奇異 (GE) 2004 Q3 法說會逐字稿

Good day and welcome everyone to this Ionics, Incorporated third quarter earnings results conference call. This call is being recorded. At this time for opening remarks and introductions, I will turn the call over to Chief Executive Officer Mr. Douglas Brown. Please go ahead, sir.

Thank you very much, Nancy. Welcome everybody to our third quarter earnings conference call and review.

I would like to remind everybody this call is being made under the safe harbor provisions of the Private Securities Litigation Reform Act. There will be forward-looking statements contained in this review. These forward-looking statements are not guarantees, there are risks and we invite you to review those risks in our 10-K and 10-Q and our other SEC filings. For those of you who are new to the company or new to one of these webcasts, I would just lying to take a second to review where we believe we are today.

Ionics we think is a leading water treatment system provider supplying both water treatment equipment and supplying water to the end users. We use a broad array of technologies and are considered the technology leader in the industry, have experienced using a combination of technologies ranging from electrodialysis, reverse osmosis, ultrafiltration, evaporation, crystallization, and ion exchange to solve many different applications. Ranging from converting seawater to freshwater. Producing ultrapure water for the semi-conductor and power industries. We're recovering water from waste streams. We have the deepest applications experience and process expertise in the industry, as we've installed more water demineralization plants than any other company. We have extensive plant operating experience because we own and operate over 200 plants of our own, where we sell the water to the end customer. We also have a fleet of some 500 trailers which have water treatment systems installed in those trailers, which are able to deliver water purification systems to customers all around the world. And we finally -- we offer a very comprehensive service offering ranging from short-term emergency service, where we can have a truck on the road to a customer's site within two hours of receiving a call to deal with an emergency, ranging to long-term outsource services where we install a dedicated plant United States a customer's facility and we supply water for ten years or longer to that customer.

I took over the company as CEO in the middle of 2003. When I took over the we were a company with about $350 million in revenue and we were basically a capital equipment supplier. Half of our business -- over half of our business was supplying capital equipment for water treatment applications. We had extensive applications experience largely because of this capital equipment business where we were supplying seawater deSal equipment, wastewater recovery equipment, ultrapure water equipment, and we had some applications in food processing as well. We had an operations business. It was a bit modest in size, less than 30% of our revenue. We also had a consumer business supplying home water purification systems and systems for the office of about 6% of revenue, and we had an analytic instrument business of about 9% of revenue.

The primary products being total organic carbon analyzers and boron analyzers. When I took over the job as CEO, I took on an effort to transform the company. The two key initiatives of the plan -- of my plan were, first, to convert the company from being a capital equipment supplier to being a water service provider. The main reasons for this change in strategy were two-fold. One, water services is a recurring revenue business. Once we get in the business of supplying water to a customer, and we do that on a reliable basis, we keep that customer for the long-term, and the revenue we can generate from water sales continues on a monthly basis. The second reason, frankly, is that the margins are higher in the water service business than in the capital equipment business. The second part of the plan was to consolidate a fragmented organization. We had an expansive decentralized organization structure in place with a lot of duplication of overhead and infrastructure. It was a high fix cost structure so we put in a plan to consolidate the business, reduce overhead and reduce our fixed costs.

Included in that were these four items. First, the recruitment of the new management team, including myself today when you look at the management of the company, we have six new members of our senior management team who have been in place for the last one and a half years or less. We developed a coherent and focused strategy targeted on the water supply business and we divested some of our non-core activities. We entered into a restructuring program, which we completed, which reduced our fixed cost basis by some $15 million annually. And finally, we completed the acquisition of , this $350 million Ecolochem acquisition helped us double our water service business, brought to us short-term emergency capability we didn't have, added a complimentary portfolio of long-term BOL plants, and a broader management team that was complimentary to our own with significant experience in the water industry, and helped us take the company forward.

So when I look at the company today, this is looking specifically at Q3 of 2004, we now see plant operations which used to be about 29% of revenue is now over half of our revenue. Our capital equipment business which was 58% of our revenue is now 35% of our revenue. Consumer is a bit smaller, because we did divest some of our consumer business.

So we have, in fact, embarked on a plan and been successful significantly growing our operations business, and as a result, the percentage of our revenue, which is recurring, you can see on the right-hand side, has grown and is now over half of our business. Our long-term goal is to grow both our plant operations and our recurring revenue business so that it's about three-quarters of our total business.

In today's call, we'll review the financial performance for the third quarter.

I think the first thing you'll see is that revenue for the quarter grew modestly, only about 1% in Q3 of '04, versus Q3 of '03, if you exclude the consolidation of the Desalcott and you exclude the revenue brought to us by Ecolochem, So excluding Desalcott and Ecolochem, our revenue for our base business only grew about 1% year-over-year. However, when you look underneath that, what you see is that, in fact, we saw a decline in our capital equipment business of some $6 million, a bit over $6 million. The largest contributor of that decline is a decline in affiliated sales or sales of capital equipment to affiliated entities, which have been reporting gross margins in the 12 to 13% range. On the other hand, we've grown our more profitable business by over $7 million, and that's been primarily in plant operations and instruments, which have much higher margins. So, in fact, in the quarter, if you look -- in effect, in the quarter if you look at the revenue and financial performance of Q3 we've been dropping some revenue from our less profitable business and adding revenue to our more profitable business. The result is that EBIT has increased significantly. We reported $8.5 million of EBIT in the quarter which is 7.2% of revenue.

Between this increase in plant operation and the consolidation of Desalcott and the addition of Ecolochem revenue, operations is now over half of our business. We've been undertaking since the Ecolochem acquisition was completed in February, since that time, we have been actively engaged in a consolidation program. I'd like to report that the two companies are integrating well, and the results and opportunities for more cost savings and a particular resulting in synergies between the two organizations, which we believe will result in higher revenue growth for the future.

