansion continues across the region.

We continue to localize the formulation and production of products through our Shanghai lab and Nanjing manufacturing facility. Localizing in the region will provide us with cost leverage, more innovation, faster turnaround times for our customers, and ultimately a higher growth and profitability profile.

With that as a segment update, I'd like to now turn the call back to Michele for a brief discussion of our expectations for the last quarter of 2010 fiscal year.

Thank you, Jim. Before I make a few comments on where we are headed, let me say a few words on where I think this Company is right now. I believe we are a different and better Company. Our strategy is better. Our team is better. And we are focused on the right things.

Our execution is getting better, though it is not perfect yet. We have momentum across all of our business segments in all regions of the world. We look at the business conditions and financial results of our third quarter as a temporary interruption to our course of steady improvement.

We are taking actions to make our business better in the fourth quarter and beyond, and we are confident that these actions will produce tangible results. We are proud of the fact that we have served our customers well over the past months when our supply chain has been especially difficult to manage and predict.

So, how will this translate to financial results for the final quarter of 2010? Well, we expect organic sales growth to continue, which will produce full year net revenue approximately 10% higher than fiscal year 2009. Therefore, we now expect fourth quarter net revenue to be between $360 million and $365 million, which would indicate year-over-year growth in the fourth quarter of between 5% and 7%.

In addition, as the pricing actions over the past two quarters and the current quarter catch up to raw material inflation, and our net revenue growth remains strong, we expect gross margin to improve in the fourth quarter relative to the third quarter. With regard to raw material inflation, we expect costs for the 2010 fiscal year to be slightly over 8% higher than 2009.

Regarding taxes in the third quarter, we resolved a number of tax issues, which provided a net benefit to earnings. These one-time discrete tax items will lower our effective tax rate for the year. However, our core tax rate, excluding discrete items, remains about 34% for the full year, and the fourth quarter of 2010. Finally, we now expect capital expenditures for the fiscal year to be approximately $30 million, which is at the upper end of the range we have indicated since the beginning of the year.

Now, I would like to open the call up for your questions.

The question-and-answer session will be conducted electronically. (Operator Instructions). And we'll take our first question from Jeff Zekauskas with JPMorgan.

Good morning.

Good morning, Jeff.

Hi. Michele, you talked about the quarter as one in which HB Fuller hit a speed bump, and you essentially said that the quarter was anomalous, and you expect to be back on a more normal track next quarter.

So, what is it about next quarter that's all that different, in that the rate of volume growth is probably not so different than the rate of volume growth this quarter? Is it that raw materials are coming down, or your average prices are going up? Why should the fourth quarter be better than the third?

Well, Jeff, first thing I would say, there was a positive trend within the quarter. Sales were better in August than in the rest of the quarter. SG&A was better in August than in the rest of the quarter. Operating income was better, or let's put it that way, less worse in August than in the rest of the quarter.

At the same time, pricing actions have been taken, and we believe that the momentum on growth continues. And the team is really committed to make sure that we continue supplying our customers while we continue pushing on the top line. So overall, I think that the worst, for my year-over-year comparison, was really taking place in the third quarter.

If you remember the bottom of the raw materials were in the third quarter of last year, and that was a tough comparison that we had to face. Moving forward, there is still going to be raw material inflation in the fourth quarter, but it's going to be growing at a lower rate than in the third quarter.

And if I may ask a question to Jim, the inventories were $148 million in the quarter, which just seems very, very large. Does that have to do with you buying, I guess, higher cost raw materials that you were unable to sell, and is that something that also may diminish your fourth quarter returns?

Yes, Jeff, well, certainly we're not satisfied with inventory performance. I think it's a combination of a couple things. One is higher material costs, you mentioned. The fact that in several of our regions, we did not meet our own volume expectations for the quarter, so we tended to be over-supplied. And the third factor was really, I would say more attention being focused on just trying to procure materials as opposed to manage them efficiently in a period of extremely tight raw material supply.

Okay, thanks very much.

Thank you, Jeff.

We'll take our next question from David Begleiter with Deutsche Bank.

Thank you. Good morning.

Good morning.