And finally, we've undertaken other actions to further reduce cost. The most notable is we've instituted a centralized purchasing program, which is designed to take all of the purchasing done by the company in its fragmented organization structure of old, centralize it, consolidate it, use our purchasing power leverage to negotiate better terms with our vendors, and we are having significant success with that program, which is initiated in the beginning or the middle of this year. We expect the cost savings from that program to be comparable to the cost savings from the restructuring which we previously undertook.

This slide, this quick summary of our P&L for the quarter, $118 million in revenue, we had a 32% gross margin, SG&A was 26% of sales. You can remember that when I started SG&A was well over 30%, in the low 30s. So we've made some progress there. The net result on EBIT of 8 1/2 is 7.2% of revenue. We had a net interest expense of $5.2 million leaving profit before tax from continuing operations of $3.3 million. Income tax was 50% of PBT. We're going to talk a little bit more about that in a couple of minutes. We have minority interest leaving. Net income from continuing operations is $1.4 million or 6 cents a share. There is another 2 cents a share loss that related to discontinued operations. This is basically the home water are distributors that the company owns, which were in the process of divesting. When we complete that divestment, that will eliminate about 2 cents a share of loss. So our actual reported earnings per share total was 4 cents a share, EPS from continuing OPS at 6 cents a share.

When we look at this, this slide takes a quick look at the quarter versus last quarter. The same quarter of 2003. The revenue increases I mentioned is largely a result of Desalcott and Ecolochem. The major thing I'd like to point out here is the significant improvement in the profitability of the business. We went from reporting a loss in Q3 of 2003 of 26 million to producing -- reporting a profit in Q3 of 2004 of $8 1/2 million. Now, admittedly, there are significant charges in the 2003 quarter, because that was the first quarter we initiated restructuring. If you back out those nonrecurring charges that we took in Q3 of '03, our Q3 '03 EBIT would still be a loss of 2 million. If you take out the nonrecurring charges that are in Q3 of 2004, our Q3 2004 EBIT is 10.7. So before nonrecurring items we've improved profitability of the business from a loss of 2 million to a profit of over 10.

One of the issues, clearly the company has been dealing with since I joined, is our investment in Trinidad in Desalcott. I'm happy to report that in Q3 the financial performance of Desalcott has continued to improve. This gives a quick summary, 7 1/2 million, 7.4 million in revenue, 3.5 point 5 in EBIT, and a profit before tax contribution to Ionics of 800,000. This PBT contribution compares to Q2 of 2004 of 500,000. So we've seen a significant increase from Q2 to Q3 in the financial performance of the plant.

During Q2, we started the startup of phase five, which was a 9% capacity increase for the plant. That startup has been completed in Q3 and I'm happy to report that it is operating quite satisfactorily. In fact we added significantly more than 9% to the production capacity of the plant with that expansion, so the financial performance of the plant has improved even more.

I mentioned in previous, our last webcast, that it was my intention to seek to restructure the ownership structure of that investment. That is something that we've been working on. We've also been working on talking with the Trinidad water and sewage authority, who is our customer, to see if we can resolve any open disputes that exist on the rate increases that we are entitled to under our contract. We believe we're making good progress on both fronts. We'd like the progress to be faster, but we are dealing with a situation in the Caribbean, where, unfortunately, things do seem to take longer to move. I would say there's an interest on all parties' front, both our partners, our customers, and ours, to seek a successful resolution. So I believe we are making encouraging progress. Perhaps someone slower than we all like, but its progress nonetheless and we're continuing our effort in that area.

Now, when you look at the 6 cents a share we report, we do believe there's several items in there that are important to point out, which we believe are not normally recurring under the normal course of business, but are charges that we have had to take either related to restructuring or improving our business or certain events that are ongoing that will not be ongoing in the future. So I'd like to just take you through these items one at a time. On the tax rate front at this point, I'd like to turn it over to Dan Kuzmak, our CFO, to explain our view on the tax rate issue.

Sure, thanks, Doug. Last quarter, we reported that we had an effective tax rate for the year of about 54%, and I'm happy to say that as a result of an extensive review of our tax planning strategies, we've been able to bring that back down into the 38% range. So looking at the year, again, we currently would view our effective tax rate at 38%. That translates to 50% in the quarter, and how we get there is effectively our tax rate in the quarter is 32%. But then we have approximately 600 in tax expense that we recorded related to the tax planning strategies that we've put in place.

And I guess I'd simply comment that we're obviously a multinational company, and our tax planning strategies and initiatives encompass such things as fees for use of trade names, technology, transfer pricing. And again, as a result of initiatives that we've been able to implement this quarter, we were able to bring the effective tax rate down for the year. So the consequence of that is a 50% tax rate in the quarter that will drop in Q4, and the 2 cent per share is simply a reflex of the impact on EPS of the 50% rate versus the 38.

Thanks, Dan. The second item is related to a flood that we had at one of our facilities in the aftermath of hurricane Ivan, there was significant flooding in parts of Pennsylvania that affected our Bridgeville facility. This caused that facility to be shut down for some time. We have a second facility in the area in Cannonsberg, which we have been, and are, in the process of transferring work to. The damaged equipment and the cost of repairing the damage are all covered by insurance. But during the quarter, we did end up with delays in some jobs, where a shipment was delayed because we couldn't work on them in Bridgeville. The cost of those delays in the quarter are about a half a million dollars or a penny a share. Clearly those jobs we still have, and the lost income will be made up, through executing the project, and we also have business interruption insurance to make sure we're fully protected.

The third item is related to 404, section 404, Sarbanes Oxley preparation. Dan, do you want to talk about that?

Sure. The cost that we have culled out here are simply the external of the third party out of pocket costs, if you will, of -- expenses we've incurred in the process of documenting our internal control structure. Like all public companies, we're having to expend a significant effort getting ready for 404 testing, and again, these costs are outside costs we've incurred. It doesn't include any internal allocation of expense to ready ourself for that testing. Of course, once your internal control structure is fully documented, you wouldn't repeat this cost. That's why we've culled it out her as an unusual expense and one that won't continue at that rate. The process. The process design at Oracle, since the initiation of the Oracle implementation, we've expensed approximately $3 million, which includes 600,000 this quarter for a 2 cents a share impact. I'm happy to say that we've implemented phase one of Oracle. These expenses will be trailing down, but we pulled those out because obviously that was a very significant effort for the company, putting up Oracle. Again, we've pulled out the external expense related to the implementation of that system.

And in the final item is related to the intangible asset amortization that's resulted from our Ecolochem acquisition. I know that there's been some debate about whether that should be included or excluded in our results. We want to report it both ways, because we see some investors who look at that as a non-cash charge that's related specifically to a significant acquisition the company made and is not incurred as part of the normal operations of the business. There are others that believe that under GAAP it's a reportable item and so it should be included in the earnings per share. So we highlight the issues so that those that wish to look at our EPS on more of a cash basis can do so, and those that want to look at it as a GAAP basis can do so.

The net results on that last quarter and the last web site we made the statement that we expected to do about 40 cents a share in the second half of 2004, excluding amortization and excluding nonrecurring items. On the basis of that basis, we believe that our third quarter performance met that expectation.

This slide is looking at the as reported earnings per share. I'd like to, you know, obviously recognize that we've been through a period of significant restructuring for the company. In that restructuring, we had to incur considerable expense but our operations result, we believe, has steadily improved. Do we wish the improvement could have faster? Of course we do. But what we think is the most important is that we continue to make improvement from quarter to quarter. So Q2 of this year showed a 9 cent improvement over Q1, Q3 of this year showed a 14 cent improvement over Q2 on an as-reported basis.

We expect this performance and improvement to continue. We expect that in Q4 of 2004, we will be reporting earnings per share on an as-reported basis in the 11 to 12 cent range. Included in that 11 and 12 cents will be about 3 to 4 cent per share of costs related to 404. Another penny or two related to Oracle, and 6 cents related to intangible assets. So before these unusual items, if you want to include intangible asset amortization, we're expecting to report in Q4 about 17 cents a share. On a cash basis if you exclude intangible asset amortization, we're expecting to report about 23 cents a share.

The transformation of Ionic, we think, has been significant, one of the most dramatic demonstrations of that, we think, is looking at EBITDA, before one-time charges. Again, Q3 of '03 was the first quarter of our restructuring where we incurred about $24 million of one-time charges as related to our restructuring activity. If you exclude those restructuring charges, Q3 of '03, Ionics reported about 4 1/2 million of EBITDA. If you exclude the nonrecurring charges of 2.2 million in 2004, in Q3 of '04, we are now about at $23 million of EBITDA. So almost 6 times increase in EBITDA over the last year.

One of our objectives has been clearly to improve the profit margin of the company. This is looking at the profit margin as reported, the EBIT margin as reported, in Q1, Q2, and Q3. And you can see we have steadily increased the reported EBIT margin. This EBIT margin is after including what we would consider nonrecurring expenses. This is as reported EBIT margin. We see continued forecast for improvement. We've been outspoken about our objective to get our EBIT margin in the 12 to 13% range in the reasonable future. Beyond that for the longer term.

In summary, we believe that Ionics today is a leader, recognized leader, in the water treatment industry. We have leading technology, a leading reputation, and leading experience in designing, building, and operating water treatment facilities. We have experience in providing a variety of solutions, whether it'd desalting seawater, operating plants for customers, or using a mobile or fixed-based water services to help customers outsource their water supply. There's attractive industry fundamentals which lead us to believe that our long-term growth prospects will be significantly above average. We have successfully completed a restructuring program designed to lower our total cost basis, and we're encouraged that the trend of quarterly performance improvement is continuing, and we expect it to continue.

At this point, I'd like to just thank our investors, our customers, and, in particular, our employees for supporting us through a challenging time as we've transformed the company. The turnaround is significant. We've seen significant results. We still have a significant way to go, so we still have a lot of work to do. We appreciate your patience, as we've gone through and significantly changed the nature of the company. The trend of performance improvement will continue, we believe, and we are optimistic about our ability to achieve our objective, which fundamentally is delivering high profits on a continuing basis.

At this point, Nancy, I'd like to open the session up to questions.

Thank you. We'll go first to Dan Leonard of First Analysis.

Hi, Doug.

Hi, Dan.

You talked about the half million dollars from the flooding due to hurricane Ivan. From talking to your customers, and you guys do a lot of business in the Caribbean, do you think there were any customers that pushed out orders they were going to make in the third quarter to the fourth quarter due to the hurricanes?

I don't believe we saw anything like that affect. We saw some increase in urgency in some areas we're having water problems. We have a number of inquiries from some emergency business out of the hurricane.

Okay. Is that sequential to buying your equipment revenue then more just a function of the lumpiness of the business rather than any order pushouts as I was looking at it?

Can you repeat that, please?

Yeah. Your equipment revenue declined from $38 million in the June quarter to roughly $33 million this quarter. Is that just a function of the lumpiness of that business rather than, I was wondering earlier, if it was order pushouts.

It's more related to the lumpiness of the business. We did see a reduction in revenue in Bridgeville because of the inability to perform on jobs, which led to some decline. That's the half a million dollars of lost profit from those pushouts. But, you know, our business -- our capital equipment business I would define as being relatively steady. Up and down a bit, because they are lumpy orders. But in the long-term, you know, we've seen, as I said, from 2003 to 2004 a slight reduction in our capital business where that revenue has been more than replaced by increased revenue from our operations business.