Michele, you had announced a June 1 price increase of 8% to 15% on various products. How is that progressing? Are you getting half of that price increase overall?

Well, clearly we said that we are not fully satisfied of how we have implemented price increases, but clearly that is also a factor of the competition, and is also a factor of the material availability that you have, right? When you have shortages on raw materials, it's difficult to go and ask for a price increase on top of that.

So, when I look at the [work] year-over-year, I think that we have managed the price increases, taking into account the shortage and the raw material availability, decently. I think we could have done better. I think we have to do better in the future, but we also want to make sure that the growth that we have recently started becomes more solid every day.

So, of that 8% to 15% you have announced, should we assume you realized 3% or 4%, is that fair?

That was an announcement that was in the North America Adhesives portion of our business, and overall you have seen that the price volume mix that we have reported is between 2% and 3%, so that's so far what has been hitting. Clearly you can expect additional movements in price in the fourth quarter, not only in that business but throughout the Company.

And just lastly, you said you'll see higher gross margins in Q4 than Q3. Could we see gross margins as high as 30% in Q4, or would it be maybe a touch less than that do you think?

Well, given the fact that we missed our previous guidance when I said that in the third quarter gross margins were going to go higher than second quarter, I'm going to be cautious here, right? Because it is clear that shortages in raw materials are still there, and clearly the conversations with customers are on multiple levels, not just on price increases and (inaudible) inflation, but it's also being able to supply them to make sure that we don't compromise the long term with the short term. So, directionally we are targeting the gross margins to go higher, I would prefer to be cautious at this point in time before we commit to a specific number.

Thank you.

And we'll take our next question from Christopher Butler with Sidoti & Company.

Hi, good morning, guys.

Good morning, Chris.

If I remember correctly, in the second quarter you said that your raw material costs were up 5%. How much were they up here for the third quarter, year-over-year?

Well, year-over-year they were up north of 15%. And the reason for that, Chris, is that if you remember last year third quarter of 2009 was the lowest point, so we're having a [special] situation in terms of raw material evolution to the one that we had in 2008.

And as we look forward here with, at the lean prices that it came down from the spring, when do we expect that to kind of move down the ethylene chain, and be something that will help you out with lower costs?

Well, that's not going to happen right away. What I can tell you is that our expectation is that raw material increases sequentially in the fourth quarter will be lower than in the third quarter, but I am also telling you that the expectation is that it will still move up.

And the majority of that is not really an inflationary situation, but is really on availability. Everybody has been cutting down capacity over the last two years, and there is talking of the first half in industries like automotive and electronics, that we don't participate in, being a higher year-over-year 50%, 70%, has been putting a lot of stress on the raw material supply.

I'm sort of touched on the -- my last question here -- with the shortages that you had pointed out, any indication from your suppliers on when they feel like they can get a handle on that?

Well, I think we feel more positive in terms of 2011 in all terms, not only in raw materials, clearly than in the fourth quarter. There has been a lot of war going on. I think we have closed a lot of the gross margin gap in terms of reformulations, but the jury is still out to see what we can do in the fourth quarter to be having a more substantial gross margin improvement. I think directionally we will be there, but we have to be cautious.

Are there specific materials that you commonly use for reformulation that you're unable to get right now because of shortages?

Well, it's all over the place, but clearly [waxes], hydrocarbon resins, have been really hitting the most.

I appreciate your time.

Thank you, Chris.

And we'll take our next question from Dmitry Silversteyn with Longbow Research.

Good morning. A couple of questions. Number one, you've addressed the tax rate guidance for the fourth quarter. Can you go over again what brought the tax rate down to below 20% on a reported basis in the third quarter?

Excuse me. Can you -- ?

Yes, the taxes?

Taxes, yes.

This is Jim, I'll take that one. We had discrete items in the third quarter that totaled $2.9 million. So those were one-time discrete items. And that is a variety of things. It's basically settling open tax issues from prior filing years in the United States, Canada, Germany, Costa Rica, several places. Some of these things were positive, some negative. They netted out to $2.9 million positive.

Got you. Okay. That's fine. I just wanted to make sure that this wasn't kind of a catch-up for a lower tax expectation for the year.