Okay. On the Oracle and 404 expenses. These nearly doubled from the second quarter. And it looks like you are expecting them to remain about the same level on the fourth quarter. When can we expect these to start trending down? Is this more of an '05, and when in '05?

I think you'll see a substantial trend down in those with the start of next year. So you're exactly right.

404 readiness is documentation. And that's what we're employing the outside consultants with, documentation and testing of control systems. The documentation process is the bulk of the expense. That needs to be done by the end of the year. So we would certainly expect that the 404 expense to go away. Now, there may be a tail in Q1 of '05 to clean up some things. But that should be an expense that largely goes to 0 in '05.

Oracle is up and running here in Watertown. We have planned to roll it out to other facilities around the world. The major cost is obviously the investment in the software, customizing it and developing systems, the systems that have to go around it. So the cost of rollout, our expectation is the cost of rollout will be significantly lower than the cost of the basic installation that we've already incurred. In fact, I think Oracle Q4 of 2003 was about a million four in expense, and now it's down to about 600,000 a quarter. That will probably continue through Q2 of next year.

Okay. Thank you.

Our next question is from Lorraine Macath of Merrill Lynch.

Thank you. Good morning.

Good morning.

Can you tell us the average life of the intangible assets that you're amortizing?

There's several categories but I think the largest of those is about ten years.

So we'll be getting this unusual amortization for the next 40 quarters.

It's a non-cash charge, but, yes, going for ten years. But it declines. It's a declining balance amortization.

Yeah, it does change. The items have differing depreciation bases, including the more significant ones around an economic consumption basis. So it will decline. Yes, it will go over an extended period of time.

Okay. Thanks. And then could you just talk about your growth prospects going forward? You've been focusing a lot on this operations business. Should we expect the capital equipment sale business to stay where it is or decline because of your focus on operations, or do you anticipate some larger projects coming in on that side in the next couple of years?

Overall, you know, we've talked about the capital equipment business and how important it is to the development of our applications expertise, which is why we want to continue that business. But our forecasts are for modest growth in that area. And, you know, we're not expecting it to decline. But it is also a lumpy business so it depends on, you know, the purchasing cycles in the market. It depends on specific contracts that are available. A large or couple of large contracts can skew the performance of this area significantly. We've gone through -- a large part of the decline of our capital equipment sales is occurring because we have gone through a period where we had two significant projects where we were selling capital to affiliated parties. We sold capital to the Trinidad project. We sold capital to the Kuwait project. These were on the order of 75 to $100 million capital sales for the company. And so as we go forward, we don't expect to have those large capital sales, because we're not going to be a minority party in one of these projects. So it's -- we've effectively had to wean ourselves off of that type of business. The good news is it's always been a low margin business because of the way we report gross margin, it's typically been less than 15% gross margin on those contracts.

Thanks. And finally, which geographic regions look most interesting to you now for large project work?

The -- well, do you want to take that.

I would say the larger projects, probably the North Africana, Arabian Gulf, parts of the Pacific rim, are the areas of hottest activity now.

Thank you.

Richard Eastman of Robert W. Baird Baird is next.

Good morning.

Hi, Rick.

Couple of questions. One just surrounds the service business. Trying to do the math on this, in particular at Ecolochem, that seemed to run a bit behind the second quarter, and perhaps, a bit further behind here in the third quarter, relative to when you -- when you purchased it and the run rate. Also that being the case, that -- is that impacting the gross margin line, which looks low.

Yes and yes.

Okay. What's the basis for the revenue trailing off?

Rick, Skip Dickerson. I can help you on that. It's clearly tied to the power industry. If you'll remember when we became part of Ionics, Ecolochem came in as 75% of our revenue was directly related to the power industry. The power industry has seen a significant downturn. We're doing -- putting a lot of effort into diversifying our marketing away from power but clearly we've been tied to the production of power for so long, that's been the -- that's had the most dramatic impact on our top line revenue.

When you said there's been a decline in the power industry, people know that profits have been squeezed there for various reasons. How much of this -- if I annualize your revenue run rate, it's off maybe 15%. And I'm a little surprised that they can defer that kind of what I would perceive to be more preventive maintenance.

Let me try to explain to you why it does impact. Basically one area in the power industry that went through significant run-up, starting in the -- in 2000 was the construction phase. Late '90s, and up through basically '03, we went through a construction phase, which all construction -- power construction consumes significant amount of deminerallized water for commissioning and startup purposes. So the construction business is basically wound down to the point where they have stopped construction on some plants and just deferred on others. You know, in some cases just canceled. So the construction market has dried up. Now, that's not going to stay dried up for long, but it has dried up temporarily.

Secondly, another portion of our business was tied to the merchant and peak power stations that basically run on demand but are not base loaded facilities. These peak power and merchant plants have had a significant downturn in your operating hours simply because of a downturn in the economy and downturn in demand that's been weather related. As you know, we had not only a mild winter last year but we've also had a very mild summer this year. And a lot of these peak plants, peakers were driven by that need, and that need didn't develop. We have a number of clients, Rick, that actually rely on us for 100% of their water when they operate. These plants have just not been called on to operate.

But clearly it's a situation that will change. It will change because the older plants that are continuing to run are not as efficient as the newer plants. And there will be a drive eventually to get construction back going again. We'll see an upturn. They have already predicting upturns in '05 and obviously even larger in '06. So let's hope they are right.

Can I ask you what, maybe, the utilization rate is running at? I assume this isn't price, it's a matter of how much your trucks are utilized. Is that the gross margin impact?

Absolutely.

It's a fixed cost business. When you lose a revenue, it definitely hurts the margin.

Okay.

The effort to get the utilization up, one of the things they are doing is targeting other industries that are stretched on our water supply.