No. As we said, the 34% plus or minus a tick, is a good core tax rate for us for the full year and the quarter, fourth quarter.

Very good. Second question, you're continuing to push price increases into the market, obviously the raw material costs are going up. We've seen some additional increase announcements just in the past couple of days, particularly in the acrylic chain. Given that the basic petrochemicals, the propylenes, the ethylenes, have been declining for a couple of months now, I'm assuming your customers are watching that. Is it becoming more difficult to get pricing into the market, or are your customers well aware of the shortages, and the sharp increases in the particular raw materials that you're using, and are continuing to be amenable to price increases?

I can tell you that, Dmitry, everybody is aware of these serious shortages in the market. What I can tell you is that everybody has been surprised by the violence of this trend, of these lack of availability, us, our competitors, our customers. Could have we done a better job of thinking ahead that everybody was cutting down capacity? Absolutely.

Lesson learned for the future, but it is clear that there is tightness in the marketplace. Everybody understands, and that's why we have been and we are and we will raise prices as, from what we hear, our competitors are as well raising prices. It's a matter of reaction time.

Got you. Okay. And then final question, and I think it was maybe asked earlier, but I just want to make sure that I understand the answer. If you look at inventory turns and days sales outstanding, they've been climbing throughout this year. Some of it may be seasonal. But if I look at just inventory turns, they seem to be at the lowest level, you have to go back to 2005, and a couple of quarters in there saw inventory levels relative to sales at this level.

Is it a question of you pre-buying, or buying materials as they become available? Is that a question of perhaps a slowdown in the end market? Can you help us understand, and get a handle on the DSOs and the inventory turns, and what it says about the business?

Well, a lot of that is related to growth. We have been expanding in several regions of the world, which is something we are pretty happy about. We have been ramping up a new factory in China, in Nanjing, and basically we had to create inventory. So, yes, there have been some pre-buys, but with a lot of the lack of availability, that was not the major thing. So I would say mainly it's growth. That does not mean also that there are not some efficiencies in projects that we have to work on as well.

Okay. So we could expect so see these levels start to trend down as your investments wind down, and the business catches up sort of with what you've put in place in terms of inventories?

That's directionally correct.

Okay. All right. I'll get back into queue. Thank you.

And we'll take our next question from Steve Schwartz with First Analysis.

Good morning, everyone.

Good morning.

If we could talk about SG&A for FY 2011, it looks like maybe F Y 2010 falls in at $290 million to $300 million. I know some of those expenses in there were one-time in nature with hiring new people, but it sounds like you're adding more. So, can you tell us whether or not you think FY 2011 will be at, above, or below where 2010 might fall?

Well, what we said, and you heard Jim here saying that, is that our rate of growth is going to abate. Clearly, we are going to continue to invest over time, but that rate of growth is going to diminish progressively, right? We also said that our SG&A growth was going to be slower than revenue growth, so it is clear that in 2011 there is going to be leverage of these SG&A.

Okay. So, Michele, should I take it then, when you say growth, it will probably be a little bit higher in FY 2011 versus flat?

We are going to invest. We are going to be discriminating. Clearly, there is inflation, and there is a carryover because the investments have continued during the year, so there is going to be an increase in SG&A, but it's going to be less than in 2010.

Jim, do you want to add something?

Yes, sure. Steve, just to give a little bit more perspective, if you look at 2010 for the full year, and if you just assume that our SG&A in the fourth quarter is flat to the third quarter, which I'm not saying that it will be, but just for an assumption, our SG&A is going to be up 11% in 2010 versus 2009. And that's on a sales increase of 10%.

So that's our negative leverage that we're seeing in 2010, as we invest for growth, as we've talked about. So it's pretty slight negative leverage. And then, again, just using that as context, what Michele said, next year we see additional revenue growth, and our SG&A growth is going to be a fraction of our revenue growth.

Got you. Okay. That's very helpful. And then just as a quick follow-up on the EU polysulfide business, I think, Jim, it sounds like volume was truly up about 15.5% then in Europe?

I think our organic number that we reported was up 16%, or up over 15%, I think it's closer to 16%. Without the windows business, the organic was closer to 19%.

Closer to 19%. Okay. And then you expected higher SG&A spending in Europe to kick in in the second half of the year. How much higher was it? Can you give us an idea of the magnitude there?

Well, Steve, we had by design planned a lot of investment in Europe to basically get growth started after several years. As you have seen, we are pretty happy on that, and as investment money goes out first, and then you get the return. So, that's going to be part of our 2011 leverage.

So far, we haven't seen this growth in Europe for several years. We are very happy. We have very strong committed leadership, and things are going well from a top line perspective, and next year we will start seeing hitting the bottom line what is the return on these investments.

Yes, definitely top line looks good. Thanks for answering the questions.

Thank you, Steve.

And we'll take our next question from Rosemarie Morbelli with Ingalls & Snyder.

Good morning, all.

Good morning, Rosemarie.

Michele, during last quarter's session, you talked about the fact that you were seeing customers getting projects off the shelves. What are you seeing now? Do you see more of those projects coming out? Do you see them being shelved again? Could you give us a feel for the underlying growth that you are seeing out there?

Well, I don't think, Rosemarie, we are still in a full market recovery situation, and actually we expect the second half to show less restocking, and a more muted level of industrial activity. Also due to tougher comps, lots of people we saw in June are starting to take a look at their inventories, and that's clearly contributed to our [bad month] in the quarter.

Overall, I think there is going to be growth, but it's going to be less stellar than in the first half. Let's not forget, there have been segments in the first half in the economy, not only in North America, that have been growing at 50%, 60%, 70% year-over-year. I think that's going to go down in the second half, not just for us.

No, I understand that. I was just wondering if you were hearing from customers that, well, they had decided to start this or that project, and then suddenly were changing their mind?

No, I don't think that anybody's changing their minds. I think simply that the comps are different, and I think that maybe we all got a bit too optimistic on the speed of this recovery, so I think it's growing but it's still growing from a [bottom] situation. Customers are working well with us, are very happy. Clearly, so far, the main concern for everybody as in our customers in the third quarter was getting the raw materials to fulfill, first of all daily needs, and then thinking about growth projects.

Okay. And could you, if I may ask a couple of additional short questions, what was behind the negative pricing in Asia Pacific? Raw material costs are going up everywhere, I'm assuming that it is the case there also. Why couldn't you get any price increases?

Well, there has been a mix there, and clearly there have been lots of efforts that we were targeting in terms of reformulations to avoid price increases that didn't happen. Overall, that's a theme for the entire Company. Maybe we were more aggressive there with targets, and when we started leveraging more selling price increases, we were a bit delayed, but I can tell you that price increases are going on right now in Asia Pacific.

Okay. And the last one, if I may, I am a little confused by one of your comments when you say that there were shortages in raw materials, and that price increases were more difficult to obtain. I would have assumed that if you have a shortage in raw materials, and your customers want the products, they would be willing to pay. What am I missing?

Well, it all depends if you're having a short or a long-term orientation, right? I think in several situations when there is no raw material availability, you are creating (inaudible) service and you want to make sure that in many cases you procure the raw materials from somewhere else, and that's at the higher cost, and you need to have a collaborative discussion with the customer to see who eats that.

Okay. Thanks.

Thank you, Rosemarie.

(Operator Instructions). And we'll take a follow-up question from Jeff Zekauskas with JPMorgan.

The results in Europe on an operating profit basis were relatively depressed in the quarter, especially in the context of very strong volume growth and reasonably good pricing, though currency was negative. Were there some operating issues in Europe in the quarter?

Well, Jeff, nothing really that we would have to talk about in this call, differently than what happens normally. A lot of that was by design, and was the investments, and really our operating expenses, if you look at Europe even from a euro base, they were up significantly. Clearly, together with that, there was raw material inflation that caught us a bit by surprise.

So if we take a step back, I think in 2007, Fuller earned about $42 million in operating profit in Europe on an annual basis, and this year maybe it's going to be about $18 million or $19 million. And the revenues this year are pretty much comparable to what they were back in 2007. So when you take a step back, what's the real difference in Europe that makes the return so much lower, and Europe seems to be different from all of your other segments where your current returns are very similar to strong returns that you've had in the past?