Rick, the refinery market is clearly a situation where these guys need to run, have to run, and can't take outages if there's any way they can avoid it. So we're re-emphasizing our efforts in the refining and petrochemical markets. As well as we are seeing -- where we have seen a little bit of improvement has been overseas. The conditions I've been discussing with you have been pretty much related to the U.S. market. We see some brighter signs in Europe, especially in southern Europe. So there are some opportunities in -- continuing in power. Obviously, everybody knows the big power market somewhere in the future is going to be China. Everybody is trying to figure out how they participate. But there are some changes coming, but the downturn has clearly been in North America.

Is there any seasonality to the business? Would you expect your -- Ecolochem's business to improve in the fourth quarter?

Oh, absolutely. Give me a nice hard, cold winter, we'll show you a little improvement in numbers. No question, we do have --

On a different topic. Now that Kuwait -- I would presume from the revenue recognition on Kuwait in the quarter that is largely complete from an equipment standpoint. Is that correct?

Answer, Sean.

Probably about 85% complete on the equipment piece. We're in the final stages of commissioning. The plant -- about 20 to 40% of the plant is making water now. We expect by the end of Q4, or early December, to start water sales to the customer.

And is there any revenue recognition on that affiliate line in the fourth quarter, or will that drop to 0?

There is a revenue from sales to affiliates in Q4. It probably will trail into Q1.

Over the next two quarters. It's declining significantly.

Then we go through shakeout in the first quarter, you said, and we should start to see the benefit of the run rate then in the second quarter?

We're going through shakeout right now. When we say finish commissioning --

Water sales will start in Q4, December.

December.

Okay.

And we should start seeing in 2005, we should start seeing about $10 million in operating revenue for operating plant. That will show up in plant ops.

Okay.

Then we hope to see equity income all coming in from our ownership in the plant.

But those will come in as the equipment revenues play down or play out.

Okay. Then maybe just one last question. Doug, you alluded in your earlier comments about some centralized purchasing, some added cost, andI think you tossed in there that the cost savings would be about 15 million. Is that incremental over the next 12 months, or how should we view that?

That's something that we -- a program that we really started in the middle of the year, this year. And on a long-term basis, we expect that our objective is to save between 5 and 8% of cost of goods, purchased goods, through this program, which should save us about 15 million. I would say it will probably take them into Q2 or so of next year, Q2 or Q3 of next year to get the full benefit of that. Because basically we have to go through vendor-by-vendor, consolidate our purchases, and then go and negotiate. So that's something that's just started to trickle through in Q3. And I think we're going to see the full affect probably by Q3 of next year.

That's a cost of sales. We're talking about steel and components?

Yes.

Very good. Thank you.

The one other thing that I'd like to point out with Rick is that we did see a reduction in revenue in Ecolochem that was made up for by an increase in revenue from other plant operations. Because Ecolochem has fixed cost basis, we didn't see a reduction in the cost related to the Ecolochem decline. We did see an increase in cost related to the other plants that we took on. So that's what's resulted, I think you'll see as you pointed out there was 170 basis point decline in margin and operations.

Yeah.

And that's really become as a result of the fact that we replaced some lost Ecolochem business with some other plant operations business. As Skip said, we're actively pursuing other industries outside of power to get back and increase the Ecolochem revenue. Since that's such a highly leveraged business, we expect those operating margins to recover significantly.

So over and above this 36% gross margin level, you know, getting significantly back towards 40, for instance, is going to be a function of Ecolochem's utilization more so than the balance of the business and a half?

It's actually a combination of the two.

Okay.

We have actually in the quarter instituted some cost reductions in Ecolochem that should allow us to achieve a higher margin even at the reduced revenue.

Okay.

But the real leverage to get well over 40% margins, which is our objective is driven by recovery in that business, yes.

Okay. Thank you.

We will now go to John Quealy of Adams Harkness.

Good afternoon, folks.

Good morning, I guess, John.

Going to Trinidad you had roughly a 50% increase quarter-on-quarter, If I understand finds the numbers correct in your profit before tax, going from 500 K in June to about 800 K in September. In the context of some ongoing negotiations, can you talk about the rate of increase of improvement for that operation? Are we getting close to what the maximum contribution could be, or could you just sort of frame that for us?

We think that we can still increase the profitability of the plant. There are operating things that we can do to improve, and we're working -- we're actively working with our partner to identify those things. So there is an opportunity to improve gross margin. The other thing that's going to happen is as we repay debt, we will see a reduction in interest expense. So the profit margin -- the PBT contribution should continue to increase. So 800,000 a quarter, I think, is a good number to have achieved considering where we came from. But our long-term objective is higher. Our long-term objective obviously is to pay off the debt. We think that will take about ten years to pay off the debt. And which would result in even a significant increase in profitability.

And Doug, in terms of the next step of the negotiation for Trinidad, I know in the queue you mentioned or the company mentioned potential arbitration coming up in '05. Can you just outline for us what the steps are from your perspective on this renegotiation of this relationship?

Yeah. The -- the customer has disputed the rate increase that Desalcott passed through and we're going to arbitration to resolve that dispute. The resolution and negotiation has been led by our partner. We believe that as part of our restructuring we have an opportunity, and we will have an opportunity to resolve that dispute. The customer has expressed a willingness to work with Ionics in resolving that dispute. The customer has expressed an interest in potentially becoming a partner in the project. So there's a number of things going on. I can't -- unfortunately because I'm in the middle of trying to negotiate these items, I can't really go into great detail in public about what we're doing. But I would say that the most encouraging thing is that all of the parties seem to be -- have the same objective of trying to successfully resolve this situation. Unfortunately I can't really shed more light on it right now. But this is something I think we will have resolved one way or another. I was hoping to have it resolved by the end of this year. I think I may still be able to get agreements in principal in place to do that by the end of this year. But it's probably going to be into Q1 of next year by the time we actually get this thing put to bed.

Okay. Then in terms of the capital equipment business, I know the proportion of those revenues are decreasing or at least according to the strategy moving forward, you talked in the queue about softness in municipal flat or stronger in semi-, can you talk about those two markets in details, what you're seeing right now halfway through Q4.

You want to talk about municipal, Ed.

I would say the municipal market is -- to use Doug's term earlier, lumpy. They tend to be larger projects. Those can vary from quarter to quarter. We still think there's a strong demand out there. But with municipalities, a lot of factors weigh into the timing of the final decisions on contracts.

There are some things going on in the municipal space that are opportunities for us. There's an opportunity in asenic removal. There id legislation in place that requires municipalities in the U.S. to lower the threshold of allowable arsenic in their water supply. We think there's a number of communities that are going to have to plan to do something about that. That's an opportunity. There's a lot of discussion, especially up -- out west for chlorate removal. And there's a lot of discussion about deSal out west. But you know, the deSal market is one that we've all been talking about for a long time. So I think we're a little bit, I don't know, I hate to use the word cynical about it but I guess we'll believe it when we see it. But the microelectronics business, meanwhile, has been very strong, and continues to be. I think that what's happened is that the market went basically to 0 in a short period of time, and no one was spending any money on their water facility. Now what we're seeing is a combination of new facilities. But most of our business is expanding existing facilities or putting in new systems so they can meet higher water specks, higher quality water specs. So it's like skip was talking about some of these old power plants have old, tired systems that barely meet the job. In a semi-conductor plant because the specs keep going up, sometimes you find these old plants that need to be replaced because they need to meet higher specs or they recognize they could save a lot on their water costs by putting in a new facility.

Okay, great. Lastly on Algeria, looks like you folks are looking to get some financing up in the Q1 '05 timeframe. Can you give us a little bit more detail in terms of the progress you made this quarter, or what the discussions are at this stage?

Yeah, this is Ed. You're correct. Yeah, we are close to completing the long-term financing. We've got two groups running with who have significant interest. The more advanced group, the decision that we expect in principal in December and then final close documentation in Q1. But it's taken a little bit longer than we originally projected, but I think the important thing is we're making very solid progress, and everyone is on the same page, ourselves, our partner in Algeria, the off taker, and the banks.

Okay, great. Thanks.

Deborah Coy of Washington Research Group is next. Thanks.

Good morning, guys.

Good morning, Deborah.

Just to follow up on Algeria, Ed, and to your earlier comment, Doug. I know there's a lot of other deSallization plants in the area. What is your thought in terms of pursuing additional contracts there. There seems to be six or seven the government is looking at. Is that something you would consider or in the interest of kind of restructuring the business toward the operating side, rather than these minority participation projects, is that something you're going to let go?

Maybe I'll take a shot at that, Deborah. We've had some real debate about becoming overall dependent on one specific geography, whether it's Algeria or Israel or any other country. We are looking at the other projects in Algeria. There are a couple of specific projects that we would have a definite cost advantage, because we have this base facility in place. And so first thing we need to do is make sure we get this facility funded and built and operating. But in the meantime we are looking at two other specific projects where we think we would have a very significant cost advantage over somebody else, because we would have this facility already in place. But we are cognizant not to become overall exposed to -- overly exposed to too much in one country.

So we would expect to see the affiliated revenues, then, starting to ramp up again for Algeria --

No. There will be no -- the thing that's different about Algeria, because we own 70%.

That's right.

Of the company. It is a fully consolidated entity. As we build this plant, there will be no revenue, and there will be no cost, but there will be an increase in Cap Ex.

That's right. And it will go onto the balance sheet.

Goes onto the balance sheet. We don't start generating revenue until we sell water.

Sometime in '06.

That said, Deborah, of course it's a sizable project and there will be an uplift in terms of absorption and utilization of facilities and engineering, et cetera, but there won't be any revenue to Doug's point.

And Israel, just a quick update.

Which one, in general?

In general, yeah.

I would say we are -- I would say that Israel probably is not a high a priority as it has been in the past. And I think that's not that they don't have a demand there but when you look at it relative to other regions in the world, Deborah, we feel that it's probably wiser to focus our attention in some of those other spots right now.

So that the political issues there haven't really been resolved.

You know what the problem is, they got in their mind these water rates that are unrealistic. They managed to go out and sell the four or five facilities in the sub-60 cent per cubic meeter range. And just, you know, when you really come down to it, it's hard to see how you make money when you're selling water at 60 cents a cubic meter. As a result of most of the projects are delayed or having problems getting financed. We had a problem getting our project financed at CDL.

Right.

And I think what they have come back with is they recognize they need to do something. They have taken an approach of trying to consolidate some of these smaller facilities into a bigger facility so that they can make it more economical, but they want to keep the old water rate. Until in the end they get off the water rate issue, it's going to be hard for them to get something done. One of the big challenges we have in the seawater market in general is a recognition by government that the cost of producing water from the sea is material. It's come down a lot from what it used to be. But they have to face up to it and be willing to pay for the water. That's probably one of the things that delays most of these projects is governments trying to figure out who is going to pay the increased cost to get seawater converted to freshwater.

Okay. So adding all that up, it sounds like we wouldn't -- given your kind of strategic focus, we wouldn't really expect to see you book more than maybe one large deSal project in '05. You'll kind of pick and choose and see where your best opportunities are.

I think that's exactly right.

Okay. And Skip, coming just back to the earlier questions on Ecolochem, just in terms of trying to understand the little -- the leverage potential in the business as you're going through the power downturn. I think Rick asked the question, I didn't hear the answers to kind of we can get a sense of where your utilization rate is, particularly in the North American business overall right now, so we can get some sense of where the upside is.