Well, in 2007, Jeff, we were in a turnaround mode. The reason why we changed the strategy, and we went for a differentiated growth strategy was because we needed to put some legs behind our story, and turnaround over the long term cannot survive on its own.

Europe had lots of issues. The first one that we saw was lack of growth, lack of critical mass, lack of geographic expansion in the areas that we're growing. And I would say that in 2010, we have focused on getting the growth kicked off, and I am sure that in 2011 you're going to see better leverage, and also better margin management.

So is it fair to say that the gross margins in Europe today are not so different than what they were years ago? It's really the SG&A ratio, or is that not correct?

Well, I don't have in front of me the 2007 P&L for Europe, but directionally I think you are correct. The main thing is the volume and the SG&A that has generated so far, better results on the volume, then not on the price and margin management.

And you had very strong volume growth in the first two fiscal quarters of the year. Do you think that for one or both of those quarters next year, your volume growth will be negative year-over-year?

That's absolutely not our intention, and we have a pipeline that is evolving pretty well, and we believe that next year we're going to have volume, price growth, and bottom line growth. Actually, I can tell you that we have a long-term EPS growth of 10% to 15%, which I understand we missed in this quarter, but you have seen from Jim that over the period that we consider, we are still in line with our target. I reaffirmed that target, and it's our commitment to be at or above that target next year.

What's the competitive environment like with Dow and Henkel? Are they going for market share or price? Is it a good competitive environment? Is it a tough competitive environment?

Henkel and Dow made major deals, I would say really especially for Henkel, transformational deals. From what we read overall on the [business] side, Henkel has been delivering very well on the synergies, and clearly there are differences between the different segments. And we believe we have been doing relatively better than them in their industrial packaging business, but again, there are different ways of reporting, so this is our intelligence.

But Henkel, like us, for sure has been surprised by the violence of these raw material trends. So we have seen the announcements they have made in the marketplace in terms of price increases, and we expect them to be rational. Now, clearly, they are only one of the thousands of business competitors around the world, even if they are the biggest and the market leader, so we have to cope not just with them.

As far as Dow, their business component is so small in their portfolio, that it's more difficult to judge.

Okay. Thank you very much.

Thank you.

(Operator Instructions). We'll take our next follow-up question from Dmitry Silversteyn with Longbow Research.

A follow-up on a pricing question just to see how far you have to go. If you take a look at the inflation you experienced in raw materials, and the pricing that you realized, how much of the raw material inflation do you think your pricing has captured in either percentage terms or however you look at this, and contribution margin?

Well, let me give you the [full-in walk], and I hope I'm making myself clear. Last year in the third quarter of 2009, we had a gross margin of 31.8%. If you factor the volume growth, and the raw material inflation that we had, we were at risk, without doing anything, of losing more than 10 points of gross margin, basically moving from 31.8% to 21%, 21.2%.

We reacted to that by applying 250 basis points of price increases, around I would say, 70 basis points as volume leverage. Around 400 basis points were reformulations, and the rest was the gap versus 31.8% of last year, or going sequentially higher than 2Q of 29.6%.

When we were giving the guidance for the third quarter, we were thinking of getting north of 29.6%, so you see 100 basis points, 200 basis points gap, and that is mainly related to price increases, but even more to lack of availability that basically hindered our ability to reformulate. Our target for reformulations was higher, pricing was more or less in line with our target. I hope that's clear.

That's helpful, and so, Michele, if I understand you correctly, the reformulation efforts actually did more to preserve your margin than the price increases in terms of absolute magnitude, right?

Yes.

Okay. And your reformulation efforts should continue as availability hopefully of some of the secondary materials improves, so even if pricing is stalling a little bit, we should continue to expect improving margins from reformulation efforts then?

That's part of our business model. And I think every adhesive player has that in their model. I think we have done better than others, but clearly, again, reformulating and reformulating for lower cost and better performance, is also a function of the raw materials that you find around.