Okay, Deborah, yeah. Rick was talking about how could the power industry have such a downturn, it's the fact we were dealing with a lot of these entities that don't run on a continuous basis.

No, I understand that. I'm just trying to understand what the impact has been on your capacity utilization.

Oh, yeah, our capacity, Deborah, is significantly underutilized right now. The fact this these costs are, as Doug said earlier, are all fixed. So clearly an uptick in our revenue, a lot of that flows directly to the bottom line, simply because we're covering most of our cost. Do we have no problem, we've probably taken our position and doubling it with what we currently have in place without making any capital expenditures.

Okay.

Mark it up, we'd love to see a turn around and an opportunity to do that and we would not incur Cap Ex to do that.

You could double your business without significant Cap Ex?

That's right --

That helps. I understand.

Let the phone ring. We're ready to go. We're out there knocking on doors.

Then on the outlook, did you give us a booking number, Doug? Did I miss that? I haven't heard the booking number for Q2.

I just talked about bookings we hooked 103, 102 million this quarter. We did not give an outlook for bookings. Probably it will be an increase over that.

For Q4.

Booking is a tough one. That's even more lumpy than the revenue number I mean, if you look --

It has been.

Look at our bookings through the year. We did 95 in Q1, 58 in Q2, 85 in Q3. Our bookings number is definitely lumpy. We didn't really give a forecast. It will be -- we would expect an uptick from where we are but not a huge uptick.

Based on what you're seeing.

There's some big jobs out there. If they fall, it could be a significant increase. It's a little hard to forecast.

Okay. My final question is when do you expect to be giving us some sense of your outlook for '05? This has been obviously you have set a work in progress and analyst estimates are all over the board. I'm wondering if you're going to wait until you report Q4. Or are you going to talk to us perhaps next month. What's your sense of forecasting for next year?

I think we'd like to wait and let you know when we report Q4, because that's our budgeting cycle. And we'd like to go through the budgeting cycle so we can give you, you know, -- budgeting cycle, so we can give you a more informed and better forecast.

Okay. Thanks. Appreciate it.

Thank you, Deborah.

We will now go to Adam Comorra of Intrust Capital.

I want to understand the revenue shortfall a little better this quarter. Which business lines was it that underperformed what we thought they were going to do?

The revenue reduction this quarter is related to capital equipment. If you look at it, instruments was on line, consumer was on line, plant ops was on line. Although we explained that in plant ops we saw a slight reduction in Ecolochem revenue and increase in our other plant ops business so. That ended up being flat, where we would have thought it would have grown. You could argue on the revenue line, we missed a couple million dollars in revenue from plant ops. But the bulk of it was capital equipment. That's as we talked about earlier related to the lumpiness of the business and the fact we lost some revenue related to the flood in Bridgeville.

Okay. So as we look at revenues in the fourth quarter, do we get those back? Should we see the revenues tick up to that 125, 126 level in the fourth quarter?

I think so, yes.

Okay. Then previously on the second quarter conference call, you guys talked about a free cash flow of 30 to 40 million for the year. You burned another couple of million in the third quarter, we're at negative 22 million for the date. Do we till think the positive 30 to 40 is achievable?

We in the free cash flow arena, one of the items that's impacted working capital during the year has been our Kuwait equipment contract. And we expected and did achieve in the quarter a substantial reduction of working capital related to that. We did, though, have an increase as I'm sure you've noted, in our third party accounts receivable in the quarter. That's really a function of several late billings on major projects. In some cases, the cash has already been received as we go out in through Q4. So we still -- I won't give you a specific number for the year but we still believe our free cash flow should be very good. Obviously we are working in managing our working capital levels. Because of projects and timing of billings, becomes a little bit difficult to predict precisely period to period. But that's what impacted us in Q4 -- Q3. Late billings on contract they say in some cases have already been collected but it manifests itself in an increase in third party receivables in the quarter.

Thanks.

Allan Fornyea Penn and Capital is next.

Can you give us your unbilled AR in the quarter, please?

Unbilled AR is in the 32, 33 range, million relatively flat quarter-to-quarter.

And in terms of the power business, I guess I'm trying to understand how much of the weakness there is because of sort of warm weather and utilization versus the construction downturn. Can you give us some order of magnitude of those two affects.

Sure, Allan. It's a combination, really. Probably based on the power bubble, the construction was maybe a bigger chunk of it at one time. Since we do so much business in the peaking and merchant power market, and that business is so soft now that that's pretty comparable to that. So I'd say you've got a pretty even split there between those two. They are both depressing our revenues.

Okay. So it's about half each.

Yeah, that's probably without having the numbers in front of me, I sort of have a feel for that. I think you're going to see obviously the merchant market will come back quicker than the construction market. The construction market, a lot of it is sitting there somewhat on hold. And if you see a comeback in the merchant market, you'll see the construction market begin again as well.

In the merchant market, just to be clear, is that weak due to weather or just due to overbuilding of merchant plants.

Put it all in the same plant, that's right. The weather has been mild, the economy has been soft, and there's been a substantial run-up in construction, that's true. All those have added in some cases, especially parts of the country, overbuilding. I think there was an article written not too long ago said southeastern United States was a wash in power capacity. So they were building power plants where they had natural gas lines crossing transmission lines, and without maybe a lot of thought to where all this power was going to go. Now they have got sections of the country where they are clearly overbilled.

I got you. Okay. In terms of the tax rate, I guess I'm unclear as to the 50% reported tax rate that really is 32%. Could you help me understand that?

Sure. I think the important thing to note there is that our effective tax rate for the year is 38. And in the quarter, it's 50, because it reflects the 38% for the year. But also some tax expense that we booked related to, as I mentioned, tax planning initiatives that we put in place in the quarter. So it's just simply the reflection of those two items that gave us 50% in the quarter. But again, we're 38 for the year.

I guess I'm trying to understand, is that a cash tax? Is there a cash tax differential.

It's a non-cash item, basically taking a reserve against foreign tax credits.

I see. Okay. Thank you.

David Cursman of Nadaman [phonetic] & Company is next.

Thank you. Most of my questions have been answered. I do have a question on the debt paydown. It was kind of small in the third quarter, 6 million and change. What should we expect for the fourth quarter, and your projections, perhaps, for debt reduction in 2000?

Okay. Well, we obviously manage that. We would look to reduce our ratios as we've talked in past calls, low our leverage ratio isn't that high. I think we manage that based on opportunities we face in the business. You know, we are not looking at other uses of the cash, clearly we would pay that down. I guess I would it to be moderate over the next year. Certainly we'll manage that in an effort again to keep our leverage ratio down in the maybe a turn from where we started out this year when we pick out the debt related to Ecolochem.

Fair enough. Let me switch gears. The flooding of the Pennsylvania facility, that half million dollar charge, I assume that was in cogs.

It wasn't a charge, just an income affect resulting in delays of shipments, and the temporary shutdown of the facility because of the flood.

That would be in cost of goods sold, the assumption.

Yes, affect margin, primarily.

And the Sarbanes and system development I assume would be SG&A.

That is correct.

Okay. Thanks, guys.

Star one. And we will go to a follow-up question from Richard Eastman of Robert W. Baird.

Hi, just a few more things. Given we trued up the tax rate here in the quarter, for the fourth quarter on a reported basis, we should be using 38%.

Yes, correct.

Any thought or guess on '05? I mean, should we use something below 38? I think that was comment originally?

Yeah, I think we would still expect to come in below 38 for next year.

Okay. In terms of the absorption, when we book Algeria, we get the financing, we book Algeria, we're going to be able to do some things with the absorption, which essentially I guess ends up in PP& E. Is that right? That absorption benefit should show up at the gross profit line or a lower cost of sales in the equipment business? Is that how that's going to flow through.

I think so. Whether it shows up in the equipment business, that's the only thing I think we're balking at a little bit.

Could affect that or operations.

It's absorbing engineering, engineering and overheads.

Any guess at all as to what that could do, you know, from a basis points standpoint? I don't know how -- I guess the construction --

I'd like to answer that -- Rick, I'd like to answer that after we've had our chance to go through our budgeting process for the year.

Then if I try to do back of the muscle math, this lost profit at the PA plant, if I assume a 20% gross margin, would I assume about 2 1/2 million of revenue was pushed out into Q4?

It's not a 20% gross margin. Unfortunately Bridgeville was not that high a business for out. The amount of revenue pushout is higher.

It's higher. Okay. Then the last question.

Probably --

On this bookings number, if we pull out the Ecolochem impact sell the Desalcott impact on bookings, it drops that number to maybe 73 million, kind of from a core equipment standpoint. How do you feel about that number? It's up sequentially.

Closer to 80. Our analysis is closer to 80. I think we may have a little difference in the way we're --

Desalcott, I think as we explained in the last call, is sort of a structural decline and backlog receipt to that, you book the concession agreement and it plays out. If you back out Ecolochem and look at the traditional Ionics business it's closer to 80 million dollars, in the vicinity.

Desalcott you're not going to replace that revenue in the backlog until you get into the end of that five-year, is that how that works?

Yes.

$80 million number, is that -- are you comfortable enough that that can sustain the equipment business kind of to your -- two-year plan over the next six months?

Yes.

Okay. All right. Thank you.

Okay.

We will go now to George crack os of Rosen & Company.

Hi, Doug. The question on Algeria was answered. But are there any RFPs coming out of Spain?

RFPs in Spain. Ed, you want to answer that?

There's a number of opportunities in Spain, some of which we've been pursuing over the last couple of years, and some new ones that have resulted, been prompted by the Spanish government's decision not to build the pipeline from northern Spain to southern Spain. So we're seeing a lot of activity in mainly-of-mainland Spain right now.

Basically who are you competing with, the french company?

Usually competing with the Spanish company.

The Spanish company.

Spanish construction company.

I see. Thank you.

Okay.

Dan Leonard of First Analysis has a follow-up question.

Yeah, I just have one final line to go after. The equity income line, it improved to 1.2 million from 800,000 in the June quarter. Is that improved all from Torre. A substantial piece of that was Torre. In terms of going forward, Doug, when you talked about Kuwait, you specifically saying avoided saying in the about the equity income impact. In terms of a bulk number, is that going to be like 3 million a year, or is that what do you think?

I'd like to wait until we give you the forecast for next year, if you don't mind.

All right. That's fine. Thank you.

And David Kurtzman of Needham & Company also has a follow-up question.

Hi, folks. Two quick ones. First of all, did we hear you right, you said something around 125 million of revenue in the fourth quarter?

Yes.

Okay. Thanks for that. Also assuming no additional one-time items in the fourth quarter, what would SG&A as a percentage of sales, what kind of run rate should I use, kind of 23%? That's close. I think more like 24%, 24, 25.

24, 25.

All right. Great. Thanks, folks.

Okay.

There appear to be no further questions. I will now turn the conference back over to Mr. Brown for any closing remarks.

Thanks very much, Nancy. And thank you all for staying with us for such a long call. We appreciate your patience as we've gone through a significant transformation for the company. But as I said in the original presentation, we're very encouraged with the progress we've made. We're very encouraged with our prospects for the future. We think we're on the right track and we thank again our shareholders, our customers and our employees and our suppliers for their support to Ionics. Thank you very much.

We thank you for your participation in today's Ionics conference call. The conference call is now concluded. You may disconnect at this time.