Okay. And then one final question on the Malaysian acquisition, you mentioned that it was closed in the beginning of the quarter, so am I to understand that at least two month's worth of the business were in the third fiscal quarter reported?

No, actually we had three months in basically the full quarter, of course, there are step-ups in inventories, and the typical stuff when you get an acquisition. But so far what I can report is that the integration is going on properly, and we are starting to generate the commercial synergies.

Was the operating margin of this business after the step-ups and costs of accounting, purchase accounting, was it higher or lower than the regional margin before the acquisition?

I would say more or less in line. Clearly, overall, over the long term it's expected to be accretive to both top line growth and bottom line growth.

Right. But I just wanted to make sure that the drop you saw in Asia Pacific, a margin to below 2%, was not largely a function of the acquisition?

No, it was not largely, but it was a component.

Got you. Okay. Thank you very much.

And we'll take a follow-up question from Rosemarie Morbelli with Ingalls & Snyder.

Michele, in your remarks you said that you were taking actions in the fourth quarter. Could you give us a little more detail as to what you are doing other than price increases? Is there something that we should be aware of?

Well, I think a lot of this is making sure that we are delivering performance, not only from an operating standpoint but also from a strategic standpoint. We are making sure that we are very, very focused in the segments, and technologies that we want to grow the most, and that we put our resources in the right place, right? Like everybody, we have our metrics, and we are segmenting at all levels, and we are making sure that whatever we do on pricing, whatever we do on SG&A, whatever we do on talent, is really following that prioritization metrics.

Any region where you are doing more than elsewhere?

I think from a growth standpoint, we are really pushing a lot in the eastern Europe, Middle East, Africa, [India] part of Europe, and we are also pushing very, very hard on China and southeast Asia.

And as you are building local production in Asia Pacific, can you quantify the savings that you will get if you look at what you are selling now, the cost of getting it there, and what your costs will be once you can produce locally?

Well, clearly, you avoid duties, tax, transportation of all the products that we have been importing over the years from Europe and from North America. And at the same time, some of the money that you save, you have to invest in not just in the plant, but also in people that are really dedicated to selling those technologies, and in the same lab that we also invested in. So that's (inaudible) in Nanjing plant, and (inaudible) technology is what we can talk about. [Wan jo], which is mainly hot melt and water-based is as it was before.

So you cannot give us a feel as to next year, the net benefit from all of those steps would be, I don't know, an additional $10 million, $20 million in profitability? You can't help us on that?

What I can tell you is that we are committed to growing both the top and the bottom line in Asia, and especially in China, and make sure they contribute to get to our 10%, 12% ROGI, maybe not by 2012, and we all had a hiccup, but hopefully by 2013.

Okay, thanks.

We'll take a follow-up question from Jeff Zekauskas with JPMorgan.

Okay, I'm almost done. So, can you talk about the acquisition environment in terms of whether there are any properties that seem alluring to you, and what size those properties might be?

Well, clearly there are properties that are interesting to us. I think they are both into the consolidation part. They are also in the bolt-on part, they are also in the geographic expansion part.

I would say so far, when you look at the last three years, we have executed better on the geographic expansion part than really on the consolidation and bolt-on parts, but that's part of our strategic plan. And I am asking the teams, and helping them to make sure that we deliver also on those two axes of M&A that so far have been missing.

I think Dave Begleiter asked the question early in the call, where he said, well, could your gross margin get to 30% in the fourth quarter, and I don't know, Michele, last year your gross margin was 31%. That is meaningfully higher than the 30%, and it looks like your price increases will exceed your raw material increases year-over-year, and it looks like your volumes are going to be up. So, why shouldn't your gross margins be over 31%, let alone 30%, in the fourth quarter?

Well, you could have asked me the same question when I was giving my expectation for the third quarter, right? And unfortunately things happen. Before saying that we can do that , I have to be cautious, and I don't want to give a guidance that we are not yet comfortable

Right, but the logic seems to be one that points to pretty good returns in the fourth quarter, though things may go wrong.

Well, if you have volume leverage, and you have good reformulations, and good price increases, I am with you. It's all a matter of, from one side the controllables, call it the execution part on the price increases and the reformulations and the volume leverage. But it's also, are raw materials available, are competitors playing their leadership role, and that's -- things that clearly we are monitoring.

But one thing is clear, right? We have started this double-digit volume growth and revenue growth in 2010, and we need to make sure that it's not the start of one year but it continues over the years. That's our commitment, and clearly when you change things, you hit speed bumps. It's not linear, the path of change.

What I can tell you is we have long-term growth rates from an EPS, and an organic growth standpoint. I think so far, when you look at it (inaudible) we are somehow hitting it, and we have to improve on the profitability profile, that's for sure. Some of it will come with the growth, but some of it is through profitable pricing, through innovation, and through really better value propositions in the segments of focus.

So there is work to do, but we are committed to the five-year plan. Maybe we were not expecting such a huge bump in terms of recession, but we are reconfirming our financial goals.

Are there any divestitures you might make?

Well, we have always said over the years, whether you were speaking of powdered coatings or EFTEC, what things were non-core, and we have always said that we are mainly a global adhesives Company. And clearly we will make sure that over time we converge, I don't know if 100% is right, but we converge more and more to that adhesives focus.

Okay. Thanks very much.

Thank you, Jeff.

We'll take a follow-up question from Steve Schwartz with First Analysis.

Michele, if we could talk a little bit about Jim Owens, he's done a good job in North America. You gave him Latin America, and revenue in Latin America has been pretty much flat across the past couple of years, and volatile earnings. What has he come up with so far? Any ideas, things he might change there to improve the performance?

Well, I think that more than ideas, he's come with facts, right? The growth -- he's been a key player behind the growth that we haven't seen. And you have (inaudible) with Fuller, so you know that very well. I can tell you that he has done also in Latin America, especially the adhesives part, clearly paints is a different business, it is not an adhesives business, and we need to make sure that the profitability is taken care of in that business.

So I would say that when you put it into context, and you look at the market segments we operate in, so not the automotive, not the electronics that were growing in the first half of 50%, 70%, we've been having very solid volume growth. We have been having good market share gains. We are doing it the right way. We have been acquiring talent, working on our operating systems, so I think he's been doing a great job, and clearly this is what we can disclose, but we are all committed and energized for a strong 2011.

Have you guys established any quantitative goals, and set any timelines up for that sort of thing?

The clear goals are those that we set in 2007 when I became CEO, I stick to those. Maybe the timeline is not 2012 for the ROGI and the EBITDA margin, maybe it's going to be 2013, but that's the commitment, not just for me, but for every one of the thousands of employees we have at Fuller.

So, 3% to 5% organic growth, this year we've been doing better than that. EPS growth, when you put things into perspective, our EPS growth over the year-to-date three quarters is up 18%. Clearly, ROGI and the EBITDA margin are not where they should be. With things stabilizing in 2011, I think we should get closer to those numbers.

Okay, that's great. Thanks, Michele.

Thank you, Steve.

We'll take a follow-up question from Dmitry Silversteyn with Longbow Research.

Yes, Michele, I'm still a little bit confused about the acquisition component of the Malaysian deal in Asia. I just looked back in my notes, this is an $80 million business in 2009. So adjusting for seasonality, you should do somewhere between $15 million and $20 million a quarter, assuming no growth. But it looks like you've done only about a third of that, if you kind of go through the numbers.

What am I missing? Was the seasonality that bad in the August quarter for this business, and we should see a return to kind of a $20 million quarterly run rate beginning in the fourth quarter?

Yes, Dmitry, this is Jim. I think your starting point is off. The company that we acquired is about a $20 million annual revenue company. So the quarterly would be about $5 million, which is pretty much on track with what we saw.

No, that makes perfect sense. We started out with the wrong -- I have to go back, because I'm just looking at my notes rather than the press release. But my notes had said it was an $80 million business. Okay, that explains it.

It's about $20 million -- rough numbers, about $20 million annual revenue.

Got you. Okay.

Yes.

Thank you.

Thank you, ladies and gentlemen. This does conclude today's HB Fuller third quarter 2010 investor conference call. You may now disconnect.